Elasticity Application PDF

9/13/24 APPLICATION 2: Predicting Changes in Total Revenue Finding %ΔQD Predict...

9/13/24 APPLICATION 2: Predicting Changes in Total Revenue Finding %ΔQD Predicting changes in total revenue, given ED and the %∆QD change in P ED = %∆P § Suppose… § You work at Starbucks § Since we know Ed and %ΔP, we can find %ΔQd § Price for a small (tall) cup of coffee is $2.50 § Management is considering raising the price to $3 |%ΔQ D |= ED * |%ΔP| § From past data, we estimate ED = 1.5 § Use traditional formular § Ed = 1.5 (This was given in the problem) § What is %∆P? § What will happen to QD? (cups coffee per hour) § The 50 cents increase in price from $2.50 is a 20% increase § QD will fall, but by how much? 0.50 § What are we solving for? %ΔQD %∆P = x 100 = 20% 30 2.50 30 31 Finding %ΔQd Predicting Changes in Total Revenue § Since we know ED and %ΔP, we can now find %ΔQD Total Revenue (TR) = Price (P) * Quantity (Q) |%∆QD |= ED x |%∆P| |%∆QD |= 1.5 x 0.20 § What happens to TR when we raise the price of coffee? |%∆QD |= 0.30 § We are charging a higher price, so that tends to raise TR § But, we are selling fewer cups, so that tends to lower TR Or 30% § What is the final effect on TR?? § Therefore, we estimate that a 20% increase in price § Will it rise or fall? will cause us to sell 30% fewer cups of coffee 32 33 32 33 1  9/13/24 Finding Changes in Total Revenue Finding changes in TR (cont) § Assume: Old price was $2.50 and we sold 200 cups of coffee/hour § We know the new P = $3 What is the new QD ? TR = P * Q § We know the old QD was 200 (cups/hour) (old) TR = $2.50 * 200 § We determined that the new QD will be around 30% less, so what is 30% of 200? (old) TR = $500/hour 200 * 0.30 = 60 § Before the price change, total revenue was $500/hour § Therefore, we expect to sell 60 cups less than before § What is the new TR? § New expected QD is 140 cups/hour (200 – 60) § We need to plug in new P and QD to find the new TR § New TR = $3 * 140 = $420/hour § We can expect TR to fall if we increase the price 34 35 34 35 Finding TR Graphically Finding TR Graphically (cont) P ($) Which of the 2 boxes has the larger area? Since the area of a box is length * width… P ($) The blue box (old TR): area $500 TR can be thought of graphically: The red box (new TR): area $420 the area of this box = TR 3.00 old P 2.50 2.50 Area = 2.50 * 200 Area = 500 D D 200 Q (cups/hour) old Q 36 140 200 Q (cups/hour) 37 36 37 2  9/13/24 Finding TR Graphically (cont) Ed and Total Revenue Which of the 2 boxes has the larger P ($) area? § Total revenue depends on both P and QD Price effect § Since P and QD are negatively related, they always move in the opposite The blue box (old TR): area $500 Area gained in this direction example $70 The red box (new TR): area $420 3.00 § That is, if P↑, then QD ↓, and if P↓ then QD ↑ 2.50 Quantity effect Area lost in this § Therefore, they have opposing effects on TR… example $150 § Is there any way to predict if TR will ↑ or ↓ when P changes? D 140 200 Q (cups/hour) 38 39 38 39 BIG IDEA IN ECONOMICS Case Study - Netflix § Netflix has announced that it added 8.8 million new subscribers during the third quarter of 2023. If Demand is… § The company saw its revenue Change in P Elastic Inelastic increase by 8% to $8.5 billion. § For its next move, the When P Û Total Revenue falls Total Revenue rises company dropped the basic plan, while increasing the higher tier plan from $20 to When P Ü Total Revenue rises Total Revenue falls $23. 40 4-41 40 41 3  9/13/24 PRICE ELASTICITY OF SUPPLY Discussion § Measures the responsiveness of producers (sellers) to changes in price 1. Does Netflix believe its market § Categories (elastic, inelastic and unit elastic) are the same as demand as well demand is elastic or inelastic? as the calculation 2. Which of the determinants of elasticity would contribute to the § 0 < ES < 1 Inelastic supply %∆QS demand for Netflix being elastic or ES = inelastic? § Supply is unresponsive to changes in price %∆P § ES = 1 Unit Elastic 3. How does creating original content affect the elasticity of demand for § ES > 1 Elastic supply Netflix? § Supply is responsive to changes in price 4-42 43 42 43 Elasticity Factors Application 3: Policy Analysis § Determinants I. Can good news for farming be bad 1. Flexibility of sellers: e.g., Fixed amount of production leads to inelastic news for farmers? supply 2. Time horizon: short run (inelastic supply) vs. long run (elastic supply) § A new hybrid of wheat is developed that is more productive than those used in the past. § What could happen to the wheat market? inelastic supply elastic supply 44 4-45 44 45 4  9/13/24 Why does the price of gasoline fluctuate? Application 3: Policy Analysis II. Why did OPEC fail to keep price of oil high? § Oil Embargo: OPEC reduced the globe oil supply in 1970s and 1980s. § What could happen to the oil market? § Any differences in short-run and long- run? short-run long-run 4-46 47 46 47 Application 3: Policy Analysis Income Elasticity of Demand III. Does drug 𝜼= %∆QD interdiction increase or decrease drug- %∆Y related crime? § The federal government § Y is consumer’s income increased the # of federal agents devoted to the war § 𝜼>0, normal good. When income Y rises, quantity QD also increases. on drugs. § 𝜼