Economics I - 5. Elasticity and Its Applications - ELTE PDF

Economics I 5. Elasticity and Its Applications András Székely-Doby ELTE Faculty of Social Sciences, Department of Economics What is elasticity? Elasticity is a measure of how much buyers and sellers respond to changes in market conditions An example: A 10 percent increase in gasoline pr...

Economics I 5. Elasticity and Its Applications András Székely-Doby ELTE Faculty of Social Sciences, Department of Economics What is elasticity? Elasticity is a measure of how much buyers and sellers respond to changes in market conditions An example: A 10 percent increase in gasoline prices reduces gasoline consumption by about 2.5 percent after a year and by about 6 percent after five years About half of the long-run reduction in quantity demanded arises because people drive less, and half arises because they switch to more fuel-efficient cars ECONOMICS I – ANDRÁS SZÉKELY-DOBY 2 The price elasticity of demand Consumers usually buy more of a good when its price is lower To measure how much consumers respond to changes in these variables, economists use the concept of elasticity The price elasticity of demand measures how much the quantity demanded responds to a change in price ECONOMICS I – ANDRÁS SZÉKELY-DOBY 3 Elastic and inelastic demand Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in the price Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the price ECONOMICS I – ANDRÁS SZÉKELY-DOBY 4 Determinants of elasticity Availability of close substitutes: a good with close substitutes tends to have more elastic demand because it is easier for consumers to switch from that good to others Necessities versus luxuries: necessities tend to have inelastic demands, whereas luxuries have elastic demands ECONOMICS I – ANDRÁS SZÉKELY-DOBY 5 Determinants of elasticity Definition of the market: narrowly defined markets tend to have more elastic demand than broadly defined markets because it is easier to find close substitutes for narrowly defined goods Time horizon: goods tend to have more elastic demand over longer time horizons ECONOMICS I – ANDRÁS SZÉKELY-DOBY 6 Computing the price elasticity of demand Economists compute the price elasticity of demand as the percentage change in the quantity demanded divided by the percentage change in the price: Percentage change in quantity demanded Price elasticity of demand = Percentage change in price We follow the practice of dropping the minus sign and using all price elasticities as positive numbers (absolute value) ECONOMICS I – ANDRÁS SZÉKELY-DOBY 7 The variety of demand curves We classify demand curves according to their elasticity: Demand is considered elastic when the elasticity is greater than one, which means the quantity moves proportionately more than the price Demand is considered inelastic when the elasticity is less than one, which means the quantity moves proportionately less than the price If the elasticity is exactly one, the percentage change in quantity equals the percentage change in price, and demand is said to have unit elasticity ECONOMICS I – ANDRÁS SZÉKELY-DOBY 8 Elasticity of ice-cream EXERCISE Suppose that a 10 percent increase in the price of an ice-cream cone causes demand to fall by 20 percent. We calculate the elasticity of demand as: 20 percent Price elasticity of demand = = 2, which is elastic, because >1 10 percent Here, 2 means that the change in the quantity demanded is proportionately twice as large as the change in the price ECONOMICS I – ANDRÁS SZÉKELY-DOBY 9 Tuna fish and gasoline EXERCISE Suppose that the prices of red tuna fish and gasoline increase by 20 percent The demand for gasoline falls by 5 percent While the demand for red tuna fish falls by 40 percent The demand for gasoline is: The demand for red tuna fish is: ECONOMICS I – ANDRÁS SZÉKELY-DOBY 10 Tuna fish and gasoline EXERCISE Suppose that the prices of red tuna fish and gasoline increase by 20 percent The demand for gasoline falls by 5 percent While the demand for red tuna fish falls by 40 percent The demand for gasoline is: inelastic (5/201) ECONOMICS I – ANDRÁS SZÉKELY-DOBY 11 Elastic and inelastic demand The flatter the demand Price Inelastic demand (B) Supply curve, the greater the price elasticity of demand (A) The steeper the Elastic demand (A) demand curve, the smaller the price elasticity of demand (B) Quantity ECONOMICS I – ANDRÁS SZÉKELY-DOBY 12 Perfectly inelastic demand If elasticity is zero, Price Supply demand is perfectly inelastic, and the demand curve is vertical In this case, regardless Perfectly inelastic demand of the price, the quantity demanded stays the same Quantity ECONOMICS I – ANDRÁS SZÉKELY-DOBY 13 Perfectly elastic demand At the opposite Price Supply extreme, demand is perfectly elastic This occurs as the price elasticity of demand Perfectly elastic demand approaches infinity and the demand curve becomes horizontal Quantity ECONOMICS I – ANDRÁS SZÉKELY-DOBY 14 Elasticities from the Real World CASE STUDY Here are some Good Elasticity price elasticities Eggs 0.1 Very