Elasticity and Its Application

Un Unit it 3: E Elas las lasti ti ticit cit city y an and d Its Ap Appl pl plic ic icaation 1 1 Con Conte te ten nts 3.1 Introduction to Elasticity 3.2 Elasticity of Demand 3.3 Elasticity of Supply 3.4 Application of Elasticities 2 2 1 1/26 3.1 Intr Introd od oducti ucti uction on to Elas Elastticity You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per month. Your costs are rising (including the opp. cost of your time), so you’re thinking of raising the price to $250. The law of demand says that you won’t sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase? 3 3 Elas Elastic tic ticity ity . . . • … allows us to analyze supply and demand with greater precision. • … is a measure of how much buyers and sellers respond to changes in market conditions 4 4 2 2/26 3.2 THE ELA ELAST ST STICIT ICIT ICITY Y OF DEMA DEMAND ND • Price 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. • Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price. 5 5 Wha Whatt det determ erm ermin in ines es price elast elastici ici icity? ty? To learn the determinants of price elasticity, we look at a series of examples. Each compares two common goods. In each example: • Suppose the prices of both goods rise by 20%. • The good for which Qd falls the most (in percent) has the highest price elasticity of demand. Which good is it? Why? • What lesson does the example teach us about the determinants of the price elasticity of demand? 6 6 3 3/26 Det Determ erm ermin in inant ant antss of Elas Elastici tici ticity ty • Whether close substitutes are available • Broadly defined goods vs. narrowly defined goods • Necessities vs. Luxuries • How much of the consumer’s budget is spent on the good • Long run vs. Short run 7 7 EXAM EXAMPL PL PLE E 1: Clos Closeup eup vvs. s. Elect Electricity ricity • The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why? • Closeup toothpaste has lots of close substitutes (e.g., Colgate, Sensodyne), so buyers can easily switch if the price rises. • Electricity has no close substitutes, so consumers would probably not buy much less if its price rises. • Lesson: Price elasticity is higher when close substitutes are available. 8 8 4 4/26 EXAM EXAMPL PL PLE E 2: “Blue Je Jeans” ans” vs. “Cloth “Clothing ing ing”” • The prices of both goods rise by 20%. For which good does Qd drop the most? Why? • For a narrowly defined good such as blue jeans, there are many substitutes (khakis, shorts, Speedos). • There are fewer substitutes available for broadly defined goods. (Can you think of a substitute for clothing?) • Lesson: Price elasticity is higher for narrowly defined goods than broadly defined ones. 9 9 EXAM EXAMPL PL PLE E 3: Insuli Insulin n vs. Car Caribbe ibbe ibbean an Cruis Cruises es • The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why? • To millions of diabetics, insulin is a necessity. A rise in its price would cause little or no decrease in demand. • A cruise is a luxury. If the price rises, some people will forego it. • Lesson: Price elasticity is higher for luxuries than for necessities. 10 10 5 5/26 EXAM EXAMPL PL PLE E 4: Gas Gasoline oline in the Sh Short ort Run vs. Gasol Gasoline ine in the Long Run • The price of gasoline rises 20%. Does Qd drop more in the short run or the long run? Why? • There’s not much people can do in the short run, other than ride the bus or carpool. • In the long run, people can buy smaller cars or live closer to where they work. • Lesson: Price elasticity is higher in the long run than the short run. 11 11 EXAM EXAMPL PL PLE E 4: Tooth othpic pic pick k vs. Mot Motor or orbik bik bikee • Motorbike represents a large share of a consumer’s budget. A price increase importantly reduces the amount of the good that a consumer is able to buy • The amount demanded will decrease significantly. • Toothpick represents a smaller share of the consumer’s budget, the consumer’s overall income and purchasing power are less effected by an increase in price. • Therefore, demand is less price elastic in these cases. Lesson: Price elasticity is higher for good that represents a large share of a consumer’s budget. 