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Chapter 4 Elasticity Additional Questions 1-9 End-of Chapter Ex. 4, 8 Elasticity • It represents the ratio of the % change in one variable to the % change in another variable • 1) Price Elasticity of Demand - measures the responsiveness of quantity demanded for good x to a change in price of good x % change in Qx % change in Px • 2) Price Elasticity of Supply - measures the responsiveness of quantity supplied for good x to a change in price of good x % change in Qx % change in Px Elasticity %Q %P Unit elastic Elastic -5 -4 -3 Inelastic -2 -1 -0.5 0 • Elastic : -the % change in quantity demanded is larger than the % change in price - If elasticity is between -1 and infinity • Inelastic: -the % change in quantity demanded is less than the % change in price -If elasticity is between 0 and -1 Elasticity • Unit Elastic, - Elasticity = -1 - the % change in quantity demanded equals to the % change in price P Unit Elastic Q Elasticity • Perfectly Inelastic Demand/Supply • Perfectly Elastic Demand/Supply P P Elasticity = 0 Elasticity = infinitely Q • Ex. Pepsi, coke Q • Ex. Tamiflu, Insulin Elasticity and TE / TR • If demand is elastic, (% change in quantity demanded is larger than the % change in price) • Decrease in price will increase TR • Increase in price will decrease TR If Price decrease: P % change in Q = 3 % change in P = -0.5 Elasticity = -6 (Elastic) TR increases 10 5 D 5 20 Q Elasticity and TE / TR • If demand is inelastic, (% change in quantity demanded is less than the % change in price) • Decrease in price will decrease TR • Increase in price will increase TR P If Price decrease: % change in Q = 0.4 % change in P = -0.5 Elasticity = -0.8 (Inelastic) TR decreases 10 5 D 5 7 Q Elasticity and TE / TR • If Demand is Elastic, (% change in quantity demanded is larger than the % change in price), Q and PQ move in the same direction, similarly to increase in price P Q X = PQ • If Demand in Inelastic, (% change in quantity demanded is less than the % change in price), P and PQ move in the same direction, similarly to increase in price P X Q = PQ Elasticity • 3) Cross-Price Elasticity of Demand - measure the responsiveness of quantity demanded for good y to a change in price of good x % change in Qy % change in Px • Substitute goods: Elasticity is positive (Increase in price of good x will result in an increase in demand of good y) • Complement goods: Elasticity is negative (Increase in price of good x will result in a decrease in demand of good y) Elasticity • 4) Income Elasticity of Demand - measure the responsiveness of quantity demanded for good x to a change in income % change in Qx % change in I • Normal goods: Elasticity is positive (Increase in income will result in an increase in demand of good x) i.e., Mercedes Benz • Inferior goods: Elasticity is negative (Increase in income will result in a decrease in demand of good x) i.e., 2nd hand clothing Chapter 4, Additional Question #1 When the price of hot dog is $1.50 each, 500 hot dogs are sold every day. After lowering the price to $1.35 each, 510 hot dogs are sold every day. At the original price, what is the price elasticity of demand for hot dogs? A) B) C) D) E) 66.67 5 1 0.2 0.015 Calculating Price Elasticity of Demand %Q %P QNew QOld PNew POld QOld POld Q P Q P Q P P Q Price Elasticity of Demand for Hot Dogs QOld 500, QNew 510 POld $1.50, PNew $1.35 Q 510 500 10 P $1.35 $1.50 $0.15 Q POld 10 1.50 P QOld 0.15 500 0.2 (D) Chapter 4, Additional Question #2 For which of the following products is demand likely to be least price elastic? A) B) C) D) E) Frozen Food Soft Drinks Groceries Diet Coke Not enough information provided to answer this question What affects Price Elasticity of Demand? • One major factor is the availability of substitutes. • If there are many substitutes for Good X available in the market, people tend to be very responsive to changes in PX, and hence, higher elasticity. • In this question, we check out which option is the most difficult to be substituted, i.e., necessity good. • (A) Frozen food can easily be replaced by fresh food. • (B) Soft drinks and (D) Diet coke can easily find substitutes, e.g. orange juice, coffee, tea, Zero coke, Diet Pepsi • (C) Groceries are the hardest to be replaced as they are necessities. Ans: C Chapter 4, Additional Question #3 If the price is $2 in both locations, the Price Elasticity of Demand for a candy bar at an airport is likely to be the price elasticity for a candy bar in a grocery store. A) B) C) D) E) Less than Equal to Greater than The reciprocal of Not enough information