Micro Chapter 7

Consumer Choice and Elasticity

This chapter is an extension of the first part of Chapter 3 on demand

and consumer theory

Refer back to your Chapter 3 notes and mentally combine them with Chapter 7 notes

6 Learning Goals1) List the key factors influencing consumer

behavior (repeat from Chapter 3)

2) Apply the concept of marginal utility to determine how a demand curve is derived (repeat from Chapter 3)

3) Define, calculate, and graph elasticity of demand

4) Relate demand elasticity to total revenue

5) Define and calculate income elasticity

6) Define and graph elasticity of supply

Elasticity of Demand

Law of demand states that if price rises (falls), quantity demanded falls (rises)

Elasticity gives us more information about the consumer

Price elasticity seeks to quantify how much quantity demanded falls (rises)

Class Activity: Draw two demand curves side by side. Increase price by the same amount in each graph. Draw the first demand curve illustrating a small reduction in quantity demanded. Draw the second demand curve illustrating a large reduction in quantity demanded.

Graphs:

Watch content video: Inelastic-Elastic demand curves

Other questions to consider:

By how much does price need to rise to decrease quantity demanded by X%?

By how much does price need to fall to increase quantity demanded by Y%?

Price elasticity of demand= percentage change in quantity demanded / percentage change in price

Elasticity = % Δ Qd

% Δ P

Values of price elasticity

If ε > 1, then elastic

Consumers change their behavior a lot

If ε < 1, then inelastic

Consumers change their behavior a little

If ε = 1, then unitary elastic

Consumers don’t change their behavior

Key point:

Price elasticity is NOT the slope of the demand curve– A straight-line demand curve will have

constant slope but a different elasticity at every point

I often do a survey of my students to see if their demand for places at the university responds to prices. The price of places at the university is the tuition charged. I offer students the possibility of zero tuition increase for next year, a 5 percent increase for next year, and a 10 percent increase. Each student is then asked whether he or she will return next year. I recently got the following results: For a 5 percent tuition increase, the number of students returning would decrease by 2.2 percent, implying a price elasticity of demand equaling -0.44. For a 10 percent tuition increase, however, the number returning would fall by 11.8 percent, implying an elasticity of -1.18. The demand curve is surely downward sloping. Not only does the number of places demanded decline when tuition rises more; the responsiveness of demand- the price elasticity of demand- is greater in percentage terms when the university tries to raise tuition by higher amounts. That’s not surprising: Substitutes that suddenly become slightly cheaper don’t affect behavior proportionately as much as substitutes that suddenly become relatively a lot cheaper.Q: Who is likely to be more inelastic, freshmen or juniors? Why?

Q7.1 If a large percentage increase in the price of a good results in a small percentage reduction in the quantity demanded of the good, demand is said to be

1. unitary elastic.

2. relatively inelastic.

3. relatively elastic.

4. perfectly elastic.

Q7.2 When economists say the demand for a good is highly inelastic, they mean that

1. even if the price rose substantially, suppliers would be unwilling to offer much more of the good.

2. the facilities utilized by producers of the good are inflexible; producers cannot easily expand their facilities, even in the long run.

3. consumers will respond to a change in the price of the good by purchasing substantially more of it.

4. a large (percentage) change in the price of a good will result in only a small (percentage) change in the quantity demanded.

What determines elasticity?

(1) Availability of substitutes– More substitutes, more elastic (more

responsive)

(2) Share of budget– Greater share, more elastic

(3) Time– More time, more elastic

Q7.3 Members of Alpha fraternity have developed a strong liking for Coca-Cola. Beta fraternity members buy the same amount of Coke but believe Pepsi is just about as good. From this, we can infer that

1. Alpha members will not care what the price of Coke is.

2. compared to Alpha members, Betas will have a smaller price elasticity of demand for Coke.

3. compared to Alpha members, Betas will have a larger price elasticity of demand for Coke.

4. Alpha members will increase their purchases by a larger amount of Pepsi than Beta members in response to a "50 cents off" sale on a case of Pepsi.

How Demand Elasticity and Price Changes

Affect Total Expenditures (or

Revenues) on a Product

Impact of lower priceon total consumerexpenditures or a

firm’s total revenue

increase

decrease

-- unchanged --

Price elasticityof demand

Elastic

Inelastic

Unitary Elastic

Elasticitycoefficient

(in absolute value)

1 to

0 to 1

1

Impact of higher price on total consumer expenditures or a firm’s total revenue

decrease

increase

-- unchanged --

Don’t memorize this chart!

Use it as a tool

Think about what elasticity tells us and then apply it to total revenue

Total Revenue (TR) to the firm is Total Expenditure (TE) by the consumer. TR = TE = P x Q

If elastic and price falls: ↓ P x ↑Q = ↑TR– Lower price and lots more is bought, Q dominates equation

If elastic and price rises: ↑ P x↓Q = ↓TR– Raise price and lots less is bought, Q dominates equation

If inelastic and price falls:↓P x ↑ Q = ↓TR– Lower price and a little more is bought, P dominates equation

If inelastic and price rises: ↑ P x ↓ Q = ↑TR– Raise price and a little less is bought, P dominates equation

A different way to look at this:

4 graphs

Watch content video: Elasticity and TR

The local airport in Austin, Texas, opened in 1999 with on-site parking, priced from $18 per day for garage parking to $6 per day for distant uncovered parking. The lots were so crowded that soon the Airport Authority built an additional lot. By 2002, off-site parking places had opened up, offering covered parking for $8 per day, and some offering three-minute shuttle service to the terminal. Not surprisingly, this entry of new competitors into the parking market has left many on-site places empty, and the airport’s parking revenues this year have fallen from $22 million to $18 million. If the Airport Authority is smart, it would think about what its demand elasticity is, lower prices if it believes demand is elastic, not lower them, and maybe even raise them (especially on garage parking) if it believes demand is inelastic. The evidence suggests management believes that the demand is elastic for the garage parking, because in 2004 they lowered the price for garage parking to $15 per day.Q: For which part of the airport parking areas is the demand likely to be more or less elastic, the garage parking or the uncovered distant parking? In light of your beliefs about this question, how would you alter prices?

Q7.4 Suppose ε = 0.52 and the firm raises price. What happens to TR?

1. TR rises

2. TR falls

3. TR remains constant

Q7.5 Suppose the firm wants to raise TR and it knows demand is elastic. What should the firm do?

1. Raise price

2. Lower price

3. Keep price the same

Q7.6 (MA) In which of the following cases will the total spending on a good decrease?

1. Demand is elastic, and price decreases.

2. Demand is elastic, and price increases.

3. Demand is inelastic, and price increases.

4. Demand is inelastic, and price decreases.

Income Elasticity

Price elasticity measures the change in consumer purchases when price changes

Income elasticity measures the change in consumer purchases when income changes

Income Elasticity = % Δ Qd

% Δ I

Values of income elasticity

If positive, consumers buy more when income rises

Normal good - a good that consumers will buy more of when income rises

If negative, consumers buy less when income rises

Inferior good - a good that consumers will buy less of when income rises

Price Elasticity of Supply

Price elasticity of supply measures the responsiveness of quantity supplied to price changes

How much does quantity supplied increase (or decrease) when price rises (or falls)?

Graphs:

Watch content video: Inelastic-Elastic supply curves

Question Answers:

Q7.1 = 2

Q7.2 = 4

Q7.3 = 3

Q7.4 = 1

Q7.5 = 2

Q7.6 = 2 & 4