Elasticity And Its Applications (PDF)

Chapter 5: Elasticity and Its Applications Shuo Xu October 9, 2024 1/27 What is Elasticity? I Elasticity measures the responsiveness of quantity demanded or quantity supplied to one of its determinants. I...

Chapter 5: Elasticity and Its Applications Shuo Xu October 9, 2024 1/27 What is Elasticity? I Elasticity measures the responsiveness of quantity demanded or quantity supplied to one of its determinants. I Commonly used to assess the impact of changes in price, income, or other factors. 2/27 Price Elasticity of Demand I Definition: The percentage change in quantity demanded divided by the percentage change in price. I Formula: %∆Qd Ed = %∆P I If |Ed |> 1: Demand is elastic. I If |Ed |< 1: Demand is inelastic. I If |Ed |= 1: Demand is unit elastic. 3/27 Determinants of Price Elasticity of Demand I Availability of close substitutes. I Necessities vs. luxuries. I Defining the market broadly or narrowly. I Time horizon. 4/27 Price Elasticity of Demand: Determinants I Ed is elastic when the consumers have goods substitutes. (Cabbage) I Ed is elastic when the consumer must use a large share of their budget to purchase the item. (Housing) I Ed is elastic if it is a luxury good. (Porsche) I Ed is inelastic if it is a necessity good. (Salt) I Ed is more elastic if the time frame is longer. (Energy Consumption) 5/27 Other Elasticities I Income Elasticity of Demand: %∆Qd EI = %∆I - Measures how quantity demanded changes with consumer income. I Cross-Price Elasticity of Demand: %∆QdX EXY = %∆PY - Measures the response in the demand for one good when the price of another good changes. 6/27 Price Elasticity of Supply I Definition: Measures how much quantity supplied responds to changes in price. I Formula: %∆Qs Es = %∆P I Determinants include production flexibility and time horizon. 7/27 Elasticity: Definition Let EX ,Y denote the X elasticity of Y. I It is perfectly elastic:|EX ,Y |= ∞. 8/27 Elasticity: Definition Let EX ,Y denote the X elasticity of Y. I It is perfectly elastic:|EX ,Y |= ∞. I It is elastic: |EX ,Y |> 1. 8/27 Elasticity: Definition Let EX ,Y denote the X elasticity of Y. I It is perfectly elastic:|EX ,Y |= ∞. I It is elastic: |EX ,Y |> 1. I It is unit elastic: |EX ,Y |= 1. 8/27 Elasticity: Definition Let EX ,Y denote the X elasticity of Y. I It is perfectly elastic:|EX ,Y |= ∞. I It is elastic: |EX ,Y |> 1. I It is unit elastic: |EX ,Y |= 1. I It is inelastic: |EX ,Y |< 1. 8/27 Elasticity: Definition Let EX ,Y denote the X elasticity of Y. I It is perfectly elastic:|EX ,Y |= ∞. I It is elastic: |EX ,Y |> 1. I It is unit elastic: |EX ,Y |= 1. I It is inelastic: |EX ,Y |< 1. I It is perfectly inelastic: |EX ,Y |= 0. 8/27 Calculating Elasticity: Midpoint Formula I To avoid different values depending on the direction of change, use the midpoint formula: (Q2 − Q1 )/((Q2 + Q1 )/2) Ed = (P2 − P1 )/((P2 + P1 )/2) 9/27 Price Elasticity of Demand: Total Revenue Rule Total Revenue (TR) = P × Q. Quantity Effect vs. Price Effect: I Quantity Effect: When P decreases, more units are sold. I Price Effect: When P decreases, revenue on units sold decreases. Elasticity and Price-Quantity Tradeoff: I When Ed is elastic, Quantity Effect dominates. I When Ed is unit elastic, two effects cancel out. I When Ed is inelastic, Price Effect dominates. 10/27 Price Elasticity of Demand: Total Revenue Rule Total Revenue Rule: I If Ed is elastic: P decreases → TR increases. I If Ed is unit elastic: P decreases → TR does not change. I If Ed is inelastic: P decreases → TR decreases. 11/27 Price Elasticity of Demand: Total Revenue Rule As price decreases, Price Effect becomes stronger. 