LESSON 3. Elasticity and Its Application

LESSON 3 Elasticity and Its Application Assigned Reading 1. Mankiw, N. Gregory, et al. 2014. Principles of Microeconomics (6th Canadian Edition). Tor...
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LESSON 3 Elasticity and Its Application Assigned Reading 1.

Mankiw, N. Gregory, et al. 2014. Principles of Microeconomics (6th Canadian Edition). Toronto: Nelson Education Ltd. Chapter 5: Elasticity and Its Application

Recommended Reading 1.

Mankiw, N. Gregory, et al. 2014. Study Guide to Accompany Principles of Microeconomics (6th Canadian Edition). Toronto: Nelson Education Ltd. Chapter 5: Elasticity and Its Application

Learning Objectives After studying this lesson, students should be able to: 1.

define and calculate the price elasticity of demand;

2.

describe what determines the price elasticity of demand;

3.

define and calculate the income elasticity of demand and the cross-price elasticity of demand;

4.

define and calculate the price elasticity of supply;

5.

describe what determines the price elasticity of supply;

6.

apply the elasticity concept to different situations;

7.

show how a straight-line demand curve that is elastic will, when extended, intersect the vertical axis, while a demand curve that is inelastic will intersect the horizontal axis; and

8.

show how a straight-line supply curve that is elastic will, when extended, intersect the vertical axis, while a supply curve that is inelastic will intersect the horizontal axis.

Instructor's Comments This lesson extends the discussion of supply and demand that was introduced in the previous lesson. To measure the sensitivity of consumers and producers to changes in market conditions (such as price), economists use the term elasticity. For example, consumers' relative responsiveness to changes in price as they move along the demand curve is known as price elasticity of demand. When consumers (or producers) are relatively more responsive to changes in price, their demand (or supply) is considered to be more elastic, just as a rubber band that is very elastic is highly responsive or stretchy. Thus, when demand (supply) is more elastic, a small change in prices causes a large change in the quantity demanded (supplied).

3.1

Lesson 3

Knowledge of consumers' elasticity is useful for sellers, who need to know how price changes will affect sales and total revenues. When demand is elastic, total expenditures by consumers increases as prices fall, so a business could increase total revenue by dropping prices. In contrast, when demand is inelastic, raising prices leads to increased revenues for the firm as consumers' total expenditures on the good increase. Government officials also need to understand the elasticities of demand and supply to know how changes in taxes or other public policies will affect behaviour. The major objective of this lesson is to develop the idea of elasticity. The relationship between demand elasticity and total revenue is central, because this is the most important way we will use elasticity later in this course. Supply and demand analysis shows how market equilibrium price and quantity are determined. It also predicts the direction of change when one of the variables changes. The concept of elasticity more precisely reports the magnitudes of these changes. The elasticity measures are a way to quantify the direction and size of changing equilibrium price and quantity. It is probably obvious that the concept of elasticity is relevant in real estate and in nearly every other area of business. One of the key marketing decisions that any businessperson makes is setting price. Developers must decide on a price for the housing, office space, and industrial property that they build (we refer to rental rates as price because they are the price to use space for a fixed interval of time). Equivalently, they must decide how the amount of space that they construct will impact the price that they will be able to charge. Property managers as well must decide on an appropriate price. Other real estate professionals such as appraisers, inspectors, and brokers must decide how to price their services. A higher price will only increase revenues if the price elasticity of demand is relatively low. To illustrate the concept of demand elasticity, suppose that a property manager has six vacancies. From recent experience, the manager believes that the demand for apartments is given by the following table: Table 3A: Demand for Apartment Rentals Price

Quantity Rented

Elasticity

Total Revenue

$1,700

1



$1,700

$1,500

2

5.3

$3,000

$1,300

3

2.8

$3,900

$1,100

4

1.7

$4,400

$900

5

1.1

$4,500

$700

6

0.7

$4,200

The third column gives the elasticity of demand associated with each $200 price decrease. It is easy to see that for high prices, the demand is elastic (the quantity demanded responds significantly to the change in price). The elasticity decreases as price decreases (so that the quantity demanded changes less with each $200 change in price). What does this imply about the price that the property manager should set? Suppose that the property manager's goal is to maximize total revenues, equal to price times quantity. Values for total revenue are reported in the table's last column. The table shows that it is not possible to earn more than $4,500. One way to do this would be to set a price equal to $900, allowing the rental of 5 units. It is not accidental that at this price-quantity pair, the price elasticity of demand is closest to one. It is always true that the point on the demand curve where the elasticity equals one will give the price and quantity that maximize total revenue. Although the example presented applies to property management, it also clearly applies to most areas of real estate in general.

