Econ 100.

2
Discussion Class 4
2/8/18
JC Punongbayan
 Outline
• Housekeeping:
– Please submit Exercise Set 1
– Exercise Set 2: Will upload on February 15 (Th)
– Exam 1: February 25 (Sun)
• Elasticity
– Some exercises
 Elasticity
• S-D model.
– Law of demand.
– “Law” of supply.
• Not all demand curves look
alike. Source

– But by how much?

• Applications:
– Revenue maximization
– Taxes
– Illegal drugs
 Elasticity
• “Elastic” supply/demand:
– “Quantity is very responsive to a price change.”
• “Inelastic” supply/demand:
– “Quantity is not very responsive to a price change.”
• Unitless measure (usually in absolute value).

EP = % change in quantity /
% change in price
If Q=quantity,
P=price:
 Elasticity
Price
DQ > DQ
D1 DQ /Q0 > DQ /Q 0
DQ /Q0 >DQ
_____ /Q0
_____
D2 -DP /P0 – DP /P0

P0 From the same price and

quantity on the same scale,
P a steeper curve is less elastic.
P1
Q Q

Q0 Q1 Q2
Quantity
Source: Prof
Noel de Dios N.B. DP is negative in this example.
Source
 Elasticity of demand
(factors)

• Availability of substitutes
• Necessities vs. luxuries
• Broad vs. narrow markets
• Smaller share of budget
• Brand loyalty
• Time
 Q1
• In each of the following, which good has a
relatively more price elastic demand?
Why?
– Principles of Economics by Mankiw or
Turtles All the Way Down
– Root beer or water
– Cars or Chevy Camaro
– Vacation air travel or air travel
prompted by illness in the family
– 2017 Toyota Vios or same model 5 years
later
 Q2
• The DOF found out in a
study that the price
elasticity of demand for
all soft drinks in the PH
ranges from –0.8 to –1.0.
• If prices increase by
10%, by how much will
soft drink consumption
change?
 Elasticity and revenue
Price

D1
Revenue decreases as price falls
on the inelastic curve.
D2
Revenue increases as price falls
on the elastic curve.
P0

a So for the same price

change, revenue falls for
P1 inelastic curve, rises for
elastic curve.
b c d

Q0 Q1 Q2
Quantity
Source: Prof
Noel de Dios
 Application: Illegal drugs
Supply reduction (a.k.a. “drug interdiction”)

Price (1) A reduction in supply…

P1 (4) And also

increases
revenues to
suppliers (and
P0 consequently,
drug-related
(3) But
increases the
Revenue 1 crimes).

price of drugs… (20% increase)

Revenue 0

Quantity
Q1 Q0
(2) Reduces drug use…
 Application: Illegal drugs
Demand reduction (e.g., education, rehab)

Price
(1) A reduction in demand…

P0
(4) And also
decreases
P1 revenues to
suppliers (and
(3) Decreases consequently,
the price of
Revenue
Revenue 1 0 drug-related
drugs… (52% decrease) crimes).

Quantity
Q1 Q0
(2) That reduces drug use
by the same amount…
 Note: Elasticity can vary
along the same demand curve
Price
D1
Revenue increases as price falls
on the elastic part of the curve
P0
Revenue falls as price falls
a on the inelastic part of the curve.

P1
So for the same curve,
d
revenue falls for inelastic
P2 b c segment, rises for elastic
segment.
e f

Q0 Q1 Q2
Quantity
Source: Prof
Noel de Dios
APPLICATION
Bad harvest is good news
(for farmers)
Price
S
D
Revenue decreases on a good harvest.
• Loss greater than gain (a>c).

Revenue increases as on a bad harvest.

P0
• Gain greater than loss (a>c).
a
P1

b c

Q0 Q1
Quantity
 APPLICATION Hotel/resort rates are higher
during weekends & holidays
• Peak and off-peak pricing (e.g., electricity rates, Uber).
 Elasticity of demand:
midpoint method
• Problem with the simple method of
computing elasticity:
– Formula can give a different value depending on
whether one is measuring a price increase or a
price decrease.
– Because the percentage increase in price or
quantity depends on the “base” or starting point:
Q0 and P0.
 Exercise!
(Calculators out!)
• From 2 to 9. • 350%

• From 33 to 100. • 203.03%

• From 9 to 2. • –77.8%

• From 100 to 33. • –67%

 Elasticity of demand:
midpoint method
price From A to B, elasticity is:
(40 – 30)/30)(2 – 4)/4
= (1/3)/(–1/2) = 2/3.

