© 2005 Thomson
C

Economic Principles
Demand sensitivity
Determinants of demand
Sensitivity to price changes
Price elasticity of demand
Cross elasticity
Gottheil - Principles of Economics, 4e
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Economic Principles
Substitute and complementary goods
Normal and inferior goods
Supply elasticity
Relationship between price
Elasticity of supply and
© 2005 Thomson tax revenues
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EXHIBIT 1A DEMAND RESPONSE TO PRICE CHANGE
4
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EXHIBIT 1B DEMAND RESPONSE TO PRICE CHANGE
5
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EXHIBIT 1C DEMAND RESPONSE TO PRICE CHANGE
6
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Exhibit 1: Demand Response to Price Change
1. The demand curve in panel a can be described as:
•
Vertical
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Gottheil - Principles of Economics, 4e
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Exhibit 1: Demand Response to Price Change
The demand curve is vertical in panel a because:
• The demand for penicillin doesn’t change
–regardless of what price is charged.
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© 2005 Thomson

Exhibit 1: Demand Response to Price Change
The demand curve in panel b can be described as:
•
Fairly steep
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Exhibit 1: Demand Response to Price Change
The demand curve in panel b compares to the demand curve in panel c:
•
The demand curve in panel b is steeper than in panel c.
10
Gottheil - Principles of Economics, 4e
© 2005 Thomson

Exhibit 1: Demand Response to Price Change
This tells us that the demand response for spark plugs versus
Coca-Cola:
•
When price is cut, the demand response for Coca-Cola is greater than the demand response for spark plugs.
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© 2005 Thomson

Demand Sensitivity
Demand Sensitivity
•
Demand sensitivity describes how consumer demand reacts to changes in price.
• High sensitivity: a given change in price will result in a large change in quantity demanded.
•
Low sensitivity, or insensitivity: a given change in price will result in little or no change in quantity demanded.
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© 2005 Thomson

EXHIBIT 2 MARKET DEMAND FOR COCA-COLA AND
SPARK PLUGS
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13

Exhibit 2: Market Demand for
Coca-Cola and Spark Plugs
In Exhibit 2, which demand curve, Panel a or b, has a steeper slope?
•
Panel a, the demand for Coca-Cola, has a steeper slope.
14
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© 2005 Thomson

Exhibit 2: Market Demand for
Coca-Cola and Spark Plugs
Which panel depicts high demand sensitivity?
•
Panel a depicts high demand sensitivity.
•
A decrease in the price of Coca-Cola results in a large increase in quantity demanded.
•
The slope of the demand curve is steep.
15
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What Factors Influence
Demand Sensitivity?
All else equal, the demand for low-priced goods is less elastic than high-priced goods.
•
When something is inexpensive people are less price sensitive.
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What Factors Influence
Demand Sensitivity?
The elasticity of demand for poor people is larger than for rich people.
•
Poor people are more sensitive to price changes than rich people.
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What Factors Influence
Demand Sensitivity?
The price elasticity of demand for basic goods (necessities) is not larger than for less essential goods.
•
There are fewer substitutes for basic goods
(such as bread, electricity, or gasoline) than for less essential goods (such as slices of pizza or specific brands of running shoes).
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What Factors Influence
Demand Sensitivity?
A product used as a compliment with an essential good will have the elasticity characteristics of the essential good.
•
If something is used in conjunction with an essential good, then consumption will not decline very much if price rises.
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What Factors Influence
Demand Sensitivity?
In which of the following situations will the price elasticity of demand be largest:
•
When people have a brief period of time to adjust
•
When people have a long time period to adjust.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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What Factors Influence
Demand Sensitivity?
In which of the following situations will the price elasticity of demand be largest:
•
When people have a brief period of time to adjust
•
When people have a long time period to adjust.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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From Sensitivity to Elasticity
The price elasticity of demand is not the same thing as the slope of the demand curve.
•
The slope of the demand curve will differ based on the units used to measure price and quantity.
22
Gottheil - Principles of Economics, 4e
© 2005 Thomson

