Download - Micro Ch 05 Lecture
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What do you do when the price
of gasoline rises?
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5When you have completed your
study of this chapter, you will be able to
1 Define the price elasticity of demand, and explain thefactors that influence it and how to calculate it.
2 Define the price elasticity of supply, explain the factorsthat influence it and how to calculate it.
3 Define the cross elasticity of demand and the incomeelasticity of demand, and and explain the factors that
influence them.
CHAPTER CHECKLIST
Elasticities ofDemand and Supply
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5.1 THE PRICE ELASTICITY OF DEMAND
Price elasticity of demand is a measure of the
extent to which the quantity demanded of a good
changes when the price of the good changes.
To determine the price elasticity of demand, we
compare the percentage change in the quantity
demanded with the percentage change in price.
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5.1 THE PRICE ELASTICITY OF DEMAND
Percentage Change in Price
Percent change in price =New price Initial price
Initial Pricex 100
Percent change in price =$5 $3
$3x 100 = 66.67 percent
Suppose Starbucks raises the price of a latte from $3
to $5 a cup. What is the percentage change in price?
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5.1 THE PRICE ELASTICITY OF DEMAND
Suppose Starbucks cuts the price of a latte from $5 to
$3 a cup. What is the percentage change in price?
Percent change in price =New price Initial price
Initial Pricex 100
Percent change in price =$3 $5
$5x 100 = 40 percent
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5.1 THE PRICE ELASTICITY OF DEMAND
The Midpoint Method
x 100Percent change in price =New price Initial price
(New Price + Initial Price) 2
To calculate the percentage change in the price dividethe change in the price by the average price and then
multiply by 100.The average price is at the midpoint between theinitial price and the new price, hence the namemidpoint method.
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5.1 THE PRICE ELASTICITY OF DEMAND
The percentage change in price calculated by the midpointmethod is the same for a price rise and a price fall.
x 100Percent change in price =$5 $3
($5 + $3) 2
Percent change in price = 50 percent.
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5.1 THE PRICE ELASTICITY OF DEMAND
Percentage Change in Quantity Demanded
x 100Percent changein quantity =
New quantity Initial quantity
(New quantity + Initial quantity)2
x 100Percent changein quantity =
5 15
(5 + 15) 2= 100 Percent
If Starbucks raises the price of a latte, the quantity oflatte demanded decreases.
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5.1 THE PRICE ELASTICITY OF DEMAND
When the price rises, the quantity demanded decreasesalong the demand curve.
Similarly, when the price falls, the quantity demandedincreases along the demand curve.
Price and quantity always change in opposite directions.
So to compare the percentage change in the price and thepercentage change in the quantity demanded, we ignorethe minus sign and use the absolute values.
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5.1 THE PRICE ELASTICITY OF DEMAND
Elastic and Inelastic Demand
Demand is elastic if the percentage change in the
quantity demanded exceeds the percentage change inprice.
Demand is unit elastic if the percentage change inthe quantity demanded equals the percentage change
in price.
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5.1 THE PRICE ELASTICITY OF DEMAND
Demand is inelastic if the percentage change in thequantity demanded is less than the percentage change
in price.
Demand is perfectly elastic if the quantitydemanded changes by a very large percentage in
response to an almost zero percentage change in price.
Demand is perfectly inelastic if the quantitydemanded remains constant as the price changes.
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Figure 5.1(a) shows aperfectly elastic demand.
1. For a small change in theprice of spring water,
2. The quantity of spring water
demanded changes by alarge amount.
3. The demand for springwater is perfectly elastic.
5.1 THE PRICE ELASTICITY OF DEMAND
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Figure 5.1(b) shows anelastic demand.
1. When the price of aSony PlayStation risesby 10%,
2. The quantity of PlayStations
demanded decreases by 20%.
3. Demand for SonyPlaystations is elastic.
5.1 THE PRICE ELASTICITY OF DEMAND
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Figure 5.1(c) shows a unitelastic demand.
1. When the price of a triprises by 10%,
3. The demand for trips isunit elastic.
5.1 THE PRICE ELASTICITY OF DEMAND
2. The quantity of trips demandeddecreases by 10%.
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Figure 5.1(d) shows aninelastic demand.
