principles of microeconomics - lecture - elasticity

8/3/2019 Principles of Microeconomics - Lecture - Elasticity

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Elasticity

Dr. Katherine Sauer

Principles of Microeconomics


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I. Evaluating Elasticity


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Extreme Cases:

There are some goods that no matter what the price is,

consumers demand the same quantity.

perfectly inelastic demandd = 0

There are some goods that when theprice changes even a

little, consumers completely change their buyingbehavior.perfectly elastic demand

d =


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Examples of estimated price elasticities:


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B. Rules for Evaluating Price Elasticity of Supply

When s > 1, we say supply isELASTIC

- large change in Qs in response to a price change

When s=1, we say supply isUNIT ELASTIC

-proportional change in Qs in response to a price

change

When s


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Extreme Cases:

There are some goods that no matter what the price is,

there is only a fixed quantity.perfectly inelastic supply

d = 0

There are some goods that when theprice changes evena little, producers completely change the quantity.

perfectly elastic supply

d =

Note: firms often have capacity constraints. That is,

they may be elastic at low levels of production and then

very inelastic at high levels of production.


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Ex: Consider the milk industry.

- in the short run a farmer has a certain size of dairy and

number of cows- in the long run, the farmer could expand the herd and size of

the dairy

It is estimated that a 10% increase in the selling price of milkwill result in a

1.2% increase in quantity supplied in the short run.

25% increase in quantity supplied in the long run.

Short Run s=? Long Run s=?

s= 1.2 % / 10% = 0.12

inelastic supply

s= 25 % / 10% = 2.5

elastic supply


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C. Rules for Evaluating Income Elasticity

I > 0 normal good

I < 0 inferior good

Necessities have small income elasticities.

Luxuries have large income elasticities.


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D. Rules for Evaluating Cross Price Elasticity

1,2 > 0 substitutes1,2 < 0 complements

1,2 = 0 not related


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Go back to the worksheet and evaluate each elasticity.


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II. Elasticity

Graphically


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A. Demand

quantity

price

quantity

price

D

D

Inelastic Demand Elastic Demand

P1

P2

P1

P2

Q1 Q2 Q2Q1

small change in quantity large change in quantity


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quantity

price

quantity

price

D

D

Perfectly Perfectly

Inelastic Demand Elastic Demand

P2

P1

P2

P1

Q1 Q2 Q1

no change in quantity total change in quantity

D =0

D =


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B. Supply

quantity

price

quantity

priceS

S

Inelastic Supply Elastic Supply

P2

P1

P2

P1

Q1 Q2 Q2Q1

small change in quantity large change in quantity


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quantity

price

quantity

price

S

S

Perfectly Perfectly

Inelastic Supply Elastic Supply

P2

P1

P2

P1

Q1 Q2 Q1

no change in quantity total change in quantity

S =0s =


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C.Applications: Supply, Demand, and Elasticity

Example 1: The demand for basic food commodities (e.g.wheat, corn) tends to be fairly inelastic. The supply of such

commodities is fairly inelastic as well.

S

D

quantity

price

P

Q


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Suppose a new hybrid of wheat is developed that is more productive

than those used in the past. What happens?

- supply increases, price falls, and quantity rises-because demand is inelastic, the change in quantity

demanded is less than the change in price

S

D

quantity

price

P

Q

S2

P2

Q2

Farmers receive a lower

price, but only sell alittle more.

Revenue for farmers

falls.


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Example 2: The demand and supply of oil tend to both be fairly

inelastic in the short run. They tend to both be more elastic in the

long run.

In the 1970s and 1980s, OPEC restricted the supply of oil in order

to increase prices (and revenues).

S

D

quantity

price

P

Q

S2

P2

Q2

Because demand for oil isinelastic, even though the

price increased, quantity

only fell a little.

Revenues for OPECincreased.


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Over the long run, consumers switched to more fuel efficient cars

and carpooled. Non-OPEC oil producers respond to the higher

price of oil and increase drilling. When OPEC decreases supply,

the effect on quantity is much more dramatic.

S

D

quantity

price

P

Q

S2

P2

Q2

When demand is elastic,

revenues for OPEC

decrease when supply isreduced.


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quantity

price

D

P2

P1

Q2 Q1

S2

Example 3: The war on drugs: reducing supply vs reducing demand

The demand for illegal drugs tends to be somewhat inelastic relative

to supply .

S

When the government focuses on

decreasing the supply of drugs

entering the nation:

- supply falls

-price rises- quantity demanded falls,

but not much

The higher price often leads to

higher crime.

Also, higher revenues for drug

suppliers.


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quantity

price

D

P2

P1

Q2 Q1

When the government instead pursues better drug education, the

demand for drugs falls.

S

The price and quantity will fall.

Also, revenues for drug suppliers

will fall.

D2


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III

. Elasticity and a Firms Revenue


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On a linear demand curve, the elasticity changes as you

move down the curve.

- the slope is constant- the elasticity changes

quantity

price

D

ELASTIC

INELASTIC

UNIT ELASTIC


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The Price Elasticity of DemandAffects a Firms Revenue

Total Revenue (TR) = Price x Quantity Sold

Recall that forconsumers, quantity is inversely related to

price.

When a firm raises prices, the quantity sold falls.

When a firm lowers prices, the quantity sold rises.

- elasticity tells us how much quantity rises or falls


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If demand is elastic (d > 1), consumers are quite

responsive to a price change:

- an increase in price by 5% will reduce quantity

by more than 5%

- total revenue will fall when price is increased


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If demand is inelastic (d < 1), consumers are not very

responsive to a price change:

- an increase in price by 5% will reduce quantityby less than 5%

- total revenue will rise when price is increased


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If demand is unit elastic (d = 1), consumers have a

proportional response to a price change:

- an increase in price by 5% will reduce quantity

by exactly 5%

- total revenue will be unchanged when price is

increased


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Information on price elasticity of demand is very

useful for businesses.

principles of microeconomics - lecture - elasticity

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