inelastic Healthcare 0.2 of demand, Cigarettes 0.4 obtained from Rice 0.5 various studies, Housing 0.7 for a range of Beef 1.6 goods: Restaurant Meals 2.3 Mountain Dew 4.4 Very elastic ECONOMICS I – ANDRÁS SZÉKELY-DOBY 15 Total revenue and price elasticity Total revenue (TR) is the Price amount paid by buyers and received by sellers of a good, computed as $4 the price of the good times the quantity sold P P X Q = $400 (revenue) Demand Quantity 0 100 Q ECONOMICS I – ANDRÁS SZÉKELY-DOBY 16 Revenue change with inelastic demand The extra revenue from Price selling at a higher price (A) is greater than the Demand lost revenue from selling fewer units (B) A Total revenue increases B Quantity ECONOMICS I – ANDRÁS SZÉKELY-DOBY 17 Revenue change with elastic demand The extra revenue from Price selling at a higher price (A) is less than the lost revenue from selling Demand fewer units (B) A Total revenue decreases B Quantity ECONOMICS I – ANDRÁS SZÉKELY-DOBY 18 Some general rules When demand is inelastic (price elasticity is less than one), price and total revenue move in the same direction: If the price increases, total revenue also increases When demand is elastic (price elasticity is greater than one), price and total revenue move in opposite directions: If the price increases, total revenue decreases If demand is unit elastic (price elasticity exactly equals one), total revenue remains constant when the price changes ECONOMICS I – ANDRÁS SZÉKELY-DOBY 19 The case of a linear demand curve At points with a low price Price and high quantity, the 6 demand curve is inelastic, 5 Elasticity is larger than 1 at points with a high price and low quantity, the 4 Elasticity equals 1 demand curve is elastic 3 Elasticity is In the mid-point, elasticity 2 less than 1 equals one 1 0 Quantity 0 2 4 6 8 10 12 ECONOMICS I – ANDRÁS SZÉKELY-DOBY 20 The case of a linear demand curve In the mid-point, where Price elasticity equals one, total 6 revenue is maximized 5 Elasticity is larger than 1 The total revenue cannot 4 exceed 6 x 3 = 18 Elasticity equals 1 3 In case of a linear demand 2 Elasticity is less than 1 curve it is always true 1 0 Quantity 0 2 4 6 8 10 12 ECONOMICS I – ANDRÁS SZÉKELY-DOBY 21 The income elasticity of demand The income elasticity of demand measures how the quantity demanded changes as consumer income changes It is calculated as the percentage change in quantity demanded divided by the percentage change in income: Percentage change in quantity demanded Income elasticity of demand = Percentage change in income ECONOMICS I – ANDRÁS SZÉKELY-DOBY 22 Normal goods, and inferior goods Most goods are normal goods: Higher income raises the quantity demanded Because quantity demanded and income move in the same direction, normal goods have positive income elasticities A few goods, such as bus rides, are inferior goods: higher income lowers the quantity demanded Because quantity demanded and income move in opposite directions, inferior goods have negative income elasticities ECONOMICS I – ANDRÁS SZÉKELY-DOBY 23 Engel’s law Even among normal goods, income elasticities vary substantially in size Engel’s Law: As a family’s income rises, the percent of its income spent on food declines, indicating an income elasticity less than one By contrast, luxuries such as jewelry and recreational goods tend to have large income elasticities because consumers feel that they can do without these goods altogether if their incomes are too low ECONOMICS I – ANDRÁS SZÉKELY-DOBY 24 Cross-price elasticity The cross-price elasticity of demand measures how the quantity demanded of one good responds to a change in the price of another good It is calculated as the percentage change in quantity demanded of good one divided by the percentage change in the price of good two Percentage change in demand of good 1 Cross-price elasticity of demand = Percentage change in price of good 2 ECONOMICS I – ANDRÁS SZÉKELY-DOBY 25 Cross-price elasticity Whether cross-price elasticity is positive or negative depends on whether the two goods are substitutes or complements In case of substitutes, cross-price elasticity is positive, the price of good one and the demand of good two move to the same direction In case of complements, cross-price elasticity is negative, the price of good one and the demand of good two move to the opposite direction ECONOMICS I – ANDRÁS SZÉKELY-DOBY 26 The elasticity of supply The price elasticity of supply measures how much the quantity supplied responds to changes in the price Supply of a good is said to be elastic if the quantity supplied responds substantially to changes in the price Supply is said to be inelastic if the quantity supplied responds only slightly to changes in the price The price elasticity of supply depends on the flexibility of sellers to change the amount of the good they produce ECONOMICS I – ANDRÁS SZÉKELY-DOBY 27 Short run and long run Supply is usually more elastic in the long run than in the short run Over short periods of time, firms cannot easily change the size of their factories to