Principles of Economics Chapter 5 Elasticity PDF

Principles of Economics Thirteenth Edition Chapter 5 Elasticity Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Chapter 5 Elasticity (1 of 2) The model of supply and d...

Principles of Economics Thirteenth Edition Chapter 5 Elasticity Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Chapter 5 Elasticity (1 of 2) The model of supply and demand tells us a good deal about how a change in the price of a good affects behavior. But knowing the direction of a change is not enough. Economists measure market responsiveness using the concept of elasticity. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Chapter 5 Elasticity (2 of 2) elasticity A general concept used to quantify the response in one variable when another variable changes. %ΔA elasticity of A with respect to B = %ΔB Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Price Elasticity of Demand price elasticity of demand The ratio of the percentage change in quantity demanded to the percentage change in price; measures the responsiveness of quantity demanded to changes in price. %changeinquantity demanded price elasticity of demand = %changeinprice Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 5.1 Slope Is Not a Useful Measure of Responsiveness Changing the unit of measure from pounds to ounces changes the numerical value of the demand slope dramatically, but the behavior of buyers in the two diagrams is identical. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Types of Elasticity (1 of 4) perfectly inelastic demand Demand in which quantity demanded does not respond at all to a change in price. perfectly elastic demand Demand in which quantity drops to zero at the slightest increase in price. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Types of Elasticity (2 of 4) A good way to remember the difference between the two perfect elasticities is: Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 5.2 Perfectly Inelastic and Perfectly Elastic Demand Curves Panel (a) shows a perfectly inelastic demand curve for insulin. Price elasticity of demand is zero. Quantity demanded is fixed; it does not change at all when price changes. Panel (b) shows a perfectly elastic demand curve facing a wheat farmer. A tiny price increase drives the quantity demanded to zero. In essence, perfectly elastic demand implies that individual producers can sell all they want at the going market price but cannot charge a higher price. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Types of Elasticity (3 of 4) elastic demand A demand relationship in which the percentage change in quantity demanded is larger than the percentage change in price in absolute value (a demand elasticity with an absolute value greater than 1). inelastic demand Demand that responds somewhat, but not a great deal, to changes in price. Inelastic demand always has a numerical value between 0 and 1. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Types of Elasticity (4 of 4) unitary elasticity A demand relationship in which the percentage change in quantity of a product demanded is the same as the percentage change in price in absolute value (a demand elasticity with an absolute value of 1). Because it is generally understood that demand elasticities are negative (demand curves have a negative slope), they are often reported and discussed without the negative sign. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Calculating Elasticities (1 of 2) Calculating Percentage Changes Here is how we calculate percentage change in quantity demanded using the initial value as the base: changeinquantity demanded %changeinquantity demanded= ×100% Q1 Q2 - Q1 = ´100% Q Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Calculating Elasticities (2 of 2) We can calculate the percentage change in price in a similar way. By using P1 as the base, the percentage of change in P is: changeinprice %changeinprice = ´100% p1 p2 - p1 = ´100% p1 Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Elasticity Is a Ratio of Percentages Recall the formal definition of elasticity: %change in quantity demanded price elasticity of demand = %change in price Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Midpoint Formula midpoint formula A more precise way of calculating percentages using the value halfway between P1 and P2 for the base in calculating the percentage change in price and the value halfway between Q1 and Q2 as the base for calculating the percentage change in quantity demanded. change in quantity demanded %change in quantity demanded = ´100% Q1 Q2 - Q1 = ´100% Q1 Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Point Elasticity (1 of 3) point elasticity A measure of elasticity that uses the slope measurement. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Point Elasticity (2 of 3) Elasticity is the percentage change in quantity demanded divided by the percentage change in price, i.e., ΔQ Q1 ΔP P1 where Δ denotes a small change and Q1 and P1 refer to the original price and quantity demanded. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Point Elasticity (3 of 3) The formula can be rearranged and written as: ΔQ P1 ´ ΔP Q1 ΔQ is the reciprocal of the slope. Notice that ΔP Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Elasticity Changes along a Straight- Line Demand Curve (1 of 4) Table 5.1 Demand Schedule for Figure 5.3 Demand Curve for Lunch at the Office Office Dining Room Lunches Dining Room Price (per Quantity Demanded Lunch) (Lunches per Month) $ 11 0 10 2 9 4 8 6 7 8 6 10 5 12 To calculate price elasticity of demand between 4 14 points A and B on the demand curve, first calculate 3 16 the percentage change in quantity demanded: 2 18 4-2 2 1 20 % change in quantity demanded = ´ 100 % = ´ 100 % = 66.7 % 0 22 (2 + 4) / 2 3 Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Elasticity Changes along a Straight- Line Demand Curve (2 of 4) Next, calculate the percentage change in price: 9 - 10 -1 %change in price = ´ 100% = ´ 100% = - 10.5% (10+9) / 2 9.5 Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Elasticity Changes along a Straight- Line Demand Curve (3 of 4) Finally, calculate elasticity: 66.7% elasticity of demand = = - 6.33 -10.5% Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Elasticity Changes along a Straight- Line Demand Curve (4 of 4) Between points A and B, demand is quite elastic, at −6.33. Between points C and D, demand is quite inelastic, at −.294. