ECON 103 Chapter 5 Elasticity and its Application PDF

Principles of Microeconomics ECON 103 – 2024/25 Dr. Hussain Muhammad 1  CH 5: Elasticity and Its Application What we learned in CH. 4 and what is next? In CH.4, we developed our basic model to explain the determination...

Principles of Microeconomics ECON 103 – 2024/25 Dr. Hussain Muhammad 1  CH 5: Elasticity and Its Application What we learned in CH. 4 and what is next? In CH.4, we developed our basic model to explain the determination of prices and quantities in the markets - through the interaction of supply and demand In CH.5, we will deal with some important characteristics of supply and demand curves The word elasticity refers to How changes in prices affect quantities? How changes in quantities affect prices? Information about the reaction of prices and quantities to one another is vital for many aspects of economic decision 2  CH 5: Elasticity and Its Application Elasticity Elasticity is a practical measure developed by economists to enrich our understanding of the forces of supply and demand and how they interact. Elasticity calculates the response of buyers and sellers to changes in market conditions. Through this measure , producers and government gain valuable insights about the behaviour of different markets. 3  CH 5: Elasticity and Its Application Types of Elasticity Price elasticity of demand Income elasticity of demand Price elasticity of supply 4  CH 5: Elasticity and Its Application 1. Price Elasticity of Demand Price elasticity of demand is the percentage change in quantity demanded given a one percent change in the price. 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 5  CH 5: Elasticity and Its Application 1. Price Elasticity of Demand Price elasticity of demand = P percentage change in Q d  percentage change in P P rises P2 15% by 10% P1  1.5 10% D Along a D curve, P and Q move in opposite Q directions, which would make price Q2 Q1 elasticity negative. Q falls We drop the minus sign and report the by 15% absolute values for all price elasticities as positive numbers.  CH 5: Elasticity and Its Application Calculating Percentage Changes Standard method of computing the percentage (%) change: P end value  start value B  100% $250 start value A Going from A to B: $200 the % change in P = ($250– D $200)*100/$200 = 25% the % change in Q = (8–12)*100/12 = - Q 8 12 33% Price elasticity = 33/25 = 1.33 We get different Going from B to A: values! the % change in P = - 20% 7  CH 5: Elasticity and Its Application Computing % changes - Midpoint method The midpoint is the number halfway between the start and end values The average of those values Midpoint method: end value – start x value midpoint 100% 8  CH 5: Elasticity and Its Application Computing % changes - Midpoint method Using the midpoint method P of computing % changes: B end value – start $250 x A value midpoint $200 100% D $250  $200 % change in P = 100% 22.2% $225 Q 8 12 12  8 % change in Q = 100% 40% 10 40% Price elasticity = 1.8 22.2% 9  CH 5: Elasticity and Its Application Calculate the Price Elasticity of Demand using the Midpoint Method - Homework Use the following information to calculate the price elasticity of demand for iPhones: if P = $400, Qd = 10,600 if P = $600, Qd = 8,400 Use the midpoint method to calculate percentage changes. 10  CH 5: Elasticity and Its Application Determinants of price elasticity of demand Availability of Close Substitutes Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others. For example, butter and margarine are easily substitutable. A small increase in the price of butter, assuming the price of margarine is held fixed, causes the quantity of butter sold to fall by a large amount. By contrast, because eggs are a food without a close substitute, the demand for eggs is less elastic than the demand for butter. Price elasticity is higher when close substitutes are available. Necessities versus Luxuries Necessities tend to have inelastic demands, whereas luxuries have elastic demands. For example, Insulin is a necessity to diabetics. A rise in price would cause little or no decrease in demand A yacht is a luxury. If the price rises, some people will forego it. Price elasticity is higher for luxuries than for necessities. 11  CH 5: Elasticity and Its Application Determinants of price elasticity of demand Definition of the Market Price elasticity is higher for narrowly defined markets/goods than for broadly defined ones. For a narrowly defined good, blue jeans, there are many substitutes, however, there are fewer substitutes available for broadly defined goods (clothing). Time Horizon Goods tend to have more elastic demand over longer time horizons. For example, the price of gasoline rises 20%. Does Qd drop more in the short run or the long run? Why? There’s not much people can do in the short run, other than ride the bus or carpool. In the long run, people can buy smaller cars or live closer to work. Price elasticity is higher in the long run. 12  CH 5: Elasticity and Its Application Ranges of Elasticity of Demand Depending on the value of the price elasticity of demand, we can say that demand is, Perfectly Inelastic: When the quantity demanded remains unchanged when price changes. Example: Insulin for diabetic patients. Even if the price increases significantly, the quantity demanded will stay the same because it is a life-saving medication. Perfectly Elastic: When the quantity demanded changes by very large amounts with small changes in price. Example: A perfectly competitive market for identical products, like wheat. If a seller increases their price even slightly, buyers will switch to another seller offering a lower price. Unit Elastic: When the quantity demanded changes by the same percentage as the price. Inelastic: When the quantity demanded does not respond strongly to price changes. Example: Gasoline. Even if the price rises, people still need to buy it for their daily commutes, so the quantity demanded doesn’t decrease much. Elastic: When the quantity demanded responds strongly to changes in price. Example: Luxury goods like designer handbags. If the price of a handbag increases, many consumers may choose not to buy it, leading to a large decrease in quantity demanded. 13  CH 5: Elasticity and Its Application Perfectly Inelastic Demand Price elasticity % change in Q 0% = = =0 % change in P 10% of demand P D P1 D curve: Vertical P2 Elasticity: 0 P falls Q by 10% Q1 Q changes by 0% 14  CH 5: Elasticity and Its Application Perfectly Elastic Demand Price elasticity % change in Q any % = = = infinity % change in P 0% of demand P D curve: P2 = P1 D horizontal P changes by 0% Elasticity: Q Q1 Q2 infinity Q changes by any % 15  CH 5: Elasticity and Its Application Unit Elastic Demand Price elasticity % change in Q 10% = = =1 % change in P 10% of demand P D curve: P1 intermediate slope P2 D P falls Q Elasticity: by 10% Q1 Q2 1 Q rises by 10% 16  CH 5: Elasticity and Its Application Elastic Demand Price elasticity % change in Q >10% = = =>1 % change in P 10% of demand P P1 D curve: relatively flat P2 D P falls Q Elasticity: by 10% Q1 Q2 >1 Q rises more than 10% 17  CH 5: Elasticity and Its Application Inelastic Demand Price elasticity % change in Q