[Music]
Happiness happens when someone supplies what
you need and want, both matched at marginal
cost and marginal benefit equilibrium.
Then something unexpected happens,
like a
serious cold front blowing in the middle of July.
Will stores have winter boots and snow shovels
ready?
People will want them, but to get them, they
will need to pay big time.
Let's look to Wandering Oaken's Trading Post
for some insights about elasticity of Demand.
Wandering Oaken's Trading Post and Sauna?
Big summer blow out!
Half off swimming suits clogs and a Sun Balm
of my own invention, yeah
oh great for now um how about
boots winter boots and dresses?
that would be our winter department
oh um I was just wondering has another
young woman the Queen perhaps I don't
know passed through here?
only one crazy enough to be out
in this storm is you dear
You and this fellow who hoo big summer
Blowout.
Oh a real howler in July, yes?
Where ever could it be coming from?
The North Mountain.
That'll be forty.
Forty?
No ten.
Oh dear, that's no good.
see is this is from out of winter stock
where supply and demand have a big problem.
You want to talk about supply
and demand problem?
I sell ice for a living.
Whoo, that's a rough business to be in right
Now, I mean that is really ...
that's unfortunate
Still 40 but I will throw in a visit to
Oaken's Sauna.
Whoo ho!
Hi family!
Ten is all I got!
Help me out.
OK, ten will get you this and
no more.
it seem magical?
Yes, now back up while
I deal with his Crook here.
What did you call me?
We need to look closer at Oken's Trading Post
situation to see what was happening to inventory
as it went from mid-July supplies to face
the storms Elsa wrought.
Seems Anna needed some boots and dry clothes,
and maybe a sauna.
Oaken had dropped his summer inventory prices
because of the blizzard outside.
Half-off swim suits, clogs and that homebrew
sun balm.
Demand was way down and elasticity of demand
was super flat.
Oken saw how his customers would have a very
elastic demand curve for these summer products,
meaning they would not pay what we might call
a high demand price for them.
Remember the rubber band symbolism I shared
in Chapter 3?
That is elastic and represents demand for
the carrots Kristoff wanted and the balm Oken
wants to sell.
Oken drops the price on the summer goods because
Demand dropped seriously low.
Pivot that around to the ice pick and the
rope Kristoff wants and see that Oken's inventory
was super low for those so he felt he could
stand firm on the price of 40.
It is supposed to be summer in July so his
inventory matches the season.
Oken saw the inelastic demand curves for Anna
for boots and a dress, and Kristoff's ice
pick and rope, think of the stiff crutch for
those winter goods.
Flash winter weather in July?
Limited stock in his inventory?
Patrons with a need?
Ja sikkert!
Yah, sure!
Oken was willing to throw in a Sauna session
with his family!
Don't get too surprised by that detail: it's
a Scandinavian thing.
Kristoff should have understood Oken's dilemma
since he was an ice salesman in the middle
of a blizzard.
Both knew something about inelastic supply
and demand curves.
Kristoff should not have called Oken a crook!
He is a poster of good business edict, especially
in Norway!
That is the world of Disney-economics, OK
we got it, so now we bring ourselves back
to life here in the real world.
We explore something near and dear to most
of our hearts - the cost of gasoline.
In September 2012, when the average price
of gasoline was $3.91 per gallon,
U.S. consumers bought about 5 percent less than
they had in September 2011 when the average
price of gasoline was $3.66 per gallon.
This behavior contradicts those who argue
that consumers don't vary the quantity of
gasoline they buy as the price fluctuates.
Consumers have found many ways to cut back
on the quantity of gasoline they purchase,
including moving closer to their work places
and buying more fuel-efficient automobiles.
Some folks learn to ride a bike to work, or
even walk!
[Music]
Unless you have been living in the shadow
of the North Mountain with the Rock People,
you have heard of life saving drugs whose
prices have been elevated by hundreds of percent.
People facing the choice of living with the
drug, or dying, will pay the price at least
until that option is also gone.
You might ask, "how can companies do this?!"
They do it because they know of inelastic
demand for certain products and how it enables
them to increase profits.
We will look more at this example in several
minutes.
Elasticity is a measure of how much one economic
variable responds to changes in another economic
variable.