1. When the price of gumrises by 20%,
2. The quantity of gum
demanded decreases by 10%.
3. The demand for gum isinelastic.
5.1 THE PRICE ELASTICITY OF DEMAND
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Figure 5.1(e) shows aperfectly inelastic demand.
1. When the price of adose rises,
2. The quantity of dosesdemanded does not change.
3. Demand for doses isperfectly inelastic.
5.1 THE PRICE ELASTICITY OF DEMAND
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5.1 THE PRICE ELASTICITY OF DEMAND
Influences on the Price Elasticity of Demand
Influences on the price elasticity of demand fall into twocategories:
Availability of substitutes
Proportion of income spent
Availability of Substitutes
The demand for a good is elastic if a substitute for it iseasy to find.
The demand for a good is inelastic if a substitute for it is
hard to find.
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5.1 THE PRICE ELASTICITY OF DEMAND
Three main factors influence the ability to find asubstitute for a good:
Luxury Versus Necessity
A necessity has poor substitutes, so the demand fora necessity is inelastic. Food is a necessity.
A luxury has many substitutes, so the demand for aluxury is elastic. Exotic vacations are luxuries.
Narrowness of Definition
The demand for a narrowly defined good is elastic.
The demand for a broadly defined good is inelastic.
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5.1 THE PRICE ELASTICITY OF DEMAND
Time Elapsed Since Price Change
The longer the time elapsed since the price change, the
more elastic is the demand for the good.Proportion of Income Spent
A price rise, like a decrease in income, means that
people cannot afford to buy the same quantities.
The greater the proportion of income spent on a good,
the more elastic is the demand for the good.
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5.1 THE PRICE ELASTICITY OF DEMAND
Computing the Price Elasticity of Demand
If the price elasticity of demand is greater than 1,demand is elastic.
If the price elasticity of demand equals 1, demand isunit elastic.
If the price elasticity of demand is less than 1, demandis inelastic.
Price elasticity
of demand
Percentage change in quantity demanded
Percentage change in the price
=
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Figure 5.2 shows theprice elasticity ofdemand calculation.
The percentage changein the price equals$2/$4 100, or 50%.
The percentage changein the quantity equals 10cups/10 cups 100, or100%.
5.1 THE PRICE ELASTICITY OF DEMAND
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The price elasticity ofdemand is 2.
The price elasticity ofdemand equalsPercentage change in
quantityPercentage change inprice.
The price elasticity of
demand equals 100%divided by 50%.
5.1 THE PRICE ELASTICITY OF DEMAND
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5.1 THE PRICE ELASTICITY OF DEMAND
Computing the Price Elasticity of Demand
We can use this formula to calculate the priceelasticity of demand for a Starbucks latte:
Price elasticity
of demand
Percentage change in quantity demanded
Percentage change in the price
=
Price elasticity of demand100%
50%= 2=
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5.1 THE PRICE ELASTICITY OF DEMAND
Interpreting the Price Elasticity of DemandNumber
The elasticity of demand for a Starbucks latte of 2 tells
us three things:1. The demand for Starbucks lattes is elasticit has
substitutes and the proportion of a buyers incomespent is small.
2. If Starbucks raised its price, revenue per cup will risebut it will lose potential business.
3. Even a slightly lower price could bring in morerevenue.
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Figure 5.3 shows that theelasticity decreases along alinear demand curve as theprice falls.
1.At any price above themidpoint, demand is elastic.
3. At any price below themidpoint, demand isinelastic.
2. At the midpoint, demand
is unit elastic.
5.1 THE PRICE ELASTICITY OF DEMAND
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5.1 THE PRICE ELASTICITY OF DEMAND
Total Revenue and the Price Elasticity of
Demand
Total revenue is the amount spent on a good andreceived by its sellers and equals the price of the good
multiplied by the quantity of the good sold.
Total revenue test is a method of estimating the price
elasticity of demand by observing the change in totalrevenue that results from a price change.
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5.1 THE PRICE ELASTICITY OF DEMAND
If demand is elastic:
A given percentage rise in price brings a largerpercentage decrease in the quantity demanded.
