Elasticity, price changes, and changes in total revenue (TR) (total expenditure, (TE)).

In the market for a particular good:Total revenue (TR) is the amount of money sellers take in.Total expenditure (TE) is the amount of money buyers pay out.

Assuming no excise taxes:

TR = TE = p x Q (price x quantity)

Question: When p and Q change as the result of movements along a demand curve, what is the relationship between changes in price and changes in TR?

p

Q

Demand

When p increases,Q decreases, so it’snot clear, withoutmore information,how TR is affected.

Need infoabout elasticityof demand.

p2

Q2

p1

Q1

TR1 = p1 x Q1

TR2 = p2 x Q2

Let’s look at some cases:

Suppose demand is inelastic (%Q < %p) and priceincreases (quantity decreases).

(Keep in mind -- we’re talking about movements along a demand curve.)

TR = TE = p x Q

“big” increase in p . . . combined with “small” decrease in Q

TR = TE increases, on balance.

This is easy to remember by visualizing a demand curve close to the limiting case of perfectly inelastic:

For a demand curve that isclose to perfectly inelastic,it’s obvious that TR = TEincreases when priceincreases.

Q2

p2

p1

Q1

p

Q

Now suppose that demand is elastic (%Q > %p)and price increases (quantity decreases).

TR = TE = p x Q

“small” increase in p. . . combined with “big” decrease in Q

TR = TE decreases, on balance.

Once again, visualizing a demand curve close to thelimiting case -- perfectly elastic this time -- helps usremember the general result:

With a demand curvethat is close to perfectlyelastic, it’s obvious thatthe TR = TE rectanglegets smaller when priceincreases.

p

Q

p1

Q1

p2

Q2

Let’s organize the findings in a table:

inelastic

When demandis . . .

. . . and price

increases

TR = TE

elastic TR = TE

decreases

TR = TE

TR = TE

perf. inelastic TR = TE TR = TE

perf. elastic (can’t really talk about price changes)

unit elastic no change in TR = TE

Own price elasticity of demand can vary . . .from one demand curve to another . . .

and even along a given demand curve.(Text’s discussion of elasticity and linear

demand. (p. 97))

What determines the elasticity of demand?

Availability of substitutes:

A good with close substitutes tends to have more elastic demand than a good with no close substitutes.

Breadth of definition:

Any one of a group of related goods tends to have more elastic demand than the group taken as a whole.

Time horizon (period of time allowed for adjustment to a price change):

The long-run demand for a good will tend to be more elastic than the short-run demand.

Consider the demand for gasoline:

DSR

DLR

p

Q

A price increase from p1 to p2 . . .

p2

Q2

leads to a smaller quantity response (Q1 Q2) in the short-run

Q3

. . . than in the long-run (Q1 Q3)

p1

Q1

Elasticity is a general concept. Whenever we have one variable (X) that depends on another variable (Y) . . .

. . . we can use elasticity to provide a “unit-free” measure of the degree of responsiveness of X to changes in Y.

Elasticities are always ratios of percentage (rather than absolute) changes.

Some other elasticities in economics:

Income elasticity of demand =% in Q demanded

% in income

Algebraic sign and normal vs. inferior goods?

Cross-price elasticity of demand =

% in Q demanded of one good (x)

% in price of another good (y)

Algebraic sign and substitutes vs. complements?

Own price elasticity of supply =

% in Q supplied

% in price

Like demand, supply tends to be more elastic in thelong-run than in the short-run.

OPEC (Organization of Petroleum Exporting Countries) and the price of crude oil.

(http://en.wikipedia.org/wiki/OPEC)

OPEC members include several Persian Gulf region countries (Saudi Arabia, Egypt, United Arab Emirates, etc.) plus a few others (Venezuela, Indonesia, etc.)

An example of a cartel : a group of firms (usually, in this case countries) acting in unison.

Collusion: An agreement among firms (countries) about quantities to produce or prices to charge.

OPEC’s game: Raise the price of crude oil through a coordinated reduction in quantity produced.

OPEC’s greatest successes occurred in mid- to late-70s.

Price, to U.S. buyers, of crude oil imports for Decemberof each year ($/bl.)

(source: http://www.economagic.com/ . . .)

1973 1977 1981 1985 1989

6.34 13.41 34.56 24.23 18.80

1993 1997 2001 2005 2009

11.63 14.21 15.22 50.06 71.24

Inflation-adjusted price, to U.S. buyers, of crude oilimports for Dec. of each year (1973$/bl.)

Real (inflation-adjusted) price increases throughout mid- to-late-70s, peaking around 1981.

Real price decreases though remainder of 80s. Fairlystable through 90’s until about 2003.

Until 2003, prices comparable, in real terms, to 1973.

1973 1977 1981 1985 1989

6.34 9.97 17.00 10.25 6.89

1993 1997 2001 2005 2009

3.68 4.07 3.97 11.70 15.18

Why was OPEC’s success only temporary?

One reason is that both supply and demand are more elastic in the long-run than in the short-run.

DSR

SSR1

When supply decreasesin the short-run (withquite inelastic supplyand demand) . . .

. . . price increases substantially.

Q1973

p1973

SSR2price ofcrude

quantity of crude

DLR

SLR1

SLR2

The same supply shift (same horizontal distancebetween supply curves) in the long-run (with much moreelastic supply and demand) . . .

. . . results in a more modest price increase.

Other reasonsfor OPEC’s short-lived success?

Breakdown incartel discipline. (chapter 16)

Q1973

price ofcrude

p1973

quantity of crude

Market for illegal drugs and drug-related crime.

Costs to society:Ruined lives of addicts and their families are main costs, but . . .. . . there are additional significant costs because addicts often turn to crime to support their addiction.(Drug-related crime: robberies, thefts, muggings.)

Drug-related crime victims’ losses, and law enforcement costs of fighting drug-related crime are additional costs of illegal, addictive drugs.

Two strategies for fighting illegal addictive drugs.

Drug interdiction: Law enforcement efforts to reduce supply . . .. . . by catching and prosecuting pushers, intercepting drug shipments, finding and destroying illegal drug labs, etc.

Drug education: Public educational efforts to decrease demand . . .. . . “Just say ‘No!’” “Drug-free zones” etc.

Effects of drug interdiction:

price ofillegaldrugs

quantity of illegal drugs

Demand -- very! inelastic

S1

S2

Drug interdiction decreases supply . . .. . . increasing the street price of illegal drugs and, because demand is inelastic, increasing expenditureon illegal drugs. More drug-related crime.

Effects of drug education:

price ofillegaldrugs

quantity of illegal drugs

Demand -- very! inelastic

S1

Drug education decreases demand . . .

D2

. . . reducing drug consumption, price, and expenditure. Less drug-related crime.