Economics

ECO 2301, Principles of Microeconomics 1

Course Learning Outcomes for Unit III Upon completion of this unit, students should be able to:

3. Discuss types of economic market structures. 3.1 Identify the determinants of price elasticity of demand. 3.2 Calculate price elasticity of supply and price elasticity of demand. 3.3 Interpret price elasticity of supply and price elasticity of demand.

Course/Unit Learning Outcomes

Learning Activity

3.1

Unit Lesson Chapter 5 Article: “Using Gasoline Data to Explain Inelasticity” Article: “Using FRED Data to Teach Price Elasticity of Demand” Webpage: Gasoline Prices Tend to Have Little Effect on Demand for Car

Travel Document: Cross-Price Elasticities of Demand Across 114 Countries Document: International Evidence on Food Consumption Patterns Video: Elasticity Unit III Assignment

3.2

Unit Lesson Chapter 5 Article: “Using FRED Data to Teach Price Elasticity of Demand” Document: Cross-Price Elasticities of Demand Across 114 Countries Video: Elasticity Unit III Assignment

3.3

Unit Lesson Chapter 5 Article: “Using FRED Data to Teach Price Elasticity of Demand” Document: Cross-Price Elasticities of Demand Across 114 Countries Video: Elasticity Unit III Assignment

Required Unit Resources Chapter 5: Elasticity of Demand and Supply In order to access the following resources, click the links below. Eitches, E., & Crain, V. (2016, March). Using gasoline data to explain inelasticity. Beyond the Numbers, 5(5).

https://www.bls.gov/opub/btn/volume-5/using-gasoline-data-to-explain-inelasticity.htm Méndez-Carbajo, D., & Asarta, C. J. (2017, July–September). Using FRED data to teach price elasticity of

demand. The Journal of Economic Education, 48(3), 176–185. https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc t=true&db=bsu&AN=123299006&site=ehost-live&scope=site

Morris, M. (2014, December 15). Gasoline prices tend to have little effect on demand for car travel. U.S.

Energy Information Administration. https://www.eia.gov/todayinenergy/detail.php?id=19191

UNIT III STUDY GUIDE

Elasticity

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Regmi, A., & Seale, J. L., Jr. (2010, March). Cross-price elasticities of demand across 114 countries (Technical Bulletin No. 1925). Economic Research Service, United States Department of Agriculture. https://www.ers.usda.gov/webdocs/publications/47558/8508_tb1925_reportsummary_1_.pdf?v=0

Seale, J., Jr., Regmi, A., & Bernstein, J. (2003, October). International evidence on food consumption

patterns (Technical Bulletin No. 1904). Economic Research Service, United States Department of Agriculture. https://www.ers.usda.gov/webdocs/publications/47429/14755_tb1904_1_.pdf?v=0

Unit Lesson Recall from Unit II the law of demand. This law suggests that price and quantity demanded are inversely related (McEachern, 2019). In other words, as the price of a good increases, quantity demanded of that good will decrease (and vice versa) as long as nothing else changes. This law of demand tells us the direction that quantity demanded will move as the price changes. However, it does not tell us how much quantity demanded will change as price changes. Think about the actions of an automobile dealership. Right before the new models are released for the year, dealerships would like to sell all the older models. The dealership knows how many of the older models they will have to sell. The dealership also understands the law of demand in that lowering the price of the older models will result in an increase in sales of these older models. They also have an idea of how much sales will increase if they drop the price of each older model automobile by $1,000; $2,000; or even $10,000. Understanding both the law of demand and how much quantity demanded will change as price changes can help firms when attempting to price goods and services. They can also help governments decide tax rates for goods and services as well as help explain consumer behavior.

Price Elasticity of Demand How much quantity demanded will change as price changes is called price elasticity of demand. Formally, price elasticity (PED) measures the percentage change in quantity demanded divided by the percentage change in price (McEachern, 2019). Aside from reviewing the information here, please watch the video Elasticity, which explains price elasticity of demand.