The price elasticity of demand is the responsiveness
of the quantity demanded to a change in price,
measured by dividing the percentage change
in the quantity demanded of a product by the
percentage change in the product's price.
The slope of the demand curve is not used
to measure elasticity because the measurement
of slope is sensitive to the units chosen
for quantity and price.
Measure in US dollars and the result is different
than if you use Canadian dollars,
or Japanese Yen.
We need to use an ultimately stable metric.
To avoid the slope problem, we look to the
percent change of quantity demanded divided
by the percent change in price.
This gives us, specifically, a Price Elasticity
of Demand.
The price elasticity of demand is always negative.
That is because of the downward sloping to
the right Demand curve -
you remember  that part, right?
Because we are usually interested in the relative
size of elasticities, we often compare their
absolute values.
Negative numbers are generated, but we really
never repeat that negative sign, instead just
knowing that everyone recognizes it as a negative.
It is stated in absolute value.
Elastic demand refers to when the percentage
change in quantity demanded is greater than
the percentage change in price, so the price
elasticity is greater than 1 in absolute value.
Inelastic demand refers to when the percentage
change in quantity demanded is less than the
percentage change in price, so the price elasticity
is less than 1 in absolute value.
Unit-elastic demand refers to when the percentage
change in quantity demanded is equal to the
percentage change in price, so the price elasticity
is equal to 1 in absolute value.
When calculating the price elasticity between
two points on a demand curve, we may run into
a problem because we get a different value
for price increases than for price decreases.
Study Demand curve 1 to recognize it is relatively
flat, or elastic -
you remember that rubber band getting stretched horizontally?
Here it is.
Start with point A at $4 and a quantity of
1,000 gallons.
Price is cut to $3.70 and people buy 1,200
gallons.
We consider this shift to be elastic.
On Demand 2 the same price reduction shifted
gas demand from 1,000 to 1,050 gallons.
It is a steeper demand curve, or more inelastic
within this price change range.
We need to apply the percent change formula
to this situation with a huge caution about
getting different answers when we take A minus
B percentage versus B minus A percentage.
The method of avoiding this unfortunate situation
is to use a strategy called the midpoint formula.
In the numerator, calculate A minus B and
set the denominator as A plus B divided by two.
Then you have the percentage change you can
use.
There is no movement from a low price to a
high price, or vice versa.
The answer is always right.
The midpoint formula arranges the calculation
of demand challenges of the movement going
up in prices versus down in prices.
At first glance, this formula looks a little
intimidating, but really it is just four numbers
plugged into specific places to get your answer.
A little trick I use might help you.
I am an economist who uses these calculations
occasionally, but not so much that I have
them perfectly memorized.
I do have a poster on the wall next to my
office desk with formulas like this one printed
on it.
When I need those results, I just look it
up and make double sure I have it right.
We can light this candle to see what our gasoline
market looks like.
We study gas prices falling from $3.50 to
$3.30 and a jump in Demand matching at
2,000 gallons and 2,500 gallons.
We find gas quantity averages 2,250 gallons
and price average over this range is $3.40.
Our next step is finding the percentage change
in quantity as B minus A divided by the average
quantity, times 100 to discover a 22.2% change
in quantity demanded.
Same path for the percentage change in price,
B minus A over average price in this range,
and we get -5.9%.
Last step, our quantity percent divided by
our price percent shows us -3.8.
Notice that the percent signs cancel out with
numerator and denominator both carrying the
percent sign so we get that -3.8 as an elasticity
value.
Also, remember we talk in absolute terms on
these measurements.
We would say that at this range, it is greater than -1
so we have a price elastic demand curve.
You might get into the results of your product
to find different demand responses to the
changes in price.
What if price dropped like it did before,
from $3.50 to $3.30 per gallon, but the quantity
demanded increased from 2,000 gallons to 2,100?
We still have a 5.9% drop in price, but now
the change in quantity is 4.9%, instead of
the 22.2% we saw a minute ago.
Plugging in these new numbers, we have price
elasticity of demand resulting in a -0.8.
This is smaller than -1 so we conclude it
is inelastic.
Remember the vertical crutches and inelasticity?
This is the idea here.
It is not perfectly inelastic, but it is more
vertical than the earlier example.
In these comparative numbers, we talk of more
elastic and more inelastic measurements.
