This Document Contains Chapters 5 to 6 Chapter 5: Price Controls and Quotas: Meddling with Markets What’s New in the Fifth Edition? • Updated case studies Chapter Objectives • Explain why governments sometimes control prices. • Define the concept of a price ceiling and discuss the effect on equilibrium price and quantity. • Define the concept of a price floor and discuss the effect on equilibrium price and quantity. • Define the concept of a quantity restriction and discuss the effect on equilibrium price and quantity. • Define the concept of deadweight loss. • Identify the winners and losers resulting from government intervention in the market. Teaching Tips Price Ceilings Creating Student Interest • Ask students if they think a cap (price ceiling) on tuition is a good idea. Discuss how a tuition maximum might affect quantity demanded, quantity supplied, and the quality of classes at their school. Another possibility is to ask the students if they think a price ceiling on gasoline is a good idea. Presenting the Material • Students will not usually have difficulty grasping the concept of a price ceiling, but they may struggle with graphically illustrating the effects of the price ceiling. Start with a simple example using the following table, which should be familiar from Chapter 3. Rent Quantity demanded (units rented per month) Quantity supplied (units for rent monthly) $1,400 1,000 2,000 1,200 1,100 1,500 1,000 1,200 1,200 800 1,500 1,000 600 1,800 750 400 2,100 600 1. If a price ceiling of $800 is set on apartment rentals, how much of a shortage is created? (500 units.) 2. How would this shortage manifest itself in the market? (In the short run, many renters will be unable to find an apartment. In the long run, there will be a lack of construction of new apartment buildings.) Now take the numbers from the table and illustrate on a graph to show the effect of the price ceiling on quantity supplied and quantity demanded. Identify deadweight loss on the graph. Depending on the level of your students, illustrate the new consumer surplus and the new producer surplus. Figure 5-4 in the text illustrates these areas. At this point you can discuss who wins and who loses as a result of the price ceiling. Price Floors Creating Student Interest • Ask the class if anyone knows how much the federal minimum wage is. Ask the class if anyone is (or ever has, or knows someone who is) earning the minimum wage. What about a wage above the minimum wage? Below it? (Be careful here—many college students have jobs waiting tables at restaurants; they are paid below the minimum wage, but are expected to make the minimum when tips are included.) Do they think the minimum wage should be raised? Why or why not? Be clear that the answer is normative. Use this discussion to segue into the presentation of the effects of a minimum wage on the market. Presenting the Material • As with the price ceiling, students will usually be able to grasp the concept of a price floor, but will struggle with the graph. Start with the table below and then illustrate the effects of the price floor graphically. Once you have identified quantity demanded and quantity supplied on your graph, you can identify the deadweight loss. Wage Quantity of labor demanded Quantity of labor supplied $6.75 300 500 6.00 400 400 5.75 500 300 5.50 550 200 5.00 600 100 4.75 650 50 1. What is the equilibrium wage rate? ($6.00) 2. If a price floor is set at $6.75 (minimum wage), how much of a surplus of unemployed workers will be created? (200) Controlling Quantities Creating Student Interest • Ask students why New York City would want to have a law to limit the quantity of taxi licenses issued. What are the pros and cons of such a law? Give other examples of quantity controls, such as fishing catch limits and quotas on imported goods. Presenting the Material • Consider this concrete example to illustrate quantity controls. Sugar market (U.S. domestic market without sugar quotas) Price (per pound) Quantity demanded (thousands of pounds) Quantity supplied (thousands of pounds) $3.00 600 1,400 2.75 700 1,300 2.50 800 1,200 2.00 900 1,100 1.75 1,000 1,000 1.50 1,500 900 In the absence of a quota, the equilibrium quantity will be 1 million pounds. Let’s say the government restricts the quantity of imported sugar, and the quantity limitation is now set at 900,000 pounds. The effect of the quota is shown in the following graph. With the quota, 900,000 pounds will be sold at a price of $2.00; $2.00 is the demand price for 900,000 pounds. Domestic producers of sugar get a quota price of $0.50 per pound of sugar. Ask students to brainstorm who wins and who loses from the quota. Students may at first have a difficult time understanding why sugar would sell for $2.00 and not $1.50. Emphasize that the seller will want to charge the highest price possible. Also note that the quota will create a shortage, and this shortage will increase the price for which the good sells. Note that if you extend the supply and demand curves to the vertical axis, you can identify the areas that represent consumer and producer surplus, as well as the deadweight loss. Common Student Pitfalls • Identifying where effective ceilings and floors are placed. Since ceilings are high, it is easy for students to think they must be above equilibrium. And since floors are low, it is easy for students to think they must be below equilibrium. Remind the students that a price ceiling is a maximum price. If the equilibrium price happens to fall below the price ceiling (maximum