12/27 Elasticity and Tax Incidence I The division of the tax burden depends on the relative elasticity of supply and demand. I The side of the market that is less elastic bears a greater share of the tax burden. 13/27 Elasticity and Surplus I The one with a more inelastic demand/supply bears more burden of the tax, and enjoys more benefit of the subsidy. After tax (subsidy), there is a fixed decrease (increase) in quantity. If I am more inelastic, then for each unit, I lose (gain) more. 14/27 Comparing Price Elasticity of Two Intersecting Curves Use definition 1. Start from the intersecting point. 2. Draw a fixed change in price level. 3. A larger change in quantity implies more price elasticity. 15/27 Quick Quiz 1 A good tends to have a small price elasticity of demand if: (a) The good is a necessity. (b) There are many close substitutes. (c) The market is narrowly defined. (d) The long-run response is being measured. 16/27 Quick Quiz 2 An increase in a good’s price reduces the total amount consumers spend on the good if the ˙˙˙˙˙˙˙˙ elasticity of demand is ˙˙˙˙˙˙˙˙ than one. (a) Income; less (b) Income; greater (c) Price; less (d) Price; greater 17/27 Quick Quiz 3 A linear, downward-sloping demand curve is: (a) Inelastic. (b) Unit elastic. (c) Elastic. (d) Inelastic at some points and elastic at others. 18/27 Quick Quiz 4 The citizens of Rohan spend a higher fraction of their income on food than do the citizens of Gondor. The reason could be that: (a) Rohan has lower food prices, and the price elasticity of demand is zero. (b) Rohan has lower food prices, and the price elasticity of demand is 0.5. (c) Rohan has lower income, and the income elasticity of demand is 0.5. (d) Rohan has lower income, and the income elasticity of demand is 1.5. 19/27 Quick Quiz 5 The price of a good rises from $16 to $24, and the quantity supplied rises from 90 to 110 units. Calculated with the midpoint method, the price elasticity of supply is: (a) 1/5. (b) 1/2. (c) 2. (d) 5. 20/27 Quick Quiz 6 If the price elasticity of supply is zero, the supply curve is: (a) Upward sloping. (b) Horizontal. (c) Vertical. (d) Fairly flat at low quantities but steeper at larger quantities. 21/27 Quick Quiz 7 The ability of firms to enter and exit a market over time means that, in the long run: (a) The demand curve is more elastic. (b) The demand curve is less elastic. (c) The supply curve is more elastic. (d) The supply curve is less elastic. 22/27 Quick Quiz 8 An increase in the supply of grain will reduce the total revenue grain producers receive if: (a) The supply curve is inelastic. (b) The supply curve is elastic. (c) The demand curve is inelastic. (d) The demand curve is elastic. 23/27 Quick Quiz 9 In competitive markets, farmers adopt new technologies that will eventually reduce their revenue because: (a) Each farmer is a price taker. (b) Farmers are short-sighted. (c) Regulation requires the use of best practices. (d) Consumers pressure farmers to lower prices. 24/27 Quick Quiz 10 Because the demand curve for oil is ˙˙˙˙˙˙˙˙ elastic in the long run, OPEC’s reduction in the supply of oil had a ˙˙˙˙˙˙˙˙ impact on the price in the long run than it did in the short run. (a) Less; smaller (b) Less; larger (c) More; smaller (d) More; larger 25/27 Quick Quiz 11 Over time, technological advances increase consumers’ incomes and reduce the price of smartphones. Each of these forces increases the amount consumers spend on smartphones if the income elasticity of demand is greater than ˙˙˙˙˙˙˙˙ and the price elasticity of demand is greater than ˙˙˙˙˙˙˙˙. (a) Zero; zero (b) Zero; one (c) One; zero (d) One; one 26/27 Summary I Elasticity is a crucial concept for understanding market dynamics. I Helps explain the impact of price changes, income changes, and related goods on supply and demand. 27/27