Total revenue decreases.
If demand is inelastic:
A given percentage rise in price brings a smallerpercentage decrease in the quantity demanded.
Total revenue increases.
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5.1 THE PRICE ELASTICITY OF DEMAND
Total revenue test:
If price and total revenue change in the oppositedirections, demand is elastic.
If a price change leaves total revenue unchanged,demand is unit elastic.
If price and total revenue change in the same
direction, demand is inelastic.
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Figure 5.4(a) shows totalrevenue and elastic demand.
At $3 a cup, the quantitydemanded is 15 cups an hour.
Total revenue is $45 an hour.
Total revenue decreases to$25 an hour.
When the price rises to $5 acup, the quantity demanded
decreases to 5 cups an hour.
Demand is elastic.
5.1 THE PRICE ELASTICITY OF DEMAND
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Figure 5.4(b) shows totalrevenue and inelastic demand.
At $50 a book, the quantitydemanded is 5 million books.
Total revenue is $250 million.
Total revenue increases to$300 million.
When the price rises to $75 abook, the quantity demanded
decreases to 4 million books.
Demand is inelastic.
5.1 THE PRICE ELASTICITY OF DEMAND
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5.1 THE PRICE ELASTICITY OF DEMAND
Applications of the Price Elasticity of Demand
Orange Prices and Total Revenue
Price elasticity of demand for agricultural products(oranges) is 0.4.
So if a frost cuts the supply of oranges (and demand
doesnt change), a 1 percent decrease in the quantityharvested will lead to a 2.5 percent rise in the price.
Demand is inelastic and farmers total revenue willincrease.
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5.1 THE PRICE ELASTICITY OF DEMAND
Addiction and Elasticity
Nonusers demand for addictive substances is elastic.
A moderately higher price will lead to a substantiallysmaller number of people trying a drug.
Existing users demand for addictive substances is
inelastic.
So even a substantial price rise brings only a modest
decrease in the quantity demanded.
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5.2 THE PRICE ELASTICITY OF SUPPLY
Price elasticity of supplyis a measure of the extent
to which the quantity supplied of a good changes when
the price of the good changes.
To determine the price elasticity of supply, we compare
the percentage change in the quantity supplied with the
percentage change in price.
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5.2 THE PRICE ELASTICITY OF SUPPLY
Supply is unit elastic if the percentage change in thequantity supplied equals the percentage change in
price.
Supply is inelastic if the percentage change in thequantity supplied is less than the percentage change in
price.
Supply is perfectly inelastic if the percentagechange in the quantity supplied is zero when the price
changes.
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Figure 5.5(a) shows perfectlyelastic supply.
1. A small rise in the price,
2. Increases the quantitysupplied by a very large
amount,
3. Supply is perfectly elastic.
5.2 THE PRICE ELASTICITY OF SUPPLY
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Figure 5.5(b) shows anelastic supply.
1. A 10% rise in the priceof a book,
2. Increases the quantity ofbooks supplied by 20%.
3. The supply of books iselastic.
5.2 THE PRICE ELASTICITY OF SUPPLY
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5.2 THE PRICE ELASTICITY OF SUPPLY
Figure 5.5(d) shows aninelastic supply.
1. A 20% rise in the price ofa hotel room,
2. Increases the quantity of hotelrooms supplied by 10%.
3. The supply of hotel rooms isinelastic.
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5.2 THE PRICE ELASTICITY OF SUPPLY
Figure 5.5(e) shows aperfectly inelastic supply.
1. A small rise in the price ofa beachfront lot,
2. The quantity of beachfront lotssupplied increases by 0%.
3. The supply of beachfrontlots is perfectly inelastic.
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5.2 THE PRICE ELASTICITY OF SUPPLY
Influences on the Price Elasticity of Supply
The two main influences are:
Production possibilities
Storage possibilities
Production Possibilities
Goods that can be produced at a constant (or verygently rising) opportunity cost have an elastic supply.
Goods that can be produced in only a fixed quantity
have a perfectly inelastic supply.