make more or less of a good Thus, in the short run, the quantity supplied is not very responsive to changes in the price Over longer periods of time, firms can build new factories or close old ones ECONOMICS I – ANDRÁS SZÉKELY-DOBY 28 Computing the price elasticity of supply We compute the price elasticity of supply as the percentage change in the quantity supplied divided by the percentage change in the price: Percentage change in quantity supplied Price elasticity of supply = Percentage change in price ECONOMICS I – ANDRÁS SZÉKELY-DOBY 29 Elastic and inelastic supply The flatter the supply curve, Price Inelastic supply (B) the greater the price elasticity of supply (A) The steeper the supply Elastic supply (A) curve, the smaller the price elasticity of supply (B) Demand Quantity ECONOMICS I – ANDRÁS SZÉKELY-DOBY 30 Perfectly inelastic supply If elasticity is zero, Price supply is perfectly Perfectly inelastic supply inelastic, and the supply curve is vertical In this case, regardless Demand of the price, the quantity demanded stays the same Quantity ECONOMICS I – ANDRÁS SZÉKELY-DOBY 31 Perfectly elastic supply At the opposite Price extreme, supply is perfectly elastic This occurs as the price Perfectly elastic supply elasticity of supply approaches infinity and Demand the supply curve becomes horizontal Quantity ECONOMICS I – ANDRÁS SZÉKELY-DOBY 32 The paradox of record harvest EXAMPLE When especially good weather Price conditions increased the supply of S1 S2 wheat, the price of wheat fell from P1 to P2 P1 Because the demand for wheat is P2 inelastic, the quantity sold rose Demand only slightly (from Q1 to Q2) Quantity Q1 Q2 ECONOMICS I – ANDRÁS SZÉKELY-DOBY 33 The paradox of record harvest EXAMPLE When especially good weather Price conditions increased the supply of S1 S2 wheat, the price of wheat fell from P1 to P2 P1 Because the demand for wheat is P2 inelastic, the quantity sold rose Demand only slightly (from Q1 to Q2) Farmers’ total revenue fell Q1 Q2 Quantity ECONOMICS I – ANDRÁS SZÉKELY-DOBY 34 OPEC and the price of oil CASE STUDY In 1973, members of the Organization of Petroleum Exporting Countries (OPEC) decided to raise the world price of oil to increase their incomes These countries accomplished this goal by agreeing to jointly reduce the amount of oil they supplied As a result, the price of oil (adjusted for overall inflation) rose more than 50 percent from 1973 to 1974 A few years later, OPEC did the same thing again. From 1979 to 1981, the price of oil approximately doubled ECONOMICS I – ANDRÁS SZÉKELY-DOBY 35 Prices in the short run CASE STUDY In the short run, Price when supply and S2 S1 demand are inelastic, a shift in supply P2 leads to a large P1 increase in price from P1 to P2 Demand Quantity Q2 Q1 ECONOMICS I – ANDRÁS SZÉKELY-DOBY 36 Prices in the long run CASE STUDY In the long run, when Price supply and demand are elastic, a shift in S2 S1 supply leads to a small increase in price from P2 P1 P1 to P2 Quantity Q2 Q1 ECONOMICS I – ANDRÁS SZÉKELY-DOBY 37 Problem one PROBLEM Last week 25 pieces of university T-shirts were sold in a small shop on the third floor. The owner decided to decrease the price from $12 to $8. It turned out that by this week the quantity sold doubled. What is the price elasticity of university T-shirts? ECONOMICS I – ANDRÁS SZÉKELY-DOBY 38 Problem one PROBLEM Last week 25 pieces of university T-shirts were sold in a small shop on the third floor. The owner decided to decrease the price from $12 to $8. It turned out that by this week the quantity sold doubled. What is the price elasticity of university T-shirts? Price elasticity is: 100/33=3 (50/25: 100% increase, 2000/3000: 33% decrease) ECONOMICS I – ANDRÁS SZÉKELY-DOBY 39 Problem two PROBLEM The Golden Pins Bowling Center gets a $20,000 monthly revenue if the entry fee is $10, and gets a $24,000 monthly revenue if the entry fee is $6 Is the price elasticity of demand in this price range elastic or inelastic? ECONOMICS I – ANDRÁS SZÉKELY-DOBY 40 Problem two PROBLEM The Golden Pins Bowling Center gets a $20,000 monthly revenue if the entry fee is $10, and gets a $24,000 monthly revenue if the entry fee is $6 Is the price elasticity of demand in this price range elastic or inelastic? It is elastic, because the increase of demand (100%) is higher than the decrease of price (40%) ECONOMICS I – ANDRÁS SZÉKELY-DOBY 41 Problem three PROBLEM A firm is producing 300 thousand mobile-devices at a price of $200, while at a price of $150 it produces only 200 thousand pieces What is the firm’s price elasticity of supply? ECONOMICS I – ANDRÁS SZÉKELY-DOBY 42 Problem three PROBLEM A firm is producing 300 thousand mobile-devices at a price of $200, while at a price of $150 it produces only 200 thousand pieces What is the firm’s price elasticity of supply? From 300 thousand to 200 thousand = a decrease of 33%, from $200 to $150 = a decrease of 25% The price elasticity of supply is: ES = 33/25 = 1,33 ECONOMICS I – ANDRÁS SZÉKELY-DOBY 43 Thank you for the attention! András Székely-Doby [email protected]