Price Elasticity of Demand

=

Percentage Change in Quantity Demanded

Percentage Change in Price

Calculating Price Elasticity of Demand Now the question becomes how to determine the percentage change in quantity demanded and the percentage change in price. While it may sound complex, the formula is fairly simple. Let’s say we are trying to calculate the price elasticity of demand for bread. Let’s also say that the price of bread was $1.50 in April, and 500 loaves of bread were purchased at a store. In May, the price of bread has increased to $2.00 per loaf, and 200 loaves of bread were purchased. This is all the information we need. Below is a step-by-step process for calculating the price elasticity of demand for bread.

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Step 1 The first thing to do is label the prices and quantities. Below are the two prices and the quantities sold, along with their labels:

Price or Quantity Amount Label

Price in May $2.00 P Price in April $1.50 P´

Quantity in May 200 Q Quantity in April 500 Q´

It does not matter if you label the earlier or later price/quantity with the “prime symbol” (´). You will want to make sure, though, that your labels are consistent. In other words, here the price in April was labeled as P´ (P prime). That would mean the quantity in April would need to be labeled as Q´ (Q prime). Our calculations would be thrown off if we used the prime symbol (´) for the price in April and the prime symbol for the quantity in May. Making sure you stay consistent is key here. Step 2 The next step is to calculate the following using the prices we were given:

(P + P´) =

($2.00 + $1.50) =

$3.50 = 1.75

2 2 2 Step 3 Now, calculate the following using the quantities:

(Q + Q´) =

(200 + 500) =

700 = 350

2 2 2 Step 4 The next step is to calculate the change in price.

P – P´ = $2.00 – $1.50 = $0.50 Step 5 Next, we will calculate the change in quantity.

Q – Q´ = 200 – 500 = – 300 Step 6 Divide the result in Step 2 by the result in Step 3.

Step 2 Result

= 1.75

= 0.005 Step 3 Result

350

Step 7 Divide the result in Step 5 by the result in Step 4.

Step 5 Result

= – 300

= – 600 Step 4 Result

0.50

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Step 8 Multiply the result in Step 6 by the result in Step 7.

Result in Step 6

X Result in Step 7

= 0.005 * (– 600) = – 3.0

We have now calculated our price elasticity of demand for bread as being -3.0.

Interpreting Price Elasticity of Demand When price elasticity of demand is calculated, we interpret the estimate by discussing how a percentage change in price impacts the percentage change in quantity demanded. You will notice above that the price changed by more than one percent. However, economists talk about how a 1% change in price will impact the percentage change in quantity demanded; the calculations above reduce the change to a 1% change in price and the percentage impact on quantity demanded. For instance, above, our calculated price elasticity of demand for bread was -3.0. This would suggest that a 1% change in the price of bread results in a 3% change in the quantity demanded of bread in the opposite direction. First, notice that the interpretation started off with having a 1% change in price. This could be either an increase or a decrease. Also, notice that the result on quantity demanded took the 3.0 that was calculated. The wording “in the opposite direction” refers to the negative sign in front of the calculated price elasticity of demand. The interpretation suggests that if price increases by 1%, quantity demanded would decrease by 3.0%. Also, if price decreases by 1%, quantity demanded would increase by 3.0%.

Categories for Price Elasticity of Demand When price elasticity of demand is calculated, it also falls into one of three categories: inelastic, elastic, or unit (or unitary). These categories are used to explain how responsive quantity demanded is to changes in price (McEachern, 2019). The first thing to do when determining whether price elasticity of demand is inelastic, elastic, or unit (or unitary) is to take the absolute value of the calculated price elasticity of demand. The absolute value just means that whatever the calculated value is, make it a positive number. For example, when price elasticity of demand was calculated for bread above, the estimate was – 3.0. The absolute value of this estimate is 3.0 (just take away the negative sign). If the absolute value of the calculated price elasticity of demand is between 0 and 1.0, the price elasticity of demand is said to be inelastic. If the absolute value of the calculated price elasticity of demand is greater than 1.0, the elasticity of demand is said to be elastic. If the absolute value of the calculated price elasticity of demand is equal to 1.0, the elasticity of demand is said to be unit (or unitary).

Absolute Value of Price Elasticity of

Demand

Elasticity Interpretation

Between 0 and 1.0 = Inelastic

Equal to 1.0 = Unit (or Unitary)

Greater than 1.0 = Elastic A discussion of what each of these categories mean is provided below.

