AP Microeconomics Chapter 4 Outline

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1 I. Introduction A. Learning Objectives In this chapter students should learn: 1. What price elasticity of demand is and how it can be applied. 2. The usefulness of the total revenue test for price elasticity of demand. 3. What price elasticity of supply is and how it can be applied. 4. What cross elasticity of demand and income elasticity of demand are and how they can be applied. B. Elasticity of demand measures how much the quantity demanded changes with a given change in price of the item, change in consumer income, or change in the price of a related product. C. Price elasticity is a concept that also relates to supply. D. The chapter explores both elasticity of supply and demand and applications of the concept. II. Price Elasticity of Demand A. The law of demand tells us that consumers will respond to a price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more. B. The degree of consumer responsiveness or sensitivity to a change in price is measured by the price elasticity of demand. 1. If consumers are relatively responsive to price changes, demand is said to be elastic. 2. If consumers are relatively unresponsive to price changes, demand is said to be inelastic. 3. Note that with both elastic and inelastic demand, consumers behave according to the law of demand; that is, they are responsive to price changes. The terms elastic or inelastic describe the degree of responsiveness. A precise definition of what we mean by responsive or unresponsive follows. C. Price elasticity coefficient formula: Quantitative measure of elasticity Ed = percentage change in quantity demanded / percentage change in price. 1. Using averages the midpoint formula a. Using traditional calculations, the measured elasticity over a given range of prices is sensitive to whether one starts at the higher price and goes down, or the lower price and goes up. The midpoint formula calculates the average elasticity over a range of prices to alleviate that problem. b. The midpoint formula for elasticity is: Ed = [(change in Q) / (sum of Q s/2)] divided by [(change in P) / (sum of P s/2)] 2. Emphasis: The percentage changes are compared, not the absolute changes. a. Absolute changes depend on the choice of units. For example, a \$1 change in the price of a \$10,000 car is very different from a \$1 change in the price of a \$1

2 can of soft drink. The car price is rising by a fraction of one percent, while the soft drink price is rising 100 percent. b. Percentages also make it possible to compare elasticities of demand for different products. 3. Because of the inverse relationship between price and quantity demanded, the actual elasticity of demand will be a negative number. However, we ignore the minus sign and use absolute value of both percentage changes. 4. Interpreting Elasticity a. Demand is elastic if a specific percentage change in price results in a larger percentage change in quantity demanded (E>1). b. Demand is inelastic if a specific percentage change in price results in a smaller percentage change in quantity demanded (E<1). c. Demand is unit elastic if the percentage changes in price and quantity demanded are equal (E=1). d. Demand is perfectly inelastic if a price change causes absolutely no change in quantity demanded (E=0), as illustrated by a perfectly vertical demand curve. e. Demand is perfectly elastic if any increase in price causes the quantity demanded to fall to zero, or if any decrease in price causes the quantity demanded to increase from zero to as many as can be produced (E=infinity), as illustrated by a perfectly horizontal demand curve. D. Graphical Analysis 1. Illustrated graphically perfectly elastic, relatively elastic, unitary elastic, relatively inelastic, and perfectly inelastic demand curves (Figures 4.1 and 4.2).

3 2. Figure 4.3 in the textbook, explains that elasticity varies over a range of prices.

4 a. Demand is more elastic in upper left portion of curve (because price is higher and quantity smaller). b. Demand is more inelastic in lower right portion of curve (because price is lower and quantity larger). 3. It is impossible to judge elasticity of a single demand curve by its flatness or steepness, since demand elasticity can be measured as both elastic and inelastic at different points on the same demand curve. E. Consider This A Bit of a Stretch 1. The Ace bandage stretches a lot when force is applied (elastic). 2. The rubber tie down (not to be confused with a rubber band) moves stretches little when force is applied (inelastic). F. The total revenue test is the easiest way to judge whether demand is elastic or inelastic. This test can be used in place of elasticity formula unless there is a need to determine the elasticity coefficient. Total revenue = price x quantity sold 1. Elastic demand and the total revenue test: Demand is elastic if a decrease in price results in a rise in total revenue, or if an increase in price results in a decline in total revenue. (Price and revenue move in opposite directions.) 2. Inelastic demand and the total revenue test: Demand is inelastic if a decrease in price results in a fall in total revenue, or an increase in price results in a rise in total revenue. (Price and revenue move in the same direction.) 3. Unit elasticity and the total revenue test: Demand has unit elasticity if total revenue does not change when the price changes. 3. The graphical representation of the relationship between total revenue and price elasticity is shown in Figure 4.2. (see above in addition to the following Figure 4.3) Figure 4.3b