Perfectly inelastic would be totally vertical,
this one is not.
Elastic demand refers to when the percentage
change in quantity demanded is greater than
the percentage change in price, so the price
elasticity is greater than 1 in absolute value.
Inelastic demand refers to when the percentage
change in quantity demanded is less than the
percentage change in price, so the price elasticity
is less than 1 in absolute terms.
Unit-elastic demand refers to when the percentage
change in quantity demanded is equal to the
percentage change in price, so the price elasticity
is equal to 1 in absolute value.
I keep using relative terms like "more elastic"
and "less inelastic".
Always having a reference to relate to leads
to confusion.
Here is how we avoid that situation.
When we conclude demand is elastic, it means
price elasticity is greater than 1, in absolute
terms, and the line is pretty much at a 45
degree angle.
Not perfectly 45 degrees, but in this range.
Maybe more, maybe less.
The stepper the demand sloping to the right,
the more it is trending vertical,
like a stiff crutch,
under someone who is too short for
the support, so it leans to the side.
Here price elasticity is less than 1.
In the most recent example about gas prices,
we had the first demand curve with a price
elasticity of demand equal to 3.8: that is
like the first demand curve.
In the second example, price elasticity of
demand was 0.8:
that is the inelastic demand curve shown here.
When that nearly 45 degree demand curve is
exactly at 45 degrees, we have unit elastic
and midpoint formulas giving us the result
of exactly 1.
When increases in price results in complete
drop in demand
you have perfectly elastic goods.
We will explore this in a lot more detail
with Perfectly Competitive markets for things
like carrots, bottled water, and even gasoline
for your car.
Stay tuned.
At the far end of the spectrum, we have perfectly
inelastic goods where price can be increased
without decreasing the quantity demanded.
This can be seen when considering a life-saving
pharmaceutical medicine: people will pay anything
they can to save their life, right?
Actually, if that is the situation then the
person in need of the drug will eventually
die and the quantity demanded will drop.
That is definitely the deep end of this scenario
and hopefully an alternative will be identified
before we go that far.
We can drive back into some examples a bit
more relevant to our daily lives: gasoline.
Is gasoline for our vehicles elastic or inelastic?
We look at our demand curve for gas as a perfectly
inelastic demand curve, consider if supply
shifts to the left.
The new intersection is at a higher price,
but demand does not change.
If we have a more elastic demand curve, the
supply curve shift to the left causes price
to go up, but quantity demanded goes down.
This is a lot closer to our reality.
When fuel price goes up, holding everything
else constant, people buy less gasoline.
We walk to work or class, we take the bus,
and we travel less.
Fuel demand is elastic.
[Music]
Now we know price elasticity of demand is
important, but what really gives us the insights
to predict it?
There are five key factors we give our attention
to.
The availability of substitutes is the most
important determinant of the price elasticity
of demand.
In general, if a product has more substitutes
available, it will have a more elastic demand.
If a product has fewer substitutes available,
it will have a less elastic demand.
A close substitute might be your jeans, shoes,
farm foods like apples and oranges, but in
terms of gasoline, we really do not have a
direct substitute for it,
so we look for alternatives to travel.
The passage of time is a key variable to elasticity.
In the short-run, you will shoulder increases
in fuel prices, but you may directly deal
with it in the long-run by moving to a new
home closer to work, or find a place along
the bus-route.
You might look really close at Tesla motor
company
to purchase one of their electric cars.
People find loads of techniques to deal with
price and demand challenges.
There are certain goods we all feel we need
and will buy at about any price.
In big categories, these are things like food
for our home, and basic clothing.
When the price goes up, we may purchase less,
but not drastically less -
we still need to eat.
We will purchase bread and milk to feed us.
We might not purchase those luxury foods like
lobster tail or Beluga Caviar.
Price goes up on those foods, we can take
a pass.
Look around your town and see how many luxury
restaurants remain open after the general
slowdown of the US economy from about 2005
through 2016.
Where once there were some nice eateries scattered
around the bigger cities, today those are
few and far between.
The demand for food from those luxury restaurants
went down, and as a result, many of them closed.
If you are a style horse, only wearing high
style outfits made by the best clothiers of
France, your narrow definition of fashion
will dictate that you are much less influenced
by price then the rest of us.