price), then the price will stay at equilibrium. You may point out that shifts in supply and demand can cause the equilibrium price to either rise above or fall below the price ceiling. The same holds true for the price floor. If the equilibrium price falls above the price floor, then the price will stay at equilibrium. • Product versus labor markets and the minimum wage. Since students have not yet been formally introduced to a labor market, they may be confused by the minimum wage graph. Tell them the labor market works essentially the same way, but the labels are different. Households supply the labor and businesses demand it. (There has been a change in roles from the product market.) The price of labor is called the wage, and quantity refers to employment level—the number of workers or hours, or some measure of labor. There is an inverse relationship between price and quantity demanded (the law of demand still applies in the labor market) and there is a positive relationship between price and the quantity of labor households are willing to supply. • Quotas (or quantity controls). Make clear that with quotas (or quantity controls) we have moved to discussing limits on Q rather than P. • Calculating deadweight loss. The deadweight loss triangle can be difficult for students. Refer back to consumer and producer surplus to help students. Show what has happened to consumer and producer surplus to explain the resulting deadweight loss. Chapter Outline Opening Example: Rent control and taxi licenses are given as examples of what happens when the logic of the market is defied by government intervention. I. Why Governments Control Prices A. Price controls are enacted by governments in response to political pressures from buyers and sellers. II. Price Ceilings A. Modeling a price ceiling: A price ceiling is set below the equilibrium price. A price ceiling set above the equilibrium price has no effect. This is illustrated in text Figure 5-2, shown below. B. A price ceiling set below the equilibrium price creates a shortage. C. A price ceiling causes inefficiency because it: 1. Causes a deadweight loss. 2. Inefficiently allocates to consumers who have a lower willingness to pay and keeps people who would be willing to pay a higher price from receiving the good. 3. Causes people to spend resources dealing with a shortage. 4. Causes sellers to offer low-quality goods at a low price even though buyers would prefer a higher quality at a higher price. D. Price ceilings lead to black markets. E. Price ceilings are enacted because: 1. They do benefit some people. 2. When they have been in effect for a long time, buyers may not have a realistic idea of what would happen without them. 3. Government officials often do not understand supply and demand analysis. III. Price Floors A. Price floors lead to excess supply; the quantity supplied is greater than quantity demanded at the set price. Price floors are ineffective if set below the equilibrium price. B. Modeling a price floor: A price floor is set at a price that is above the equilibrium price. This is illustrated in text Figure 5-6, shown here. C. A price floor causes inefficiency because it: 1. Results in a quantity below the efficient level. Since a price floor raises the price of a good to consumers, quantity demanded falls, so the quantity bought and sold falls, creating deadweight loss. 2. Leads to an inefficient allocation of sales among sellers. 3. Causes wasted resources when the government buys and destroys surplus product. Minimum wages result in fewer jobs available and so would-be workers waste time searching for a job. 4. Causes the production of goods of inefficiently high quality. 5. Results in illegal activity. F. Government officials often disregard warnings about the consequences of price floors, either because they believe that the relevant market is poorly described by the supply and demand model or, more often, because they do not understand the model. IV. Controlling Quantities A. Modeling a quantity control: This is shown graphically by a vertical line set at the quantity limit, as illustrated in text Figure 5-9, which follows. B. The costs of quantity controls are: 1. Inefficiencies, or missed opportunities, in the form of mutually beneficial transactions that don’t occur. 2. Incentives for illegal activities. Case Studies in the Text Economics in Action Why Price Controls in Venezuela Proved Useless—This EIA explains how price controls in Venezuela have affected the availability of imported and staple goods. Ask students the following questions: 1. What was the goal of the price controls Hugo Chavez’s government placed on basic foods in Venezuela? (To hold down the cost of living.) 2. What were the actual consequences of the price controls? (Shortages of necessities, availability of imported luxury goods, black markets.) The Rise and Fall of the Unpaid Intern—This EIA discusses the rising popularity of unpaid internships. Ask students the following questions: 1. Is the minimum wage binding for interns? How do you know? (Yes, because there are many interns unwilling to work for no pay.) 2. Are unpaid internships legal? (Yes, if the work is mainly for the benefit of the student intern and it does not displace a regular worker.) Crabbing, Quotas, and Saving Lives in Alaska—This EIA discusses quota systems that have been in place since 1983 for catching crab in Alaska. Ask students the following questions: 1. The first quota system limited the amount of crab that could be harvested in a year, but did not assign individual quotas to fishermen. What was the problem with this system? (Catching crabs was essentially first come, first serve. The incentive was to catch as many crabs as you could during the short season before the quota limit was reached, and this led to unsafe practices that resulted in boat accidents and deaths.) 