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Economics

[[Economics|Economics Lectures]]

Outline of Lecture:

Third Lecture – Elasticity

 

<br>III. Income Elasticity

I. Introduction

==Introduction==

In a free market, and after enough time passes and information is exchanged to reach equilibrium, supply equals demand for both price and quantity sold.  That is one of the beauties of free enterprise.  It is efficient, productive and generates little economic waste.  If every good and service stayed at equilibrium, then we could end the course right now.

In a free market, and after enough time passes and information is exchanged to reach equilibrium, supply equals demand for both price and quantity sold.  That is one of the beauties of free enterprise.  It is efficient, productive and generates little economic waste.  If every good and service stayed at equilibrium, then we could end the course right now.

You then ask, “how much fewer sales?”  If sales decline by a smaller percentage than the price increased, then overall revenue (Price times quantity sold) will increase.  If, however, sales decline by a larger percentage than the price increased, then overall revenue will decline.

You then ask, “how much fewer sales?”  If sales decline by a smaller percentage than the price increased, then overall revenue (Price times quantity sold) will increase.  If, however, sales decline by a larger percentage than the price increased, then overall revenue will decline.

II. Price Elasticity of Demand

==Price Elasticity of Demand==

The “price elasticity” of demand is the percentage change in quantity demanded divided by the percentage change in price.  It is usually negative but the sign is dropped so that price elasticity is always a positive number.

The “price elasticity” of demand is the percentage change in quantity demanded divided by the percentage change in price.  It is usually negative but the sign is dropped so that price elasticity is always a positive number.

Let’s take another example.  Suppose that airlines increase the price on their flights from New York to Florida from an average of $300 per seat to $500 per seat.  That is a 67% increase.  What would that do to the tourist traffic to Florida from New York?  It only takes a day and a half to drive to Florida, which incurs gas charges of less than $100 and a hotel charge of perhaps $80.  Tourists would likely drive rather than pay the higher fares.  The demand for these higher-priced tickets could fall by 75%, assuming that business travel is only a small percentage of that traffic.

Let’s take another example.  Suppose that airlines increase the price on their flights from New York to Florida from an average of $300 per seat to $500 per seat.  That is a 67% increase.  What would that do to the tourist traffic to Florida from New York?  It only takes a day and a half to drive to Florida, which incurs gas charges of less than $100 and a hotel charge of perhaps $80.  Tourists would likely drive rather than pay the higher fares.  The demand for these higher-priced tickets could fall by 75%, assuming that business travel is only a small percentage of that traffic.

What is the price elasticity of this demand?  The percent change in quantity demanded is -75% (3/4) and the percent change in price is 67% (2/3), so the elasticity is -3/4 divided by 2/3 = -9/8.  The sign is dropped so the elasticity is expressed as 9/8.  It is greater than 1, and thus is described as having an “elastic demand” rather than an “inelastic demand,” which is less than 1.  (If it equaled 1, then it would be called “unit elasticity of demand.”)

What is the price elasticity of this demand?  The percent change in quantity demanded is -75% (3/4) and the percent change in price is 67% (2/3), so the elasticity is -3/4 divided by 2/3 = -9/8.  The sign is dropped so the elasticity is expressed as 9/8.  It is greater than 1, and thus is described as having an “elastic demand” rather than an “inelastic demand,” which is less than 1.  (If it equalled 1, then it would be called “unit elasticity of demand.”)

What does it mean to a company if its goods have “elastic demand”?  It means the company should be cautious in raising prices.  Look at what happens to the revenue to the airlines due to the elastic demand for seats on their planes.  The initial revenue was price times quantity, which is PxQ, or PQ.  The revenue after the pricing change is (5/3)(P)(1/4)(Q) = (5/12)PQ.  Its revenue fell to 5/12 of its initial revenue due to the price increase.  The airlines lost over half of its revenue by increasing its price!  Uh oh, that requires laying off many employees, reporting losses to the investors, and firing the persons responsible for that price increase.

