Econ Ch04 Lecture Presentation PDF

4 Elasticity After studying this chapter, you will be able to:  Define, calculate, and explain the factors that influence the price elasticity of demand  Define, calculate, and explain the factors that influence the income elasticity of demand and the cross elasticity of demand...

4 Elasticity After studying this chapter, you will be able to:  Define, calculate, and explain the factors that influence the price elasticity of demand  Define, calculate, and explain the factors that influence the income elasticity of demand and the cross elasticity of demand  Define, calculate, and explain the factors that influence the elasticity of supply Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand You know that when supply decreases, the equilibrium price rises and the equilibrium quantity decreases. But does the price rise by a large amount and the quantity decrease by a little? Or does the price barely rise and the quantity decrease by a large amount? The answer depends on the responsiveness of the quantity demanded of a good to a change in its price. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand You might think about the responsiveness of the quantity demanded of a good to a change in its price in terms of the slope of the demand curve. If the demand curve is steep, the price rises by a lot; if the demand curve is almost flat, the price barely rises. But the slope of a demand curve depends on the units in which we measure the price and the quantity. We can choose these units to make the demand curve steep or flat. To measure responsiveness we need a measure that is independent of units of measurement. Elasticity is such a measure. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand The price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buying plans remain the same. Calculating Price Elasticity of Demand The price elasticity of demand is calculated by using the formula: Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand To calculate the price elasticity of demand: We express the change in price as a percentage of the average price—the average of the initial and new price, … and we express the change in the quantity demanded as a percentage of the average quantity demanded—the average of the initial and new quantity. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand Figure 4.1 calculates the price elasticity of demand for pizza. Initially, the price of a pizza is $20.50 and the quantity demanded is 9 pizzas an hour. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand The price of a pizza falls to $19.50 and the quantity demanded increases to 11 pizzas an hour. The price falls by $1 and the average price is $20. The quantity demanded increases by 2 pizzas and the average quantity is 10 pizzas. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand The percentage change in quantity demanded is DQ/Qave x 100, which is (2/10) x 100 = 20%. The percentage change in price is DP/Pave x 100, which is ($1/$20) x 100 = 5%. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand The price elasticity of demand equals: The percentage change in quantity demanded divided by the percentage change in the price. Price elasticity of demand equals 20% ÷ 5% = 4. The elasticity equals 4 at the mid-point between the two prices. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand Average Price and Quantity By using the average price and average quantity, we get the same elasticity value regardless of whether the price rises or falls. A Units-Free Measure Elasticity is a ratio of percentages, so a change in the units of measurement of price or quantity leaves the elasticity value the same. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand Minus Sign and Price Elasticity of Demand The formula yields a negative value, because price and quantity move in opposite directions. But it is the magnitude, or absolute value, that reveals how responsive the quantity change has been to a price change. So for price elasticity of demand we use the absolute value and drop the minus sign. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand Inelastic and Elastic Demand Demand can be inelastic, unit elastic, or elastic, and can range from zero to infinity. If the quantity demanded doesn’t change when the price changes, the price elasticity of demand is zero and the good has a perfectly inelastic demand. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand Figure 4.2(a) illustrates the case of a good that has a perfectly inelastic demand. The demand curve is vertical. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand If the percentage change in the quantity demanded equals the percentage change in price, … the price elasticity of demand equals 1 and the good has unit elastic demand. Figure 4.2(b) illustrates this case—a demand curve with ever declining slope. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand If the percentage change in the quantity demanded is smaller than the percentage change in price,  the price elasticity of demand is less than 1 and the good has inelastic demand. If the percentage change in the quantity demanded is greater than the percentage change in price,  the price elasticity of demand is greater than 1 and the good has elastic demand. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand If the percentage change in the quantity demanded is infinitely large when the price barely changes, … the price elasticity of demand is infinite and the good has a perfectly elastic demand. Figure 4.2(c) illustrates the case of perfectly elastic demand—a horizontal demand curve. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand The Factors That Influence the Elasticity of Demand The elasticity of demand for a good depends on:  The closeness of substitutes  The proportion of income spent on the good  The time elapsed since a price change Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand Closeness of Substitutes The closer the substitutes for a good or service, the more elastic is the demand for the good or service. Necessities, such as food or housing, generally have inelastic demand. Luxuries, such as exotic vacations, generally have elastic demand. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand Proportion of Income Spent on the Good The greater the proportion of income consumers spend on a good, the larger is the elasticity of demand for that good. Time Elapsed Since Price Change The more time consumers have to adjust to a price change, or the longer that a good can be stored without losing its value, the more elastic is the demand for that good. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand Elasticity Along a Linear Demand Curve Figure 4.3 shows that at the mid-point of a linear demand curve, demand is unit elastic. At prices above the mid- point, demand is elastic. At prices below the mid- point, demand is inelastic. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand Let’s calculate the price elasticity of demand at different prices … to confirm that the demand for pizza becomes more inelastic as pizza becomes cheaper. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand If the price falls from $25 to $15, the quantity demanded increases from 0 to 20 pizzas an hour. The average price is $20 and the average quantity is 10 pizzas. The elasticity of demand is (20/10) ÷ (10/20), which equals 4. