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Elasticity Review for AP Economics (page 2)

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By — McGraw-Hill Professional
Updated on Mar 4, 2011

Special Cases

If it is true that any increase in the price results in no decrease in the quantity demanded, then we are describing the special case where demand for the good is perfectly inelastic: Figure 7.2 shows the demand for a life-saving pharmaceutical, for which there is no substitute, and without which the patient dies. A vertical demand curve (D0) tells us that no matter what percentage increase, or decrease, in price, the quantity demanded remains the same. Mathematically speaking, Ed = 0.

Elasticity

In the case where a decrease in the price causes the quantity demanded to increase without limits, then we have the special case where demand is perfectly elastic for that good. Figure 7.2 shows demand for a good (D1), maybe one farmer's grain, which has many substitutes. A horizontal demand curve tells us that even the smallest percentage change in price causes an infinite change in quantity demanded. Mathematically speaking, Ed = ∞.

Comparing the vertical (perfectly inelastic) demand curve to the horizontal (perfectly elastic) demand curve allows us to draw an important generalization. As a demand curve becomes more vertical, the price elasticity falls and consumers become more price inelastic. The opposite generalization can be made as the demand curve becomes more horizontal. Figure 7.3 illustrates some general points about slope and elasticity.

Elasticity

  • In general, the more vertical a good's demand curve (D0), the more inelastic the demand for that good.
  • The more horizontal a good's demand curve (D1), the more elastic the demand for that good.
  • Despite this generalization, be careful, elasticity and slope are not equivalent measures.

Determinants of Elasticity

Perfectly elastic and perfectly inelastic demand curves are usually reserved for the hypothetical example, but they illustrate that Ed differs across consumer goods. Your intuition is that consumers respond to a price change in different ways. A 10 percent increase in the price of a car might have a drastically different consumer response from what we observe from a 10 percent increase in the price of a college education, a package of mechanical pencils or a hotel stay in Fort Lauderdale. Let's look at some general explanations for why elasticity differs.

  1. Number of Good Substitutes
  2. If the price of good X increases, and many substitutes exist, the decrease in quantity demanded can be quite elastic. For this reason we expect Ed of orange juice to be high since there are many substitutes available to drinkers of fruit juice.

    Corollary: Often times you hear of a good that is a "necessity" or a "frivolity." These adjectives are reiterating a relative lack of or a relative wealth of good substitutes.

    Example:

    The more narrowly the product is defined, the more elastic it becomes. If we narrow our focus from orange juice down to one brand of orange juice (i.e., Minutemaid), the number of substitutes grows and we predict that so too does the price elasticity of demand for Minutemaid brand orange juice. Likewise, the demand for blue Chevrolet SUVs is more elastic than the demand for Chevrolet SUVs which, in turn, is more elastic than the demand for all SUVs.

  3. Proportion of Income
  4. If the price of a good increases, the consumer loses purchasing power. If that good takes up a large proportion of the consumer's income, he greatly feels the pinch of the income effect, and his responsiveness might be significant. If the price of toothpicks increased by 10 percent, the typical household probably would not feel the lost purchasing power and Ed would be low. The opposite would be true if the price of food items increased by 10 percent.

    Example:

    A young full-time college student is purchasing her education by the credit-hour and supporting herself with a part-time job on the weekends and evenings. Since the student is living on a relatively small monthly income, if the price of a credit-hour increases, the response might be very elastic. The student might drop down to part-time status or drop out of college altogether so that she can save enough money to return next quarter.

  5. Time
  6. Consumers faced by a rising price are usually fairly resourceful in their ability to find a way of decreasing the quantity demanded of a good. The difficulty faced by consumers is that they might not have time, at least not initially, to find a substitute for the more expensive good. We expect price elasticity to increase as more time passes after the initial increase in the price.

    Example:

    If the price of gasoline rises, consumers driving large SUVs do not immediately switch to small cars and Ed is low. But given enough time, if the gas price remains high, the Ed for gasoline increases.

Total Revenue and Elasticity

Discussing price elasticity and making simple calculations is not just a delightful academic exercise for students. Knowing how sensitive consumers are to changes in price is important to those who benefit from selling goods to those consumers—the sellers. Sellers compute total revenues collected from selling goods.

    Total Revenue = Price * Quantity demanded

A seller might think, "If I continue to raise the price, my total revenues must continue to rise." A student of microeconomics knows that this is flawed logic, because quantity demanded falls when the price rises, making the impact on total revenue uncertain.

    Here's what's happening: (Price↑) * (Quantity demanded↓) = Total Revenue

With price going up and quantity demanded going down, it's like a tug-of-war between two teams, with total revenue being pulled in the direction of the strongest team.

Whether or not the total revenue increases with a price increase depends upon whether or not the gain from the higher price offsets the loss from lower quantity demanded. Price elasticity is an excellent way to predict how total revenue changes with a price change. This is sometimes called the total revenue test. Table 7.2 extends our earlier table by adding a column for total revenue at points A through G.

As you can see, if the price rises in the inelastic range of the demand curve, total revenues rise. However, if the price continues to rise into the elastic range, total revenues begin to fall. Why? Maybe a reminder of what it means for demand to be elastic helps to predict which team wins the tug-of-war.

In Figures 7.4 and 7.5, we can graphically illustrate the connection between the demand curve, elasticity, and total revenue.

Elasticity

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