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Inelastic Demand When the calculated price elasticity of demand is between 0 and 1.0, the percentage change in price is much greater than the percentage change in quantity demanded. This suggests that quantity demanded is not very responsive to price changes. Think about the demand for goods that are not very sensitive to price changes. Gasoline, for instance, is a classic example of a good whose demand curve is price inelastic. If the price of gasoline increases by $1.50 per gallon, you may not go for many Sunday drives in the country or take long vacations in the car, but your daily driving will not change much. In this case, the demand for gasoline still follows the law of demand (e.g., price increases still result in quantity demanded decreases). However, the amount that quantity demanded decreases will be nowhere near as great in percentage terms as the percentage increase in the price of gas. Some of the reasons price elasticity of demand may be price inelastic is that the good or service is a necessity or that there are very few substitutes for the good. Gasoline is, again, a great example because if you want to drive a car that uses gas, you will need gas. Also, if you are driving a car that requires gasoline, there are no other substitutes for gasoline other than a blend of ethanol. Another way to look at a price elasticity of demand that is inelastic is to think about a rubber band. A rubber band that requires a lot of force to make it stretch even a little bit is considered to be inelastic. You may have to exert a lot of force just to make the rubber band stretch 1 inch. In regards to price elasticity of demand, price is the force that is being applied. A lot of force (price changing by a great percentage) can be applied, but quantity demanded (the stretch of the rubber band) does not move by much. Elastic Demand When the calculated price elasticity of demand is greater than 1.0, the percentage change in price is much less than the percentage change in quantity demanded. This means quantity demanded is very responsive to changes in price. For example, fresh green beans would be a good that has a relatively elastic demand curve. If the price of fresh green beans increased by 50%, you might choose to purchase canned green beans or another vegetable. The availability of substitutes causes the demand for goods and services to become elastic. The more substitutes there are for a good, the more elastic the demand can become. Using the rubber band example again, a rubber band would be said to be elastic if it required very little force to make it stretch 1 inch. As before, price is the force that is being applied, and the “stretch” is the quantity demanded response. Unit (or Unitary) Demand Unit (or unitary) demand means that there is a one-for-one change between price and quantity demanded. In other words, a 1% change in price results in a 1% change in quantity demanded. It is rare to ever find a good or service that has unit (or unitary) demand.

Relationship Between Price Elasticity of Demand and Total Revenues Price elasticity of demand can be very helpful when a firm is attempting to decide whether to increase or decrease the price of a good or service (McEachern, 2019). Total revenues of a firm are determined by multiplying the price of a good or service by the quantity demanded.

Total Revenues = Price x Quantity Demanded If the price goes up and quantity demanded remains the same, total revenues go up. If price remains the same and quantity demanded goes up, total revenues go up. However, we know from the law of demand that a change in price impacts quantity demanded. This also means that just increasing the price may not result in an increase in total revenues. Whether total revenues increase or not depends on the percentage change in price and the resulting percentage change in quantity demanded (e.g., price elasticity of demand).

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For example, let’s assume that the price of a gumball sold at a store equaled $1.00. At this price, 1,000 gum balls were demanded. Using the formula for calculating total revenues, we would know that the store generated $1,000 from the sale of gumballs. Now, let’s assume that the owner of the store wants to increase total revenues generated from selling gumballs. The owner would like to determine whether price should be increased or decreased. The owner knows that the price elasticity of demand for gumballs is equal to -2.5. You know that this price elasticity of demand means that a 1% change in the price of gumballs would result in a 2.5% change in quantity demanded of gumballs, in the opposite direction. This means that if the price of gumballs was increased by 1%, the new price would be $1.01. Decreasing quantity demanded by 2.5% means the new quantity demanded would be 975 gumballs. Using the same formula for calculating total revenues (price multiplied by quantity demanded), we would know that increasing the price by 1% would result in total revenues falling to $984.75. On the other hand, what if price were decreased by 1%? If the price of gumballs were decreased by 1%, the new price would be $0.99. We know from the calculated price elasticity of demand that a 1% decrease in the price would cause quantity demanded to increase by 2.5%. A 2.5% increase in quantity demanded from the original 1,000 gumballs would suggest that 1,025 gumballs would be purchased at a price of $0.99. Using the same formula for total revenues, at a price of $0.99, total revenues would increase to $1,014.75. The example above shows that decreasing the price of a good that has an elastic demand curve will result in an increase in total revenues. The same steps can be performed for a good that has an inelastic demand curve, only the results would be just the opposite. Increasing the price of a good that has an inelastic demand curve results in an increase in total revenues. This is why you see that goods such as gasoline, cigarettes, and tobacco have a higher associated tax rate. Federal, state, and city governments know they can impose a higher tax rate on these goods because these are goods that have a relatively inelastic demand curve.