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand If the price falls from $15 to $10, the quantity demanded increases from 20 to 30 pizzas an hour. The average price is $12.50 and the average quantity is 25 pizzas. The elasticity of demand is (10/25) ÷ (5/12.50), which equals 1. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand If the price falls from $10 to $0, the quantity demanded increases from 30 to 50 pizzas an hour. The average price is $5.00 and the average quantity is 40 pizzas. The elasticity of demand is (20/40) ÷ (10/5), which equals 1/4. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand The price elasticity of demand varies along a downward–sloping linear demand curve. At the mid-point of a linear demand curve, demand is unit elastic. At prices above the mid- point, demand is elastic. At prices below the mid- point, demand is inelastic. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand Total Revenue and Elasticity The total revenue from the sale of a good or service equals the price of the good multiplied by the quantity sold. When the price changes, total revenue also changes. But a rise in price doesn’t always increase total revenue. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand The change in total revenue due to a change in price depends on the elasticity of demand:  If demand is elastic, a 1 percent price cut increases the quantity sold by more than 1 percent, and total revenue increases.  If demand is inelastic, a 1 percent price cut increases the quantity sold by less than 1 percent, and total revenues decreases.  If demand is unit elastic, a 1 percent price cut increases the quantity sold by 1 percent, and total revenue remains unchanged. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue that results from a price change (when all other influences on the quantity sold remain the same).  If a price cut increases total revenue, demand is elastic.  If a price cut decreases total revenue, demand is inelastic.  If a price cut leaves total revenue unchanged, demand is unit elastic. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand Figure 4.4 shows the relationship between elasticity of demand and the total revenue. As the price falls from $25 toward $12.50, the quantity demanded increases and demand is elastic. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand In part (b), as the quantity increases from 0 toward 25 pizzas, demand is elastic, so total revenue increases. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand When the price hits $12.50 a pizza, demand is unit elastic, so total revenue stops increasing. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand At 25 pizzas an hour, demand is unit elastic, so total revenue is at its maximum. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand As the price falls below $12.50, the quantity demanded increases, and demand is inelastic. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand As the quantity increases from 25 toward 50 pizzas, demand is inelastic, so total revenue decreases. Copyright © 2023 Pearson Education, Ltd.  Price Elasticity of Demand Your Expenditure and Your Elasticity  If your demand is elastic, a 1 percent price cut increases the quantity you buy by more than 1 percent and your expenditure on the item increases.  If your demand is inelastic, a 1 percent price cut increases the quantity you buy by less than 1 percent and your expenditure on the item decreases.  If your demand is unit elastic, a 1 percent price cut increases the quantity you buy by 1 percent and your expenditure on the item does not change. Copyright © 2023 Pearson Education, Ltd.  More Elasticities of Demand Income Elasticity of Demand The income elasticity of demand measures how the quantity demanded of a good responds to a change in income, other things remaining the same. The formula for calculating the income elasticity of demand is Copyright © 2023 Pearson Education, Ltd.  More Elasticities of Demand If the income elasticity of demand is greater than 1, demand is income elastic and the good is a normal good. If the income elasticity of demand is greater than zero but less than 1, demand is income inelastic and the good is a normal good. If the income elasticity of demand is less than zero (negative) the good is an inferior good. Copyright © 2023 Pearson Education, Ltd.  More Elasticities of Demand Cross Elasticity of Demand The cross elasticity of demand is a measure of the responsiveness of demand for a good to a change in the price of a substitute or a complement, other things remaining the same. The formula for calculating the cross elasticity is: Percentage change in quantity demanded Percentage change in price of substitute or complement Copyright © 2023 Pearson Education, Ltd.  More Elasticities of Demand The cross elasticity of demand for  a substitute is positive.  a complement is negative. Copyright © 2023 Pearson Education, Ltd.  More Elasticities of Demand Figure 4.5 shows the increase in the quantity demanded of pizza when the price of a burger (a substitute for pizza) rises. The figure also shows the decrease in the quantity demanded of pizza when the price of a soft drink (a complement of pizza) rises. Copyright © 2023 Pearson Education, Ltd.  Elasticity of Supply You know that when the demand for a good increases, its equilibrium price rises and the equilibrium quantity of the good increases. But does the price rise by a large amount and the quantity increase by a little? Or does the price barely rise and the quantity increase by a large amount? The answer depends on the responsiveness of the quantity supplied of a good to a change in its price. The answer depends on the elasticity of supply of the good. Copyright © 2023 Pearson Education, Ltd.  Elasticity of Supply The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good, when all other influences on selling plans remain the same. Calculating the Elasticity of Supply The elasticity of supply is calculated by using the formula: Percentage change in quantity supplied Percentage change in price Copyright © 2023 Pearson Education, Ltd.  Elasticity of Supply Figure 4.6 on the next slide shows three examples of the elasticity of supply. Supply is perfectly inelastic if the supply curve is vertical and the elasticity of supply is 0. Supply is unit elastic if the supply curve is linear and passes through the origin. (Note that slope is irrelevant.) Supply is perfectly elastic if the supply curve is horizontal and the elasticity of supply is infinite. Copyright © 2023 Pearson Education, Ltd. Elasticity of Supply Copyright © 2023 Pearson Education, Ltd.  Elasticity of Supply The Factors That Influence the Elasticity of Supply The elasticity of supply depends on  Resource substitution possibilities  Time frame for supply decision Resource Substitution Possibilities The easier it is to substitute among the resources used to produce a good or service, the greater is elasticity of supply of the good. Copyright © 2023 Pearson Education, Ltd.  Elasticity of Supply Time Frame for Supply Decision As the time following a price change increases, the greater is the elasticity of supply. Momentary supply is perfectly inelastic. The quantity supplied immediately following a price change is constant. Short-run supply is somewhat elastic. Long-run supply is the most elastic. Copyright © 2023 Pearson Education, Ltd.  Compact Glossary of Elasticity Table 4.1 provides a glossary of all the elasticity measures. Copyright © 2023 Pearson Education, Ltd.