topic 3

Chapter 4: Elasticity - The Responsiveness of Demand and Supply

4.1 Learning Objectives

• Define and calculate the price elasticity of demand.

• Explain the determinants of price elasticity of demand.

• Discuss the relationship between price elasticity of demand and total revenue.

4.2 Price Elasticity of Demand

• Definition of Elasticity:

  • Measures how one economic variable responds to changes in another (e.g., quantity demanded responds to price changes).

• Calculation of Price Elasticity of Demand (PED):

  • PED = (% Change in Quantity Demanded) / (% Change in Price).

  • Indicates responsiveness of the quantity demanded to price changes.

4.3 Types of Price Elasticity of Demand

• Elastic Demand:

  • PED > 1 (quantity demanded changes more than price).

  • Example: Demand changes by 20% when the price changes by 10%.

• Inelastic Demand:

  • PED < 1 (quantity demanded changes less than price).

  • Example: Demand changes by 10% when the price changes by 20%.

• Unit Elastic Demand:

  • PED = 1 (quantity demanded changes equal to price change).

  • Example: Price changes by 10% and demand also changes by 10%.

• Perfectly Inelastic Demand:

  • PED = 0 (no change in quantity demanded with price changes).

• Perfectly Elastic Demand:

  • PED = ∞ (any price change results in infinite change in quantity demanded).

4.4 Computing Price Elasticity of Demand

• General Calculation Method:

  • Use midpoint formula to avoid different elasticity values between points on a demand curve:PED = (Q2 - Q1) / [(Q2 + Q1) / 2] ÷ (P2 - P1) / [(P2 + P1) / 2]

• Example Calculation:

  • From $30 to $20 (33% decrease) results in a 25% increase in quantity, yielding PED of -0.8.

  • From $20 to $30 (50% increase) results in a 20% decrease in quantity, giving PED of -0.4.

4.5 Determinants of Price Elasticity of Demand

• Availability of Close Substitutes:

  • Elastic demand if substitutes are easy to find (e.g., apples).

  • Inelastic demand if substitutes are hard to find (e.g., cigarettes).

• Luxuries vs. Necessities:

  • Elastic demand for luxuries (e.g., sports cars).

  • Inelastic demand for necessities (e.g., food, water).

• Definition of Market:

  • Narrowly defined goods tend to have more elastic demand (e.g., Coca Cola).

  • Broadly defined goods tend to have inelastic demand (e.g., all soft drinks).

• Proportion of Income Spent:

  • Greater proportion leads to more elastic demand (e.g., houses).

  • Smaller proportion leads to more inelastic demand (e.g., pens).

• Time Elapsed Since Price Change:

  • Longer time allows consumers to find alternatives, making demand more elastic.

  • Shorter time leads to inelastic demand.

4.6 Relationship Between Price Elasticity and Total Revenue

• Total Revenue Definition:

  • Total revenue = Price × Quantity Demanded.

• Total Revenue Test for Price Elasticity:

  • If demand is elastic:

    • Price increase decreases total revenue, and price decrease increases total revenue.

  • If demand is inelastic:

    • Price increase increases total revenue, and price decrease decreases total revenue.

  • If demand is unit-elastic:

    • Price changes do not affect total revenue.

4.7 Summary of Elasticity and Revenue Effects

• Elastic Demand: An increase in price causes a decrease in total revenue.

• Inelastic Demand: An increase in price causes an increase in total revenue.

• Unit Elastic Demand: Price changes do not affect revenue.

4.8 Check Your Knowledge Questions

1. An increase of 10% in price results in a 4% decrease in quantity sold (tortilla chips). This is an indication of:

   • A) Inelastic

   • B) Elastic

   • C) Unit-elastic

   • D) Perfectly inelastic

2. Why is the demand for table salt inelastic?

   • A) Luxury good.

   • B) Small proportion of income spent.

   • C) Rare commodity.

   • D) Luxury for high-income; necessity for low-income.

