Answers for the Day
Elasticity
1. A common belief is that the demand for gasoline is inelastic. Some even suggest this is one of the reasons why the expenditures on foreign oil continue to increase as the price of oil increases. To study the demand for gas, a group recently conducted a study in which they interviewed a number of Shell gasoline stations scattered around the country. The results showed a price elasticity of demand to be 1.43. Should this be taken as proof of an elastic demand for gas? Explain the basis for your decision in a brief memo. This is not a statistics question.
The key to this question is identifying the product that we are looking at. It is very much like the sin tax question, in fact it is nearly identical. Just as booze and RI booze are not the same product, neither are gas and Shell gas. While it may be true that you will continue to buy gas at the pump if the price at all stations rises by 5 cents a gallon, you will likely see some customers switch from Shell to other brands if the price of Shell rose while the other prices remained constant. It should be no surprise that the demand for Shell gas is elastic while the demand for gas is inelastic.
2. The effects of the internet are widespread. Some have suggested that the internet "is opening up a new era of pricing." [WSJ 6/8/1998] According to the authors of the article, the internet has decreased substantially the cost of comparison shopping. Based on your knowledge of elasticity, what should happen to the price of goods sold on the internet?
The growth in comparison shopping means that shoppers will have access to more substitutes which should increase the elasticity of demand. If the elasticity of demand increases, then you would expect that prices would fall given the relationship between elasticity and profit maximizing prices. This helps explain why most products that are sold both on and off the internet are cheaper on the internet.
3. Universities charge set one tuition rate for all student, two if you consider the in- and out-of-state rates, but in reality there are many different prices. The difference between the actual price and the stated price is financial aid and universities have sought help in determining the allocation of the financial aid. One proposal is to reduce aid to those who come for an on-campus interview and who ask for early acceptance. How would you defend these proposals?
The answer should not be a surprise given that we are in the section on elasticity. The decision to charge different prices is at the heart of the pricing decision when the concern is with maximizing revenue. The revenues will be greater when price discrimination occurs - charging higher prices (lower financial aid) when elasticity is lower. The individuals who have already invested time in visiting and who have asked for early admission are likely to have a lower elasticity of demand which should translate into a higher price (lower financial aid).
4. The university has a general education program that designates certain courses as satisfying the general education requirements and others that do not. How would the elasticity of demand for the general education courses compare to that in the other courses? Given that the price is the same, where do you think you would 'see' the differences in elasticity?
Given that there would be more substitutes for the non general education courses, you should expect that the elasticity of demand should be higher for the general education courses. The difference in the demand would show up in longer waiting lists for the general education courses. Prices and waiting lists are only two ways of allocating scarce resources. Higher price and longer lines would be the response to the increased scarcity.
5. Assume that someone high up has found out that you have mastered many of the basic economic principles and you are asked to be a consultant to the Bay Area Transit Authority. Your job is to raise revenue. You need to decide on the appropriate price change - should you increase or decrease the tolls on the bridges coming into San Francisco?
We can see that this is an elasticity problem because we are being asked to link revenue and price, so let's return to the discussion of the determinants of elasticity.
Given these assumptions regarding demand, we would conclude that demand is inelastic. We would then go to the equation that linked revenue and elasticity and see that when demand is inelastic, an increase in price will not substantially lower driving and revenue will increase.
6. By now you are familiar with the concept of government budget deficits - one of the hot issues in the 1996 presidential election. Legislators at both the federal and state level are under increasing pressure to reduce the deficit so they are always on the lookout for ways to close the deficit. Given that the budget deficit is defined as government spending - government revenues, the obvious choices to reduce the deficit would be a decrease in spending or an increase in taxes. [a less obvious choice would be a cut in taxes but that will be the subject matter of a later discussion]. At this time I would like you to consider the possibility of raising the sin taxes (booze and butts) to raise revenue. Do you think it will work? For example, would you propose a rise in the RI sin taxes as a way of raising additional revenue, some of which may be earmarked for higher education?
There are three ways to approach this question, verbally, graphically, and algebraically, but regardless of the approach, the question is all about the responsiveness of demand. What would happen if demand dropped significantly as a result of adding a higher tax to the price? Without the need for any high powered economic or math, we would expect that the tax revenue earned from the sales could actually decline if the decline in demand was greater than the increase in the tax rate.
The measure of responsiveness that economists tend to use is elasticity. If demand were elastic, we would expect demand to be responsive to price changes. If we looked at this graphically, we would draw a relatively flat demand curve. In the diagram below, the left-side diagram would be the picture if demand were responsive while the right-side diagram represents an inelastic demand.
Returning to our problem, should we expect demand to be responsive to the price increase. To answer this we need to return to the determinants of elasticity. When we talk about booze and butts, we are talking about products that may be addictive and that have few substitutes which is why we tend to find inelastic demand. The problem here is that we are not talking about booze, but Rhode Island booze-and there are a good number of substitutes for Rhode Island booze. Because of the small size of the state and the fact that the majority of the population lives close to a border, we would expect that these people could easily find a cheaper substitute if Rhode Island raised the price of booze by raising its taxes. Massachusetts found out about this when they attempted to raise the tax on booze and people began streaming across the border into the New Hampshire state liquor stores.
How do we look at this graphically? Let's assume that there is an increase in the tax which we could demonstrate as an inward shift in supply-a shift from the red to the black supply curves. In the initial situation the revenue earned from selling the output was the areas A + C. After the increase in supply, the revenue area is B + A. Revenue will increase as a result of the decrease in supply if A>C, which is the case in the right-hand diagram (steep demand curve - inelastic demand). What we see is that when demand is elastic, sales revenue will decrease if we increase the price or decrease supply. In this case we would expect the increase in the tax to reduce state excise tax revenue.
Elastic Demand Inelastic Demand