What does it mean to a company if its goods have “elastic demand”?  It means the company should be cautious in raising prices.  Look at what happens to the revenue to the airlines due to the elastic demand for seats on their planes.  The initial revenue was price times quantity, which is PxQ, or PQ.  The revenue after the pricing change is (5/3)(P)(1/4)(Q) = (5/12)PQ.  Its revenue fell to 5/12 of its initial revenue due to the price increase.  The airlines lost over half of its revenue by increasing its price!  Uh oh, that requires laying off many employees, reporting losses to the investors, and firing the persons responsible for that price increase.

In that prior example, however, consider price increases on the same route that are due only to increases in fuel costs.  Will they have the same elasticity?  (No, because the alternative of traveling by car increases in cost by a similar amount.  However, some people will simply stay at home rather than travel.)

In that prior example, however, consider price increases on the same route that are due only to increases in fuel costs.  Will they have the same elasticity?  (No, because the alternative of travelling by car increases in cost by a similar amount.  However, some people will simply stay at home rather than travel.)

Take a straight line demand curve and consider what the shape the total revenue has as a function of price.  It has the shape of a semi-oval opening downward: it starts at zero revenue (when quantity is 0) and ends at zero revenue (when price is 0).

Take a straight line demand curve and consider what the shape the total revenue has as a function of price.  It has the shape of a semi-oval opening downward: it starts at zero revenue (when quantity is 0) and ends at zero revenue (when price is 0).

III. Income Elasticity

==Income Elasticity==

Once you grasp the price elasticity of demand, you’ll see that you can describe the elasticity (or responsiveness) of many other variables in economics.

Once you grasp the price elasticity of demand, you’ll see that you can describe the elasticity (or responsiveness) of many other variables in economics.

A [[necessity]] is a good that has a positive income elasticity that is less than 1.  A [[luxury]] is a good that has an income elasticity greater than 1.

A [[necessity]] is a good that has a positive income elasticity that is less than 1.  A [[luxury]] is a good that has an income elasticity greater than 1.

IV. Calculating Elasticities

==Calculating Elasticities==

There is an ambiguity in calculating the percentage change in price or quantity.  What should be used as the denominator in deriving the percentages?  If $100 increases to $110, then the percent change could be described as $10/$100 x 100% or $10/$110 x 100%.  Above we used the initial price and quantity as the denominator, but be could have used the final price and quantity as the denominator instead.

There is an ambiguity in calculating the percentage change in price or quantity.  What should be used as the denominator in deriving the percentages?  If $100 increases to $110, then the percent change could be described as $10/$100 x 100% or $10/$110 x 100%.  Above we used the initial price and quantity as the denominator, but be could have used the final price and quantity as the denominator instead.

Economists resolve this by typically using the average overall value as the denominator in calculating the elasticities.  So if the price changes from $20 to $30, the percentage change in price is $10 divided by the average of $20 and $30, which is $25.  The percentage change is thus $10/$25, which is 40%.  This is also known as the “arc elasticity” because it is a more accurate depiction of the “arc” or curve of demand.  Use this method when doing specific calculations on homework.

Economists resolve this by typically using the average overall value as the denominator in calculating the elasticities.  So if the price changes from $20 to $30, the percentage change in price is $10 divided by the average of $20 and $30, which is $25.  The percentage change is thus $10/$25, which is 40%.  This is also known as the “arc elasticity” because it is a more accurate depiction of the “arc” or curve of demand.  Use this method when doing specific calculations on homework.

V. Complements and Substitutes

==Complements and Substitutes==

A complement of a good is something that is used with it.  Compact disks (CDs) are complements of CD players.  Hole punchers are complements to three-ring binders.  Monitors are complements to desktop computers.  Gasoline is a complement to cars.  Bread is a complement to sandwich meat.