Other Forms of Price Elasticity There are other ways we can use elasticity when we study the economy around us. We can calculate price elasticity of supply and income elasticity, as well as cross-price elasticity. Each of these are discussed below.

Price Elasticity of Supply As we already know, a change in price not only impacts quantity demanded but also quantity supplied. The law of supply tells us that an increase in the price of a good or service will result in an increase in the quantity supplied of that good or service as long as nothing else changes (McEachern, 2019). Similar to above, the question now becomes just how much does quantity supplied change as price changes. To determine the responsiveness of quantity supplied to price changes, we can calculate price elasticity of supply. Price elasticity of supply is calculated using the following formula:

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Title Price Elasticity of

Supply =

Percentage Change in Quantity Supplied

Percentage Change in Price

You would use the same steps shown for calculating price elasticity of demand to calculate price elasticity of supply; you would only need to replace quantity demanded in each formula with quantity supplied. Also, the same categories (inelastic, elastic, and unit or unitary) and rules for those categories apply for price elasticity of supply as they do for price elasticity of demand.

Income Elasticity of Demand Think about consumers and their purchases when they first move out on their own. Meals may consist of ramen noodles and a lot of lower-priced foods. However, as time goes by, these same consumers may start earning more money, and inexpensive foods such as ramen noodles are no longer required on the menu. The lower-priced foods may be replaced by steak, fish, chicken, and other higher-priced foods. Firms may make decisions regarding where to locate their businesses or what to sell based on the income demographics of an area. This is where income elasticity of demand is used. Income elasticity of demand tells us how responsive quantity demanded is to changes in income (McEachern, 2019). Income elasticity of demand is calculated using the following formula:

Income Elasticity of Demand

=

Percentage Change in Quantity Demand

Percentage Change in Income

Calculating Income Elasticity of Demand

We take the same steps when we calculate income elasticity of demand as we did with price elasticity of demand. The difference is that we replace quantity demanded with income. For example, let’s assume the average income in the area around a store that sells cars is $75,000 per year. The total number of cars sold at this income level is 5,000 cars per year. Sometime in the future, the average income increases to $80,000. At this new income level, it is calculated that 6,000 cars will be purchased. Step 1 The first thing to do is to label the prices and quantities. Below are the two prices and quantities, along with their labels:

Income or Quantity Amount Label

Income in the future $80,000 I Income this year $75,000 I´

Quantity in the future 6,000 Q Quantity this year 5,000 Q´

It does not matter if you label the earlier or later price/quantity with the prime symbol (´). You will want to make sure, though, that your labels are consistent, as explained earlier. Step 2 The next step is to calculate the following, using incomes:

(I + I´) =

($80,000 + $75,000) =

$155,000 = $77,500

2 2 2

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Step 3 Now, calculate the following using the quantities:

(Q + Q´) =

(6,000 + 5,000) =

11,000 = 5,500

2 2 2 Step 4 The next step is to calculate the change in price.

I – I´ = $80,000 – $75,000 = $5,000 Step 5 Next, calculate the change in quantity.

Q – Q´ = 6,000 – 5,000 = 1,000 Step 6 Divide the result in Step 2 by the result in Step 3.

Step 2 Result

= 77,500

= 14.09 Step 3 Result

5,500

Step 7 Divide the result in Step 5 by the result in Step 4.

Step 5 Result

= 1,000

= 0.2 Step 4 Result

5,000

Step 8 Multiply the result in Step 6 by the result in Step 7.

Result in Step 6

X Result in Step 7

= 14.09 * 0.2 = 2.82

Interpreting Income Elasticity of Demand

We interpret income elasticity of demand in the same manner we did for price elasticity of demand. Above, the income elasticity of demand was calculated as 2.82. We interpret this calculation as follows: a one percent change in income results in a 2.82 percent change in quantity demanded in the same direction. The reason the change in quantity demanded is “in the same direction” as the change in income is that the calculated income elasticity of demand is positive. If the calculation resulted in a negative number, the interpretation would be “in the opposite direction.”

