Chapter 6 - Elasticity PDF

The Verge, 01/20/22 Elasticity Chapter 6  Why does Netflix keep doing this to us? Raising prices, that is.  LEARNING OBJECTIVES How to calculate and interpret the following: price elasticity of demand, income elasticity of demand cross-price elasticity of demand price elastic...

The Verge, 01/20/22 Elasticity Chapter 6  Why does Netflix keep doing this to us? Raising prices, that is.  LEARNING OBJECTIVES How to calculate and interpret the following: price elasticity of demand, income elasticity of demand cross-price elasticity of demand price elasticity of supply What factors influence the size of these various elasticities PRICE ELASTICITY OF DEMAND P Qd E l a s t I c demand curve Inelastic P Qd demand curve PRICE ELASTICITY OF DEMAND, Ed % Δ QUANTITY = % Δ PRICE Ü Always negative (law of demand), but we write absolute value. Ü Big number à greater elasticity. SLIDE 5 DEFINING PRICE ELASTICITY OF DEMAND Ed < 1 INELASTIC Ed > 1 ELASTIC Ed = 1 UNITARY ELASTIC SLIDE 6  DEFINING AND MEASURING ELASTICITY If the price of oil increases by 10% and the quantity demanded falls by 5%, then the price elasticity of demand for oil is: We drop the negative sign (for price elasticity of demand ONLY).  PRICE ELASTICITY OF DEMAND Price More responsive = more elastic = flatter The same $50 price increase… $40 Elastic demand Inelastic demand Quantity 20 75 80 … causes a small decrease in … causes a big decrease in quantity demanded if demand is quantity demanded if inelastic. demand is elastic. Elasticity ≠ slope! When Netflix increases prices, what type of change is it? a) A shift in demand to the right b) A shift in demand to the left c) An increase in the quantity demanded, i.e. moving down along the existing demand curve d) An decrease in the quantity demanded, i.e. moving up along the existing demand curve When Netflix announced the price increase, its stock price rose. Do shareholders believe demand is elastic or inelastic? a) Elastic demand b) Inelastic demand “Estimates of over 1,000 people lined up for Build-A-Bear's "Pay Your Age" promotion at Galleria at Sunset shopping center in Henderson on July 12, 2018.” (Janna Karel Las Vegas Review- Journal) In a statement about the event, Build-A-Bear said, “Based on the information available to us before the day began, we could not have predicted this unprecedented reaction to our Pay Your Age Day event,” calling the response to the sale “massive” and “overwhelming.” According to this statement we can assume that: a) Demand was more inelastic than Build-A-Bear predicted. b) Demand was more elastic than Build-A-Bear predicted. c) Profits for the store increased. d) Profits for the store decreased. e) None of the above.  If the average BAB price drop was 15% and the quantity demanded rose by 30%, what is the elasticity of demand? a) 0.2 b) 0.5 c) 0.15 d) 2.0  Standard method Divide by the initial quantity or price 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑋 % 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑋 = ∗ 100 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑋 Or (10 – 5)/5 * 100 = 100% (price goes from $5 to $10) (5 - 10)/10 * 100 = -50% (price goes from $10 to $5) 𝑋!"# − 𝑋$%& % 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑋 = ∗ 100 𝑋$%&  THE MIDPOINT METHOD Instead of dividing by the initial quantity or price, we’ll use the average quantity or price. Change in X % change in X = x100 Average Value of X Where % change = (10-5)/7.5 * 100 = 2/3 % change = (5-10)/7.5 * 100 = –2/3 Starting value of X + Final Value of X Average value of X = 2 Fine print: Is this method an approximation? Yes! We could use some calculus, but we’re saving that for EC172 If the price of a sushi roll drops from $8 to $4 and sales rise from 20 to 40 units, what is the price elasticity of demand? a) 0.5 b) 0.66 c) 1 d) 2 EXTREMELY LOW ELASTICITY OF DEMAND (a) Perfectly Inelastic demand: price elasticity of demand = 0 Price of snake antivenom (per dose) D 1 $3 An increase in price… $2 … leaves the quantity demanded unchanged. 0 1 Quantity of snake antivenom (thousands of doses) EXTREMELY HIGH PRICE ELASTICITY OF DEMAND Price elastic demand: price elasticity of Price of pink demand = ∞ tennis balls (per dozen) At exactly $5, At any price above consumers will $5, quantity buy any quantity. demanded is zero. $5 D 2 At any price below $5, quantity demanded is infinite. 0 Quantity of pink tennis balls (dozens per year) UNIT ELASTICITY OF DEMAND Price of crossing (Toll) B $1.10 A 0.90 D 1 0 900 1,100 Quantity of crossings (per day) INELASTIC DEMAND Price of crossing (Toll) B $1.10 A 0.90 D 2 0 950 1,050 Quantity of crossings (per day) ELASTIC DEMAND Price of crossing (Toll) B $1.10 A 0.90 D 3 0 800 1,200 Quantity of crossings (per day) What’s an example of a good with very inelastic demand? What’s an example of a good with very elastic demand? TOTAL REVENUE BY AREA Price of crossing Total revenue: price times quantity demanded (sold). TR = P × Q $0.90 Total revenue = price × quantity = $990 D 0 1,100 Quantity of crossings (per day) EFFECT OF A PRICE INCREASE ON TOTAL REVENUE Price of crossing Price effect of price increase: higher price for each unit sold. Quantity effect $1.10 of price C increase: fewer 0.90 units sold. B A D 0 900 1,100 Quantity of crossings (per day) A = quantity effect on revenue C = price effect on revenue  Price effect and quantity effect Price effect: Change in revenue from price change, holding quantity constant (old quantity) Quantity effect: Change in revenue from quantity change, holding price constant (new price)  Is demand for Disney elastic or inelastic? a) Elastic b) Inelastic c) Unit elastic d) Cannot tell  