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8. Application: Elasticity and hotel rooms

The following graph input tool shows the daily demand for hotel rooms at the Peacock Hotel and Casino in Las Vegas, Nevada. To help the
hotel management better understand the market, an economist identified three primary factors that affect the demand for rooms each

night. These demand factors, along with the values corresponding to the initial demand curve, are shown in the following table and
alongside the graph input tool.

Demand Factor Initial Value

Average American household income $40,000 per year
round trip airfare from Los Angeles (LAX) to Las Vegas $100 per round trip
(LAS)
Room rate at the Grandiose Hotel and Casino, which is near $200 per night
the Peacock

Use the graph input tool to help you answer the following questions. You will not be graded on any changes you make to this graph.

Note: Once you enter a value in a white field, the graph and any corresponding amounts in each grey field will change accordingly.

Graph Input Tool

500 Market for Peacock's Hotel Rooms

450
Price 300
400 (Dollars per
room)
PRICE (Dollars per room)

350
Quantity
300 Demanded
(Hotel rooms
250
per night)
200

150
Demand Demand Factors
100

50 Average 40
Income
0 (Thousands of
0 50 100 150 200 250 300 350 400 450 500 dollars)
QUANTITY (Hotel rooms) Airfare 100
from LAX
to LAS
(Dollars per
round trip)

Room 200
Rate at
Grandiose
(Dollars per
night)

For each of the following scenarios, begin by assuming that all demand factors are set to their original values and that Peacock is charging
$300 per room per night.
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If average household income increases by 50%, from $40,000 to $60,000 per year, the quantity of rooms demanded at the Peacock

rises from 150 rooms per night to 155 rooms per night. Therefore, the income elasticity of demand is positive ,
meaning that hotel rooms at the Peacock are a normal good .

Points: 0.6 / 1

Explanation: Close Explanation

When the Peacock charges $300, and average household income is $40,000, it can fill 200 rooms per night at that price. However, if

average household income increases to $60,000, the quantity of rooms demanded rises to 250 rooms per night.

The income elasticity of demand measures how much the quantity demanded of a good changes when there is a change in
consumers’ income. You can calculate the income elasticity of demand for Peacock's hotel rooms by dividing the percentage change in

quantity demanded by the percentage change in income:

Percentage Change in Quantity Demanded

Income Elasticity of Demand Income Elasticity of Demand = = Percentage Change in Income
Percentage Change in Quantity Demand
25%
= =
50%
25%50%
= = 0.50.5

Using the income elasticity of demand, you can then categorize goods as either normal or inferior. When an increase in income leads

to an increase in quantity demanded (or a decrease in income leads to a decrease in quantity demanded), the good is called
a normal good. Therefore, goods with a positive income elasticity of demand are normal goods.

However, when an increase in income leads to a decrease in the quantity demanded (or a decrease in income leads to an increase in
quantity demanded), the good is called an inferior good. Therefore, goods with a negative income elasticity of demand are inferior

goods.

Because the income elasticity of demand is positive for Peacock's hotel rooms, it is a normal good. (Note: The percentage change

calculations in this problem do not use the midpoint method.)

If the price of a room at the Grandiose were to decrease by 20%, from $200 to $160, while all other demand factors remain at their initial
values, the quantity of rooms demanded at the Peacock falls from 150 rooms per night to 155 rooms per night. Because

the cross-price elasticity of demand is positive , hotel rooms at the Peacock and hotel rooms at the Grandiose are
substitutes .