3.2

Elasticity and Its Application

Another area where elasticity is very important is in the economics of transportation. This is relevant in real estate, since the value of real estate depends crucially on the transport resources that are available. Urban transportation is an area of economics that is subject to considerable study. What has been found? The key result is that price elasticities of demand are very low. This applies to both automobile commuting and to commuting via mass transit. The consensus estimate of the price elasticity of automobile trips is about 0.10. For mass transit, the estimate is 0.33. Raising the cost of using a car by 50% would only lower car trips by 5%. A 50% reduction in bus fares would only raise transit ridership by 16.7%. Why should elasticities be so low? One key feature of commuting is that there are two kinds of costs. One is monetary or out-of-pockets costs, such as the gasoline required to operate a car or the fare charged by mass transit. The other is time costs. Both elasticities above refer only to the monetary costs. For many routes, the extra time that it would require from commuters to take mass transit means that even if the out-of-pocket monetary costs were high, it would still be economical to commute by car. With regard to mass transit, even if its price is high, it is unlikely that bus riders will choose to buy a car. What do these low price elasticities imply? They imply that even if mass transit were free, ridership would not increase all that much. They also imply that increasing the costs of auto travel would not necessarily get people out of their cars and onto buses. Since time costs are so important, it has been suggested that the key to getting more people to commute using mass transit is to make transit more convenient, thus reducing time cost. In early 2000, Vancouver's Translink, the regional transport authority, proposed additional changes to both bus and car travel (i.e., higher fares for buses and a fixed fee for cars). The revenues from these charges would be used to increase transit access and also to improve roads. Would these changes increase transit ridership and decrease automobile use? The low estimates of price elasticity suggest that, contrary to some outraged claims made after the fare increases were announced, transit ridership will not respond much to the increases. And in fact, transit ridership in the Fall of 2002 exceeded numbers for a similar period in 2000. If the increased revenues are effectively used to decrease the time cost of transit, then the cost increases may in fact actually increase ridership. The increased charges for cars have been justified on the grounds that they will decrease car commuting. However, the estimates of price elasticities suggest that the fee for cars would cause little reduction in automobile use. As well, if the proposed road improvements reduced travel time, then the net effects might actually be to increase automobile use. Improving roads will reduce auto travel times, and if this reduction is sufficiently large, then the positive effect on automobile trips would exceed the negative effects of fees for auto ownership. Therefore, the final answer depends on the size of the fee, changes in travel time, and both the monetary and time cost elasticities of automobile use.

Review and Discussion Questions 1.

What are the determinants of price elasticity of demand, and how does each affect elasticity?

2.

Sketch three demand curves. Curve A should be perfectly elastic, curve B should be perfectly inelastic, and curve C should be unit elastic.

3.

Draw a linear demand curve on a graph. Now identify the part of the demand curve that is elastic, the part that is inelastic, and the part that is unit elastic.

4.

What are the determinants of the price elasticity of supply, and how does each affect elasticity?

5.

Suppose that there is an increase in demand for a manufactured product in a competitive industry. What would likely happen to equilibrium price and quantity of the product in the short run and in the long run? 3.3

Lesson 3

6.

Suppose that you are the CEO of an automobile company, and want to plan your production for the new model year. How might information on elasticity of demand help you in your planning?

7.

Suppose a property manager is interested in increasing total revenue from an apartment building by adjusting rents. Should she raise or lower rents? Explain.

8.

Suppose you are the leasing manager for a large mall. You currently charge the same rent to all non-anchor tenants, regardless of location within the mall. You hire a real estate economist to determine the price elasticity of demand by tenants for space by location. The economist reports that tenant demand for space near the food court and near the anchor tenant is inelastic, demand near the mall entrances has unit elasticity, and in other areas the demand is elastic. If you want to increase total revenues by adjusting your rents what should you do?