From Sensitivity to Elasticity
The price elasticity of demand is not the same thing as the slope of the demand curve.
•
We want a measure of sensitivity that will be the same regardless of the units used to measure price and quantity.
23
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© 2005 Thomson

From Sensitivity to Elasticity
The price elasticity of demand is not the same thing as the slope of the demand curve.
•
Price elasticity of demand is the percent change in quantity demanded divided by the percentage change in price.
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Gottheil - Principles of Economics, 4e
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From Sensitivity to Elasticity
Formula for computing the price elasticity of demand:
• e d
(P
2
= (Q
2
- Q
1
)/[(Q
2
- P
1
)/[(P
2
+ P
1
+ Q
)/2]
1
)/2] divided by
25
Gottheil - Principles of Economics, 4e
© 2005 Thomson

EXHIBIT 3A
PRICE
ELASTICITIES
OF DEMAND
FOR
FOOTBALL
TICKETS
AND MILK
© 2005 Thomson
26

EXHIBIT 3B
PRICE
ELASTICITIES
OF DEMAND
FOR
FOOTBALL
TICKETS
AND MILK
© 2005 Thomson
27

Exhibit 3: Price Elasticities of Demand for Football Tickets and Milk
In Exhibit 3, elasticity of demand for football tickets within the $4 to
$3 price range is 3.5. This means:
•
A price elasticity of 3.5 means that a 1 percent change in price generates a
3.5 percent change in quantity demanded.
28
Gottheil - Principles of Economics, 4e
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Exhibit 3: Price Elasticities of Demand for Football Tickets and Milk
In Exhibit 3, elasticity of demand for football tickets within the $4 to
$3 price range is 3.5. This means:
•
Elasticities greater than 1.0 are
price elastic.
29
Gottheil - Principles of Economics, 4e
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Exhibit 3: Price Elasticities of Demand for Football Tickets and Milk
In the $2 to $1 price range, elasticity of demand for football tickets falls to 0.5. This means:
•
A 0.5 price elasticity means that a 1 percent change in price generates a
0.5 percent change in quantity demanded.
30
Gottheil - Principles of Economics, 4e
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Exhibit 3: Price Elasticities of Demand for Football Tickets and Milk
In the $2 to $1 price range, elasticity of demand for football tickets falls to 0.5. This means:
•
Elasticities less than 1.0 are price inelastic.
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Gottheil - Principles of Economics, 4e
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Exhibit 3: Price Elasticities of Demand for Football Tickets and Milk
When the price of football tickets rises from $1 to $2, quantity demanded falls from 700 to 500.
The price elasticity of demand is:
•
(Q
2
- Q
1
)/[(Q
2
+ Q
1
)/2]
= (700 - 500)/[(700 + 500)/2] = 1/3.
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Gottheil - Principles of Economics, 4e
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Exhibit 3: Price Elasticities of Demand for Football Tickets and Milk
When the price of football tickets rises from $1 to $2, quantity demanded falls from 700 to 500.
The price elasticity of demand is:
•
(P
2
- P
1
)/[(P
2
+ P
1
)/2] = (2 - 1)/[(2 + 1)/2] = 2/3
33
Gottheil - Principles of Economics, 4e
© 2005 Thomson

Exhibit 3: Price Elasticities of Demand for Football Tickets and Milk
When the price of football tickets rises from $1 to $2, quantity demanded falls from 700 to 500.
The price elasticity of demand is:
• e d
= (1/3)/(2/3) = 1/2.
34
Gottheil - Principles of Economics, 4e
© 2005 Thomson