A complement of a good is something that is used with it.  Compact disks (CDs) are complements of CD players.  Hole punchers are complements to three-ring binders.  Monitors are complements to desktop computers.  Gasoline is a complement to cars.  Bread is a complement to sandwich meat.

Ponder that for a minute.

Ponder that for a minute.

VI. Addictions

==Addictions==

The colony of Virginia survived and thrived by turning to tobacco and slavery.  Much of the economy, even today, is based on vices.  Sad but true.  The largest building west of the Mississippi, which includes all of California and many other states, is located in Las Vegas, built on gambling.  In fact, Las Vegas has far more hotel space than any other city in the United States, including even New York.

The colony of Virginia survived and thrived by turning to tobacco and slavery.  Much of the economy, even today, is based on vices.  Sad but true.  The largest building west of the Mississippi, which includes all of California and many other states, is located in Las Vegas, built on gambling.  In fact, Las Vegas has far more hotel space than any other city in the United States, including even New York.

What do all these economic activities have in common?  They exploit addictions.  The prices on these goods and services can be increased much more easily than on anything else.  Someone addicted to drugs is still going to try to buy it even if the price increases by 10%, 20%, 50%, or 100%.  The same can be said for gambling, pornography, alcohol and almost every other vice.  They are profitable to sellers who exploit the addiction.  Buyers lose their money and ultimately their lives.

What do all these economic activities have in common?  They exploit addictions.  The prices on these goods and services can be increased much more easily than on anything else.  Someone addicted to drugs is still going to try to buy it even if the price increases by 10%, 20%, 50%, or 100%.  The same can be said for gambling, pornography, alcohol and almost every other vice.  They are profitable to sellers who exploit the addiction.  Buyers lose their money and ultimately their lives.

VII. Assignment

 

Read and, if necessary, reread the above lecture. Complete the homework assignments through the level in which you choose to enrol in this course:

Introductory:  1. In a free market, the responsiveness of demand to a change in price is known as its ____________.

1. In a free market, the responsiveness of demand to a change in price is known as its ____________.

2. A good that is addictive often has (elastic or inelastic) demand for it.  Choose the correct answer.  

2. A good that is addictive often has (elastic or inelastic) demand for it.  Choose the correct answer.  

3. Give examples of a complement and a substitute for breakfast eggs.   

3. Give examples of a complement and a substitute for breakfast eggs.   

Intermediary:

===Intermediary===

 

4. Describe a perfectly elastic demand curve, and a perfectly inelastic one.

4. Describe a perfectly elastic demand curve, and a perfectly inelastic one.

6. Describe what a negative income elasticity of demand means.  Give an example of a good or service that might have a negative income elasticity of demand.

6. Describe what a negative income elasticity of demand means.  Give an example of a good or service that might have a negative income elasticity of demand.

Honors: 

===Honors===

 

7. Suppose the demand for a special type of colored corn is inelastic.  Suppose there was a disease that uniformly killed 20% of all the cornstalks, but did not affect demand at all (i.e., the public was not scared by the disease).  Explain if corn farmers are better or worse off due to the disease, and why.

7. Suppose the demand for a special type of colored corn is inelastic.  Suppose there was a disease that uniformly killed 20% of all the cornstalks, but did not affect demand at all (i.e., the public was not scared by the disease).  Explain if corn farmers are better or worse off due to the disease, and why.

Write an essay of about 200 words total on one or more of the following topics:

Write an essay of about 200 words total on one or more of the following topics:

<br>8.  Should there be a minimum wage law?

 

<br>9.  Does free trade add value or simply redistribute wealth?

8.  Should there be a minimum wage law?

<br>10. Is economics almost always determinative of the outcome on political issues, such as elections?

 

9.  Does free trade add value or simply redistribute wealth?

 

10. Is economics almost always determinative of the outcome on political issues, such as elections?

[[Category:Economics]]

[[Category:Economics]]