2. How was the 2006 quota share system different from the original quota system? (The quota share system assigned each boat a quota for a three-month season. The quotas could be sold or leased.) For Inquiring Minds Winners, Losers, and Rent Control—This FIM discusses rent control and illustrates the effect of the price ceiling on consumer and producer surplus. Mumbai’s Rent-Control Millionaires—This FIM looks at extreme effects of rent control in Mumbai, India. Global Comparison Check Out Our Low, Low Wages!—This Global Comparison provides a comparison of minimum wages in six countries. Business Case Why Taxi Medallion Lenders Are Feeling Like Roadkill—This business case discusses a lawsuit by four taxi-medallion lending companies against the City of New York for failing to protect the industry’s quantity-controlled status. Web Resources The following U.S. Department of Labor website gives information about the federal minimum wage: https://www.dol.gov/general/topic/wages/minimumwage The Department of Homeland Security, U.S. Customs and Border Protection web page provides information on U.S. import quotas (particularly in textiles and agriculture): http://www.cbp.gov Handout 5-1 Date_________ Name____________________________ Class________ Professor________________ Rent Control What are the pros and cons of rent-control laws? Pros Cons How is this issue an example of the trade-off between equity (fairness) and efficiency? How do rent-control laws cause the “market to strike back”? Price Ceilings and Essential Goods Consider the following situation: During the Northridge earthquake in Los Angeles County, water was in short supply in the Valley and the price of bottled water skyrocketed. The city invoked a state law that prohibits businesses from charging more than 5% extra for certain “essential goods” within 30 days after a natural disaster. Should a state be able to put price ceilings on “essential” goods following a natural disaster, or should market prices prevail? What would be the result of such price ceilings? Prescription Medications (15–30 minutes) Analyze the pros and cons of putting price ceilings on prescription medicine. Pros Cons Handout 5-2 Date_________ Name____________________________ Class________ Professor________________ Quantity Control of Sugar Imports The United States has quantity limits on the amount of sugar that can be imported into the United States. The purpose of the limit is to protect U.S. sugar growers. What are the pros and cons of this limit? Pros Cons Chapter 6: Elasticity What’s New in the Fifth Edition? • New Economics in Action discussing China’s slowdown in demand for commodities. • Handouts for use in class. Chapter Objectives • Define elasticity as a measure of responsiveness to changes in price and income. • Discuss the meaning and importance of the price elasticity of demand. • Discuss the meaning and importance of income elasticity and cross-price elasticity. • Discuss the meaning and importance of the elasticity of supply. • Identify some of the factors that influence the magnitude of the different elasticities. Teaching Tips Defining and Measuring Elasticity Creating Student Interest • Present the class with the following scenario: You are suffering from a rare disease and need to take a single pill every day to stay alive. Right now, you are paying $10 per pill for the life-saving medication. If the price of the pill goes up to $20 per pill, how many will you buy? What if the price falls to $5 per pill? Help students to understand that because one pill per day is needed, you will buy one pill. Also, because the treatment is one pill, there is no need to buy more than one pill per day. The quantity of pills purchased is unresponsive to changes in price. In this special case, when the price of the pills changes, there is no change in quantity demanded. • Choose a student in class and say, “Let’s assume that we both have the same hair stylist or barber. What would you do if he raised the price of a haircut by $10?” If the student changes hair stylists, she is demonstrating “responsiveness” to a price change. Indicate that you would not change stylists, and so your response is less sensitive to a price change. This can lead to a definition of the difference between inelastic and elastic demand. • Parking space on campus is limited. Is your demand for a guaranteed space on campus sensitive to price or not? Would you pay “anything” for it? • Ask students if the demand for college textbooks is very responsive to price increases. How many substitutes are available? Have they checked online for textbooks? Presenting the Material • Many students struggle with the concept of elasticity. They often have difficulty calculating elasticity, and they also have difficulty understanding and applying the concept of elasticity. Be sure to provide a variety of examples to help them with this difficult concept. Since the chapter discusses several different elasticities, it is useful to introduce elasticity as a general concept before introducing the common elasticities used in economics. If students learn the concept, rather than memorizing various formulas, they will be better able to interpret elasticities and to apply what