EXHIBIT 4 ELASTICITIES, PRICE, AND REVENUE
CHANGES
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Gottheil - Principles of Economics, 4e
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Exhibit 4: Elasticities, Price, and
Revenue Changes
If demand is price inelastic and price goes down, total revenue decreases .
•
When demand is price inelastic, the increase in quantity is less than proportionate to the decrease in price.
•
Price falls more than quantity increases and total revenue decreases.
Gottheil - Principles of Economics, 4e
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Cross Elasticity
Cross elasticity of demand
•
It is the ratio of a percentage change in quantity demand of one good to a percentage change in the price of another good.
37
Gottheil - Principles of Economics, 4e
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EXHIBIT 5 PRICE ELASTICITIES OF DEMAND FOR
SELECTED GOODS
Source: Edward Mansfield, Microeconomics (New York: W. W. Norton, 1997); Robert Hall and Mark Lieberman, Economics (Cincinnati: South-
Western College Publishing, 1998); Gary Brester and Michael Wohlgenant, “Estimating Interrelated Demands for Meat Using New Measures for
Ground and Table Cut Beef,” American Journal of Agricultural Economics (November 1991); and Heinz Kohler, Intermediate Economics: Theory and
Applications (new York: Scott, Foresman, 1986).
Gottheil - Principles of Economics, 4e
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© 2005 Thomson

Which of the following has the largest price elasticity of demand?
•
Corn
•
Cigarettes
•
Movies
© 2005 Thomson
Gottheil - Principles of Economics, 4e
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Which of the following has the largest price elasticity of demand?
•
Corn
•
Cigarettes
•
Movies
© 2005 Thomson
Gottheil - Principles of Economics, 4e
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EXHIBIT 6 PRICE ELASTICITIES OF DEMAND IN THE
SHORT RUN AND LONG RUN
Source: H. S. Houthakker and Lester Taylor, Consumer Demand in the United States, 1929 –1970 (Cambridge, Mass.:
Harvard University Press, 1970); Richard Voith, “The Long-Run Elasticity of Demand for Commuter Rail Transportation,”
Journal of Urban Economics (November 1991); and James Griffen and Henry Steele, Energy Economics and Policy (New
York: Academic Press, 1980).
Gottheil - Principles of Economics, 4e
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Exhibit 6: Price Elasticities of Demand in the Short Run and Long Run
Which of the following has the smallest price elasticity of demand in the long run?
•
Gasoline
•
Jewelry and watches
•
Hospital care
42
Gottheil - Principles of Economics, 4e
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Exhibit 6: Price Elasticities of Demand in the Short Run and Long Run
Which of the following has the smallest price elasticity of demand in the long run?
•
Gasoline
•
Jewelry and watches
•
Hospital care
Gottheil - Principles of Economics, 4e
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EXHIBIT 7 CROSS ELASTICITIES BETWEEN
SUBSTITUTES
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In Exhibit 7, the demand for Tums increase when the price of Rolaids increased because:
• Tums and Rolaids are substitute goods— goods that can replace each other.
• When the price of Rolaids increases, some consumers are willing to switch to a cheaper substitute—Tums.
45
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In Exhibit 7, the demand for Tums increase when the price of Rolaids increased because:
• Cross elasticities for substitute goods are positive.
• A decrease (or increase) in the price of one good generates a corresponding decrease (or a corresponding increase) in the quantity demanded of the other.
46
© 2005 Thomson

EXHIBIT 8 CROSS ELASTICITIES OF DEMAND FOR
SUBSTITUTE GOODS
Source: Edwin Mansfield, Microeconomics (New York: W. W. Norton, 1997); F. Gasmi, J. J. Laffont, and Q. Vuong, “Econometric Analysis of
Collusive Behavior in a Soft Drink Market,” Journal of Economics and Management Strategy (Summer 1992); and Gary Brester and Michael
Wohlgenant, “Estimating Interrelated Demands for Meats Using New Measures for Ground and Table Cut Beef,” American Journal of Agricultural
Economics (November 1991).
Gottheil - Principles of Economics, 4e
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© 2005 Thomson

Which of the following are the closest substitutes, according to
Exhibit 8:
•
Butter and margarine
•
Poultry and ground beef
•
Natural gas and electricity
Gottheil - Principles of Economics, 4e
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Which of the following are the closest substitutes, according to
Exhibit 8:
•
Butter and margarine
•
Poultry and ground beef
•
Natural gas and electricity
Gottheil - Principles of Economics, 4e
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Butter and margarine the closest substitutes because:
•
They have the largest cross elasticity of demand.
50
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© 2005 Thomson

