The theory of supply and demand can be used to answer a wide range of practical questions. When a new tax is put on gasoline, do drivers bear the burden of the tax or does it fall on the oil companies> Does raising the minimum, wage help workers or hurt them? When all airline lowers its ticket prices. will the number of passengers increase so milch that total revenue actually rises?

In order to turn supply and demand into a truly useful tool, we need to know how much supply and demand respond to changes in price. Some purchases, like those for vacation travel, are very sensitive to price changes. Others, like food or electricity, are necessities for’ which consumer purchases respond very little to price changes. The quantitative relationship between price and quantity purchased is analyzed using the crucial concept of elasticity. The payoff to .this new concept will come in the second half of the chapter, when we examine the micro economic impacts of taxes and other types of government intervention.

PRICE ELASTICITY OF DEMAND

Let’s look first at the response of consumer demand to price changes:

The price elasticity of demand (sometimes simply called price elasticity) measures how much the quantity demanded of a good changes when its price changes. The precise definition of price elasticity is the percentage change in quantity demanded divided by the percentage change in price.

Goods vary enormously in their price elasticity, or sensitivity to price changes. When the price elasticity of a good is high, we say that ·the good has “elastic” demand, which means that its quantity demanded responds greatly to price changes. When the price elasticity of a good is low, it is “inelastic” and its quantity demanded responds little to price changes.

For necessities like food; fuel, shoes, and prescription drugs demand tends to be inelastic. Such items are the staff of life and cannot easily be forgone when their prices rise. By contrast, you can easily substitute other goods when luxuries like, European holidays, 17-year-old Scotch whiskey, and Italian designer clothing rise in price.

Goods that have ready substitutes tend to have more elastic demand than those that have no substitutes’. If all food or footwear prices We,re to rise 20 percent tomorrow, you would hardly expect people to stop eating or to go around barefoot, so food and footwear demands are price-inelastic. On the other hand, if mad-cow disease drives up the price of British beef, people can turn to beef from other countries or to lamb or poultry for their meat needs. Therefore, British beef shows a high price elasticity.

The length of time that people have to respond to price changes also plays a role. A good example is that of gasoline, Suppose you are driving across the country when the price of gasoline suddenly increases, Is it likely that you will sell your car and abandon your vacation? Not really. So in the short run, the demand for gasoline-may be- very inelastic.

In the long run, however, you can adjust your behavior to the higher price of gasoline. You can buy a smaller and’ more fuel-efficient car, ride a bicycle, take the train, move closer to work, or carpool with other people. The ability to.adjust consumption patterns implies that demand elasticizes are generally higher in the long run than in the short run.

Economic factors determine the size of price elasticizes for individual goods: elasticizes tend to be higher when the goods are luxuries, when substitutes are available, and when consumers have more time to adjust their behavior.

 

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