5 4. Table 4.2 provides a summary of the rules and concepts related to elasticity of demand. G. Price elasticity of demand is determined by several factors. 1. Substitutability: Generally, the more substitutes for the product, the more elastic the demand. 2. The proportion of price relative to income: Generally, the larger the expenditure relative to one s budget, the more elastic the demand, because buyers notice the change in price more. 3. Whether the product is a luxury or a necessity: Generally, the less necessary the item, the more elastic the demand. 4. The amount of time involved: Generally, the longer the time a customer has available to respond to price changes, the more elastic the demand becomes. H. Table 4.3 presents some real world price elasticities. Use the determinants discussed to see if the actual elasticities are equivalent to what one would predict. I. Practical applications of the price elasticity of demand 1. Inelastic demand for agricultural products helps to explain why bumper crops depress prices and total revenues for farmers. 2. Governments look at elasticity of demand when levying excise taxes. Excise taxes on products with inelastic demand will raise the most revenue because they have the least impact on the quantity demanded.

6 3. Demand for cocaine is highly inelastic and presents problems for law enforcement. Stricter enforcement reduces supply, raises prices and revenues for sellers, and provides more incentives for sellers to remain in business. Crime may also increase as buyers have to find more money to buy their drugs. 4. Opponents of legalization think that occasional users or dabblers have a more elastic demand and would increase their use at lower, legal prices. Removal of the legal prohibitions might make drug use more socially acceptable and shift demand to the right. III. Price Elasticity of Supply A. The concept of price elasticity also applies to supply. The elasticity formula is the same as that for demand, but we must substitute the word supplied for the word demanded everywhere in the formula. Es = percentage change in quantity supplied / percentage change in price As with price elasticity of demand, the midpoint formula is more accurate. B. The ease of shifting resources between alternative uses is very important in price elasticity of supply, because it will determine how much flexibility a producer has to adjust the output to a change in the price. The degree of flexibility, and therefore the time period, will be different in different industries (Figure 4.4). 1. The market period is so short that elasticity of supply is inelastic; it could be almost perfectly inelastic or vertical, as in Figure 4.4a. In this situation, it is virtually impossible for producers to adjust their resources and change the quantity supplied in such a short time. (Think of adjustments on a farm once the crop has been planted.) 2. The short run supply elasticity is more elastic than the market period and will depend on the ability of producers to respond to price change, as in Figure 4.4b. Industrial producers cannot change the plant size, but are able to make some output changes by having workers work overtime or by bringing on an extra shift.

7 3. The long run supply elasticity is the most elastic, because more adjustments can be made over time and quantity can be changed more relative to a small change in price, as in Figure 4.4c. The producer has time to build a new plant and new firms have time to enter the industry. C. Applications of the Price Elasticity of Supply 1. Antiques and other non reproducible products are inelastic in supply; sometimes the supply is perfectly inelastic. This makes their price highly susceptible to fluctuations in demand. 2. Gold prices are volatile because the supply of gold is highly inelastic, and unstable demand resulting from speculation causes prices to fluctuate significantly. IV. Cross Elasticity and Income Elasticity of Demand A. Cross elasticity of demand refers to the effect of a change in a product s price on the quantity demanded for another product. Numerically, the formula is shown for products X and Y. Exy = percentage change in quantity of X / percentage change in price of Y 1. If cross elasticity is positive, then X and Y are substitutes (an increase in the price of product Y causes consumers to increase demand for product X).

8 2. If cross elasticity is negative, then X and Y are complements (an increase in the price of product Y makes it more expensive to use product X, so consumers buy less of product X). 3. If cross elasticity is zero, then X and Y are unrelated, independent products. B. Income elasticity of demand refers to the change in quantity demanded that results from a change in consumer incomes. Ei = percentage change in quantity demanded / percentage change in income 1. A positive income elasticity indicates a normal or superior good. 2. A negative income elasticity indicates an inferior good. 3. Those industries that are income elastic will expand at a higher rate as the economy grows. C. Table 4.4 provides a summary of the values and descriptions related to cross and income elasticity of demand. V. LAST WORD: Elasticity and Pricing Power: Why Different Consumers Pay Different Prices A. Sellers often charge different prices for goods based on differences in price elasticity of demand. B. The ability to charge different prices depends on market power; that is, some ability to control price (unlike the competitive model where all buyers and sellers exchange at exactly the same price). C. Customers are grouped according to elasticities. Business travelers have more inelastic demand for air travel, and thus can be charged a higher price than the more price elastic tourist. The low budgets of children make their demand more price elastic, explaining why they receive discounts for movies or sporting events. In a like manner, colleges and universities recognize that income differences cause students to have different elasticities of demand for higher education, and schools attempt to discount prices (through financial aid) based on price sensitivity. D. The above are examples of price discrimination, a topic covered in more detail in Chapter 10.

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