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ECON Melvin (9th Edition)

CHAPTER 19: Elasticity: Demand & Supply

How do we measure how much consumers alter their purchases in

response to a price change?
Elasticity gives us a way to measure how people react to price changes or to
changes in other variables. Specifically, the price elasticity of demand measures
how much consumers respond to changes in price by changing the quantity
demanded, ceteris paribus. Price elasticity of demand is calculated using this
formula:
ed = | percentage change in quantity demanded |
| percentage change in price |
-

All elasticity must be looked at its absolute value since it is always negative

The absolute value signs in the formula ensure that the price elasticity of demand is
always a positive number.
For most products, the price elasticity of demand is different at different prices. If
Pepsi usually cost $.05 a can, you would pay much less attention to a sale on Pepsi
that you would if Pepsi cost $5 a can.
If we follow along a straight-line demand curve:
o Demand is ELASTIC at high prices (ed more than 1) over reactive in
change in price
If demand is elastic, government revenues will go down.
o Demand is INELASTIC at low prices (ed less than 1)
o Demand is UNIT-ELASTIC (ed equal to 1) in the middle.
ELASTICITY

IMPLIES

|EP| > 1

Elastic

%Q > %P

|EP| = 1

Unit-Elastic

%Q = %P

|EP| < 1

Inelastic

%Q < %P

INCREASING
PRICE
Decreases
Revenue
No effect on
Revenue
Increases Revenue

DECREASING
PRICE
Increases Revenue
No effect on
Revenue
Decreases Revenue

Why are measures of elasticity important?

Buyers respond to price changes by charging the quantity they want to buy.
Elasticity measurements give economists a way to compare consumers responses
to price changes for different products.
How does a business determine whether to increase the price of the
product it sells in order to increase revenues?
When your favorite store has a sale on jeans, it sells more jeans but takes in less
money per pair.
Did it gain or lose revenue from the sale?
o The answer depends on the price elasticity of demand for the product.
o If the demand is elastic, the percentage change in quantity is bigger

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than the percentage change in price, so a sale increases total revenue.

But if the demand for the product is inelastic, the percentage change in
price is bigger than the percentage change in quantity, so a sale would
decrease total revenue. When demand is inelastic, increasing the
price increase total revenue.

Why might senior citizens or children receive price discounts relative to

the rest of the population?
Senior citizens and children receive discounts because they usually have more
elastic demands than the rest of the population.
If childrens demand for movies is elastic, giving them a discount lowers the price
they pay and increases the theaters total revenue. The rest of us arent as
responsive to the price of movies, so the theater doesnt gain by giving us a
discount.
Whenever different groups of customers have different price elasticities of demand,
firms can increase their total revenue by using price discrimination.
What determines whether consumers alter their purchases a little or a lot
in response to a price change?
Three factors help determine how elastic the demand for a particular product is.
o First, the greater number of close substitutes, the more elastic the demand.
o Second, the greater the proportion of a households budget a good
constitutes, the more elastic the demand.
o Third, the longer the period under consideration, the more elastic the
demand.
How do we measure how much income changes, changes in the prices of
related goods or changes in advertising expenditures affect consumer
purchases?
The income elasticity of demand, the percentage change in demand divided by
the percentage change in income, measures how much changes in income affect
consumer purchases.
The cross-price elasticity of demand, the percentage change in demand of one
good divided by the percentage change in the price of a related good, measures
how much changes in the price of related goods affect consumer purchases.
The advertising elasticity of demand, the percentage change in demand divided
by the percentage change in advertising expenditures, measures how much
changes in advertising expenditures affect consumer purchases.
How do we measure how much producers respond to a price change?
- We do this in the same basic way we measure whether consumers respond to a
price change:
o Calculate the price elasticity of supply. The price elasticity of supply
is the percentage change in the quantity supplied divided by the
percentage change in price. The price elasticity of supply depends
primarily on the length of time producers have to vary their output in
response to changes in price.

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NOTES
- Complements are goods that have a negative cross-price elasticity of
demand. As the price of one good increases, the quantity demanded of the
other good decreases.
- The formula for the cross-price elasticity of demand is percentage of change
in quantity demanded of good A percentage change in the price of good B.
Goods are complements because there is a negative cross-price elasticity of
demand.
- Luxuries have a larger income elasticity of demand than do necessities.
- A PERFECT ELASTIC (or horizontal) demand curve shows that consumers can
purchase any quantity they want at the prevailing price.
- Other things being equal, when demand is elastic and supply is inelastic, the
incidence of tax will fall MORE on BUSINESSES and LESS on CONSUMERS.
- The price elasticity of demand is not a measure of the degree to which
consumers alter the quantities of a product they purchase in response to
changes in their family income.
- The total expenditures made on a product by a group of buyers is found by
multiplying price times quantity bought.
- One factor of price elasticity of demand depends on is how readily consumers
can switch their purchases from one product to another.
- A business knows that it has two sets of customers, one of which has a much
more elastic demand than the other. If the business uses PRICE
DISCRIMINATION, the set with the more elastic demand should receive a
lower price.
- The percentage change in the quantity demanded of one product divided by
the percentage change in the price of a related product is called the CROSSPRICE ELASTICITY OF DEMAND.
- The PRICE ELASTICITY OF SUPPLY demands in large part on the length of time
producers have to vary their output in response to price changes.