Other folks will buy the generic brands, visit
the Goodwill outlet, or just shop around for
a better price.
Right there, you are adjusting your definition
of your market for goods and therefore, your
definition of the market.
In general, the demand for a good will be
more elastic the larger the share of the good
in the average consumer's budget.
For instance, I purchase a new computer rarely,
like one every 10 years, when I purchase one
it is a really strong computer, but my sensitivity
to computer prices is pretty low.
On the other hand, I purchase coffee beans
and chai mix every week spending a good share
of my disposable income on them.
So, my sensitivity to those prices is quite
a bit higher than a computer or tires for
my car and truck.
Take a look through this list to find items
like milk, gas, and sugar with super low price
elasticities of demand.
Folks are mostly insensitive to price when
buying these goods.
A big step up comes on with beer, cigarettes,
or cocaine.
Those are only marginally lower than water,
bread, or health insurance.
Health insurance became especially less sensitive
to price with the Affordable Care Act of 2010
when the choice to buy it or not became a
penalty enforcement.
Look at automobiles to see its price elasticity
of demand approaching 2.0 where people are
much more sensitive to price.
This is why there is such a stable market
for used cars.
I will put off the big purchase of big ticket
items to avoid spending the big bucks.
Finally, be surprised to see printed books
topping this list with a price elasticity
of demand at 4.0.
Kindle apps really made clinic on the market
for printed books.
Now if it could only make the pass to college
textbooks!
The question about market scope is most interesting.
Personally, when I was a young guy I was most
happy to have a meal in the morning and whether
it was oatmeal, cheerios, an egg on flapjacks
I was eating.
Now as a grandfather, I see the preferences
for the right food to be pretty important
to most breakfast visitors.
If we look only at the broad collection of
breakfast foods, then the price elasticity
of demand is about 0.9, but as I narrow the
classification to cereals, then specifically
to Post Raisin Bran, the elasticity climbs
to 2.5.
Seems those folks who like their Raisin Bran
are very particular about their 5 juicy raisins
in every spoon.
Hey Post Cereals, nice job of marketing!
[Music]
You are in a microeconomics class and I have
trekked through this mind numbing discussion
about a stretching rubber band and someone's
crutches.
You might be thinking, "what can this possibly
have to do with my life?"
Now, I give you a shocking example of what
this has to do with your understanding of
price elasticities.
The following video is a term report video
completed for the Fall 2016 microeconomics
class, by Stephanie Peters about pharmaceutical
companies and their pricing and marketing
of EpiPen.
I like this video for this lecture because
it describes an inelastic demand curve while
also preparing us for Chapter 7, next week,
as we talk about healthcare in the USA.
Stephanie, take it over.
[Music]
In this video I'll be discussing the
prescription drug industry including the
process of research and development and
the FDA's involvement I'll also be
discussing the manufacturing process the
way that drugs are marketed and sold the
in elasticity of demand in the
pharmaceutical market and the ever
increasing prices of prescriptions
in 1850 the life expectancy at birth was
38.3 years of age
fast forward to 2013 and that number has
more than doubled to 78.7 years our
world has changed drastically over the
last hundred and sixty-six years thanks
in part to the ever-decreasing
physicality of everyday life increasing
knowledge of healthy habits and
practices and most importantly the
incredible advances and technology and in medicine
when a pharmaceutical company is looking
to introduce a new drug to market the
FDA requires that they perform their own
testing the results of which are then
submitted to the Food and Drug
Administration the test results are
required to show evidence of the drugs
effectiveness to the FDA's Center for
Drug Evaluation and Research if the
proven benefits are not outnumbered by
the known risks the drug will be
approved for sale
the Center for Drug Evaluation and
Research is the largest of the FDA six
centers they do not perform any testing
themselves and instead review new drug
applications as well as the proposed
labeling
while pharmaceutical company is often
point to the high cost of research and
development as the reason behind high
medication costs
this isn't entirely the truth the
majority of the research that leads to
the discovery of new drugs is either
funded by venture capital or federal
grants the FDA and advertently plays a
role in the rising cost of prescription
drugs to the approval process taking an
extremely long time with backlogs
causing delays upwards of three years
many generic options for high-priced
brand-name drugs are often stuck in this
backlog the introduction of two generic
alternatives to market and cause a
fifty-five percent price decline in the
