ELASTICITY : PART TWO

RELATED CONCEPTS :|PRICE ELASTICITY OF DEMAND |ELASTIC, INELASTIC, UNIT ELASTIC |TOTAL REVENUE |INCOME ELASTICITY OF DEMAND |NORMAL GOODS, INFERIOR GOODS |CROSS ELASTICITY OF DEMAND |SUBSTITUTES |COMPLEMENTS |PRICE ELASTICITY OF SUPPLY |

a. Compare the effect of a $1,000 tax on cars with the effect of a 10% tax on cars. Which tax is likely to have the same impact on the demand for cars (in percentage terms) no matter which year it was imposed?
b. What does your answer imply about the relative advantages of using slopes or elasticities to predict the impact of a price change?

• a. Due to inflation, the $1,000 represents a smaller percentage of car prices over time. When cars were sold for $2,000, the $1,000 in added price meant car prices would go up 50%: we’d expect a huge decrease in demand. When cars sell for $10,000, this is only a 10% increase in price: we expect a smaller decrease in demand. On the other hand, the 10% tax would probably have a similar impact if imposed today or 30 years ago.

• b. Inflation does not harm the usefulness of elasticities; this is one reason why economists use them.

a. When the wheat harvest falls by 10% due to bad weather, wheat prices go up 40%. What is the price elasticity of demand for wheat?
b. Using this number, what will happen to the wheat bought by consumers if the government raises the price of wheat by 20%? What happens to the total revenue of wheat farmers?
c. Still using the elasticity from (a) above, what will happen to the price of wheat if the government destroys 10% of the crop? To the total revenues of wheat farmers?

• a. o.25 (10%/40%).

• b. It will decrease by 5% (-.25x 20%). Total revenues will rise 15% [(1-.25)x 20%]

• c. Price will go up 40%. (105/.25); total expenditures on wheat will go up 30%.

Why will tourists likely have a more inelastic demand curve for restaurant food than will “locals”?

• Tourists have little time to price shop among substitute restaurants, so their demand curve for any one restaurant is likely to be more inelastic. Tourists also lack the substitute of home-cooked meals.

Why do merchants often have sales (and cut their prices) on air-conditioners in spring and early summer when demand is highest?

• In spring and early summer, more people are seeking to buy air-conditioners. This makes the advertising cost per customer lower. With more merchants advertising, customers can more easily price shop. So merchants face a more elastic demand curve for their air-conditioners. This leads them to cut prices (to increase their total revenues), causing sales to occur at these times.

Select from each of these groups the good that is likely to have the highest price elasticity of demand :
Group A : Energy, oil, gasoline, Shell Gasoline, Bill’s Shell Station gas.
Group B : The gasoline bought by truckers, the gasoline bought by week-end drivers.
Group C : Gas bought from Joe, who has no competitors, gas bought from Bill, who has many competitors.
Group D : Eyeglasses from Sid’s Glass Emporium in a state that does not permit advertising, eyeglasses from the same store in a state that does permit advertising.

• a. Bill’s Shell Station gas.

• b. The gasoline bought by truckers (they have more incentive to price-shop).

• c. Bill.

• d. The store in the state that permits advertising.

When Titantown Bus Company raised its bus fare, its local revenues fell. When Petrogard Bus Company raised its bus fare, its total revenues went up. When can we conclude about the elasticity of demand for each company?

• Tintantown’s demand is elastic; Petrogard’s is inelastic.

Which of these groups do you expect to be complements and which do you expect to be substitutes? What is the likely sign of the cross elasticity of demand?
Group A : Tires and cars.
Group B : Buses and airplanes.
Group C : Coal and oil.
Group D : Hot dogs and hamburgers.

• Group A : Complements (negative).

• Group B : Substitutes (positive).

• Group C : Substitutes (positive).

• Group D : Substitutes (positive).

You are president of the American Bicycle Federation and you have been asked to predict how the

sale of American bicycles will do next year (giving the percent change from this year’s sales). Give

your answer using the following facts:

1. The price elasticity of demand for American bicycles is 2.5

2. Their income elasticity is 3.0

3. The cross elasticity of demand with foreign bikes is 4.0

4. American bikes will go up 5% in price, foreign bikes will go up 7% in price, and American income will go up 3%

What will happen to the total expenditures of Americans on American bicycles (which equals the total revenues of the American bicycle makers)?

• We sum the effect of price, foreign bike prices, and income: (-2.5x5)+(4x7)+(3x3)= 24.9%. With 24.9% more bikes sold at a 5% higher price, total expenditures will be up (by approximately the percent change) in quantity plus the percent change in price, or 29.9%).

As people earn more income, their food purchases go up but their share of income spent on food goes down. What can we conclude about the income elasticity of food demand?

• The income elasticity is positive (since food purchases went up) but less than unity (since food’s share of income went down).

Copyright 2008 by Sujanto Rusli
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