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Chapter 5

Chapter 5.docx

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Bridget O' Shaughnessy

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Unit 3: The Elasticity of Demand and Supply - Objective 1: The Elasticity of Demand and its Application 3.1.1 Application of Elasticity of Demand Suppose the local bus company finds itself faced with higher costs and unchanged revenues. It must somehow increase its revenue in order to meet its additional costs. How might this best be done? One might immediately suggest an increase in fares, but is this the correct answer, given what we know about the elasticity of demand? Isn’t it possible that revenues could be raised by decreasing fares? Yes, it is possible, if the demand for public transportation is elastic. It is also possible that a rise in fares will decrease revenue, again if the demand curve happens to be elastic. The problem for the bus company is, therefore, to estimate the demand curve for public transportation and the elasticity of that demand curve within the appropriate price range. Only after the elasticity of demand is ascertained can a reasonable decision be made about changes in fares. If the demand curve is elastic, a reduction in fares would make sense, provided the increase in revenues covers the cost increase. If the demand is inelastic, a fare increase large enough for revenues to cover costs is probably the answer. If the demand curve were to be unit elastic, a fare change would not affect total revenue. 3.1.2 Factors that Determine Elasticity There are four major factors that are likely to affect the price elasticity of demand for goods and services. 1. Time Suppose the price of electricity were to drop by 15 percent. What do you think would happen to the quantity demanded in the first month or so after the drop? How would you expect the quantity demanded to respond over the next several years? In the first month or so there would be some increase in quantity demanded as people used more of a cheaper product. People would be less careful to turn lights off, and they might use their electric appliances more often. However, one would expect the response to be moderate because, given certain appliances, certain heating arrangements, and established living patterns, people can use only so much electricity. Over a longer period of time, however, the response would be much stronger. People would tend to buy more electric appliances. Those who were buying or replacing gas or oil heaters might switch to the now cheaper electric heating. Thus, elasticity of demand would be much greater over the long run than over the short term. 2. Substitutability One of the most important determinants of demand is the availability of good substitutes. A commodity such as butter, for example, can be replaced by margarine. A change in the price of such a commodity would probably produce quite a change in the quantity demanded. A rise in price will cause people to substitute something else, and a fall in price will cause people to switch back from the substitutes. Other commodities, such as housing and medical care, do not have close substitutes. A rise in their price can be expected to cause a smaller fall in the quantity demanded than would be the case if close substitutes could be found. 3. Definition of the market Narrowly defined markets (like ice cream) have more elastic demand than broadly defined markets (like food). 4. Necessities and luxuries Some goods are so critical to our everyday life that we regard them as “necessities.” For example, most people consider milk a basic necessity in children’s diets; if the price of milk increases by, say, 15%, the quantity demanded will probably not fall by the same percentage. Consumers will probably sacrifice some other commodities rather than allow their children to go without milk. The demand for such an item is likely to be inelastic. A “luxury” good, in contrast, is something we would like to have (like a vacation trip) but are not likely to buy unless our income increases or the price of the good declines sharply. For example, an increase in the price of a vacation package is likely to cause a more than proportional decrease in the number of such packages bought. The demand for luxury goods is relatively elastic. Elasticity can be thought of in terms of a scale or continuum, as illustrated in Figure 3.2, below. Figure 3.2: Continuum of elasticity The continuum shows that demand may exhibit one of five types of elasticity, as illustrated in Figure 3.3, below. Figure 3.3: Demand elasticities Perfectly elastic (E d ∞): A small percentage change in price produces an infinitely large percentage change in quantity demanded. Elastic (Ed> 1): A given percentage change in price produces a larger percentage change in quantity demanded. Unit(ary) elastic (E d 1): A given percentage change in price produces the same percentage change in quantity demanded. Inelastic (E d 1): A given percentage change in price produces a lower percentage change in quantity demanded. Perfectly inelastic ( E d 0): A given percentage change in price produces no percentage change in quantity demanded. Figure 3.3, panels (a) through (e) from Mankiw/Kneebone/McKenzie/Rowe. Principles of Microeconomics © 2008 Nelson Education Ltd. Reproduced by permission. www.cengage.com/permissions. Figure 3.4: Elasticity along a given demand curve Figure 3.4 shows the demand schedule from Table 3.1 (in section 3.1.3). We saw that the elasticity coefficients for price changes from $0.40 to $0.35, and from $0.35 to $0.30 were greater than one. This part of the demand curve is “elastic.” The price change between $0.30 and $0.25 showed a unitary elastic response- coefficient of elasticity (=1). For price changes below $0.25, the coefficient of elasticity is less than one, so the demand is inelastic over this range of the demand curve. Note that the elasticity changes along this single straight-line demand schedule. 3.1.5 Elasticity and Total Revenue Along a Linear De
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