name-brand option a combination of
20-plus your patents granted by the
United States government and the FDA
granted exclusivity can create
monopolies
after a drug has been approved by the
FDA it will go into the manufacturing
process manufacturing facilities are
held to the FDA's current good
manufacturing practice regulations to
ensure a high level of quality
in the producer price index for
pharmaceutical manufacturing from 1981
to 2016 it is evident that the cost of
manufacturing has increased drastically
over the decades but I was interested to
see how it compared to the PPI for all
commodities the results were pretty
shocking in June of 1981 there was a
1.5% difference between the PPI forma
suitable manufacturing and the ppi for
all commodities but by September of
2016 the producer price index for
pharmaceutical manufacturing with
seventy-four percent higher than the
other in 2004 the FDA released a report
stating that pharmaceutical
manufacturing operations are inefficient
and costly compared to other industrial
sectors opportunities for improving
efficiency and quality assurance are not
generally well recognized it would
appear to me that despite the attention
surrounding the inefficient and costly
pharmaceutical manufacturing process it
only appears to be rapidly getting more
expensive
marketing is a crucial component of the
pharmaceutical industries mission to
make a profit
this explains why nine out of ten
companies spend more on their marketing
and sales efforts than they do on
research and development Johnson &
Johnson spends more than double on
marketing than they do on research and
development and they are not alone in
their absorbent spending
at this point you would be hard-pressed
to find a US citizen who does not know
the name EpiPen what the average person
may not know is that from the time that
mylan acquired the EpiPen in 2007 the
number of people using the product has
increased by sixty-seven percent while
the price has increased by five hundred
percent nylon made the brand EpiPen a
household name much like Kleenex this is
the ultimate goal for pharmaceutical
marketers as doctors will often write
prescriptions for the brands they know
best and not necessarily the best for
their patients needs or the most
affordable medication
pharmaceutical sales representatives
main job is to create awareness for
their firms products these firms
marketing budgets often include a large
allowance for providing free samples of
their products to physicians who in turn
give them to their patients these
samples have proven themselves to be
incredibly effective resulting in
increased prescriptions written for the
drug patients are often unaware of
generic options for the financial
savings that go along with the generic
options
unfortunately relationships between
physicians and pharmaceutical companies
can create serious conflicts of interest
while illegal for doctors to be paid
kickbacks for prescribing medication it
is legal for them to be paid to help
promote a medication some doctors are
paid tens to hundreds of thousands of
dollars to work with big pharma
companies this arrangement is aiding in
the creation of an environment where
patients need to question their
physicians motives
do they have their patients best
interest at heart for their own checking
accounts best interests at heart
the pharmaceutical industry is a
business and just like all businesses
that is focused on making a profit
determine the price of a product is part
of the marketing process and is
of the product as the quantity demanded
for certain medications increases the
quantity supplied and price also tend to
increase pharmaceutical companies are
a
sixty-two-year-old drug daraprim by 5556
percent an increase from 1350 a pill to
750 dollars per pill when demanded an
explanation by Congress and the media he
stated that his only regret was that he
didn't raise the prices higher and that
his duty was to maximize profits because
the stakeholders expected him to make
the most profit the inelastic demand of
daraprim allowed bellies morally corrupt
practices to benefit the company
financially their consumers would pay
for the drug no matter the cost
the branded pharmaceutical industry on
average increases their prices by nine
point five percent annually while milan
the maker of epi pen has increased the
cost by twenty-four percent annually an
EpiPen has about a dollars worth of
epinephrine which contained within it
when Milan CEO Heather brush testified
before congress to explain the 608
dollar price tag on a 2-pack of epi pen
she stated that Milan makes 275 / to
pack but after paying the manufacturer
$69 and paying thirty-six dollars toward
marketing and awareness island claims a
profit of one hundred dollars per to
pack the remaining seventy dollars is
not addressed but my assumption is that
it goes towards additional operating
expenses as well as Heather brushes 18
million dollar annual salary a 671
percent increase since milan acquired
the EpiPen brand
EpiPen perfectly displays the problems
that I see with the healthcare industry
as a whole sick and dying people are not
able to afford treatment
the government has no say in what