Liquor Tax Reform in Thailand: Competing Interests and Objectives

Income tax cuts for individuals and businesses, ambitious government spending
plans, financial assistance for citizens affected by the December 2004 tsunami,
rising costs of the national healthcare system, and public pressure to curb alcohol
consumption all contributed to the Government of Thailands decision to consider
raising its excise taxes on alcoholic beverages. By September 2005 the Thai cabinet
had to make a decision on reform of the system of liquor taxation. The current
scheme was a mixed system that charged excise taxes based on both liquor values
and the quantity of alcohol content, whichever yielded higher revenues. The
cabinet caught between the competing interests of its own revenue needs,
the profit objective of local producers, and consumer preferences and
welfare was considering three options for reform proposed by the ministry of
Finance's Excise Tax Department. The case reviews key factors that affected the
conditions and desires of each stakeholder, as well as provides an international
comparative perspective on the taxation of alcoholic beverages.
Dynamic interaction between government policies, corporate strategies, and
consumer interests.

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Unsuccessful stakeholder engagement is related to Thailands Liquor Tax

Reform.
Shows no stakeholder engagement and reveals that the government has
conflicts of interest in even seeking to regulate tax reform on liquors as many
elected officials are actually in the liquor manufacturing or liquor import
business.
With the government seeking to revise the tax structure to increase tariffs
while they run simultaneous campaigns to cut down on citizens drinking and
improve their health, the tariff seems self-defeating, especially when it is
revealed that declining revenues for liquor and cigarettes has already begun
occurring.
The report also makes note of redundancies in office duties that could be
streamlined and used to free up money for the infrastructure projects the
country needs to fund.
While it is noted that the public has a widespread awareness of why the
government is seeking to raise the tax on liquor, the case study also notes
that there has not been stakeholder engagement with the public, or
seemingly with the liquor industry on this issue or how to raise funds for
infrastructure needs.
By not engaging with stakeholders, lawmakers are missing an opportunity to
actively engage in an idea exchange that could lead to significant
improvements in fiscal responsibility and better benefit individuals and
businesses.

Officials should look to the success GAP has had by hiring Stakeholder Managers
(also known as boundary spanners) and engaging directly with stakeholders, even
in difficult situations. In the worst possible situations, a smart company or
government will have properly developed and managed their stakeholder
relationships to achieve maximum success. Stakeholder relations are most clearly
defined in a time of crisis when businesses can be redeemed or destroyed based on
stakeholder perceptions.
020716 CLASS DISCUSSION
Price
-

Elasticity and Total Revenue

A change in price can increase, decrease or leave total revenue unchanged
(Total Revenue) TR = PQ
Elasticity: how the quantity demanded is changed through price

Elasticities of Demand
- Responsiveness of quantity demanded to changes in another variable
- Variables may be
o ENDOGENOUS: price (non-PC), advertising expenses
o EXOGENOUS: consumer income, tastes, competitor prices
Increase & decrease in price doesnt necessarily means that you increase
or decrease sales:
- Elasticity
- You might earn less per purchase

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Price drop: everyone can buy (SNOB EFFECT)

The law of supply and demand is not enough to tell you the why there is the
change

Ubiquity of Trade-offs

IDEA
-

OF TRADE-OFF
This is everywhere
You cant achieve it all
Know the linkages and relationships

Law of supply and demand is misguiding, be more concerned with ELASTICITY.

DETERMINANTS OF PRICE ELASTICITY
- Extent to which the good is considered a necessity.
o Segmentation: additional detail
o Preferences makes a big factor
- Availability of close substitutes.
o The greater number of close substitutes, the more elastic the demand
o Differentiate your product, in the perspective of the consumer yours is
different
o Can you buy other products? Competition? Monopoly?
o Example: Apple & Samsung
- Proportion of income spend on the good.
o For the poor, they spend 40% of their income in food.
o The choices will change just to address the need of the person
Example of the potato and meat: in times of famine, rather than
having 1 potato and 1 meat, youd get 2 potatoes and no meat
at all because that is what is you can afford and/or available.
- Time Horizon.
o The price elasticity of supply depends primarily on the length of time
producers have to vary their output in response to changes in price
- Permanence of Price Change.
o When shorter, you are more elastic. (ex. Airline tickets and Gasoline)