Chapter 5: Elasticity and Its Application - Economics Slides

CHAPTER 5 ELASTICITY AND ITS APPLICATION 5-1 What is elasticity in economics? Elasticity measures the sensitivity of an economic variable with respect to another economic variable; the former is the outcome of the latter An elasticity should be a number describing “a % chan...

CHAPTER 5 ELASTICITY AND ITS APPLICATION 5-1 What is elasticity in economics? Elasticity measures the sensitivity of an economic variable with respect to another economic variable; the former is the outcome of the latter An elasticity should be a number describing “a % change to a % change” An elasticity can be positive, negative, or zero The absolute value of elasticity can be greater than, less than, or equal to 1 5-2 THE PRICE ELASTICITY OF DEMAND AND ITS DETERMINANTS 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, computed as the percentage change in quantity demanded divided by the percentage change in price Notation: Price elasticity of demand must always be negative according to the Law of Demand 5-3 What influences the elasticity of demand? 5-4  Availability of close substitutes: if there exist close substitutes, the price elasticity of demand will be greater Necessities versus luxuries: the elasticity for luxury goods will be greater than necessities (expensive jewelry vs food) Definition of the market: what can be sold in this market (the need for a specifically defined good usually has greater elasticity than the loosely –defined category; for example, chocolate vs food; houses vs dwelling; new cars vs cars…) Time horizon: longer time leads to more options and responses, thus greater elasticity 5-5 COMPUTING THE PRICE ELASTICITY OF DEMAND For example, suppose a 10 percent increase in the price of an ice cream cone causes the amount of ice cream you buy to fall by 20 percent The elasticity is -2 (minus two), meaning that the change in the quantity demanded is proportionately twice as large as the change in the price, negatively 5-6 THE MIDPOINT METHOD If you try calculating the price elasticity of demand between two points on a demand curve, you will quickly notice a problem: the elasticity from point A to point B seems different from the elasticity from point B to point A. 5-7 THE MIDPOINT METHOD (CONT’D) For example: Quantity = Point A: Price = $4 120 Point B: Price = $6 Quantity = 80 From point A to point B, the price rises by 50 percent, and the quantity falls by 33 percent, PED = - 0.66. From point B to point A, the price falls by 33 percent, and the quantity rises by 50 percent, PED = - 1.52. 5-8  5-9 THE SOLUTION: THE MIDPOINT METHOD THE MIDPOINT METHOD (CONT’D) With the midpoint method, we take the averages of both prices and quantities Quantity = Price = $5 100 From point A to point B, the price rises by 40 percent and the quantity falls by 40 percent. From point B to point A, the price falls by 40 percent and the quantity rises by 40 percent. In both directions, PED = -1. 5-10 THE VARIETY OF DEMAND CURVES Demand curves are classified according to their elasticity. Demand is elastic when the elasticity is greater than 1 in absolute value, so that quantity moves proportionately more than the price Demand is inelastic when the elasticity is less than 1 in absolute value, so that quantity moves proportionately less than the price If the elasticity is exactly 1 in absolute value, so that quantity moves the same amount proportionately as price, demand is said to have unit elasticity 5-11 FIGURE 5.1 The Price Elasticity of Demand 5-12 FIGURE 5.1 The Price Elasticity of Demand 5-13 FIGURE 5.1 The Price Elasticity of Demand 5-14 TOTAL REVENUE AND THE PRICE ELASTICITY OF DEMAND Total revenue (in a market) is the amount paid by buyers and received by sellers of a good, computed as the price of the good times the quantity sold: 5-15 FIGURE 5.2 Total Revenue 5-16  How does total revenue change as one TOTAL REVENUE moves along the demand curve? AND THE PRICE It depends on the price elasticity of ELASTICITY OF demand. DEMAND (CONT’D) 5-17 FIGURE 5.3 How Total Revenue Changes When Price Changes 5-18 The examples in Figure 5.3 illustrate some general rules: When demand is inelastic (a price elasticity less than 1), price and total revenue move in the same direction. When demand is elastic (a price elasticity greater than 1), price and total revenue move in opposite directions. If demand is unit elastic (a price elasticity exactly equal to 1), total revenue remains constant when the price changes. 5-19 ELASTICITY AND TOTAL REVENUE ALONG A LINEAR DEMAND CURVE A straight line has a constant slope. The slope of a linear demand curve is constant, but the elasticity is not. The slope is the ratio of changes in the two variables. The elasticity is the ratio of percentage changes in the two variables. 5-20 FIGURE 5.4 Elasticity of a Linear Demand Curve 5-21 How to derive the mathematical relationships between the slopes and elasticities of linear supply and demand functions? 5-22 OTHER Q: What definitions have we used to describe DEMAND different cases of this demand elasticity? ELASTICITIES 5-23 OTHER Q: What definitions have we used to describe DEMAND different cases of this demand elasticity? ELASTICITIES 5-24 End of Demand Elasticity 5-25 2nd elasticity: 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, computed as the percentage change in quantity supplied divided by the percentage change in price Notation: Price elasticity of supply must be positive according to the Law of Supply Its absolute value can also be greater than, smaller than or equal to 1 5-26  Supply of a good is said to be: Elastic if the quantity supplied responds substantially to changes in the price. Inelastic if the quantity supplied responds only slightly to changes in the price. Supply is usually more elastic in the long run than in the short run. 5-27 Example Suppose an increase in the price of milk from $2.85 to $3.15 per 4 L container raises the amount that dairy farmers produce from 9000 L to 11 000 L per month. Using the midpoint method, the percentage change in price is: Percentage change in quantity Percentage change in price supplied = (3.15 ̶ 2.85) / 3.00 × 100 = (11 000 ̶ 9000) / 10 000 × 100 = 10% = 20% 5-28 THE VARIETY OF SUPPLY CURVES Because the price elasticity of supply measures the responsiveness of quantity supplied to the price, it is reflected in the appearance of the supply curve. 5-29 FIGURE 5.5 The Price Elasticity of Supply 5-30 FIGURE 5.5 The Price Elasticity of Supply 5-31 FIGURE 5.5 The Price Elasticity of Supply 5-32 FIGURE 5.6 How the Price Elasticity of Supply Can Vary 5-33