Question

According to a news story about the bus system in the Lehigh Valley in Pennsylvania, "Ridership fell 14 percent ... after a 33 percent increase" in bus fares. Based on this information, is the demand for bus trips price elastic or price inelastic? Explain your answer in terms of the five determinants of price elasticity.

Short answer

The demand for bus trips in the Lehigh Valley is price inelastic. The calculated price elasticity of demand is -0.42, which is less than 1 in absolute terms, indicating inelastic demand. This is likely due to factors such as necessity of bus travel, lack of substitutes, and short time period for adjustment.

Step-by-step solution

Calculation of Price Elasticity of Demand

Firstly, use the percentages provided to calculate the price elasticity of demand, using the formula: \( Elasticity = (Percentage\ Change\ in\ Quantity\ Demanded) / (Percentage\ Change\ in\ Price) \). Here, the percentage change in quantity demanded is -14% (a decrease) and the percentage change in price is 33% (an increase). So, the elasticity = -14% / 33% = -0.42.

Interpretation of the Elasticity Value

The elasticity is less than 1 in absolute value terms (0.42), so demand is price inelastic. This means that the percentage change in quantity demanded is less than the percentage change in price.

Discuss the Determinants of Price Elasticity

Five main factors affecting price elasticity have been mentioned. In this case, it suggests that there might be lack of close substitutes for bus travel in the Lehigh Valley, making it a necessity for many people, hence, making the demand inelastic. A limited time of response to the fare increase may also make demand more inelastic in the short run. The extent to which bus fare takes up one's income also matters, but in most cases, it's not a big part of the income and demand remains inelastic. The price range won't fluctuate significantly for the case like this. Therefore, all the determinants tend to support the case of inelastic demand for bus rides in the Lehigh Valley.

Key concepts

Determinants of Price Elasticity

Understanding the determinants of price elasticity is crucial in predicting how changes in price might affect demand. Price elasticity of demand is a measure of how sensitive the quantity demanded of a good is to its price change. There are five primary determinants of price elasticity:

• Availability of Close Substitutes: Products that have readily available substitutes tend to have more elastic demand. Consumers can easily switch to an alternative if the price rises. Conversely, fewer substitutes lead to inelastic demand.
• Necessity vs. Luxury: Necessities tend to be inelastic since consumers will buy them despite price changes. Luxuries have more elastic demand because consumers can forego them if they become too expensive.
• Percentage of Income: The more a good costs as a percentage of a consumer's income, the more elastic the demand tends to be. Expensive items require more deliberation on purchase, thus are sensitive to price changes.
• Time Horizon: Demand elasticity can increase over time as consumers find substitutes or change habits. The immediate effect of a price change is often less elastic than the long-term effect.
• Brand Loyalty: Strong brand loyalty can make demand more inelastic, as loyal customers may not be sensitive to price changes.

These determinants are critical in evaluating scenarios like that of the Lehigh Valley bus system, where multiple factors contribute to the inelastic demand for bus trips.

Price Inelastic Demand

Price inelastic demand occurs when the quantity demanded of a good or service is relatively unresponsive to changes in price. In technical terms, demand is inelastic when the absolute value of price elasticity is less than 1. This kind of demand can be observed in essential goods or services that people need to function in their daily lives, like the bus system in the Lehigh Valley example.

When demand is price inelastic, a significant increase in price leads to a relatively smaller decrease in quantity demanded, as seen with the 33 percent fare increase resulting in only a 14 percent decrease in ridership. Factors that contribute to inelastic demand include:

• Lack of substitutes
• Necessity of the good or service
• Smaller portion of consumer's budget devoted to the good

Understanding price inelasticity aids in strategizing pricing measures, especially for providers of essential services and products.

Percentage Change in Quantity Demanded

Percentage change in quantity demanded is a fundamental concept in economics that measures the responsiveness of buyers to a change in the price of a good or service. It's calculated by taking the change in quantity demanded and dividing it by the original quantity demanded, then multiplying by 100 to get a percentage.

In the Lehigh Valley example, the 14 percent decline in ridership after a fare increase illustrates a real-world implication of how quantity demanded can change with price. To calculate this percentage change, you subtract the new quantity of bus rides after the fare increase from the original quantity, divide by the original quantity, and multiply by 100. The negative result signifies a reduction in quantity demanded, which is a typical response to a price increase, though the magnitude of that response is determined by demand's elasticity.

Monitoring the percentage change in quantity demanded helps businesses and policymakers make informed decisions about pricing strategies and understanding consumer behavior, which is crucial for operating in any market.