they learn to examples they may see in the future. • Any elasticity measures the relative responsiveness of one variable to changes in another, making it possible to calculate elasticity for any two variables that are related. For example, the temperature elasticity of ice cream measures the relative responsiveness of ice cream consumption to changes in the outdoor temperature. Students will probably presume that this will be a positive relationship—as temperature rises, the quantity of ice cream consumed increases. The question is, by how much? That is what elasticity tells us. • Percentages are used because the units of measurement are different and can’t be divided. For example, ice cream consumption can be measured in cones, cups, scoops, gallons, etc. Temperature can be measured in degrees Fahrenheit or degrees Celsius. How many scoops are in a degree Celsius? That doesn’t make sense, so we use percentages. You will need to remind students how to calculate a percentage change. You can show students how the calculation of elasticity is affected by which value you start with. This leads into explaining the midpoint formula. • For example: If 20 scoops of ice cream are consumed when the temperature is 70 degrees, and 40 scoops are consumed when the temperature goes up to 80 degrees, the temperature elasticity of ice cream is the percentage change in ice cream consumption (change/starting = 20/20 = 1) divided by the percentage change in the temperature (change/starting 10/70 = 0.14). The elasticity equals 1/0.14 = 7.14. However, if you look at the same example in terms of a temperature decrease (80 down to 70), the answer is (20/40 = 0.5) divided by (10/80 = 0.13), which equals 3.85. These examples show there are two different answers for the analogous situation. The midpoint formula gives us (20/30 = 0.67) divided by (10/75= 0.13), which is 5.15 either way! The elasticity formula is always (change/average)/(change/average) with the dependent variable on top. • Help students to see they aren’t memorizing five different formulas in this chapter—they are learning just one. • Be sure to emphasize that students need to be able to calculate elasticity and to know what it means. • After explaining how to calculate elasticity, show the students how to use the elasticity value to make predictions. For example, if the price elasticity of demand is 3.2, then a 10% increase in price will cause a 32% decrease in quantity demanded. Explain that a firm may either want to increase price, or may have to increase price in order to cover an increase in cost. Knowing the elasticity value can help the firm plan for the change. • Use a simple example to illustrate the basic elasticity formula. If price rises by 10% and quantity demanded falls by 20%, then elasticity = −2, or 2 in absolute value terms, indicating demand is elastic. If price rises by 10% and quantity demanded falls by 5%, then elasticity is −0.5, or 0.5 in absolute value terms, which indicates inelastic demand. Point out that quantity demanded is still dropping, but not by very much. And last, if price rises by 10% and quantity demanded falls by 10%, then elasticity is −1.0, or 1 in absolute value terms, and demand is unit elastic. Students may wonder why the minus sign is dropped. Tell them that because we know an increase in price always causes a decrease in quantity demanded (all else the same), the minus sign is not necessary. Interpreting the Price Elasticity of Demand Creating Student Interest • Ask students to identify some of the goods they buy that have inelastic demand. In other words, when the price of that good goes up, the student still buys about the same quantity of the good. Students will probably suggest gas and other necessities. Now ask students to name some of the goods they buy that have elastic demand. These are goods that they buy a lot less of when the price goes up. They will probably suggest different luxury goods (Starbuck’s coffee or meals eaten out), or perhaps expensive goods (cars and electronics). • Ask them what they think happens to a firm’s total revenue when price increases. You will probably get some students who say increase, and some who say decrease. Ask them if they think it would be a good idea for the firm to increase price. The answer is, it depends on elasticity. If the firm increases price, and quantity demanded falls by a relatively small amount, then total revenue rises. Toll roads are a good example to use. If the toll increases, what happens to the toll revenue collected? Another good example is the price of an adult movie ticket. Could the theater earn more revenue by increasing the price on some tickets and decreasing the price on other tickets? The answer is yes, if the elasticity of demand is elastic for some movies and inelastic for other movies. Presenting the Material • Students usually do not have trouble understanding the difference between elastic and inelastic. Emphasize that if the percentage change in quantity demanded is greater than the percentage change in price, demand is responsive or elastic. Students find the discussion of the factors that help determine whether a good is elastic or inelastic most interesting if you pick a varied selection of goods and use these to motivate the discussion. Some goods are suggested in the table that follows. Alternatively, ask students to suggest goods they think are relatively elastic or inelastic. Product Price elasticity of demand Determinants of elasticity Eggs 0.32 small part of the consumer’s budget Milk 0.63 