Elasticity and its Applications PDF

Elasticity and Its Applications Copyright © 2004 South-Western  Elasticity... … 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...

Elasticity and Its Applications Copyright © 2004 South-Western  Elasticity... … 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 Copyright © 2004 South-Western/Thomson Learning  THE ELASTICITY OF DEMAND 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. Copyright © 2004 South-Western/Thomson Learning The Price Elasticity of Demand and Its Determinants Availability of Close Substitutes Necessities versus Luxuries Definition of the Market ‘Gourmet coffee’ vs ‘all types of coffee’ Time Horizon the length of time which consumers can adjust their behavior in response to a change in price. ‘Price of petrol’ vs ‘cars’ Copyright © 2004 South-Western/Thomson Learning The Price Elasticity of Demand and Its Determinants Demand tends to be more elastic : the larger the number of close substitutes. if the good is a luxury. the more broadly defined the market. Shoes (broad category: inelastic demand) Vanilla ice-cream (narrow category: elastic demand) the longer the time period. Copyright © 2004 South-Western/Thomson Learning Computing the Price Elasticity of Demand The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. Percentage change in quantity demanded Price elasticity of demand = Percentage change in price Copyright © 2004 South-Western/Thomson Learning Computing the Price Elasticity of Demand Percentage change in quantity demanded Price elasticity of demand = 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: (10  8)  100 20% 10  2 (2.20  2.00)  100 10% 2.00 Copyright © 2004 South-Western/Thomson Learning The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities 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] X100% Price elasticity of demand = (P2 P1) /[(P2 P1) / 2] X100% Copyright © 2004 South-Western/Thomson Learning The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities 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: (10  8) (10  8) / 2 22%   2.32 (2.20  2.00) 9.5% (2.00  2.20) / 2 Copyright © 2004 South-Western/Thomson Learning The Variety of Demand Curves 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. Copyright © 2004 South-Western/Thomson Learning Computing the Price Elasticity of Demand (100- 50) (100 50)/2 ED  Price (4.00- 5.00) (4.00 5.00)/2 $5 4 Demand  67 percent  -3 - 22 percent 0 50 100 Quantity Demand is price elastic Copyright © 2004 South-Western/Thomson Learning The Variety of Demand Curves Perfectly Inelastic Quantity demanded does not respond to price changes. Rare goods, life-saving medications, and necessities. Perfectly Elastic Quantity demanded changes infinitely with any change in price. many different brands and options available, consumers can easily switch between products based on price and other factors. Unit Elastic Quantity demanded changes by the same percentage as the price. Copyright © 2004 South-Western/Thomson Learning The Variety of Demand Curves 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. Copyright © 2004 South-Western/Thomson Learning Figure 1 The Price Elasticity of Demand (a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand $5 4 1. An increase in price... 0 100 Quantity 2.... leaves the quantity demanded unchanged. Rare goods, life-saving medications, and necessities Copyright©2003 Southwestern/Thomson Learning  Figure 1 The Price Elasticity of Demand (b) Inelastic Demand: Elasticity Is Less Than 1 Price $5 4 1. A 22% Demand increase in price... 0 90 100 Quantity 2.... leads to an 11% decrease in quantity demanded. Consumers may continue to buy petrol even if the price increases  Figure 1 The Price Elasticity of Demand (c) Unit Elastic Demand: Elasticity Equals 1 Price $5 4 1. A 22% Demand increase in price... 0 80 100 Quantity 2.... leads to a 22% decrease in quantity demanded. Many close substitutes available Copyright©2003 Southwestern/Thomson Learning  Figure 1 The Price Elasticity of Demand (d) Elastic Demand: Elasticity Is Greater Than 1 Price $5 4 Demand 1. A 22% increase in price... 0 50 100 Quantity 2.... leads to a 67% decrease in quantity demanded. There are many close substitutes for the good, and consumers can easily switch to a cheaper alternative if the price of one good increases  Figure 1 The Price Elasticity of Demand (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. 