to determine What affects Price Elasticity of Demand? • Number of sellers within reach. • Suppose there exists only one kind of candy bar. • In busy areas where you can find grocery stores, it is more likely that you can find more than one shop selling candy bars. • However, in isolated areas such as airports, there may only be one seller. • In other words, one will find it difficult to locate an alternative seller of a certain goods (e.g. candy bars) at the airport. • A person will still have to buy candy bars from that seller at the airport even if prices are raised. • Hence, quantity demanded is less responsive to price changes compared to shops at other locations. Ans: a Chapter 4, Additional Question #4 The Price Elasticity of Demand for apartments is 1.3, while the Price Elasticity of Demand for toothpicks is 0.4. The likely reason for the difference is because A) B) C) D) E) There are few substitutes for toothpicks Apartments are chosen over a long period of time The fraction of income spent on toothpicks is minuscule Toothpicks are a necessity Apartments are a luxury • Demand for apartments are more price elastic than that for toothpicks. Why? • (A & D) are not true because there exist good substitutes for toothpicks, e.g. dental floss and fingernails. • (B) is true for many consumers, but is irrelevant, as we are comparing the Price Elasticity at the same point of time. • (E) is relevant only if we are talking about Income Elasticity. What affects Price Elasticity of Demand? • Budget share: the smaller the budget share of your income, the smaller the incentive to look for other substitute goods; thus, smaller the price elasticity of demand. • People tend not to respond to changes in price of toothpicks because they are too cheap. $0.20 a dozen and $0.40 a dozen do not bother consumers as they probably do not even notice the difference. - the share of your budget is very small in buying toothpick. • However, buying an apartment is a major choice in life. People spend most of their savings on acquiring their own homes, and changes in price of properties are certainly noticeable. As a result, consumers are more responsive to changes in prices of apartments. - the share of your budget is very large in buying a house. Ans: C Chapter 4, Additional Question #5 Assume the price of gasoline doubles tonight and remains at that price the next 2 years. The Demand for gasoline measured tomorrow will be _____ when compared with the demand for gasoline measured 2 years from now. A) B) C) D) E) More Elastic Larger in Absolute Value The Same More Inelastic Less Inelastic What affects Price Elasticity of Demand? • Time • It takes time for people to react to changes in price. • People wake up tomorrow and find out price of gasoline is doubled, but they do not have enough time to find substitutes for gasoline, and hence, the amount of usage will be more or less the same. • But, given more time, people can explore other alternatives (e.g. public transport) Ans: D Chapter 4, Additional Question #6 The Cross Price Elasticity for cable TV and satellite TV is estimated to be -0.3. This implies cable and satellite TV are: A) B) C) D) E) Normal Goods Substitutes Elastic Goods Complements Unrelated • Cross Price Elasticity measures the responsiveness of quantity demanded for a good to a change in price of the other good . • For complement goods, if Px↓ , Qx↑, and Qy also ↑ - The Cross Price Elasticity is negative • For substitute goods, if Px↓ , Qx↑, and Qy will ↓ - The Cross Price Elasticity if positive Ans: d Chapter 4, Additional Question #7 In surveying their alumni, State U’s economics department discovered that ramen noodle consumption declined as soon as students graduated and found jobs. One conclusion the survey team might draw from this result is that A) B) C) D) E) There is Excess Demand for ramen noodles. Equilibrium Price for ramen noodles is too high. College graduates have a high reservation price for ramen noodles. Ramen noodles are an inferior good. Ramen noodles are not nutritious. • (A&B) are not the correct answers – No price adjustments were mentioned. • (C) is not relevant at all because we are not calculating consumer surplus. • (E) is not even economics. • The question talks about Income Elasticity of Demand for ramen noodles. - measures the responsiveness of quantity demanded for a good to the change in income. - For normal goods, if Income ↑, Qd ↑ - For inferior goods, if Income ↑, Qd ↓ • Graduates graduating and finding a job implies an increase in real income. • The survey relates real income and quantity demanded for