necessity; few substitutes Soft drinks 0.79 small part of the consumer’s budget Gasoline in the long run 0.24 necessity Housing 1.2 large proportion of a consumer’s budget Restaurant meals 2.3 there are substitutes Airline travel (leisure) 1.5 there are many substitutes; luxury good Foreign travel 4.1 there are many substitutes; luxury good • Once students have grasped the concept of elastic versus inelastic, you can discuss elasticity along the demand curve. Tell students that the elasticity, or price responsiveness, depends on the current price. Use a bottle of water as an example. If the price of the bottle is $1 and it increases by 10%, will there be a big change in quantity demanded? What if the price is $100 and it increases 10%? Since the actual change in the price is larger ($10 versus $1) at higher prices, demand will be more elastic. Other Demand Elasticities Creating Student Interest • Ask your students to describe the relationship between peanut butter and jelly (if you need to, remind them of the “other goods” determinant of demand). They can be substitutes if you are considering what to put on your toast and might choose either one. They also can be complements—if you eat peanut butter and jelly sandwiches. Different people will classify peanut butter and jelly as substitutes or complements, depending on their tastes. Ask them to come up with a way to determine if peanut butter and jelly are substitutes or complements for the U.S. population as a whole. Help them to see that you would need to know how the quantity demanded of peanut butter responds to a change in the price of jelly. • Ask students to think of products that do not sell well in economic downturns or recessions. Remind students that income is a determinant of demand so income and quantity demanded are related. (Some goods with high-income elasticity are cars, houses, and luxury goods.) Have students contrast those products with products whose sales do not suffer much during a downturn. Presenting the Material • Go back to the treatment of elasticity in general and consider the income and cross-price elasticities. Have students identify the two variables and the dependent/independent variables for income and cross-price elasticity. Use these to construct both the formula for calculating the income elasticity of demand (change in Qd/average Qd) divided by (change in income/average income) and for the cross-price elasticity (change in Qd/average Qd for one good) divided by (change in P/average P for the other). Illustrate a calculation for each. • Point out that we don’t use “elastic/unit elastic/inelastic” to describe income elasticity of demand. Remind students that changes in income will affect demand differently depending on what type of good we are talking about (normal or inferior). • Do an example of a cross-price elasticity. For example, when the price of jelly goes from $1 to $2, the quantity of peanut butter Marie buys falls from 30 to 20. (Percentage change in Qd of peanut butter)/(percentage change in the price of jelly) equals (–10/25)/(1/1.5) which is –0.4/0.67 = –0.6. An increase in the price of jelly led to a decrease in the quantity of peanut butter purchased. (The two variables moved in opposite directions, so the value of cross-price elasticity is negative.) • Point out that we don’t use “elastic/unit elastic/inelastic” to describe cross-price elasticity of demand. What we are interested in finding out is whether Marie buys more or less peanut butter when the price of jelly goes up. If the price of jelly goes up, Qd of jelly will fall (the law of demand). If less jelly means less peanut butter, the goods must be consumed together; that is, they are complements. The value of cross-price elasticity is negative (–/+) for complements. If she had purchased more peanut butter when the price of jelly went up, that would mean that less jelly (due to the price increase) led to more peanut butter; that is, they are substitutes. The value of cross-price elasticity would be positive (+/+). The Price Elasticity of Supply Creating Student Interest • Ask students what they would do if the market price for their textbook suddenly increased to $1,000. Many of the students will answer that they would sell their textbooks. That is, as potential sellers, they would be responsive to changes in price. • Ask students what the supply curve for a resource (like acres of land in a prime location) would look like if there were only 200 available. Draw (or have a student draw) the graph on the board. How responsive is the quantity of this resource supplied to a change in price? Show on the graph that the quantity can never change. Presenting the Material • Go back to the treatment of elasticity in general. Have students identify the two variables and the dependent/independent variables for price elasticity of supply. Use these to construct the formula for calculating the price elasticity of supply (change in Qs/average Qs) divided by (change in P/average P). Draw a supply curve with 2 points and use the numbers to calculate price elasticity of supply. (6/23)/(20/90) = 0.26/0.22 = 1.18. Since the price elasticity of supply is greater than one, the percentage change in Qs is greater than the percentage change in price (though not by much). Therefore, Qs is fairly responsive to price (elastic). Common Student Pitfalls • Calculating elasticity. Students may not know how to calculate a basic percentage change. They may also be unclear about the units for elasticity. (The elasticity coefficient is a