Demand for Muffins $6 $5 $4 $3 Price $2 $1 $0 0 5 10 15 20 25 30 Quantity Demanded  ELASTICITY AND TOTAL REVENUE INELASTIC UNIT ELASTIC Price effect >> Quantity effect Price effect == Quantity effect Higher prices = higher revenue Higher prices = no change in revenue ELASTIC Quantity effect >> Price effect Higher prices = lower revenue The elasticity of demand for eggs has been estimated to be 0.1. If egg producers raise their prices by 10 percent, what will happen to their total revenue? a) Revenue will increase b)Revenue will stay the same c) Revenue will decrease d)Not enough information  Elasticity isn’t constant for a linear curve! At high prices, price elasticity of demand is elastic At low prices, price elasticity of demand is inelastic Why? At low prices, purchase is small share of budget  Demand for Muffins $6 $5 $4 $3 Price $2 $1 $0 0 5 10 15 20 25 30 Quantity Demanded WHAT FACTORS DETERMINE THE PRICE ELASTICITY OF DEMAND? Availability of close substitutes Whether necessity or luxury Share of income spent on the good Length of time elapsed since price change Product Price elasticity Determinants of demand of elasticity Eggs 0.32 Small part of consumer’s budget Milk 0.63 Necessity; few substitutes Soft drinks 0.79 Small part of consumer’s budget Gasoline (long run) 0.24 Necessity Housing 1.2 Big share of consumer’s budget Restaurant meals 2.3 There are substitutes Airline travel (leisure) 1.5 Many substitutes; luxury good Foreign travel 4.1 Many substitutes; luxury good What would be the impact of this plan on quantity of ambulance rides on quantity demanded? a) Big decrease in demand b) Small decrease in demand c) No change in demand d) Small increase in demand e) Big increase in demand  How did the introduction of Uber affect the price elasticity of demand for ambulances? a) Increase elasticity b) No change c) Decrease elasticity d) Depends where you are on curve HOW DO GENERICS AFFECT ELASTICITY? When the patent expires on a brand- name drug and five generic drugs come on the market, what happens to elasticity of demand for that drug? a) Elasticity of demand increases b) Elasticity of demand stays the same c) Elasticity of demand decreases  OTHER DEMAND ELASTICITIES The cross-price elasticity of demand measures how sensitive the quantity demanded of good A is to the price of good B. Cross-price elasticity of demand = % change in quantity of A demanded % change in price of B Don’t drop the sign!  CROSS-PRICE ELASTICITY OF DEMAND For substitutes, cross-price elasticity of demand is positive. An increase in the price of one brand of cookies will increase the demand for other brands. For complements, cross-price elasticity of demand is negative. An increase in the price of milk causes a decrease in demand for Oreos. The price of good B increases by 4%, causing the quantity demanded of good A to decrease by 6%. The cross-price elasticity of demand is _____, and the goods are [substitutes/complements] a) 1.5; substitutes b) –1.5; complements c) 0.67; complements d) –2.4; substitutes  INCOME ELASTICITY OF DEMAND The income elasticity of demand measures how sensitive the quantity demanded of a good is to changes in income. Income elasticity of demand = % change in quantity demanded % change in income Don’t drop the sign!  INCOME ELASTICITY OF DEMAND The income elasticity of demand can be used to distinguish normal from inferior goods. – For normal goods, income elasticity is positive. – For inferior goods, income elasticity is negative. Tonya consumes 10 boxes of ramen noodles a year when her yearly income is $40,000. After her income falls to $30,000 a year, she consumes 40 boxes of ramen noodles a year. Using the midpoint method, what is her income elasticity of demand? a) 4.2 b) –4.2 c) –2.25 d) 2.25  MEASURING THE PRICE ELASTICITY OF SUPPLY Similar to price elasticity of demand: % change in quantity supplied Price elasticity of supply = % change in price  PRICE ELASTICITY OF SUPPLY Elasticity of supply captures the sensitivity of quantity supplied to changes in price. Price per unit Inelastic supply $50 Elastic supply The same price increase… 40 Quantity 80 85 170 …causes a small increase in quantity supplied if supply is inelastic. …causes a big increase in quantity supplied if supply is elastic. WHAT FACTORS DETERMINE THE PRICE ELASTICITY OF SUPPLY? 1. Availability of inputs – If increased production is very expensive, then the supply curve will be inelastic. – If production can be increased cheaply, then the supply curve will be elastic. Ivory: increasing collection costs, inelastic supply WHAT FACTORS DETERMINE THE PRICE ELASTICITY OF SUPPLY? 2. Time – Price elasticity of supply increases as producers have more time to respond to price changes. – Long-run price elasticity of supply is usually higher than the short-run elasticity.  SUMMARY Price elasticity of demand %∆ 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 % ∆ 𝑝𝑟𝑖𝑐𝑒 Cross-price elasticity %∆ 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑔𝑜𝑜𝑑 𝑥 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 % ∆ 𝑝𝑟𝑖𝑐𝑒 𝑔𝑜𝑜𝑑 𝑦 Income elasticity %∆ 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 % ∆ 𝑖𝑛𝑐𝑜𝑚𝑒 %∆ 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑 Price elasticity of supply % ∆ 𝑝𝑟𝑖𝑐𝑒  Two ways to calculate % changes Standard method 𝑋!"# − 𝑋$%& % 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑋 = ∗ 100 𝑋$%& Midpoint method Change in X % change in X = x100 Average Value of X  An aside Shelby Tauber for The Texas Tribune  What happened? Big problem 1: negative supply shock due to cold weather Big problem 2: increase in consumer demand due to cold weather Baltimore Sun Fixed rate vs. variable rate customers Griddy