noodles. • Income ↑, causing Qd ↓ --- inferior good Ans: D Chapter 4, Additional Question #8 Period Income Px Qx Py Qy 1 8000 24 8 12 40 2 9000 24 9 12 36 a) Given the above information. Calculate the Income Elasticity of y. Is Good y normal or inferior? •Recall that Income Elasticity refers to the responsiveness of quantity demanded for y to a change in Income. • Mathematically, Income Elasticity of y can be calculated as: %∆Qy / %∆I. • To calculate the Income Elasticity of y, %∆Qy / %∆I = (∆Qy / original Qy) x (original I / ∆I) = (-4 / 40) x (8000 / 1000) = -0.8 a) Is Good y normal or inferior? • Normal goods: Demand for normal goods increases when income increases. - Mathematically, the Income Elasticity of a normal good is positive. (Quantity changes in the same direction as income) • Inferior goods: Demand for inferior goods drops as Income increases. - Mathematically, the Income Elasticity of an inferior good is negative. (Quantity changes in an opposite direction as Income) • Since the Income Elasticity of y is negative, Qy drops as Income increases. • Therefore, Good y is inferior. Period Income Px Qx Py Qy 1 9000 24 9 12 36 2 9000 21 12 12 30 b) Given the above information. Calculate the Cross Price Elasticity of y with respect to a change in Px. Are Good x and y complements or substitutes? • Cross Price Elasticity measures the responsiveness of the quantity demanded for y with respect to a change in Px. • Mathematically, %∆Qy / %∆Px. • Hence, the Cross Price Elasticity of Demand for y is %∆Qy / %∆Px = (∆Qy / original Qv) x (original Px / ∆ Px) = (-6 / 36) x (24 / -3) = 4/3 b) Are Goods x and y complements or substitutes? • For complement goods, if Px↓ , Qx↑, and Qy also ↑ - The Cross Price Elasticity is negative • For substitute goods, if Px↓ , Qx↑, and Qy will ↓ - The Cross Price Elasticity if positive • In this case, the Cross Price Elasticity of y with respect to a change in price of x is positive. • Therefore, Goods x and y are substitutes. Chapter 4, Additional Question #9 If the Price Elasticity of demand for good X is -3, your goal is to maximize the revenue, should you raise or lower the price of good X? • Recall that whether total revenue increases or decreases when the price of the good changes depends on the elasticity of demand. • If demand is elastic, (% change in quantity demanded is larger than the % change in price) • Increase in price will decrease TR • Decrease in price will increase TR P X Q = PQ • You should decrease the price of good X in order to maximize Total Revenue. Chapter 4, Problem #4 Is the demand for a particular brand of car, like a Chevrolet, likely to be more or less price-elastic than the demand for all cars? Explain. • Price elasticity of a good increases, as more close substitutes are readily available. Solution to Problem 4(1) • Demand for all cars (i.e. Motorcycle, bus, van): hard to find other substitutes for cars if price of all cars rises, for ex., it is hard to substitute motorcycle for a car. Highly insensitive to price change. • Demand for specific brand of cars: if price of Chevrolet rises, people will switch to other brand, say, Toyota. Highly sensitive to price change. • Thus, it is easier to substitute Toyota for Chevrolet than it is to substitute a motorcycle for a car. • Therefore, the market demand curve for cars is likely to be less elastic than the market demand curve for Chevrolets. Chapter 4, Problem #8 Suppose that the ingredients required to bring a slice of pizza to market and their respective costs are as listed in the table: Paper plate 2cents Flour 8cents Tomato sauce 20cents Cheese 30cents Labor (3minutes @ $12/hour) 60cents Total cost 120 cents If these proportions remain the same no matter how many slices are made, and the inputs can be purchased in any quantities at the stated prices, draw the supply curve of pizza slices and compute its price elasticity. Solution to Problem 8(1) • The proportions and prices of the ingredients are the same no matter how many slices are made, meaning that, • The price of input cost is fixed at 120 cents or $1.2. • Therefore, the marginal cost of producing an additional unit of pizza is constant at $1.2. Solution to Problem 8(2) P ($/slice) 1.2 S Q (slices per day) •The price elasticity of supply of pizza is infinite ---- Perfectly Elastic Supply Curve. •Highly sensitive to price change - A small change in price, quantity supplied drops to zero •Usually occurs when there is a larger number of perfectly substitute goods •i.e., If the price of an input increases, sellers will switch to another available substitute goods End of Chapter 4