number, not a percentage.) Finally, be certain that students understand that we drop the negative sign from the value of price elasticity of demand (we know the relationship is negative), but that the sign on income and cross-price elasticity is very important. • Interpreting elasticity. Students often focus on the formula and calculating elasticity and may not spend time thinking about what the values mean. Make sure students understand that learning to calculate elasticities is important and will be required, but that interpreting what the values mean and seeing how elasticities figure into economic analysis is even more important. • Total revenue and elasticity. Students may confuse total revenue with profits. Clarify that revenue is the amount the firm “brings in” and is equal to P × Q. Profit is TR – TC. • Distinguishing between the different elasticities. Make sure students are clear that the ranges of elasticity (inelastic/elastic) are used to describe the price elasticities of supply and demand. With income and cross-price elasticity, we are interested in the sign on the coefficient to determine normal versus inferior or complement versus substitute. Chapter Outline Opening Example: The opening example discusses the extreme variation in the cost of ambulance services in the United States. Companies can charge a high price because people are unresponsive to price in an emergency and do not think to ask who has to pay for the ambulance service. I. Defining and Measuring Elasticity A. The price elasticity of demand is the ratio of the percentage change in quantity demanded to the percentage change in the price as one moves along the demand curve. B. Using the midpoint method to calculate elasticities. 1. Midpoint formula: Used when you have information about quantity demanded for widely separated prices. 2. For convenience, the minus sign is dropped because it is understood that an increase in price will result in a reduction in quantity demanded. Elasticity values are effectively reported in absolute value terms. II. Interpreting the Price Elasticity of Demand A. How elastic is elastic? 1. Demand can be elastic (if the price elasticity of demand is greater than 1), inelastic (if the price elasticity of demand is less than 1), and unit-elastic (if the price elasticity of demand is exactly 1). These are illustrated in text Figure 6-3, shown below. B. Elasticity affects total revenue. 1. Except in the rare case of a good with perfectly elastic or perfectly inelastic demand, when a seller raises the price of a good, two effects are present. a. A price effect: After a price increase, each unit sold sells at a higher price, which tends to raise revenue. The price effect is the change in price times the new quantity. b. A quantity effect: After a price increase, fewer units are sold, which tends to lower revenue. The quantity effect is the change in quantity sold times the original price. 2. The price elasticity of demand determines which effect predominates and therefore indicates what happens to total revenue when price changes. a. If demand for a good is elastic, an increase in the good’s price reduces total revenue; a fall in price increases total revenue. In this case, the quantity effect is stronger than the price effect. b. If demand for a good is inelastic, a higher price increases total revenue; a fall in price results in a decrease in total revenue. The price effect in this case is stronger than the quantity effect. c. If demand for a good is unit-elastic, an increase or a decrease in the good’s price does not change total revenue. Here, the quantity effect and the price effect exactly offset each other. 3. Total revenue is illustrated as an area below a demand curve: price × quantity sold. C. Elasticity changes as you move along a linear demand curve. 1. At the top of a linear demand curve, the price elasticity of demand is elastic between two price points. As you move to the bottom of a linear demand curve, the price elasticity of demand is more inelastic. 2. At higher prices, consumers are more sensitive to a price change because the purchase represents a larger share of the budget. At lower prices, the purchase is a smaller share of the budget, and consumers are not as responsive to a price change. D. What factors determine the price elasticity of demand? 1. The availability of close substitutes a. The price elasticity of demand will tend to be high if there are close substitutes. b. The price elasticity of demand will tend to be low if there are no close substitutes. 2. Whether the good is a necessity or a luxury a. The price elasticity of demand tends to be low if the good is a necessity. b. The price elasticity of demand tends to be high if the good is a luxury. 3. Share of income spent on the good a. The higher the share of income spent on the good, the more elastic the demand. b. Cheap goods tend to be relatively inelastic in demand. 