The Sign Matters With Income Elasticity of Demand You might have noticed that no mention was ever made about taking the absolute value of the income elasticity of demand. This is because the sign (positive or negative) matters with this calculation. A positive sign suggests that increases in income result in increases in quantity demanded. A negative sign would suggest that increases in income results in decreases in quantity demanded. Think back to the example of eating mostly lower-priced foods such as ramen noodles when incomes are lower. As incomes start to increase, consumers tend to stop purchasing as many lower-priced foods. This would be an example of a good that had a negative income elasticity of demand (the sign was negative). In economics, we refer to a good or service with a negative income elasticity of demand as an inferior good

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(McEachern, 2019). Generic brands, excessively lower-priced goods and services, and lower-quality goods are examples of goods that may be labeled as inferior goods. Goods that have a positive income elasticity of demand are referred to as normal goods (McEachern, 2019). Normal goods might include higher-priced foods, college courses, and mid- and higher-priced automobiles. Essentially, the quantity demanded of normal goods increases as the incomes of consumers increase.

Cross-Price Elasticity of Demand Another form of elasticity is cross-price elasticity of demand. This calculation examines how a percentage change in the price of one good affects the quantity demanded of another good (McEachern, 2019). Firms that sell goods and services know that changing the price of one good can result in changes in the demand for another good. Just think about how changes in the price of peanut butter might impact the quantity demanded of jelly. Both of these goods are used together to make a peanut butter and jelly sandwich. Likewise, a change in the price of Coca-Cola will impact the quantity demanded of Pepsi because these two goods are similar and compete with each other. The cross-price elasticity of demand is calculated by the percentage change in quantity demand of one good divided by the percentage change in price of another good.

Cross-Price Elasticity of

Demand =

Percentage Change in Quantity Demand of One Good

Percentage Change in Price of Another Good

The steps for calculating cross-price elasticity of demand would follow the same as before. The quantity demanded of one good will be used along with the price of another good. Interpreting the calculated cross- price elasticity of demand will be similar as well, as you will indicate that a 1% change in the price of one good has a calculated percentage change in the quantity demanded of the other good.

The Sign Matters With Cross-Price Elasticity of Demand Again, the sign matters when you calculate cross-price elasticity of demand. A calculated negative number for the cross-price elasticity of demand suggests that a change in the price of one good or service will cause a change in the quantity demanded of another good or service in the opposite direction. In other words, increases in the price of one good will cause decreases in the price of the other good and vice versa. We refer to these as complements. Peanut butter and jelly would have a negative calculated cross-price elasticity of demand, suggesting that increases in the price of peanut butter would result in decreases in quantity demanded of jelly. Glass cleaner and paper towels would have a negative cross-price elasticity since they are used together (they are complements; they complement each other). Peas and carrots would have a negative cross-price elasticity for Forrest Gump, as he indicated that they went together well (Zemeckis, 1994). A positive calculated cross-price elasticity of demand suggests that a percentage change in the price of one good or service will result in a percentage change in the quantity demanded of another good or service in the same direction. In other words, an increase in the price of one good will cause an increase in the quantity demanded of another good, and vice versa. Goods or services with a positive calculated cross-price elasticity of demand are considered to be substitutes. If the price of one good increases, consumers will stop buying that good and purchase one that is similar. Examples of substitutes are Coke and Pepsi (two similar soft drinks), green beans and asparagus (two vegetables), and steak and chicken (two meats). In closing, elasticity is a powerful concept in economics. Firms use price elasticity of demand to help them price goods and services. Firms use income elasticity of demand to help them determine what to sell and

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where to sell it. Firms also use cross-price elasticity of demand when they want to feature one good or service knowing that the demand for another good or service will be impacted.

References McEachern, W. A. (2019). Micro ECON6: Principles of microeconomics. Cengage Learning.

https://online.vitalsource.com/#/books/9781337671828 Zemeckis, R. (Director). (1994). Forrest Gump [Film]. Paramount Pictures.