9.

How does knowledge about market vacancy rates help a property management firm to make decisions concerning what rents to charge for units in the properties under their management?

10.

Antiquated Airlines of Alberta (AAA) must decide on a pricing policy for flights between Calgary and Edmonton. It has two types of travellers, business and leisure passengers whose demand curves are DB and DL, respectively. Business Travellers

Price ($) 400 300 200 100

3.4

DB Quantity Demanded 200 300 400 500

Leisure Travellers

Price ($) 400 300 200 100

DL Quantity Demanded 0 100 300 500

(a)

If their goal is to maximize total revenue, and they have enough seats to satisfy all of the demand, what price should they charge business travellers? What about leisure travellers? Explain. Do airlines actually behave this way? How can they charge two different prices for essentially the same product (how do they separate the two markets)?

(b)

Can you think of any other examples of real-world price discrimination – charging different prices to different people for the same product – based on differences in the price elasticity of demand between two (or more) groups of consumers?

Elasticity and Its Application

11.

Suppose that your demand schedule for compact discs is as follows: Price ($)

Quantity Demanded (Income = $10,000)

Quantity Demanded (Income = $12,000)

8 10 12 14 16

40 32 24 16 8

50 45 30 20 12

(a)

Use the midpoint method to calculate your price elasticity of demand as the price of compact discs increases from $8 to $10 if (i) your income is $10,000 and (ii) your income is $12,000.

(b)

Calculate your income elasticity of demand as your income increases from $10,000 to $12,000 if (i) the price is $12 and (ii) if the price is $16.

12.

Two drivers – Tom and Jerry – each drive up to a gas station. Before looking at the price, each places an order. Tom says, "I'd like 40 L of gas." Jerry says, "I'd like $10 worth of gas." What is each driver's price elasticity of demand?

13.

Beachfront resorts have an inelastic supply and cars have an elastic supply. Suppose that a rise in population doubles the demand for both products (that is, the quantity demanded at each price is twice what it was). (a) (b) (c) (d)

What happens to the equilibrium price and quantity in each market? Which product experiences a larger change in price? Which product experiences a larger change in quantity? What happens to total consumer spending on each product?

3.5

Lesson 3

ASSIGNMENT 3 CHAPTER 5: Elasticity and its Application

Marks: 1 mark per question. 1.

Assume that demand for coffee is perfectly inelastic. This means that if the price of coffee increases by 10%, the quantity demanded: (1) (2) (3) (4)

2.

If a 10% increase in the price of a home results in an 8% increase in the quantity supplied, supply is: (1) (2) (3) (4)

3.

Laptop computers Private islands in the Caribbean Corn Textbooks

If apartments and single-family houses are substitutes, then one would expect: (1) (2) (3) (4)

5.

perfectly elastic. inelastic. unit elastic (has unitary elasticity). elastic.

Which of the following is the most likely to have an inelastic supply? (1) (2) (3) (4)

4.

does not increase or decrease. increases by 10%. decreases by 10%. decreases by 20%.

the cross elasticity of demand to be negative. the income elasticity of demand for both goods to be negative. the price elasticity of the two goods to be identical. none of the above.

The price of office space rises from $20 to $30 per square foot, and the quantity demanded falls from 110 units to 90 units. What is the price elasticity of demand? (1) (2) (3) (4)

2 1 1.5 0.5

Assignment 3 continued on the next page 3.6

Elasticity and Its Application

6.

If the price of condominiums fall and the demand for condominiums has unitary elasticity (elasticity equals 1), then: (1) (2) (3) (4)

7.

If the price of housing falls and the demand for housing has unitary elasticity, then: (1) (2) (3) (4)

8.

She should increase ticket prices. She should decrease ticket prices. She should add more seats to her theatre. She should remove some seats from her theatre.