0 Quantity 3. At a price below $4, quantity demanded is infinite. The price is determined by the forces of supply and demand and sellers/producers cannot influence the price through their actions Total Revenue and the Price Elasticity of Demand 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 Copyright © 2004 South-Western/Thomson Learning  Figure 2 Total Revenue Price $4 P × Q = $400 P (revenue) Demand 0 100 Quantity Q Copyright©2003 Southwestern/Thomson Learning Elasticity and Total Revenue along a Linear Demand Curve With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases. Copyright © 2004 South-Western/Thomson Learning  Figure 3 How Total Revenue Changes When Price Changes: Inelastic Demand Price Price An Increase in price from $1 … leads to an Increase in to $3 … total revenue from $100 to $240 $3 Revenue = $240 $1 Revenue = $100 Demand Demand 0 100 Quantity 0 80 Quantity Copyright©2003 Southwestern/Thomson Learning Elasticity and Total Revenue along a Linear Demand 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. Copyright © 2004 South-Western/Thomson Learning  Figure 4 How Total Revenue Changes When Price Changes: Elastic Demand Price Price An Increase in price from $4 … leads to an decrease in to $5 … total revenue from $200 to $100 $5 $4 Demand Demand Revenue = $200 Revenue = $100 0 50 Quantity 0 20 Quantity Copyright©2003 Southwestern/Thomson Learning Elasticity of a Linear Demand Curve Copyright © 2004 South-Western/Thomson Learning Income Elasticity of Demand 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. Copyright © 2004 South-Western/Thomson Learning  Computing Income Elasticity of Demand (YED) Percentage change in quantity demanded Income elasticity of demand = Percentage change in income Copyright © 2004 South-Western/Thomson Learning Income Elasticity Types of Goods Normal Goods Inferior Goods Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. Copyright © 2004 South-Western/Thomson Learning Income Elasticity 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 luxury bags, expensive clothes, and expensive foods. Copyright © 2004 South-Western/Thomson Learning Calculate the Income Elasticity of Demand using the Midpoint formula: Income increases from RM1,500 to RM2,000 Demand of fast food burger decreases from 5 to 1 YED = -4.67 (Inferior Goods) Copyright © 2004 South-Western/Thomson Learning  THE ELASTICITY OF SUPPLY 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. Copyright © 2004 South-Western/Thomson Learning Figure 6 The Price Elasticity of Supply (a) Perfectly Inelastic Supply: Elasticity Equals 0 Price Supply $5 4 1. An increase in price... 0 100 Quantity 2.... leaves the quantity supplied unchanged. Ie: Unique works of an artist, land and etc Copyright©2003 Southwestern/Thomson Learning  Figure 6 The Price Elasticity of Supply (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. Production of a good that requires a large investment in fixed assets or resources (specialized machinery, land, or skilled labours) Copyright©2003 Southwestern/Thomson Learning  Figure 6 The Price Elasticity of Supply (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. Production process for the good or service is relatively flexible (the resources required for production are not fixed or limited). Copyright©2003 Southwestern/Thomson Learning  Figure 6 The Price Elasticity of Supply (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. This can happen when the production process is flexible, and the resources required for production are easily available and not limited Copyright©2003 Southwestern/Thomson Learning  Figure 6 The Price Elasticity of Supply (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 Quantity 3. At a price below $4, quantity supplied is zero. Digital goods, software or music downloads: the supply can be increased quickly and easily in response to changes in price Copyright©2003 Southwestern/Thomson Learning Determinants of Elasticity 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. Supply is more elastic in the long run. Copyright © 2004 South-Western/Thomson Learning Computing the Price Elasticity 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 Copyright © 2004 South-Western/Thomson Learning  APPLICATION of ELASTICITY 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? Copyright © 2004 South-Western/Thomson Learning  THE APPLICATION OF SUPPLY, DEMAND, AND ELASTICITY Examine whether the supply or demand curve shifts. Determine the direction of the shift of the curve. Use the supply-and-demand diagram to see how the market equilibrium changes. Copyright © 2004 South-Western/Thomson Learning Figure 8 An Increase in Supply in the Market for Wheat Price of Wheat 1. When demand is inelastic, 2.... leads an increase in supply... to a large fall S1 in price... 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. Copyright©2003 Southwestern/Thomson Learning Compute the Price Elasticity of Demand 100  110 (100  110) / 2 ED  3.00  2.00 (3.00  2.00) / 2 0.095   0.24 0.4 Demand is inelastic Copyright © 2004 South-Western/Thomson Learning  Summary Price elasticity of demand measures how much the quantity demanded responds to changes in the price. Price elasticity of demand 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. Copyright © 2004 South-Western/Thomson Learning  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.. Copyright © 2004 South-Western/Thomson Learning  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. The tools of supply and demand can be applied in many different types of markets. Copyright © 2004 South-Western/Thomson Learning