Elasticity of demand

Income elasticity of demand for inferior goods. Wykis, Public domain, via Wikimedia Commons

Introduction

I recently took the Microeconomics course on Coursera and found it useful. As part of the course, we were given some practice questions related to elasticity of demand. In this article, I have listed these practice questions and my answers to the questions.

The concept of elasticity of demand is a measure of how responsive the quantity demanded of an item is to a change in some metric such as price or income. The concept of elasticity has many applications in Economics. For example calculation of total revenue, effect of taxes of buyers and sellers etc.

Price elasticity of demand

According to Wikipedia, the Price elasticity of demand is defined as: “A good’s price elasticity of demand (PED) is a measure of how sensitive the quantity demanded of it is to its price. When the price rises, quantity demanded falls for almost any good, but it falls more for some than for others. The price elasticity gives the percentage change in quantity demanded when there is a one percent increase in price, holding everything else constant. If the elasticity is -2, that means a one percent price rise leads to a two percent decline in quantity demanded. Other elasticities measure how the quantity demanded changes with other variables (e.g. the income elasticity of demand for consumer income changes)“.

Income elasticity of demand

According to Wikipedia, the Income elasticity of demand is defined as: “In economics, the income elasticity of demand is the responsivenesses of the quantity demanded for a good to a change in consumer income. It is measured as the ratio of the percentage change in quantity demanded to the percentage change in income. If a 10% increase in Mr. Ruskin Smith’s income causes him to buy 20% more bacon, Smith’s income elasticity of demand for bacon is 20%/10% = 2”.

Cross elasticity of demand

According to Wikipedia, the Cross elasticity of demand is defined as: “In economics, the cross elasticity of demand or cross-price elasticity of demand measures the percentage change of the quantity demanded for a good to the percentage change in the price of another good, ceteris paribus.[1] In real life, the quantity demanded of good is dependent on not only its own price (Price elasticity of demand) but also the price of other “related” products”.

Should the U.S. federal government decriminalize the use of marijuana for recreational purposes

Background

In the U.S. one of the most contested issues of the past 30 years has been how to deal with the issue of drug-related problems in this country. In fact, we introduced this problem in Module 2. Most of the efforts to deal with the problem so far have been by reducing the supply (mostly through enforcement) and the so-called “war on drugs”. But this war on drugs has resulted in very large expenditures in the criminal justice system. And many argue this policy has had very limited, if any, effect on reducing the use of illegal drugs.

At the center of the debate has been the use of marijuana, a product derived from the cannabis sativa plant. While some continue to argue for maintaining the same policy, a strong movement has been calling for a different approach. Alternatives include dealing with the issue as a public health issue, not an enforcement issue. This approach basically would target demand instead of supply. Nevertheless, many have argued for the complete decriminalization of marijuana.

This debate has taken the front pages in the last few years as many states have passed legislation legalizing the use of marijuana for both medical and recreational purposes.

Here is some useful background material.

In favor of legalization:

Gary S. Becker, “The Failure of the War on Drugs” James Ostrowski, “Thinking About Drug Legalization” Against legalization:

Robert L. Maginnis, “Legalization of Drugs: The Myths and the Facts” Drug Enforcement Administration, “Response to JAMA Article Titled ‘Marihuana as Medicine’” No opinion but useful:

Jenny Williams, Rosalie Liccardo Pacula, Frank J. Chaloupka, and Henry Wechsler, “Alcohol and Marijuana Use Among College Students: Economic Complements or Substitutes”

Discussion Question

Should the US federal government decriminalize the use of marijuana for recreational purposes?. You must limit your response to concepts of the price elasticity of demand for marijuana and, for purposes of this discussion, completely refrain from any moral or ethical arguments.

Answer

I think decriminalizing the use of marijuana for recreational purposes will make the use of marijuana in society common. I think this will improve public knowledge about the negative affects of marijuana and will lead to an eventual decrease in the consumption of the drug.

From the point of view of economics, decriminalizing the use of marijuana for recreational purposes will increase the supply of the drug in the market. This will cause a downward shift of the supply curve, which will decrease the equilibrium or market price of marijuana. A decrease in the price will reduce the incentive for sellers to sell marijuana. A decrease in price should not affect the quantity consumed by much, since the demand for marijuana is inelastic. A decrease in the market price of marijuana does not affect buyers much. It should decrease the burden on the criminal justice system.

What are the policy implications of the price elasticity of demand for abortions

Background

Using econometric techniques, Marshall Medoff estimated the price elasticity and the income elasticity of demand for abortions in the U.S. to be -1.07 and 1.24 respectively (see source below). To calculate these elasticities he used state data pooled over the census years 1982, 1992, and 2000.

Source: Medoff, Marshall H., “Price, Restrictions and Abortion Demand,” Journal of Family and Economic Issues, 28(4), December 2007:583–599.

Discussion Question

Use the elasticities found by Medoff to answer the following 2 questions. Again, you must limit your response to concepts of elasticity of demand for abortions and, for purposes of this discussion, completely refrain from any moral or ethical arguments.

