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0:03
[Music]
0:16
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.
0:57
Wandering Oaken's Trading Post and Sauna?
1:11
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
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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
1:49
You and this fellow who hoo big summer Blowout.
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Oh a real howler in July, yes? Where ever could it be coming from? The North Mountain.
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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!
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Ten is all I got! Help me out. OK, ten will get you this and no more.
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it seem magical? Yes, now back up while I deal with his Crook here.
2:42
What did you call me?
2:46
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.
3:21
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
4:01
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!
4:43
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!
5:16
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
5:56
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!
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[Music]
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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.
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We will look more at this example in several minutes.
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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.
7:47
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.
8:02
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.
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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.
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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
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percentage change in price, so the price elasticity is equal to 1 in absolute value.
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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.
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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.
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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.
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The answer is always right.
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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.
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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.
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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.
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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%.
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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.
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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.
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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.
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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
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percentage change in price, so the price elasticity is equal to 1 in absolute value.
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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,
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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.
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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.
18:07
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
18:46
before we go that far.
18:51
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.
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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.
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[Music]
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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So, my sensitivity to those prices is quite a bit higher than a computer or tires for my car and truck.
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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.
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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!
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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
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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!
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[Music]
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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
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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.
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[Music]
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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.
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[Music] Thank you Stephanie Peters!
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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.
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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.
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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.
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If demand is unit elastic, a change in price is exactly offset by a proportional change in quantity demanded, leaving revenue unaffected.
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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%.
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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.
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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.
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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!
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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.
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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.
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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.
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The normal goods which are also luxury goods will have income elasticity greater than 1.
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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
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lesser necessities like breakfast cereals or bread. Do you think this University of Virginia study applies anywhere else? Hmm, it is worth considering.
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[Music]
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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.
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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.
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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
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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.
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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,
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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.
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