12 12 6 6/26 The Pric icee Elast Elastici ici icity ty of Deman Demand d and Its Det Determ erm ermina ina inan nts • Demand tends to be more elastic : • the larger the number of close substitutes. • if the good is a luxury. • the more narrowly defined the market. • the longer the time period. • the larger percentage of income. 13 13 Com Comput put puting ing the Price Elas Elastici tici ticity ty of Deman Demand d • The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. Price elasticity of demand = Percentage change in quantity demanded Percentage change in price 14 14 7 7/26 Com Comput put puting ing the Price Elas Elastici tici ticity ty of Deman Demand d Price elasticity of demand = Percentage change in quantity demanded Percentage change in price • Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as: 2   20% 10%     (10 8) 100 10 EP = ( 2.20 2.00) 100 2.00 15 15 The Midpoin Midpointt Metho Method: d: A Bet Better ter W Way ay to Cal Calcula cula culatte Per Perce ce cent nt ntag ag agee Chang Changes es and Elast Elasticities icities • The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.    (Q2 Q1 ) / [( Q2 Q1 ) / 2] (P2 P 1 ) / [(P 2 P 1 ) / 2]  Price elasticity of demand = 16 16 8 8/26 The Midpoin Midpointt Metho Method: d: A Bet Better ter W Way ay to Cal Calcula cula culatte Per Perce ce cent nt ntag ag agee Chang Changes es and Elast Elasticities icities • Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:   22% 9.5% 2.32   EP =   ( 10 8) (10 8) / 2 ( 2.20 2.00) ( 2.00 2.20) / 2 17 17 Elas Elastic tic ticity ity of a Lin Linear ear Dema man nd Curve P 20 200% = 5.0 40% 67% E = = 1.0 67% 10 E = $30 $0 E = 0 20 40 60 40% = 0.2 200% The slope of a linear demand curve is constant, but its elasticity is not. Q 18 18 9 9/26 The Variet ariety y of D Deman eman emand d Curv Curves es • Inelastic Demand • Quantity demanded does not respond strongly to price changes. • Price elasticity of demand is less than one. • Elastic Demand • Quantity demanded responds strongly to changes in price. • Price elasticity of demand is greater than one. • Perfectly Inelastic • Quantity demanded does not respond to price changes. • Perfectly Elastic • Quantity demanded changes infinitely with any change in price. • Unit Elastic • Quantity demanded changes by the same percentage as the price. 19 19 The Variet ariety y of D Deman eman emand d Curv Curves es • Because 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. 20 20 10 10/26 The Varie ariety ty of Dem Deman an and d Curves (a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand $5 4 1. An increase in price . . . 0 Quantity 100 2. . . . leaves the quantity demanded unchanged. 21 Copyright©2003 Southwestern/Thomson Learning 21 The Varie ariety ty of Dem Deman an and d Curves (b) Inelastic Demand: Elasticity Is Less Than 1 Price ΔQ<ΔP $5 4 1. A 22% increase in price . . . Demand 0 90 100 Quantity 2. . . . leads to an 11% decrease in quantity demanded. 22 22 11 11/26 The Varie ariety ty of Dem Deman an and d Curves (c) Unit Elastic Demand: Elasticity Equals 1 Price $5 4 Demand 1. A 22% increase in price . . . 0 80 Quantity 100 2. . . . leads to a 22% decrease in quantity demanded. 23 Copyright©2003 Southwestern/Thomson Learning 23 The Varie ariety ty of Dem Deman an and d Curves (d) Elastic Demand: Elasticity Is Greater Than 1 Price ΔQ>ΔP $5 4 Demand 1. A 22% increase in price . . . 