providers charge American citizens for
their goods and services typically
countries with national healthcare
programs can negotiate drug prices with
pharmaceutical companies
in 2008 President Obama reach an
agreement with the pharmaceutical
industry that Medicare would continue to
be allowed to negotiate drug prices but
Medicare still pays between a hundred
and fifty to three hundred percent more
than the average wealthy nation pays for
the same prescription drugs in 2011.the
cholesterol-lowering drug lipitor
feel they're taxed too much and I can
understand the frustration but Medicare
a taxpayer funded program is one of the
largest purchasers of prescription drugs
in the country the ability for Medicare
to more effectively be able to negotiate
drug prices would save the program of
fortune if we no longer had to pay for
the portions of our medical bills not
covered by insurance and no longer paid
for private medical insurance and
instead have that money deducted from
our paychecks and put into a single pair
fund I theorize that most US citizens
would barely notice a change in their
discretionary income moving to a single
pair healthcare system that allows for
government entities to negotiate
prescription drug costs and to determine
the cost of medical procedures would
certainly mean changes and the incomes
of those and the healthcare and
pharmaceutical industry but the benefits
to society as a whole would be priceless
I'm not naive to the fact that it would
be an initially expensive transition and
I'm not ignorant enough to believe that
I know all of the facts and ins and outs
of the economic ramifications but our
healthcare system is very broken and
something needs to change
I do not believe there is a simple
solution to this need for change.
[Music]
Thank you Stephanie Peters!
After watching the EpiPen marketing experience,
you can seriously appreciate the price inelastic
demand and how it spells out excessive profits
for the producer who raises price to see demand
shift only very slightly.
Total profits increase.
Now the opposite is seen in markets for perfectly
competitive products, like farm food such
as apples or plumbs.
Slightly more elastic goods for things like
smart phones, tablets, and laptops have producers
that strive to build brand loyalty.
Everyone is striving to find the target where
price and demand bring the highest net profit.
Firms are interested in price elasticity because
it allows them to calculate how changes in
price will affect its total revenue.
Total revenue is the total amount of funds
a seller receives from selling a good or service,
calculated by multiplying price per unit by
the number of units sold.
When demand is inelastic, price and total
revenue move in the same direction: An increase
in price raises total revenue, and a decrease
in price reduces total revenue.
When demand is elastic, price and total revenue
move inversely: An increase in price reduces
total revenue, and a decrease in price raises
it.
If demand is unit elastic, a change in price
is exactly offset by a proportional change
in quantity demanded, leaving revenue unaffected.
When demand is inelastic, a cut in price will
decrease total revenue.
At point A, the price is $4.00, 1,000 gallons
are sold, and total revenue received by the
service station equals $4.00 1,000 gallons,
or $4,000.
At point B, cutting the price to $3.70 increases
the quantity demanded to 1,050 gallons, but
the fall in price more than offsets the increase
in quantity.
As a result, revenue falls to $3.70 1,050
gallons, or $3,885.
Total revenue went down $115, or 2.88%.
At point A, the areas of rectangles C and
D are still equal to $4,000.
But at point B, the areas of rectangles D
and E are equal to $3.70 times 1,200 gallons,
or $4,440.
In this case, the increase in the quantity
demanded is large enough to offset the fall
in price, so total revenue increases by $440.
Price elasticity of demand gives us the prediction
of a whether price per unit decrease will
increase total profits, or decrease it.
If elasticity is greater than one, revenue
will increase when raising the price.
Think of Mylan's acquisition of EpiPen and
the price increase by 671%.
Sure, that inelastic demand curve increased
profits.
When price elasticity of demand is less than
one, you lower price and capture more buyers
and higher revenue.
Loads of companies create market demand by
being the low-cost provider and as consumers
we often find those products preferable.
Think of your preferred mobile device service
provider - you found the plan to match your
needs at your price.
Ya, you got it!
The data from the table are plotted in the
graphs.
This panel shows that as we move down the
demand curve for gasoline, the price elasticity
of demand declines.
In other words, at higher prices, demand is
elastic, and at lower prices, demand is inelastic.
Think about what this means, when fuel is
super high priced you will buy very little
of it.
Then, even if it drops a dollar per gallon
folks would step up to buy only a little.
But when the price is below $2 a gallon, most
everyone will be happy to buy more of it.
It is relatively cheap so I consume more.