If the government raises the per litre tax on, and thus the price of, gasoline to increase tax revenue: (1) (2) (3) (4)

10.

the percentage rise in quantity demanded is greater than the percentage fall in price, and total revenue rises. the percentage rise in quantity demanded is equal to the percentage fall in price, and total revenue remains constant. the percentage rise in quantity demanded is less than the percentage fall in price, and total revenue falls. the percentage rise in quantity demanded is greater than the percentage fall in price, and total revenue falls.

Krista operates one of several small live performance theatres in your town. She has noticed revenue declining. What should Krista do to increase revenue to her theatre? (1) (2) (3) (4)

9.

the percentage increase in quantity demanded would be greater than the percentage decrease in price. the percentage increase in quantity demanded would be less than the percentage decrease in price. total revenue would increase. none of the above.

they are assuming that the demand for gasoline is price elastic. they are assuming that the demand for gasoline is price inelastic. they are assuming that the demand for gasoline is price unit elastic. they are making a mistake because raising the tax on gasoline will necessarily reduce tax revenue.

Why did OPEC fail to keep the price of oil high? (1) (2) (3) (4)

Over the long run, producers of oil outside of OPEC responded to high prices by increasing oil exploration and by building new extraction capacity. Consumers responded to higher prices with greater conservation. Consumers replaced old fuel-inefficient cars with newer fuel-efficient ones. All of the above are correct.

Assignment 3 continued on the next page 3.7

Lesson 3

THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING GRAPH:

11.

The total revenue at P1 is represented by area(s): (1) (2) (3) (4)

12.

It appears that demand between P1 and P2 is: (1) (2) (3) (4)

13.

B + D. A + B. C + D. D.

elastic. inelastic. unit elastic. There is not enough information to say anything about price elasticity of demand.

Suppose the price elasticity of demand for basketballs is 1.20. A 15% increase in price will result in: (1) (2) (3) (4)

a 15% decrease in the quantity of basketballs demanded. an 18% decrease in the quantity of basketballs demanded. an 8% reduction in the number of basketballs demanded. a 12.5% reduction in the number of basketballs demanded.

Assignment 3 continued on the next page 3.8

Elasticity and Its Application

THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING GRAPH:

14.

Which of the demand curves is most elastic at point A? (1) (2) (3) (4)

15.

A given increase in price would result in the largest increase in total revenue on demand curve: (1) (2) (3) (4)

16.

D1 D2 D3 All of the above are equally elastic at point A.

D1 D2 D3 It is impossible to answer the question with the information given.

Holding all else constant, if a pencil manufacturer increases production by 20% when the market price of pencils increases from $0.50 to $0.60, then the price elasticity of supply, using the midpoint method, must be: (1) (2) (3) (4)

slightly inelastic. very elastic. very inelastic. elastic, but only slightly.

THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING GRAPH:

Assignment 3 continued on the next page 3.9

Lesson 3

17.

Which supply curve is least elastic? (1) (2) (3) (4)

18.

S1 S2 S3 It is impossible to tell without more information.

Which supply curve is most likely the long-run supply curve? (1) (2) (3) (4)

S1 S2 S3 All of the above are equally likely to be the long-run supply curve.

THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: In Javatown, the price elasticity of demand and price elasticity of supply are both relatively inelastic (elasticity is less than 1). Javatown has dozens of independent coffee shops that are small enough that they do not affect each other's prices. Due to the opening of a new coffee bean processing plant, the amount of coffee that each of the coffee shops in Javatown can produce has increased. 19.

What will happen to the price of coffee in Javatown and the coffee shops' revenues due to the supply increase? (1) (2) (3) (4)

20.

Suppose Joe Cuppa owns a coffee shop in Javatown and he calculates his coffee shop is operating at capacity and cannot produce more coffee, despite the new processing plant. If Joe does not increase his production, what will happen to the price of coffee at his coffee shop and his coffee shop's revenues? (1) (2) (3) (4)

___ 20

Price will increase and revenue will decrease. Price will not change and revenue will increase. Price will decrease and revenue will remain the same. Price will decrease and revenue will decrease.

Price will increase and revenue will decrease. Price will not change and revenue will remain the same. Price will decrease and revenue will remain the same. Price will decrease and revenue will decrease.

Total Marks

End of Assignment 3 3.10