0 50 100 Quantity 2. . . . leads to a 67% decrease in quantity demanded. 24 24 12 12/26 The Varie ariety ty of Dem Deman an and d Curves (e) Perfectly Elastic Demand: Elasticity Equals Infinity Price 1. At any price above $4, quantity demanded is zero. $4 Demand 2. At exactly $4, consumers will buy any quantity. Quantity 0 3. At a price below $4, quantity demanded is infinite. 25 25 Tota otall Rev evenu enu enuee and the Pri Price ce Elas Elastic tic ticity ity of Dem Demand and • Total revenue is the amount paid by buyers and received by sellers of a good. • Computed as the price of the good times the quantity sold. TR = P x Q 26 26 13 13/26 Tot otal al Re Reven ven venue ue and the P Prrice Elas Elastici tici ticity ty of Dem Demand and Price $4 P × Q = $400 (revenue) P 0 Demand 100 Quantity Q 27 Copyright©2003 Southwestern/Thomson Learning 27 Elast Elasticity icity and Total Re Revenu venu venuee along a Li Linear near Dem Demand and Curve • With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases. 28 28 14 14/26 How Tota otall R Reve eve evenue nue Chang Changes es When Price Chang Changes: es: Inelas Inelastic tic Dema Demand nd Price Price An Increase in price from $1 to $3 … … leads to an Increase in total revenue from $100 to $240 $3 Revenue = $240 $1 Demand Revenue = $100 0 100 Quantity Demand 0 80 Quantity 29 Copyright©2003 Southwestern/Thomson Learning 29 Elast Elasticity icity and Total Re Revenu venu venuee along a Li Linear near Dem Demand and Curve • With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases. 30 30 15 15/26 How Tota otall R Reve eve evenue nue Chang Changes es When Price Chang Changes: es: Elas Elastic tic Dema Demand nd Price Price An Increase in price from $4 to $5 … … leads to an decrease in total revenue from $200 to $100 $5 $4 Demand Demand Revenue = $200 0 Revenue = $100 50 Quantity 0 20 Quantity 31 Copyright©2003 Southwestern/Thomson Learning 31 Elas Elastic tic ticity ity & Tot otal al Reve evenue nue Test • Elastic > 1 if P decreases => TR increases; if P increases TR decreases • Unit elastic = 1 if ΔP => no ΔTR • Inelastic < 1 if P decreases => TR decreases; if P increases TR increases 32 32 16 16/26 The Rela Relationsh tionsh tionship ip Betwee Between n Price Elasticit Elasticity y of Demand and Tot otal al Reve Revenues nues ffor or Cellular Phon Phonee Service, P Panel anel (b) 33 33 The Rela Relationsh tionsh tionship ip Betwee Between n Price Elasticit Elasticity y of Demand and Tot otal al Reve Revenues nues ffor or Cellular Phon Phonee Service, P Panel anel (c) 34 34 17 17/26 Rela lation tion tionshi shi ship p Betwe Between en Price Elasti Elasticity city of Deman Demand d and Tot otal al Rev evenues enues 35 35 Inco Incom me Elas Elastici tici ticity ty of Deman Demand d • Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. • It is computed as the percentage change in the quantity demanded divided by the percentage change in income. 36 36 18 18/26 Com Comput put puting ing Inco ncom me Elas Elasticit ticit ticity y Percentage change in quantity demanded Income elasticity of demand = Percentage change in income 37 37 Inco Incom me Elas Elastici tici ticity ty • Types of Goods • Normal Goods • Inferior Goods • Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. • Goods consumers regard as necessities tend to be income inelastic • Examples include food, fuel, clothing, utilities, and medical services. • Goods consumers regard as luxuries tend to be income elastic. • Examples include sports cars, furs, and expensive foods. 