4. Time a. The long-run price elasticity of demand is often higher than the short-run elasticity. III. Other Demand Elasticities A. The cross-price elasticity of demand 1. The cross-price elasticity of demand between two goods measures the effect of the change in one good’s price on the quantity demanded of the other good. 2. The sign on the cross-price elasticity value is important; it indicates whether the two goods are complements or substitutes. a. When the cross-price elasticity is positive, the two goods are substitutes. b. When cross-price elasticity is negative, the two goods are complements. B. The income elasticity of demand 1. The income elasticity of demand measures the responsiveness of quantity demanded to changes in income. a. Normal goods have a positive income elasticity (e.g., cars, new homes). b. Inferior goods have negative income elasticity (e.g., macaroni and cheese). IV. The Price Elasticity of Supply A. The price elasticity of supply is a measure of the responsiveness of the quantity supplied of a good to changes in the price of that good. B. There is perfectly inelastic supply when the price elasticity of supply is zero, so that changes in the price of the good have no effect on the quantity supplied. A perfectly inelastic supply curve is a vertical line. C. There is perfectly elastic supply when even a tiny increase or reduction in the price will lead to very large changes in the quantity supplied, so that the price elasticity of supply is infinite. A perfectly elastic supply curve is a horizontal line. D. What factors determine the price elasticity of supply? 1. The availability of inputs: When inputs are readily available, the price elasticity of supply will tend to be large; when the inputs are difficult to obtain, the price elasticity of supply will tend to be small. 2. Time: The price elasticity of supply tends to be larger the longer the period that producers have to respond to a price change. Long-run price elasticity of supply is often greater than short-run elasticity. Case Studies in the Text Economics in Action Estimating Elasticities—This EIA explains how elasticities of demand are estimated using real-world data. Ask students the following question: 1. Why is it so difficult to estimate the price elasticity of demand? (Other factors affect the quantity demanded at any price, such as changes in income, population, and tastes. Economists have to use statistical devices to isolate just the response to a change in price.) Responding to Your Tuition Bill—This EIA uses elasticity of demand to explain how enrollment responds to tuition changes. Ask students the following questions: 1. According to one study, a 10% increase in tuition at a four-year university would decrease enrollment by how much? (Price elasticity of demand was estimated to be 0.67, so a 10% increase in tuition would decrease enrollment by 6.7%. X/10 = 0.67 so X = 6.7.) 2. Why is demand for two-year colleges more elastic than demand for four-year colleges? (More students at two-year colleges pay their own way, plus they are more likely to go to college when the unemployment rate rises and they cannot find a job.) Spending It—This EIA presents the income elasticity of demand for food eaten at home versus food eaten away from home. It also considers rental housing as an inferior good. Ask students the following questions: 1. What do studies indicate about the income elasticity for “meals eaten at home”? (It is considerably less than 1. As a family’s income rises, the share of its income spent on meals at home falls. 2. What do the studies tell us about income elasticity of “meals eaten away from home”? (Income elasticity is closer to 1. This means that wealthier families eat away from home more often, and at fancier places.) China and the Global Commodities Glut of 2016—This EIA explores the commodities glut that occurred in 2016 when Chinese economy faltered. Ask students the following question: 1. What events conspired to create the global glut of commodities? (In response to increased demand for commodities and increased income, many producers increased output of these commodities through increased investment. Because so much investment had occurred, these producers were reluctant to reduce production when the markets began to fail, exasperating the problems.) For Inquiring Minds Will China Save the U.S. Farming Sector—This FIM shows how elasticities can be used to explain why so few people live and work on farms in the United States today. Global Comparison Foods Bite in the World Budget—This Global Comparison presents the income elasticity of demand for four different countries. Business Case The Airline Industry: Fly Less, Charge More—This business case explains how the airline industry was able to go from a huge loss in 2008 to a huge profit in 2014 by using the concept of elasticity. Web Resources The following website provides data related to elasticities. http://www.ers.usda.gov/data-products/commodity-and-food-elasticities.aspx Handout 6-1 Date_________ Name____________________________ Class________ Professor________________ Calculate the elasticity for the demand schedule below. State whether the measure is elastic, unit elastic, or inelastic? Price Quantity Elasticity Elastic, Unit Elastic, or Inelastic? $22 200 $20 300 $18 400 $16 500 $14 600 $12 700 $10 800 Do you expect this demand curve to be fairly steep or fairly flat? Answers: Price Quantity Elasticity Elastic, Unit Elastic, or Inelastic? $22 200 4.2 Elastic $20 300 2.71 Elastic $18 400 1.89 Elastic $16 500 1.36 Elastic $14 600 1.08 Elastic $12 700 0.73 Inelastic $10 800 Because most of the price changes are in the elastic portion of the demand curve, I would expect the demand curve to be fairly flat. Handout 6-2 Date_________ Name____________________________ Class________ Professor________________ Ranking Goods by Their Price Elasticity (5–10 minutes) Rank the following six goods from 1 to 6 in order of most elastic (1) to least elastic (6): ______Salt ______Audi A4 car ______A doctor’s visit ______T-bone steaks ______A luxury room at the Crowne Plaza hotel ______Electricity Why did you rank number 6 as least