Chapter 5 “Elasticity and Its Application Chp 2

Elasticity of Demand and Total Revenue If a demand curve is inelastic, an increase in price leads to a decrease in quantity that is proportionately smaller.  total revenue increases when price rises  How Total Revenue Changes When Price Increases: Inelastic Demand Price Price … leads to an Increase in total revenue from $100 to $240 An Increase in price from $1 to $3 … $3 Revenue = $240 $1 Revenue = $100 0 Demand 100 Quantity Demand 0 80 Quantity Elasticity of Demand and Total Revenue If a demand curve is elastic, an increase in the price leads to a decrease in quantity demanded that is proportionately larger.  total revenue decreases when price increases.  How Total Revenue Changes When Price Increases: Elastic Demand Price Price … leads to an decrease in total revenue from $200 to $100 An Increase in price from $4 to $5 … $5 $4 Demand Demand Revenue = $200 0 50 Revenue = $100 Quantity 0 20 Quantity Other Demand Elasticities   income elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in consumers’ income, the percentage change in quantity demanded divided by the percentage change in income. Income Elasticity   Income Elasticity of Demand = % change in quantity demanded % change in income Types of Goods    Normal Goods: Income Elasticity > 0 Inferior Goods: Income Elasticity < 0 Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods Income Elasticity  Goods consumers regard as necessities tend to be income inelastic   Examples: food, fuel, clothing, utilities, and medical services. Goods consumers regard as luxuries tend to be income elastic.  Examples: sports cars, furs, and expensive foods. Cross-Price Elasticity cross-price elasticity of demand: a measure of how much the quantity demanded of one good responds to a change in the price of another good  computed as the percentage change in the quantity demanded of the 1st good divided by the percentage change in the price of the 2nd good.  Cross-Price Elasticity of Demand = % change in quantity demanded of good 1 % change in price of good 2  The Elasticity of Supply    price elasticity of supply: a measure of how much the quantity supplied of a good responds to a change in the price of that good computed as the percentage change in quantity supplied divided by the percentage change in price. Price Elasticity of Supply = % change in quantity supplied % change in price The Elasticity of Supply Elastic Supply Extreme Cases Determinants of Price Elasticity of Supply   Flexibility of sellers: goods that are somewhat fixed in supply (beachfront property) have inelastic supplies. Time horizon: supply is more elastic in the long run The Elasticity of Supply  Example: the price of milk increases from $2.85 per gallon to $3.15 per gallon and the quantity supplied rises from 9,000 to 11,000 gallons per month. % change in price = (3.15 – 2.85)/3.00 × 100% = 10% % change in quantity supplied = (11,000 - 9,000)/10,000 × 100% = 20% Price elasticity of supply = (20%)/(10%) =2 Three Applications of Supply, Demand, and Elasticity     New hybrid of wheat is more productive than those in the past. What happens? Supply increases, price falls, and quantity demanded rises. If demand is inelastic, the fall in price is greater than the increase in quantity demanded and total revenue falls. If demand is elastic, the fall in price is smaller than the rise in quantity demanded and total revenue rises. An Increase in Supply in the Market for Wheat Price of Wheat 2. . . . leads to a large fall in price . . . 1. When demand is inelastic, an increase in supply . . . 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. Compute the Price Elasticity of Demand ED 100  110 (100  110) / 2  3.00  2.00 (3.00  2.00) / 2 0.095   0.24 0.4 Supply is inelastic Why Did OPEC Fail to Keep the Price of Oil High?   In the 1970s and 1980s, OPEC reduced the amount of oil it was willing to supply to world markets. The decrease in supply led to an increase in the price of oil and a decrease in quantity demanded. The increase in price was much larger in the short run than the long run. Why? The demand and supply of oil are much more inelastic in the short run than the long run. Short Run Short Run Long Run Summary     Price elasticity of demand measures how much the quantity demanded responds to changes in the price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price If a demand curve is elastic, total revenue falls when the price rises. If it is inelastic, total revenue rises as the price rises. Summary    The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good. The price elasticity of supply measures how much the quantity supplied responds to changes in the price. Summary   In most markets, supply is more elastic in the long run than in the short run. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price.