114. ch 4.3 price elasticity of demand - edl elasticity of demand measures how much qd will change...

Price Elasticity

California Proposition 56 increased the tobacco tax by $2.00, bringing the total tax up to $2.87 per pack of cigarettes. The average cost of a pack in 2016 was about $5.50. Prop 56 would raise prices by 36%.

The federal government also levies a tobacco tax at $1.01 per pack of cigarettes (since 2009) that is included in the average price.

Will this new tax increase change the quantity demanded for cigarettes by a lot, a little or not at all.

http://www.cbpp.org/research/higher-tobacco-taxes-can-

improve-health-and-raise-revenue

The Congressional Budget Office (CBO) summarizes the existing research and concludes that a 10 percent increase in cigarette prices will lead people under age 18 to reduce their smoking by 5-15 percent. Among adults over 18, CBO concludes, the decline would be 3-7 percent (see Figure 1). Taking the mid-point of the estimate for youth suggests that each 1 percent price increase leads to roughly a 1 percent decrease in youth tobacco consumption. (Approximately half of the decline in smoking is due to fewer smokers (people either quitting or not starting to smoke), while the other half is due to fewer cigarettes consumed by people who smoke.)

https://www.cdc.gov/tobacco/data_statis

tics/fact_sheets/adult_data/cig_smoking/

https://www.washingtonpost.com/news/t

o-your-health/wp/2015/08/27/why-a-bag-of-heroin-costs-less-than-a-pack-of-

cigarettes-2/?utm_term=.3fa8b23cb9e8

2015

Competition + Free Trade =

Price Elasticity of Demand

▪ The law of demand tells us that as the price of a good increases the quantity that will be bought decreases but it does not tell us by how much.

▪ Price elasticity of demand measures how much QD will change by when the price changes.

Uses

• Used by firms to help determine prices and total revenue

• Used by the government to decide how to tax

Price Elasticity of Demand measures how much QD will change by when the price changes.

Inelastic

buyers are not very responsive to changes in price

Elastic

buyers are very responsive to changes in price

Unit Elastic

the QD changes according to the same percentage as the change in price.

pec ha n ge in qu a ntity d em a nd ed

ch an g e in price≡

%

%

% ∆ QD = Q2 - Q1/ Q1

% ∆ P = P2 - P1/ P1

Use absolute value ( drop negatives)


Inelastic - buyers are not very responsive to changes in price.

▪ |%∆Q| < |%∆P| � ||||ep| | | | < 1

3-4/4 = 0.25

6-3/3 = 1

Effect on Total Revenue? TR = P x Q

At $3, TR = 3 x 4 = 12

At $6, TR = 6 x 3 = 18P and TR move in the same direction.

P and TR or P and TR

The price increase from $3 to $6

ep = = 0.25

Price QD

$3 4

$6 3

For every 1% change in price, QD will change by 0.25%


Elastic - buyers are very responsive to changes in price

▪ |%∆Q| > |%∆P| � ||||ep| | | | > 1

2-4/4 = 0.5

5-4/4 = 0.25

At $4, TR = 4 x 4 = $16

At $5, TR = 5 x 2 = $10P and TR move in the opposite direction

P and TR or P and TR


ep = = 2For every 1% change in price, QD will change by 2%


Unit Elastic - the quantity demanded changes according to the same percentage as the change in price.

▪ |%∆Q| = |%∆P| � ||||ep| | | | = 1

4-6/6 = 0.33

4-6/6 = 0.33

At $4, TR = 4 x 6 =$24

At $6, TR = 6 x 4 = $24TR is unchanged


ep = = 1For every 1% change in price, QD will change by 1%

Calculating Price Elasticity of Demand

Ex. When price of a car wash increases from $10 to $11, the number of

customers drop from 60 to 48.

Step 1: compute the % changes for quantity demanded & price

Step 2: plug in those % in the formula for elasticity

% change = 60-48 =

60$10-$11 =

$10

2010

elasticity = 20 =

102

x100 x100

Use absolute value so drop negatives

Practice Problem:

A dentist with 80 patients cuts his fees for a cleaning from $60 to $54. He attracts 2 new clients.

Calculate the elasticity.

80 – 82 = 2.5 & $60-$54 = 10

80 $60

Elasticity = 2.5 = .25

10

x100 x100

Is the range between A and B, elastic, inelastic, or unit elastic?

A

B

10 x 100 =$1000 Total Revenue

5 x 225 =$1125 Total Revenue

Price decreased and TR

increased, so…

Demand is ELASTIC

125%

50%

Perfectly Inelastic and Elastic

Perfectly Elastic – any price increase will cause the quantity demanded to drop to zero.

Perfectly Inelastic - QD does not respond to a price change.

In the case where a good has many different sellers and the

product (e.g. dollars) is identical. , if a firm decides to raise the price above the market price, it will lose all its

customers to other firms selling the same product.

%QD = 5/25 = 0.2 %P = 1/10 = 0.1

E = 0.2/0.1 = 2

Determinants of Price Elasticity

�Availability of substitutes – the greater availability of substitutes , the higher the elasticity

�Type of good - the broader the definition of a good, the lower the elasticity (apple vs. fruit) since there are fewer substitutes.

�Degree of necessity - The greater the necessity for a good, the lower the elasticity

�Proportion of the purchaser's budget consumed by the item

the more expensive the good is in proportion to income, the higher the elasticity since consumers will be less able at higher

prices. � Duration of price change - elasticity increases over time as

consumers are more able to adjust their consumption and find

substitutes� Brand loyalty -an attachment to a certain brand can override

sensitivity to price changes, resulting in more inelastic demand.

Perfectly inelastic demand

|ep| = 0

Perfectly elastic demand

||||ep| | | | = ∞

Assume that the prices of following goods have increased by 20%

▪ Cigarettes

▪ Salt

▪ Movies at the theater

▪ Coffee

▪ Gasoline (to be used

this weekend)

▪ Gasoline (continual 20%

increase for the next 5 years)

▪ Toothpicks

▪ Chevrolet car

▪ Automobiles

▪ Medical services

▪ Matches

▪ Lunch at Fiore Cafe

http://www.mackinac.org/article.aspx?ID=1247

Perfectly elastic demand

Perfectly inelastic demand

SaltMatches

Toothpicks0.1

movies0.9

Chevrolet4

Autos1.2-1.5

Restaurant meals

2.3

Physician Services

0.6

Coffee0.25

Gas – SR0.2

Gas – LR0.7

Tobacco – SR0.45

114. ch 4.3 price elasticity of demand - edl elasticity of demand measures how much qd will change...

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