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 5.4 Point Elasticity Changes along a Demand Curve Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Elasticity and Total Revenue (1 of 4) In any market, P ´ Q is total revenue (T R) received by producers: TR = P ´ Q Total revenue = price× quantity Effects of price changes on quantity demanded: P ­® QD ¯ and P ¯® QD ­ When price (P) declines, quantity demanded (QD ) increases The two factors, P and QD , move in opposite directions. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Elasticity and Total Revenue (2 of 4) Because total revenue is the product of P and Q, whether TR rises or falls in response to a price increase depends on which is bigger; the percentage increase in price or the percentage decrease in quantity demanded. Effect of price increase on a product with inelastic demand: ­ P ´QD ¯ =TR ­ Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Elasticity and Total Revenue (3 of 4) If the percentage decline in quantity demanded following a price increase is larger than the percentage increase in price, total revenue will fall. Effect of price increase on a product with elastic demand: ­ P ´QD ¯ =TR ¯ Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Elasticity and Total Revenue (4 of 4) The opposite is true for a price cut. When demand is elastic, a cut in price increases total revenue. Effect of price cut on a product with elastic demand: ¯ P ´QD ­ =TR ­ Effect of price cut on a product with inelastic demand: ¯ P ´QD ­ =TR ­ When demand is inelastic, a cut in price reduces total revenue. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Determinants of Demand Elasticity (1 of 2) Availability of Substitutes Perhaps the most obvious factor affecting demand elasticity is the availability of substitutes. The Importance of Being Unimportant When an item represents a relatively small part of our total budget, we tend to pay little attention to its price. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Determinants of Demand Elasticity (2 of 2) Luxuries versus Necessities Luxury goods (e.g., yachts) tend to have relatively elastic demand, and necessities (e.g., food) have inelastic demand. The Time Dimension In the longer run, demand is likely to become more elastic because households make adjustments over time, and producers develop substitute goods. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Economics In Practice (1 of 2) Elasticities at a Delicatessen in the Short Run and Long Run The graph shows the expected relationship between long-run and short- run demand for Frank’s sandwiches. Notice that if you raise prices above the current level, the expected quantity change read from the short-run curve is less than that from the long-run curve. CRITICAL THINKING 1. Provide an example of a purchasing situation in which you think your own short- and long-run elasticities differ a lot and a second in which they are similar. What drives those differences? Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Other Important Elasticities (1 of 2) Income Elasticity of Demand income elasticity of demand A measure of the responsiveness of demand to changes in income. %change in quantity demanded income elasticity of demand = % change in income Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Other Important Elasticities (2 of 2) Cross-Price Elasticity of Demand cross-price elasticity of demand A measure of the response of the quantity of one good demanded to a change in the price of another good. %change in quantity of Y demanded cross -price elasticity of demand = %change in price of X Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Elasticity of Supply elasticity of supply A measure of the response of quantity of a good supplied to a change in price of that good. Likely to be positive in output markets. %change in quantity supplied elasticity of supply = %change in price elasticity of labor supply A measure of the response of labor supplied to a change in the price of labor. %change in quantity of labour supplied elasticity of labour supply = %change in the wage rate Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved What Happens When We Raise Taxes: Using Elasticity excise tax A per-unit tax on a specific good. In the United States, we have excise taxes on gasoline and cigarettes. Example: A mayor of a city imposes a tax of $1.00 per avocado in a city where 1,000 avocados are sold per day. Will the city add $365,000 per year in taxes? Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 5.5 Original Equilibrium in the Avocado Market Store owners in the city sells 1,000 avocados per day at the market price of $2.00. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 5.6 Equilibrium in the Avocado Market after the $1.00 Tax After the mayor imposes a tax of $1.00 per avocado, the supply curve shifts up by $1.00, and there is a new equilibrium where supply equals demand at point B. At the new equilibrium, 500 avocados are sold; the equilibrium price rises to $2.50, and storeowners receive $1.50 per avocado. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Review Terms and Concepts cross-price elasticity of demand elastic demand elasticity elasticity of labor supply elasticity of supply excise tax income elasticity of demand inelastic demand midpoint formula perfectly elastic demand perfectly inelastic demand point elasticity price elasticity of demand unitary elasticity Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved