Elasticity and Its Applications

THE ELASTICITY OF DEMANDPrice elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.It is the percentage change in quantity demanded when there is a one percent change in the price (and all other factors that also affect the quantity demanded remain unchanged).

Computing the Price Elasticity of DemandSuppose the price of ice-cream increases by 10%, andthe quantity demanded decreases by 20%.The PED is 20/10 = 2. That is, a 1% change in the price will change the quantity demanded by 2%.

*Computing the Percentage of a Price ChangeUsual MethodPercent Change = [(New Value Old Value) / Old Value] 100

Old Price$2.00New Price$2.20Increase2.20 2.00 = $0.20% Increase[(2.20 2.00)/2.00] 100 = 10%

*Computing the Percentage of a Quantity ChangeUsual MethodPercent Change = [(New Value Old Value) / Old Value] 100

Old Quantity10New Quantity8Increase8 10 = 2% Increase[(8 10)/10] 100 = 20%

Computing the Price Elasticity of Demand: Traditional MethodThe price of an ice cream cone increases from $2.00 to $2.20The amount you buy falls from 10 to 8 conesWhat is your elasticity of demand?

The Midpoint Method: A Better Way to Calculate Percentage Changes and ElasticitiesThe midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.

The price of an ice cream cone increases from $2.00 to $2.20 The amount you buy falls from 10 to 8 conesWhats your elasticity of demand?use the midpoint formulaMidpoint Formula: example

Elastic, Unit-Elastic and Inelastic DemandDemand can beInelasticUnit-elasticElasticIt all depends on the magnitude of the PED

Inelastic Demand: PED < 1Suppose:Price changes by 10%Quantity demanded changes by 5%. % change in quantity is smaller than the % change in priceHere PED = 5/10 = 0.5Demand is inelastic

Unit-Elastic Demand: PED = 1Suppose:Price changes by 10%Quantity demanded changes by 10%. % change in quantity is equal to the % change in priceHere PED = 10/10 = 1Demand is unit-elastic

Elastic Demand: PED > 1Suppose:Price changes by 10%Quantity demanded changes by 30%. % change in quantity is greater than the % change in priceHere PED = 30/10 = 3Demand is elastic

Computing the Price Elasticity of Demand: ExampleDemand is price elastic$54DemandQuantity100050Price

Perfectly Inelastic and Perfectly Elastic DemandPerfectly Inelastic: Quantity demanded does not respond to price changes. PED = 0.Perfectly Elastic: Quantity demanded changes infinitely with any change in price. PED = infinity.

The Variety of Demand CurvesBecause the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.The higher the price elasticity of demand, the flatter the demand curve.

Figure 1 The Price Elasticity of Demand(a) Perfectly Inelastic Demand: Elasticity Equals 0Quantity0Price

Figure 1 The Price Elasticity of Demand(b) Inelastic Demand: Elasticity Is Less Than 1Quantity0Price

Figure 1 The Price Elasticity of DemandCopyright2003 Southwestern/Thomson Learning(c) Unit Elastic Demand: Elasticity Equals 1Quantity0Price

Figure 1 The Price Elasticity of Demand(d) Elastic Demand: Elasticity Is Greater Than 1Quantity0Price

Figure 1 The Price Elasticity of Demand(e) Perfectly Elastic Demand: Elasticity Equals InfinityQuantity0Price

Total Revenue and the Price Elasticity of DemandTotal revenue (TR) is the amount paid by buyers (and, therefore, received by sellers) of a good.It is computed as the price of the good times the quantity sold. TR = P x Q

Figure 2 Total RevenueQuantity0Price

Elasticity and Total Revenue: Inelastic DemandSuppose:Price increases by 10%, andQuantity demanded decreases by 4%. Because Total Revenue = P Q, the 10% increase in P tends to increase total revenue by 10%, and The 4% decrease in Q tends to decrease total revenue by 4%.Overall, total revenue increases by 6%.This shows that, when demand is inelastic, price and total revenue move in the same direction

Elasticity and Total Revenue: Inelastic DemandSuppose demand is inelasticSpecifically, supposePrice increases by 10%, andQuantity demanded decreases by 4%. CHAPTER 5 ELASTICITY AND ITS APPLICATION*TR = P Q+10%- 4%+6%Conclusion: When demand is inelastic, price and total revenue move in the same direction.

CHAPTER 5 ELASTICITY AND ITS APPLICATION

Elasticity and Total Revenue: Elastic DemandSuppose demand is elasticSpecifically, supposePrice increases by 10%, andQuantity demanded decreases by 25%. CHAPTER 5 ELASTICITY AND ITS APPLICATION*TR = P Q+10%- 25%- 15%Conclusion: When demand is elastic, price and total revenue move in opposite directions.

CHAPTER 5 ELASTICITY AND ITS APPLICATION

Elasticity and Total Revenue: Unit-elastic DemandSuppose demand is unit-elasticSpecifically, supposePrice increases by 10%, andQuantity demanded decreases by 10%. CHAPTER 5 ELASTICITY AND ITS APPLICATION*TR = P Q+10%- 10%No ChangeConclusion: When demand is unit-elastic, price has no effect on total revenue.

CHAPTER 5 ELASTICITY AND ITS APPLICATION

Figure 3 How Total Revenue Changes When Price Changes: Inelastic DemandQuantity0PriceQuantity0PriceAn Increase in price from $1 to $3 leads to an Increase in total revenue from $100 to $240

Elasticity and Total Revenue: Elastic DemandSuppose:Price increases by 10%, andQuantity demanded decreases by 30%. Because Total Revenue = P Q, the 10% increase in P tends to increase total revenue by 10%, and the 30% decrease in Q tends to decrease total revenue by 30%.Overall, total revenue decreases by 20%.This shows that, when demand is elastic, price and total revenue move in opposite directions

Figure 4 How Total Revenue Changes When Price Changes: Elastic DemandQuantity0PriceQuantity0PriceAn Increase in price from $4 to $5 leads to an decrease in total revenue from $200 to $100

Elasticity and Total Revenue: Unit-Elastic DemandSuppose:Price increases by 10%, andQuantity demanded decreases by 10%. Because Total Revenue = P Q, the 10% increase in P tends to increase total revenue by 10%, and the 10% decrease in Q tends to decrease total revenue by 10%.Overall, total revenue remains unchangedThis shows that, when demand is unit-elastic, price has no effect on total revenue

Elasticity of a Linear Demand CurveNote that demand can change from elastic to unit-elastic to inelastic as the price changes

What does the PED depend on?Why is the demand for gas less elastic than the demand for, say, movies?

CHAPTER 5 ELASTICITY AND ITS APPLICATION*

CHAPTER 5 ELASTICITY AND ITS APPLICATION

Determinants of Price Elasticity of DemandPED tends to be higherthe larger the number of close substitutes.if the good is a luxury. That is, if the goods income elasticity of demand (to be defined later) is highif spending on the good is a large portion of total spendingthe more narrowly defined the market.the longer the time period.

Income Elasticity of DemandIncome elasticity of demand is the percentage increase in the quantity demanded of a good after a one-percent increase in consumers incomeassuming all other factors that affect the quantity demanded are unchanged

Computing Income ElasticitySuppose: income increases 10%, andquantity demanded decreases 20%. Thenincome elasticity of demand is -20/+10 = -2.Note that IED can be positive, negative, or zero.

Income ElasticityNormal Goods: IED > 0Inferior Goods: IED < 0Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. Examples

Necessities and LuxuriesWhen IED < 1, the good is called income inelastic or a necessityExamples include food, fuel, clothing, utilities, and medical services.When IED > 1, the good is called income elastic or a luxury Examples include sports cars, furs, and expensive foods.

High Income Elasticity Implies High Price ElasticityThe effect of a change in the price of a good on its quantity demanded is the sum of:The substitution effect, andThe income effect.The higher the IED, the bigger the income effect. Therefore,The higher the IED, the higher the PED.

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND*Low IED implies low PED1. When the price of Coke decreases2. Consumers feel richer3. Consumption of Coke and other goods increases, but only a little, because IED is small4. So, a decrease in the price of Coke leads to a small increase in the consumption of Coke

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND*High IED implies high PED1. When the price of Coke decreases2. Consumers feel richer3. Consumption of Coke and other goods increases by a big amount, because IED is large4. So, a decrease in the price of Coke leads to a big increase in the consumption of Coke

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

Cross Price Elasticity of DemandThe cross price elasticity of demand (CPED) measures the responsiveness of the quantity demanded of one good to changes in the price of some other good.Suppose: The price of Coke increases 2%, andThe consumption of Pepsi increases 20%.The CPED for Coke with respect to Pepsi is +20/+2 = +10.

Substitutes: CPED > 0When the CPED for one good with respect to another is positive, the two goods are called substitutes.In the last slides example, the CPED for Coke with respect to Pepsi was +10, which is positive. This confirms our common-sense intuition that Coke and Pepsi are substitutes.

Complements: CPED < 0When the CPED for one good with respect to another is negative, the two goods are called complements.Suppose:the price of gasoline increases 50%the sale of cars decreases 10%The CPED is -10/+50 = -0.2, which is negative.This is what one would expect, given our common-sense notion that gas and cars are complements.

THE ELASTICITY OF SUPPLYPrice elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good.Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in priceIt is assumed that all other factors that affect the quantity suppliedsuch as technology and the prices of raw materials and laborare unchanged

Computing the Price Elasticity of SupplyThe price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price.

Figure 6 The Price Elasticity of Supply(a) Perfectly Inelastic Supply: Elasticity Equals 0Quantity1000Price

Figure 6 The Price Elasticity of Supply(b) Inelastic Supply: Elasticity Is Less Than 1Quantity0Price

Figure 6 The Price Elasticity of Supply(c) Unit Elastic Supply: Elasticity Equals 1Quantity0Price

Figure 6 The Price Elasticity of Supply(d) Elastic Supply: Elasticity Is Greater Than 1Quantity0Price

Figure 6 The Price Elasticity of Supply(e) Perfectly Elastic Supply: Elasticity Equals InfinityQuantity0Price

Determinants of Elasticity of SupplyAbility of sellers to change the amount of the good they produce.Beach-front land is inelastic.Books, cars, or manufactured goods are elastic.Time period. Supply is more elastic in the long run.

THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITYCan good news for farming be bad news for farmers?What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties?

CHAPTER 5 ELASTICITY AND ITS APPLICATION*

CHAPTER 5 ELASTICITY AND ITS APPLICATION

CHAPTER 5 ELASTICITY AND ITS APPLICATION*

CHAPTER 5 ELASTICITY AND ITS APPLICATION

CHAPTER 5 ELASTICITY AND ITS APPLICATION*

CHAPTER 5 ELASTICITY AND ITS APPLICATION