38 38 19 19/26 Cr Cross oss oss-P -P -Price rice Ela Elasstici ticity ty of De Deman man mand d • A measure of how much the quantity demanded of one good responds to a change in the price of another good • Cross-price elasticity of demand = percentage change in quantity demanded of good 1/percentage change in the price of good 2 • Substitute goods – cross-price elasticity of demand is positive • Complement goods – cross-price elasticity of demand is negative 39 39 3.3 THE ELA ELAST ST STICIT ICIT ICITY Y OF SUPPL SUPPLY Y • Price 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 price. 40 40 20 20/26 The Price Elastic Elasticity ity of S Supply upply (a) Perfectly Inelastic Supply: Elasticity Equals 0 Price Supply $5 4 1. An increase in price . . . 100 0 Quantity 2. . . . leaves the quantity supplied unchanged. 41 Copyright©2003 Southwestern/Thomson Learning 41 The Price Elastic Elasticity ity of S Supply upply (b) Inelastic Supply: Elasticity Is Less Than 1 Price Supply $5 4 1. A 22% increase in price . . . 0 100 110 Quantity 2. . . . leads to a 10% increase in quantity supplied. 42 Copyright©2003 Southwestern/Thomson Learning 42 21 21/26 The Price Elastic Elasticity ity of S Supply upply (c) Unit Elastic Supply: Elasticity Equals 1 Price Supply $5 4 1. A 22% increase in price . . . 0 100 125 Quantity 2. . . . leads to a 22% increase in quantity supplied. 43 Copyright©2003 Southwestern/Thomson Learning 43 The Price Elastic Elasticity ity of S Supply upply (d) Elastic Supply: Elasticity Is Greater Than 1 Price Supply $5 4 1. A 22% increase in price . . . 0 100 200 Quantity 2. . . . leads to a 67% increase in quantity supplied. 44 Copyright©2003 Southwestern/Thomson Learning 44 22 22/26 The Price Elastic Elasticity ity of S Supply upply (e) Perfectly Elastic Supply: Elasticity Equals Infinity Price 1. At any price above $4, quantity supplied is infinite. $4 Supply 2. At exactly $4, producers will supply any quantity. 0 3. At a price below $4, quantity supplied is zero. Quantity 45 Copyright©2003 Southwestern/Thomson Learning 45 Det Determ erm ermin in inant ant antss of Elas Elastici tici ticity ty of Supply • Ability 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. (Key determinant) • The amount of time a seller has to change the amount of the good they can produce • Supply is more elastic in the long run. 46 46 23 23/26 Com Comput put puting ing the Price Elas Elastici tici ticity ty of Supply • The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price. Percentage change in quantity supplied Price elasticity of supply = Percentage change in price 47 47 3.4 APPLIC PPLICA ATION of EL ELAS AS ASTIC TIC TICITY ITY • Can 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? 48 48 24 24/26 An Incr Increase ease in Supp Supply ly in the Mark Market et ffor or Whea Wheatt Price of Wheat 1. When demand is inelastic, an increase in supply . . . 2. . . . leads to a large fall in price . . . S1 S2 $3 2 Demand 0 100 110 Quantity of Wheat 3. . . . and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220. 49 Copyright©2003 Southwestern/Thomson Learning 49 AR Redu edu eduction ction in Supply in the World Mark Market et for Oil (a) Oil Market in the Short Run Price of Oil 1. In the short run, when supply and demand are inelastic, a shift in supply… (b) Oil Market in the Long Run Price of Oil 1. In the long run, when supply and demand are elastic, a shift in supply… S2 P2 P2 P1 P1 2. … leads to a large increase in price… Demand Quantity of Oil 2. … leads to a small increase in price… Demand Quantity of Oil 50 50 25 25/26 Policies to Reduce the of Illeg Illegaal Drugs (a) Drug Interdiction Price of Drugs 1. Drug interdiction reduces the supply of drugs… (b) Drug Education Price of Drugs S2 P2 1. Drug education reduces the demand for drugs… P1 P2 P1 D1 2. … which reduces the price… 2. … which raises the price… D2 Demand Q2 Q1 3. … and reduces the quantity sold. Quantity of Drugs Q2 Q1 Quantity of Drugs 3. … and reduces the quantity sold. 51 51 26 26/26