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5.2 THE PRICE ELASTICITY OF SUPPLY
Time Elapsed Since Price Change
As time passes after a price change, producers find it
easier to change their production plans, so supply
becomes more elastic.
Storage Possibilities
The supply of a storable good is highly elastic.
The cost of storage is the main influence on the
elasticity of supply of a storable good.
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5.2 THE PRICE ELASTICITY OF SUPPLY
Computing the Price Elasticity of Supply
Price elasticity
of supply
Percentage change in quantity supplied
Percentage change in quantity price=
If the price elasticity of supply is greater than 1,supply is elastic.
If the price elasticity of supply equals 1, supply isunit elastic.
If the price elasticity of supply is less than 1, supply
is inelastic.
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Figure 5.6 shows howto calculate the priceelasticity of supply.
Percentage change in theprice equals $60/$40 100, or 66.67%.
Percentage change in the
quantity equals18 bouquets/15 bouquets 100, or 120%.
5.2 THE PRICE ELASTICITY OF SUPPLY
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The price elasticity ofsupply equals thePercentage change in
the quantity
Percentage change inthe price.
The price elasticity of
supply equals120% 66.67%.
The price elasticity ofsupply is 1.8.
5.2 THE PRICE ELASTICITY OF SUPPLY
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Cross Elasticity of Demand
Crosselasticity ofdemand
Percentage change in quantity
demanded of a goodPercentage change in the price of
one of its substitutes orcomplements
=
Cross elasticity of demand is a measure of the extent towhich the demand for a good changes when the price of asubstitute or complement changes, other things remaining thesame
5.3 CROSS ELASTICITY AND INCOME ELASTICITY
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Suppose that when the price of a burger falls by 10percent, the quantity of pizza demanded decreases by 5percent.
Crosselasticity of
demand
5 percent
10 percent= = 0.5
5.3 CROSS ELASTICITY AND INCOME ELASTICITY
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The cross elasticity of demand for a substitute is positive.
A fallin the price of a substitute of the good brings a
decrease in the quantity demanded of the good.
The quantity demanded of the good and the price of itssubstitute change in the same direction.
5.3 CROSS ELASTICITY AND INCOME ELASTICITY
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Figure 5.7 shows crosselasticity of demand.
2. Pizzas and soda are
complements.
When the price of sodafalls, the demand for
pizza increases.
Cross elasticity ofdemand is negative.
5.3 CROSS ELASTICITY AND INCOME ELASTICITY5.3 CROSS ELASTICITY AND INCOME ELASTICITY
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Income Elasticity of Demand
Income
elasticity ofdemand
Percentage change in quantity demanded
Percentage change in income=
Income elasticity of demandis a measure of the
extent to which the demand for a good changes whenincome changes, other things remaining the same.
5.3 CROSS ELASTICITY AND INCOME ELASTICITY
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What Do You Do When the Price of Gasoline Rises?
If you are like most people, you complain when the price ofgasoline rises, but you dont cut back very much on yourgas purchases.
University of London economists Phil Goodwin, JoyceDargay, and Mark Hanly studied the effects of a hike in theprice of gasoline on the quantity of gasoline demanded andon the volume of road traffic.
They estimated that a 10 percent rise in the price ofgasoline decreases the quantity of gasoline used by 2.5percent within one year and by 6 percent after five years.
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What Do You Do When the Price of Gasoline Rises?
The short-run (up to one year) price elasticity of demand is2.5 percent divided by 10 percent, which equals 0.25.
The long-run (after five years) price elasticity of demand is6 percent divided by 10 percent, which equals 0.6.
Because these price elasticities are less than one, thedemand for gasoline is inelastic.
When the price of gasoline rises, the quantity of gasoline
demanded decreases but the amount spent on gasolineincreases.
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What Do You Do When the Price of Gasoline Rises?
A 10-percent rise in the price of gasoline decreases thevolume of traffic by only 1 percent within one year and by3 percent after five years.
How can the volume of traffic fall by less than the quantityof gasoline used?
The answer is by switching to smaller, more fuel-efficientvehicles.
The demand for gasoline is inelasticbecause gasolinehas poor substitutes, but it does have a substituteasmaller vehicle.