Lecture Note 3 - Chapter 5

Introduction

• Chapter 5 discusses Elasticity and Its Application from Mankiw’s Principles of Macroeconomics, Tenth Edition.

• Interactive PowerPoint slides presented by V. Andreea Chiritescu, Eastern Illinois University.

The Scenario of Maintaining Social Media Accounts

• As a social media manager, you charge P = $2,000 for 12 businesses, indicating Q = 12.

• Considering a price increase to P = $2,500 due to rising costs.

• Law of Demand indicates that a price raise typically results in a decrease in maintained accounts.

Key Questions

• How many fewer accounts will be maintained?

• Will your revenue increase or decrease due to the price change?

Understanding Elasticity of Demand

• Elasticity: A measure of buyers' and sellers' responsiveness to changes in market conditions.

• Price Elasticity of Demand: Reflects how the quantity demanded changes in response to price changes, indicating price sensitivity.

Price Elasticity of Demand

• Price elasticity is calculated based on the change in quantity (Q) and price (P) which move in opposite directions along the demand curve, hence the report is typically expressed in absolute value.

• Example: If P rises by 10% and Q falls by 15%.

Example Calculations of Percentage Changes

• From B to A:

  • % change in P = -20%, % change in Q = 50%; Price elasticity of demand = 2.5.

• From A to B:

  • % change in P = 25%, % change in Q = -33%; Price elasticity of demand = 1.33.

• Results vary based on direction of change.

Midpoint Method

• Midpoint method: Used for calculating percentage changes considering the average of start and end quantities.

• Formula: percentage change = (end value - start value) / midpoint.

Calculating Percentage Changes in Given Scenario

• If P increases from $2,000 to $2,500:

  • % change in P = (2,500 - 2,000) / 2,250 × 100 = 22.2%.

  • Price elasticity of demand calculated as 1.8.

Determinants of Price Elasticity of Demand

• Example 1: Cheerios vs. Airfare. Cheerios have close substitutes making them more elastic compared to airfare.

• Example 2: Mountain Dew vs. Soda. Mountain Dew, being more narrowly defined has more substitutes.

• Example 3: Insulin vs. Rolex watches. Insulin’s necessity leads to inelastic demand, while Rolex is elastic.

• Example 4: Gasoline Demand in Short Run vs. Long Run; demand is less elastic in the short run compared to the long run.

Types of Demand Elasticity

• Elastic Demand: Price elasticity > 1.

• Inelastic Demand: Price elasticity < 1.

• Unit Elastic Demand: Price elasticity = 1.

• Perfectly Inelastic Demand: Price elasticity = 0; vertical demand curve.

• Perfectly Elastic Demand: Price elasticity = infinity; horizontal demand curve.

Total Revenue and Price Elasticity

• For a price increase if demand is:

  • Elastic: TR decreases (fall in quantity > rise in price).

  • Inelastic: TR increases (fall in quantity < rise in price).

• Practical application in maintaining social media accounts illustrates these principles.

Drug Interdiction Policy Analysis

• Policy 1 - Drug Interdiction: Higher prices and less quantity lead to higher total revenue and potentially increased drug-related crimes due to inelastic demand for drugs.

• Policy 2 - Drug Education: Shift left in the demand curve could lead to lower prices and lesser drug-related crime.

Income Elasticity of Demand

• Definition: Responds to changes in consumer income; normal goods (elasticity > 0) vs. inferior goods (elasticity < 0).

Cross-Price Elasticity of Demand

• Responds to changes in the price of another good: substitutes (cross-price elasticity > 0) and complements (cross-price elasticity < 0).

Price Elasticity of Supply

• Definition: Measures how quantity supplied responds to price changes; elastic supply substantially reacts to price changes while inelastic supply reacts minimally.

Calculating Price Elasticity of Supply

• Example of pizza pricing highlights the application of price elasticity calculations for practical scenarios.

Conclusion

• Understanding these principles and calculations is crucial for making informed business decisions, particularly regarding pricing strategies and analyzing demand and supply in various market scenarios.

Introduction

Chapter 5 discusses Elasticity and Its Application from Mankiw’s Principles of Macroeconomics, Tenth Edition. The content is complemented by Interactive PowerPoint slides presented by V. Andreea Chiritescu from Eastern Illinois University, which help visualize and reinforce the concepts discussed.

The Scenario of Maintaining Social Media Accounts

In this scenario, as a social media manager, you charge a price (P) of $2,000 for managing accounts of 12 different businesses, indicating a quantity (Q) of 12 accounts being maintained.

Considering a price increase to P = $2,500 due to rising operational costs and market pressures, it's essential to analyze the effects of this change.

Key Questions

1. How many fewer accounts will be maintained as a result of the price increase?

2. Will your overall revenue increase or decrease due to this change in price?

Understanding Elasticity of Demand

Elasticity is a critical economic concept that measures the responsiveness of buyers and sellers to changes in market conditions. Specifically, price elasticity of demand reflects how the quantity demanded by consumers changes in response to changes in price, indicating the level of price sensitivity among consumers.