A
From B to A, elasticity is:
4 –(30 – 40)/40)((4 –2)/2)
= –(–1/4)/(1) = 1/4.
B
2

Source: Prof
30 40 quantity
Noel De Dios
 Elasticity of demand:
midpoint method
• Solution: make the base equal to the average of the
initial and terminal values.
• So instead of using Q0 and P0, use their averages:
 Elasticity of demand:
midpoint method
price
From A to B, elasticity is:
(40 – 30)/(40+30)/2
(2 – 4)/(4 +2)/2
= (10/35)/(–2/3) = 3/7.
A
4 From B to A, elasticity is:
(30–40)/(40+30)/2
B (4–2)/(4+2)/2
= (–10/35)/(2/3) = 3/7.
2

Source: Prof
30 40 quantity
Noel De Dios
 Q3
• Using the midpoint method for
calculating the elasticity of demand, if
the price of Oreos fell from P42 to P38
per pack, what would be the elasticity
of demand if the quantity demanded
changed from:
19 to 21 packs/year
27 to 33
195 to 205
 Q4
• The MRT-3 management wants to
boost revenues from fares in 2018.
You are hired as an economic
consultant and asked to advise the
management on whether to raise
or lower fares next year.
• If the elasticity of demand for MRT
rides is estimated to be 2.3, Source

what would you advise?

• What if the elasticity of demand
equals 0.1?
 APPLICATION
A tax on a good
• A tax raises the price at which a good is bought or
sold.
– Reduces quantity demanded and raises price.
• The price increase is almost never fully passed on to
the buyers, however.
– It is borne by the buyer in the form of a higher price, and
the seller in the form of lower profits.
• So who pays for a tax?
– Both consumers and producers.
• Who pays more?
– Depends on relative elasticities.
 APPLICATION
A tax on a good
Price
S+T
Revenue for
government
S
T
PD
P0
PS

D
Quantity
Source: Prof Qt Qo
Noel De Dios
 APPLICATION
A tax on a good
Price

Revenue for
government
S

PD
Hence, taxes on buyers
P 0 and taxes on producers
D are equivalent!
P S
T

D–T
Quantity
Source: Prof Qt Qo
Noel De Dios
 APPLICATION
A tax on a good
Price
T=tax “wedge”=amount of tax
per unit
Revenue for
government Tc = tax share of consumers

Consumers’ S (they used to pay P0, but now

they pay a higher PD, so the
share of total extra burden to them is PD–P0)
tax bill = Tc*Qt
PD T Tp = tax burden of producers
Producers’ Tc (they used to receive P0, but
share of total now they receive a lower PS, so
tax bill = Tp*Qt P0
Tp the extra burden to them is P0–
PS)
Total tax bill = PS
T*Qt= Note: Tc + Tp = T
Tc*Qt + Tp*Qt

D
Quantity
Source: Prof Qt Qo
Noel De Dios
 Q3: In the following, who pays more for the tax?
(Note: regardless of tax size.)

Source
 APPLICATION
A tax on a good
• Taxes on buyers and taxes on sellers are
equivalent!
– Not a matter of who pays the tax, but who
pays more.
• Whoever is less responsive
(inflexible/inelastic) to price changes
carries the tax burden more.
– Those with greater responsiveness pay less,
since they have more substitutes to switch
to.
• The burden of the tax borne by buyers is
reduced as the elasticity of demand for
the good increases. (Same for suppliers.)
– E.g. A tax on rice vs. a tax on beef (which
hurts consumers more?).
– E.g. Luxury tax in US (like yachts, planes).
• What is the equilibrium
price pre-tax? Q4
• What is the amount of the
tax? price
S after tax
• How much of the tax will 9
buyers pay? 8
• How much of the tax will
7
sellers pay? S
6
• How much will the buyer
pay for the product post- 5
tax? 4
• How much will the seller 3
receive post-tax?
2
• Because of the tax, what has D
1
happened to the level of
market activity?
2 4 6 8 10 12 14 16 quantity
• How much revenue did gov’t
earn?
END