Module 6

I like carrot juice. Not that I am some psycho-health freak (and to all psycho-health freaks out
there - I mean that in a good way)… it is just that it is actually really good.
Anyway, the regular Safeway price for a ½ gallon (?) of Odwalla carrot juice is
$6.99. I never buy it at that price. Whad’ya crazy? But frequently they have it
on sale for $4.99.. and then I will buy it. Once in awhile they have a “buy one
get one free” deal… and then I buy a lot. I actually pour myself bigger
glasses in the morning during these sales. So with enough enough trials
Safeway can get a pretty good picture of the price elasticity of
demand for carrot juice.

Price Elasticity of Demand

In plain English price elasticity of demand (d) tells us how responsive quantity demanded is to a
change in price. In symbols we can write %Qd / %P where  means
“change.” If something is elastic it is“stretchy”… like the band around
your underwear. Elastic demand means that quantity demanded responds
(stretches) a lot to a given change in price. Alternatively, inelastic means that there is little
response… it is not “stretchy” (like the band around my underwear). So, if inelastic, a rise in
price elicits a relatively small fall in the amount consumers buy.

As the book said, the actual calculation will always result in a negative number… but the
negative sign is ignored. Beware… many students mistakenly flip-flop the calculation… be careful
to put %Qd in the numerator.

Elasticity is the general concept of looking at a ratio of percentages changes to measure

responsiveness. Price elasticity of demand is just a specific example of an elasticity. For example, in
early 2009 on my way to school one day there was a discussion on NPR (national public radio) about
the relationship between the number of uninsured drivers and the unemployment rate. The study
reported that a 1% rise in unemployment leads to a 0.75% rise in uninsured drivers.

So we could say the unemployment elasticity of uninsured drivers (%Uninsured / %Ur) ≈ 0.75.

Based on this elasticity they predicted that for the US the % of drivers without insurance will rise
from 13.8% (2007) to 16.1% (2010) due to recession. Does this particular elasticity matter? Well,
sure. If you get hit by an uninsured drive … who is going to pay? Uninsured drivers can be sued but
they probably don’t have a lot of money to begin with… so either your insurance company or the
government is going to have to pick up the bill.

I want you to understand the concept of elasticity you will only have to calculate price elasticity of
demand on tests.

Let’s use this concept to dig a little bit deeper into the analysis of an excise tax that we began last
chapter. In the example (with 7-up) the burden of the tax was split evenly between the consumer and
the producer. But what if this tax was on cigarettes instead of 7-up?

6. 1
The difference is that we should expect the demand for cigarettes to be relatively inelastic. So as P 
due to the tax consumers do not shift away… and so they will end up bearing more of the tax
burden. Carefully compare the graph below, for cigarettes, to the 7-up graph from last chapte

S’
P

$6
S
$5.80

$5
$4.80

38 Q
40

After the tax, consumers pay $5.80 and producers receive $4.80. Consumers have absorbed 80% of
the tax burden.

Problem: Calculate the tax revenue in each graph above.

Answer: In the first graph, 35 mn are sold so the tax revenue is $35 mn (t x Q = $1 x 35 mn).
In the second graph, 38 million are sold… so the tax revenue is $38 mn (=38 mn x $1).

Price elasticity of supply (s)

How responsive quantity supplied is to a change in price. The calculation of s will always be
positive.

If the price of apples were to triple today then what would happen to the quantity of
apples coming onto the market today? The answer, presumably, is nothing.
Supply is perfectly inelastic in the very short run.

If, however, the price of apples were to rise and then remain high … then
producers would eventually respond to the higher prices and grow more apples in
future harvests. We would see a bigger response to the price change than we did
initially. That is, supply has become more price elastic.

Supply elasticity will be greater the easier it is for producers to acquire the resources needed to
produce the good in question. Goods needing some sort of specialized input (surgeons)
will tend to be more price inelastic than goods that do not need such a
specialized input (paper cups). You can’t do 10 years of advanced training in 2
weeks. However, over time, even the good requiring surgeons as an input
(surgery?) will become more elastic as resources (students) are converted to
production of the good (become surgeons). Because it takes time for producers to
switch from one activity to another – which may include building new buildings and

6. 2
machines as well as training new workers – the market response in the short run will be less than the
long run response.

Income elasticity of demand (I)

How responsive demand is to a change in income. I will be postive for normal goods and negative
for inferior goods.
I < 0  inferior good; I > 0  normal good; I > 1  luxury good

Cross-price elasticity of demand (x,y)

How responsive demand for good x is to a change in the price of good y. x,y will be positive for
substitutes and negative for complements.

Did you catch the bit about revenue maximization in the book? A slight extension of that logic
reveals that a firm will never choose to price its good in the inelastic region of the demand curve it
faces. Why not? Well, by definition that means that raising the price will lead to more revenues (the
fact that fewer are sold is more than offset by the fact that the firm gets more per unit sold). It also
must be true that total costs must fall (if you are producing fewer units it cannot cost more). Thus
profits must rise.

Of course, once you move into the elastic region of the demand curve we can no longer be sure that
a rise in price is profit-enhancing. Why not? (answer yourself)

Questions

The demand for Peete’s coffee in Los Altos is such that at a price of $1.90 there is
a quantity demanded of 155 cups per day. If the price is set at $2.10 then quantity
demanded falls to 145.

a. What is the price elasticity of demand over this range of prices? (use the midpoint formula)
b. If Peete’s is trying to maximize profits should they raise the price to $2.10 (from $1.90)?

This following graph is used for many of the homework questions… this one may look a little bit
clearer than the one in ETUDES. You probably want to print it out:

6. 3
Description of the above graph:

Straight line downward-sloping demand curve intersects the price axis at $120 and the quantity axis
at Q = 1200. Upward sloping (straight-line) supply curve goes from origin (0,0) and intersects the
demand curve at Q=800, P = $40.

6. 4