EXHIBIT 9A CROSS ELASTICITIES BETWEEN
COMPLEMENTS
© 2005 Thomson
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EXHIBIT 9B CROSS ELASTICITIES BETWEEN
COMPLEMENTS
© 2005 Thomson
52

When the price of flights decreases, the demand for hotel rooms:
•
The demand for hotel rooms will increase, because people fly more and need more hotel rooms.
53
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Income Elasticity
Income elasticity
•
It is the ratio of the percentage change in quantity demanded to the percentage change in income.
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Income Elasticity
Income elasticity
•
A good is considered income elastic when a 1 percent change in income generates a greater than 1 percent change in quantity demanded.
55
Gottheil - Principles of Economics, 4e
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Income Elasticity
Income elasticity
•
A good is considered income inelastic when a 1 percent change in income generates a less than 1 percent change in quantity demanded.
Gottheil - Principles of Economics, 4e
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© 2005 Thomson

EXHIBIT 10 AIR TRAVEL
© 2005 Thomson
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Exhibit 10: Air Travel
The demand curve in Exhibit 10 shift from D y to D′ y even though price remains constant because:
•
In Exhibit 10, the demand for air travel is income elastic. As income increases, the demand for flights increases, even though the price of flights remains unchanged.
58
Gottheil - Principles of Economics, 4e
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EXHIBIT 11 INCOME ELASTICITIES OF DEMAND
Source: Edwin Mansfield, Microeconomics (New York: W. W. Norton, 1997); and F. Chalemaker, “Rational Addictive Behavior and Cigarette
Smoking,” Journal of Political Economy (August 1991).
Gottheil - Principles of Economics, 4e
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© 2005 Thomson

Exhibit 11: Income Elasticities of Demand
The income elasticity of demand for electricity so much lower than for furniture because:
•
Electricity is a necessity, while furniture is a luxury.
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Gottheil - Principles of Economics, 4e
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EXHIBIT 12 COMPARISON OF INCOME ELASTICITIES
OF DEMAND FOR FOOD, BY COUNTRY
Source: Ching-Fun and James Peale Jr., “Income and Price Elasticities,” in Advances in Econometrics Supplement, ed. Henri Thell (Greenwich,
Conn.: JAI Press, 1989); and Y. Wu, E. Li, and S. N. Samuel, “Food Consumption in Urban China: An Empirical Analysis,” Applied Economics (June
1995).
Gottheil - Principles of Economics, 4e
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© 2005 Thomson

Exhibit 12: Comparison of Income
Elasticities of Demand for Food, by
Country
The type of countries which tend to have the lowest income elasticity for food are:
•
Industrialized countries
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EXHIBIT 13A ELASTICITIES OF SUPPLY
© 2005 Thomson
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EXHIBIT 13B ELASTICITIES OF SUPPLY
© 2005 Thomson
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EXHIBIT 13C ELASTICITIES OF SUPPLY
© 2005 Thomson
65

Exhibit 13: Elasticities of Supply
In Exhibit 13, the different supply curves have different price elasticities because:
•
Panel a depicts the market-day supply curve.
•
At any price suppliers are unable to adjust supply.
•
The price elasticity of supply is 0.
Gottheil - Principles of Economics, 4e
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Exhibit 13: Elasticities of Supply
In Exhibit 13, the different supply curves have different price elasticities because:
•
Panel b depicts the short-run supply curve.
•
Suppliers are willing, but not able, to meet all the demand.
•
Suppliers can only increase production with existing capacity.
•
Price elasticity is 0.47.
© 2005 Thomson
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Exhibit 13: Elasticities of Supply
In Exhibit 13, the different supply curves have different price elasticities because:
•
Panel c depicts the long-run supply curve.
•
Suppliers encounter no obstacles in adjusting quantity supplied to price.
•
The price elasticity is 1.64.
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EXHIBIT 14A WHAT GETS TAXED?
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EXHIBIT 14B WHAT GETS TAXED?
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Exhibit 14: What Gets Taxed
If government imposes a per unit tax, the type of demand (elastic or inelastic) which will generate the most revenue is:
•
Inelastic.
•
Quantity will not decline very much when the tax raises the price of the product.
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