Points: 0.6 / 1

Explanation: Close Explanation

The cross-price elasticity of demand measures the sensitivity of the quantity demanded of one good to changes in the price of
another good. To determine the cross-price elasticity of demand between hotel rooms at the Grandiose and hotel rooms at the
Peacock, divide the percentage change in the quantity demanded of hotel rooms at the Peacock by the percentage change in the price
of hotel rooms at the Grandiose. (Note: Remember to keep track of the direction of change. The sign of the cross-price elasticity of

demand can be positive or negative, and important information is conferred by the sign.)
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Percentage Change in Quantity of Rooms Demanded at Peacock

Cross-Price Elasticity of Demand Cross-Price Elasticity of Demand = = Percentage Change in Price of Hotel Rooms at the Grandiose
Percentage C
−50%
= =
−20%
−50%−20%
= = 2.52.5

Two goods are said to be complements when an increase in the price of one good decreases the quantity demanded of the other or
when a decrease in the price of one good increases the quantity demanded of the other. On the other hand, two goods are said to
be substitutes when an increase in the price of one good increases the quantity demanded for the other or when a decrease in the

price of one good decreases the quantity demanded for the other.

Because cross-price elasticity measures how the change in the price of one good affects the quantity demanded of another good, a
negative value for cross-price elasticity indicates that the two goods are likely complements, while a positive value for cross-price
elasticity signals that the two goods are likely substitutes. A value of zero for cross-price elasticity would indicate that the two goods

are unrelated—a change in the price of one good would not affect the quantity sold of the other good.

In this case, because visitors to Las Vegas can choose between staying at the Peacock and the Grandiose, if one hotel lowers its price,
demand for the other hotel will decrease (holding all else constant), so hotel rooms at the Peacock and hotel rooms at the Grandiose
are substitutes. (Note: The percentage change calculations in this problem do not use the midpoint method.)

Peacock is debating decreasing the price of its rooms to $275 per night. Under the initial demand conditions, you can see that this would
cause its total revenue to increase . Decreasing the price will always have this effect on revenue when Peacock is operating on the
elastic portion of its demand curve.

Points: 1/1

Explanation: Close Explanation

When the Peacock charges $300, it can fill 200 rooms at that price.

Total revenue is equal to price times quantity. Therefore, you can compute Peacock's revenue at this price in the following way:

Total Revenue Total Revenue = = Price × Quantity Price×Quantity

= = $300 per room per night × 200 rooms $300 per room per night×200 rooms
= = $60,000 per night $60,000 per night

By lowering its price to $275, Peacock can fill 225 rooms. In this case, total revenue is

$275 per room per night × 225 rooms = $61,875 per night $275 per room per night×225 rooms=$61,875 per night, an increase of

$1,875.

When demand is inelastic, you know that the percentage change in price is larger than the percentage change in quantity. This means

that total revenue will move in the same direction as the price change. Thus, when price increases, so does total revenue; and when
price decreases, total revenue decreases as well.

When demand is elastic, you know that the percentage change in price is smaller than the percentage change in quantity because

consumers are highly sensitive to changes in price. This means that price and total revenue move in opposite directions. Thus, when
price decreases, total revenue increases; and when price increases, total revenue decreases.
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Because total revenue decreases when Peacock decreases its price, it must be operating on the inelastic portion of its demand curve.

Another way to confirm this is by directly examining the price elasticity of demand for Peacock's rooms. The price elasticity of
demand measures the responsiveness of consumers to changes in price. For example, if consumers change their purchasing behavior

very little in response to a drastic change in price, demand is said to be inelastic; but if consumers change their purchasing behavior a

lot in response to a small change in price, demand is said to be elastic.

The price elasticity of demand is the percentage change in quantity divided by the percentage change in price. If the Peacock drops its

price from $300 to $275 per night—a decrease of 8.3%—the quantity of rooms demanded increases from 200 to 225, an increase of
about 12.5%:

Percentage Change in Quantity

Price Elasticity of Demand Price Elasticity of Demand = = Percentage Change in Price
Percentage Change in QuantityPercentage Change in P
12.5%
= =
8.3%
12.5%8.3%
= = 1.51.5

Since the percentage change in quantity demanded is greater than the percentage change in price, the price elasticity of demand is

greater than one, and demand is elastic in this region. (Note: The percentage change calculations in this problem do not use the
midpoint method. )

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