What are the economic and policy implications of the price elasticity of demand for abortions to further state and/or federal restrictions on abortions? What are the implications of the income elasticity of demand for abortions when one considers the accessibility of abortions between low- and high-income women?

Answer

The data collected by Marshall Medoff shows that the absolute values for the price and income elasticities for having abortions is more than 1, which means elastic. So a small change in cost for abortions or the income of users involved in abortions will lead to a large change in number of abortions.

States that want to place restrictions on abortions may want to increase the cost of having abortions. A small increase in cost of abortions should not affect hight income users. To decrease abortions fairly among all income classes, restrictions on abortions may involve increase in the cost of abortions in proportion to the income of the users.

Low income women are less able to afford abortions and are more affected by changes in price of abortions. The income elasticity of demand for abortions is most likely higher for low income women as compared to high income women.

Which items are best to highlight on storefronts

Background

Have you ever wondered how stores decide which discounted items to highlight on their marquee?. A drug store may choose to highlight a discount on milk, while a gas station may choose to highlight a discount on diet soda. But each of these stores sells thousands of different items; why did they highlight these 2 items?

Discussion Question

How could the use of the concept of elasticity answer this question of which items are best to highlight on storefronts?. Please give specific examples in answering the question.

Answer

Stores will want to highlighted discounted items with high elasticities of demand. This is because for items with a high elasticity of demand, a small decrease in price causes a large increase in quantity demanded. Consumers of elastic items will be more interested to know about a discount in the price of these items. Hence it makes sense to highlight discounted items with high price elasticities of demand.

Items that are non essential and have substitutes usually have a higher elasticity of demand. For a drug store, medicines are essential items, while milk is a non essential item with substitutes such as soft drinks or bottled water.Drug stores would want to highlight discounted items that have a high price elasticity of demand. This will increase the sales of that item as compared with items that have a lower price elasticity of demand.

A gas station’s main purpose is to sell gas. People who visit gas stations mainly want to buy gas. A gas station would not benefit much from highlighting discounts in prices of essential items, because consumers of essential items will most likely buy items, even in the case of price changes.

A Gas station would benefit more by highlighting non essential items that have a high price elasticity of demand such as diet soda.

If you want to pay the lowest rent possible, should you hope that demand for apartments is elastic or inelastic

Background

The price elasticity of demand determines which side of the market—buyers or sellers—have more leverage when negotiating the rent of apartments. This is an important issue to understand for any college student choosing to live outside of college dorms during his/her time in college.

Discussion Question

Suppose that in your college town real estate developers are building thousands of new student-friendly apartments close to campus. If you want to pay the lowest rent possible, should you hope that demand for apartments is elastic or inelastic?. Please explain and use a specific example.

Answer

If the demand for apartments is elastic, then a small change in price results in a large change in quantity demanded. When this happens landlords are less likely to increase prices because people are more likely to move to other apartments in case of price increase. Hence people who want to rent apartments have leverage.

If the demand for apartments in inelastic, then a change in price does not result in a large change in quantity demanded. This usually happens when apartments are in great demand and students have no choice but to rent specific apartments. When this happens students who want to rent apartments have less leverage.

So students who want to rent apartments will want to hope that the demand for apartments in inelastic.

Price elasticity of demand and the market for tablets.

Background

Say you were advising Tim Cook (CEO of Apple), who was considering decreasing the price of the iPad by 30% (in order to compete with Amazon’s new Kindle). Further, assume you knew the price elasticity for iPads was -1.3.

Discussion Question

What would be the % change in the quantity of iPads sold as a result of the reduction in price?. What would be your advice to Tim Cook?. If you did not know the price elasticity of iPads and would have to guess, would you guess the demand for iPads was price elastic or inelastic?. Please explain your answer using a specific example.

Answer

I think the demand for iPads is elastic because consumers have many options to choose from. Decreasing the price of iPads should increase the quantity sold by -1.3*-30 = 39%.

When the price of an item increases, the total revenue increases if the price elasticity of demand of the item is inelastic. This is because an increase in price results in a smaller decrease in quantity demanded. Since price increases more than quantity demanded, the total revenue increase.

But if the price elasticity of demand in elastic, then the total revenue decreases as a result of an increase in price.

Since the demand for iPads is elastic, decreasing the price increases the quantity demanded by an amount that is larger than the increase in price. Since quantity demanded increases more than the price decreases, the total revenue increases.

What would be the effect of a beer ban on campus during certain holidays

Background

Beer tends to be one of the most inelastic goods in the United States. An average of many studies suggests the price elasticity of demand for beer in the U.S. to be around -0.26.

Discussion Question

Suppose the city officials around a college town are considering banning the sale of beer during certain holidays in order to prevent student misconduct from intoxication. Given the price elasticity of demand for beer, what would be the effect of such a ban? Please explain using examples.

Answer

If a product has an inelastic demand, it means that its quantity demanded does not change much, when the price changes. This is usually the case for products that are considered essential or addictive, such as beer.

Cutting the supply of an item that is considered as essential, will result in an increase in the price of the item. Low income students will not be able to afford beer. This may result in an increase in the number of students with mental health related problems and also possibly an increase in the crime rate.