This screen shows that as the quantity of
gasoline purchased increases from 0, revenue
will increase until it reaches a maximum of
$32 when 8 gallons are purchased at a price
of $4 per gallon.
As purchases increase beyond 8 gallons, revenue
falls because demand is inelastic in this
portion of the demand curve.
This is brought into focus when considering
price elasticity of demand.
We calculate it based on the percent price
change in relation to the percent demand change
at each level of consumption.
I might have an inelastic price elasticity
of demand of high prices and another at low
prices.
Where would you like to be operating in your
business?
Do you really want to sell products at prices
in the elastic range, unit-elastic range,
or in the inelastic range.
Seriously, think about it.
It is deceptive to think you want to be in
Mylan's seat where you can raise your price
to create your own money printing press.
It really pivots on your product and the demand
for it.
In this graph recognize how total revenue
is maximized where price per gallon is $4
and total revenue is $32 because you sold
8 gallons per day.
You will not make more than this at any price
point.
I could read this table to you, but really,
the only way you will recall these reactions
is for you to read it, study it, and recreate
the reasoning to make it yourself.
Mastering this table will give you such ability
to make a difference as you price your product
to manage total revenue.
This is where your x-ray vision is found.
To estimate the price elasticity of demand,
a firm needs to know the demand curve for
its product.
To calculate the price elasticity of demand
for new products, firms often rely on market
experiments, where firms will try different
prices and observe the change in quantity
demanded.
A test market, in the field of business and
marketing, is a geographic region or demographic
group used to gauge the viability of a product
or service in the mass market prior to a wide
scale roll-out.
Firms launch new product ideas in small but
distinct markets where packaging, advertising,
prices, and related factors are tested.
They are trying to create an estimate of how
these will combine in nationwide markets.
Firms want to estimate their price elasticity
of demand in markets to get close to the product
roll out price.
[Music]
The cross-price elasticity of demand is the
percentage change in quantity demanded of
one good divided by the percentage change
in the price of another good.
An increase in the price of a substitute will
lead to an increase in quantity demanded,
so the cross-price elasticity of demand will
be positive.
An increase in the price of a complement will
lead to a decrease in the quantity demanded,
so the cross-price elasticity of demand will
be negative.
Think about this, use these terms to identify
what is reasonable to surmise about price
changes.
If the price of Lenovo tablets raises, and
the substitute commodity iPad Pro price stays
the same, folks will gravitate to the lower
priced iPad Pro tablet.
It is a positive cross-price elasticity of
demand.
When commodities are complements, their cross-price
elasticity reacts similarly to price changes.
For instance, if iPad Pro prices increase,
reducing demand, then demand for the iMovie
for iOS app will also decrease.
Cross-price elasticity of demand for iPads
will drive demand for Apps that run on it.
Finally, know we are awash in a sea of unrelated
products.
The price of parking on campus really does
not affect the cost of rice in Tokyo.
If the quantity demanded of a good increases
as income increases, then the good is a normal good.
Normal goods are often further subdivided
into luxuries and necessities.
The income elasticity of demand for a necessity
is positive but less than 1.
The income elasticity of demand for a luxury
is greater than 1.
A good is inferior if the quantity demanded
falls as income increases.
I talk loads about normal and inferior goods
and how we respond to them in the marketplace.
Their categories are based on how we each
react to them because of our income.
The normal goods which are also necessity
goods will have income elasticity less than 1.
When we make more income, our typical buying
habits of normal and necessity goods, show
how we might be buying more staple foods like
bread, meat, juice or vegetables.
The normal goods which are also luxury goods
will have income elasticity greater than 1.
These always catch me off-guard.
It seems that at the University of Virginia
folks see alcohol as a staple of life.
Price elasticity of beer indicates it is inelastic.
The Cross price elasticity between beer and
wine identifies them as compliments, but between
beer and spirits they are less of a compliment.
Really, folks are combining these?
The last one identifies beer as a necessity
good.
At this low number 0.09, consider that folks
would buy their beer before they purchase
lesser necessities like breakfast cereals
or bread.
Do you think this University of Virginia study
applies anywhere else?
Hmm, it is worth considering.
[Music]
From 1950 to 2013, the number of farms decreased
from 5 million to about 2 million, and the
number of people who lived on farms fell from
23 million to fewer than 3 million.