elastic? Why did you rank number 1 as most elastic? Answers: 4 Salt 1 Audi A4 car 5 A doctor’s visit 3 T-bone steaks 2 A luxury room at the Crowne Plaza hotel 6 Electricity Why did you rank number 6 as least elastic? Electricity is more of a necessity than other products and has no substitutes. Why did you rank number 1 as most elastic? An Audi vehicle has lots of substitutes and is not a necessity. Handout 6-3 Date_________ Name _________________________ Class ________ Professor____________ Why Do Business Travelers Pay More? Calculate the price elasticity of demand of airline tickets for vacation travelers using the midpoint formula. Then, calculate the price elasticity of demand of airline tickets for business travelers. Vacation travelers Business travelers P1 = $200 P1 = $200 P2 = $220 P2 = $220 Q1 = 10,000 tickets Q1 = 10,000 tickets Q2 = 8,000 tickets Q2 = 9,500 tickets Elasticity of vacation travelers: Elasticity of business travelers: Why does the elasticity of demand differ for these types of travelers? How does the total revenue change for each group of travelers when the price increases from $200 to $220? Calculate the price effect and the quantity effect of the price change, and then use that information to determine if demand is elastic or inelastic. Answers: Calculate the price elasticity of demand of airline tickets for vacation travelers using the midpoint formula. Then, calculate the price elasticity of demand of airline tickets for business travelers. Why does the elasticity of demand differ for these types of travelers? The elasticity is different because vacation travelers can change the dates of travel to take advantage of cheaper tickets, whereas business travelers must travel on specific dates to do business. Further, business travelers expense the cost of the tickets (i.e., they don’t pay for them), so they are less price sensitive. How does the total revenue change for each group of travelers when the price increases from $200 to $220? Calculate the price effect and the quantity effect of the price change, and then use that information to determine if demand is elastic or inelastic. For vacation travelers: • Total revenue before the price change is $200 × 10,000 tickets = $2 million • Total revenue after the price change is $220 × 8,000 tickets = $1.76 million • Price effect is $20 × 8,000 tickets = $160,000 • Quantity effect is $200 × (–2,000 tickets) = –$400,000 • The quantity effect dominates the price effect. Total revenues will fall after a price increase, so demand is price elastic. For business travelers: • Total revenue before the price change is: $200 × 10,000 tickets = $2 million • Total revenue after the price change is $220 × 9,500 tickets = $2.09 million • Price effect is $20 × 9,500 tickets = $190,000 • Quantity effect is $200 × (–500 tickets) = –$100,000 • The price effect dominates the quantity effect. Total revenues will rise after a price increase, so demand is price inelastic. Handout 6-4 Date_________ Name____________________________ Class________ Professor________________ Complements and Substitutes Make a list of goods you think are complements and goods you think are substitutes. Substitutes Complements Does the same firm ever sell two complementary goods? How can information about cross-price elasticity help the firm make better decisions? How does knowing your firm sells a good that has a close substitute affect the decisions you make as a firm? Ranking Income Elasticity Do the following goods have high or low income elasticities? Why? Bus trips Gum New home New car Used car Restaurant meals Powdered milk A can of Pepsi What’s a Baseball Card Worth? Inform students that there is only one “mint condition” Honus Wagner (he was a shortstop for the Pittsburgh Pirates in the early 1900s) baseball card in existence. What would the supply curve for this baseball card look like? Answers: Complements and Substitutes Make a list of goods you think are complements and goods you think are substitutes. Substitutes Complements Does the same firm ever sell two complementary goods? How can information about cross-price elasticity help the firm make better decisions? How does knowing your firm sells a good that has a close substitute affect the decisions you make as a firm? Yes, firms often sell complementary goods. Cross-price elasticities help them know how to appropriately price the goods. Knowing my firm also sells a substitute makes me price strategically to maximize firm revenue, not just product revenue. Ranking Income Elasticity Do the following goods have high or low income elasticities? Why? Bus trips negative income elasticity as bus trips are an inferior good Gum low income elasticity as gum is small part of income and not likely to need to buy more New home high income elasticity… get a raise, buy a new home New car high income elasticity… get a raise, buy a new car Used car low or negative income elasticity, inferior good Restaurant meals high income elasticity, not a necessity Powdered milk negative income elasticity, inferior good A can of Pepsi lower income elasticity, small portion of income What’s a Baseball Card Worth? Inform students that there is only one “mint condition” Honus Wagner (he was a shortstop for the Pittsburgh Pirates in the early 1900s) baseball card in existence. What would the supply curve for this baseball card look like? Supply would be perfectly inelastic at 1 unit. Instructor Manual for Microeconomics Paul Krugman, Robin Wells 9781319098780
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