Price Elasticity of Demand

Price elasticity is calculated based on the percentage change in quantity (Q) and price (P), which typically move in opposite directions along the demand curve. The report of elasticity is generally expressed in absolute value to facilitate understanding.

Example:

• If the price (P) rises by 10% and quantity (Q) falls by 15%, the calculation can provide insights into consumer behavior regarding demand.

Example Calculations of Percentage Changes

Understanding percentage changes is vital for grasping elasticity:

• From B to A:

  • % change in P = -20%,

  • % change in Q = 50%;

  • Therefore, Price Elasticity of Demand = 2.5.

• From A to B:

  • % change in P = 25%,

  • % change in Q = -33%;

  • Thus, Price Elasticity of Demand = 1.33.

The results vary based on the direction of the change, emphasizing the importance of context when analyzing price elasticity.

Midpoint Method

The midpoint method is a valuable tool for calculating percentage changes, as it considers the average of start and end quantities. It helps reduce biases that can occur depending on the direction of price change:

• Formula: percentage change = (end value - start value) / midpoint.

Calculating Percentage Changes in Given Scenario

If the price (P) increases from $2,000 to $2,500:

• % change in P = ((2,500 - 2,000) / 2,250) × 100 = 22.2%.

• Therefore, Price elasticity of demand calculated in this scenario is 1.8, indicating a relatively inelastic demand since it's less than 2.

Determinants of Price Elasticity of Demand

The determinants influencing price elasticity include:

• Example 1: Cheerios vs. Airfare. Cheerios are perceived to have close substitutes, leading to more elastic demand compared to airfare, which is less substitutable.

• Example 2: Mountain Dew vs. Soda. Mountain Dew, as a more narrowly defined product, has more available substitutes when compared to broader categories like soda.

• Example 3: Insulin vs. Rolex watches. Insulin has a necessity-based, inelastic demand; consumers will buy it regardless of price increases, while luxury items like Rolex watches exhibit elastic demand.

• Example 4: Gasoline Demand in Short Run vs. Long Run. Demand for gasoline is less elastic in the short run when consumers cannot easily change their consumption habits but can be more elastic in the long run when alternatives like public transport become available.

Types of Demand Elasticity

• Elastic Demand: Price elasticity > 1. Demand changes significantly with price changes.

• Inelastic Demand: Price elasticity < 1. Demand changes very little with price changes.

• Unit Elastic Demand: Price elasticity = 1. Proportional changes in price and demand.

• Perfectly Inelastic Demand: Price elasticity = 0; represented by a vertical demand curve, indicating that quantity demanded does not change regardless of price changes.

• Perfectly Elastic Demand: Price elasticity = infinity; represented by a horizontal demand curve, indicating that any price increase would cause demand to drop to zero.

Total Revenue and Price Elasticity

Understanding the relationship between total revenue (TR) and price elasticity is essential for businesses:

• When demand is elastic, an increase in price results in TR decreasing (falling quantity outweighs rise in price).

• In contrast, with inelastic demand, an increase in price leads to an increase in TR (fall in quantity does not offset the rise in price).

In the context of maintaining social media accounts, these principles can practically illustrate how firms should adjust pricing strategies based on demand elasticity.

Drug Interdiction Policy Analysis

This section analyzes two contrasting policies:

• Policy 1: Drug Interdiction - Higher prices and less quantity can lead to increased total revenue, but also potentially result in higher drug-related crimes due to the inelastic nature of demand for drugs.

• Policy 2: Drug Education - A shift left in the demand curve may lead to lower prices and consequently a reduction in drug-related crime, as consumers become more educated and potentially reduce demand.

Income Elasticity of Demand

Income elasticity measures how demand for goods responds to changes in consumer income. Key distinctions include:

• Normal goods: have an elasticity > 0, indicating that as income increases, demand increases.

• Inferior goods: have an elasticity < 0, implying that as income rises, demand falls as consumers can afford better options.

Cross-Price Elasticity of Demand

This elasticity measures how the demand for one good reacts to the price change of another good:

• Substitutes: Cross-price elasticity > 0 means that the products are substitutes; a rise in the price of one leads to an increase in demand for the other.

• Complements: Cross-price elasticity < 0 indicates that the goods are complements; an increase in the price of one will decrease the demand for the other.

Price Elasticity of Supply

Price elasticity of supply measures how the quantity supplied adjusts to price changes. Elastic supply reacts substantially to price changes, while inelastic supply has a minimal reaction.

Calculating Price Elasticity of Supply

An example of pizza pricing can illustrate the application of price elasticity calculations to real-world scenarios, showing how changes in market prices can affect the quantity producers are willing to supply.

Conclusion

Understanding these principles and calculations is crucial for making informed business decisions. Businesses need to consider price elasticity when determining pricing strategies and analyzing demand and supply across different market scenarios, as the response to pricing changes can significantly impact revenue and profitability.