Rapid growth in farm output has combined with
low price and income elasticities to make
family farming difficult in the United States.
In 1950, the average U.S. wheat farmer harvested
about 17 bushels from each acre.
By 2013, the average U.S. farmer harvested
46 bushels per acre.
This increase in wheat production resulted
in a substantial decline in prices because:
(1) the demand for wheat is inelastic, and
(2) the income elasticity of demand for wheat
is low.
In 1950, U.S. farmers produced 1.0 billion
bushels of wheat at a price of $19.29 per
bushel.
Over the next 60 years, rapid increases in
farm productivity caused a large shift to
the right in the supply curve for wheat.
The income elasticity of demand for wheat
is low, so the demand for wheat increased
relatively little over this period.
Because the demand for wheat is also inelastic,
the large shift in the supply curve and the
small shift in the demand curve resulted in
a sharp decline in the price of wheat, from
$19.29 per bushel in 1950 to $7.80 in 2013.
[Music]
To measure how much quantity supplied increases
when price increases, we use the price elasticity
of supply.
We do the supply side of these calculations
much like we do the demand side.
Same formulas, same comparisons.
But, keep in mind the downward sloping to
the right demand curve will give the negative
number.
The upward sloping to the right supply curve
will be positive.
The price elasticity of supply is the responsiveness
of the quantity supplied to a change in price,
measured by dividing the percentage change
in the quantity supplied of a product by the
percentage change in the product's price.
If price elasticity of supply is less than
1, then supply is inelastic.
If the price elasticity of supply is greater
than 1, then supply is elastic.
If the price elasticity of supply is equal
to 1, then, you guessed it, supply is unit elastic.
Whether the supply curve is elastic or inelastic
depends on the ability and willingness of
firms to alter the quantity they produce as
price increases.
The supply curve for most products will be
inelastic if we measure it for a short period
of time, but increasingly elastic the longer
the period of time over which we measure it.
When I was a young guy, living on Washington's
coast region, I worked on Christmas tree farms.
When the price of Christmas trees at local
markets went up, small land owners would convert
their cattle grassland to tree farming acres.
They wanted to cash in on the high Christmas
tree market!
It would take them about 7 years to get their
first cash crop that way.
Now you can see why the price elasticity of
supply can take years to realize.
Oil prices are a bit of an odd situation in
the USA.
Although we can drill and recover petroleum
from within the country, we purchase crude
oil from OPEC countries, Canada and other
suppliers.
But all gasoline we burn in the country is
refined right here in the USA.
It takes time to bring in the crude oil, refine
it, and distribute it to retailers.
This means that when our economy accelerates,
for instance, and demand for fuel increases
shifting the demand curve to the right, oil
refineries cannot immediately boost supply.
Prices increase as does the quantity supplied.
On the other hand, when the country enters
a recession like we did in 2009, the Great
Recession, and the demand curve shifts to
the left, crude oil refineries do not respond
immediately to the reduced demand and prices
fall.
On these screens, find the summaries you have
already seen in this lecture.
Instead of reading them each to you, I encourage
you to print these pages out, recreate them
on paper, and reason out examples of each.
It is how you will know their meaning.
If nothing else, enjoy a minute of acoustic
guitar in b minor, a major.
[Music]
Look at DemandTypical representing the typical
demand for parking spaces on a summer weekend
at a beach resort.
DemandJuly 4 represents demand on the fourth of July.
Because supply is inelastic, the shift in
equilibrium from point A to point B results
in a large increase in price, from $2.00 per
hour to $4.00,but only a small increase in
the quantity of spaces supplied,from 1,200
to 1,400.
Here, supply is elastic.
As a result, the change in equilibrium from
point A to point B results in a smaller increase
in price and a larger increase in the quantity
supplied.
An increase in price from $2.00 per hour to
$2.50 is sufficient to increase the quantity
of parking supplied from 1,200 to 2,100.
[Music]
After studying the materials in this chapter,
you should understand why knowing the income
and price elasticities of products are important
to the owners and managers of firms.
You can use these data as a consumer to time
your purchases in sync with dropping prices,
or use these approaches to set prices in your
business to maximize total revenue.
The tools found here can take you where you
want to be in product and service markets,
even in the stock market.
[Music]