3. If a school increases tuition believing it will increase revenue, they assume demand for attendance is:

   • A) Inelastic

   • B) Elastic

   • C) Unit-elastic

   • D) Perfectly elastic.

Question 1:

An increase of 10% in price results in a 4% decrease in quantity sold. This is an indication of:

Answer: (A) Inelastic

• Price elasticity of demand (PED) = % change in quantity demanded / % change in price

• PED = (-4%) / (10%) = -0.4

• Since the absolute value of PED is less than 1 (| -0.4 | < 1), demand is inelastic.

Question 2:

Why is the demand for table salt inelastic?

Answer: (B) Small proportion of income spent.

• Table salt is cheap, and people spend a very small portion of their income on it.

• Even if the price increases, people won’t significantly reduce their consumption.

Question 3:

If a school increases tuition believing it will increase revenue, they assume demand for attendance is:

Answer: (A) Inelastic

• If demand is inelastic, an increase in price (tuition) leads to a smaller percentage decrease in quantity demanded (student enrollment).

• As a result, total revenue increases.

Part - 3B

Chapter Overview

• Authors: R. Glenn Hubbard, Anne M. Garnett, Philip Lewis, Anthony O'Brien

• Focus: Incidence of Tax in Economics

• Publisher: Pearson, Essentials of Economics, 4th Edition

Learning Objectives

• Understand the economic impact of taxes on markets and consumers.

Core Concepts

Marginal Benefit (MB)

• Definition: The additional benefit from consuming one more unit of a good or service.

• Relation to Demand Curve: The marginal benefit curve corresponds to the demand curve.

• Consumer Surplus:

  • Definition: The difference between the highest price a consumer is willing to pay and the actual price paid.

  • Measures net benefits to consumers in a market.

Example of Demand and Marginal Benefit

• Scenario: Jeff's consumption of tea.

  • 4th cup: Marginal benefit = $3.00

  • 5th cup: Marginal benefit = $2.00

• Concept: The demand curve is equivalent to the marginal benefit curve.

Producer Surplus and Marginal Cost (MC)

• Definition: The additional cost to produce one more unit of a good or service, represented by the supply curve.

• Producer Surplus:

  • Definition: The difference between the price producers are willing to accept versus the price they actually receive.

  • Measures the net benefit to producers.

Supply Example

• Marginal costs for producing specific quantities of goods, example for chai tea:

  • 40th cup: $1.80

  • 50th cup: $2.00

Economic Surplus

• Defined as the sum of consumer surplus and producer surplus.

• Efficient markets maximize economic surplus when marginal cost (MC) equals marginal benefit (MB).

• Implication: Lack of deadweight loss, maintaining an efficient quantity in the market.

Impact of Taxes on Economic Efficiency

Key Effects of Taxes

• Taxes finance government activities but also lead to:

  • Reduced consumer surplus.

  • Reduced producer surplus.

  • Creation of deadweight loss.

  • A reduction in the production of goods/services.

Graphical Representation

• Sales taxes shift the supply curve upwards, leading to decreased production and economic surplus.

  • Illustrates how taxes impact efficiency and market equilibrium.

Tax Incidence

• Definition: The distribution of the burden of a tax between buyers and sellers.

Factors Affecting Tax Incidence

• Demand Curve Slope: Affects consumer burden.

• Supply Curve Slope: Affects producer burden.

• Elasticities of Demand and Supply: The more elastic the demand, the greater the burden on producers.

Consumer vs Producer Burden

• Consumer burden: Additional amount paid due to the tax.

• Producer burden: Difference between pre-tax and post-tax revenue.

Real-World Example: Cigarette Tax

• Analysis of a $1.00 tax on cigarette packs demonstrating:

  • Change in price consumers pay.

  • Price producers receive after tax.

  • Deadweight loss from taxation illustrated in the graph.

Summary of Tax Incidence

• Elastic Demand:

  • Consumers' burden < Producers' burden.

  • Smaller Qd decrease, lower DWL.

• Inelastic Demand:

  • Consumers' burden > Producers' burden.

  • Larger Qd decrease, higher tax revenue, larger DWL