Elasticity and Its Application Lecture Slides PDF

© 2007 Thomson South-Western Elasticity... … allows us to analyze supply and demand with greater precision. … is a measure of how much buyers and sellers respond to changes in market conditions © 2007 Thomson South-Western THE ELASTICITY OF DEMAND...

© 2007 Thomson South-Western Elasticity... … allows us to analyze supply and demand with greater precision. … is a measure of how much buyers and sellers respond to changes in market conditions © 2007 Thomson South-Western THE ELASTICITY OF DEMAND The 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. When we talk about elasticity, that responsiveness is always measured in percentage terms. Specifically, the price elasticity of demand is the percentage change in quantity demanded due to a percentage change in the price. © 2007 Thomson South-Western Computing the Price Elasticity of Demand 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 © 2007 Thomson South-Western The Price Elasticity of Demand and Its Determinants Availability of Close Substitutes Necessities versus Luxuries Definition of the Market Time Horizon © 2007 Thomson South-Western The Price Elasticity of Demand and Its Determinants Demand tends to be more elastic: the larger the number of close substitutes. if the good is a luxury. the longer the time period. © 2007 Thomson South-Western The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the price change. (Q2 − Q1 ) /[(Q2 + Q1 ) / 2] Price elasticity of demand = ( P2 − P1 ) /[( P2 + P1 ) / 2] © 2007 Thomson South-Western The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as: x/y, where x=(8-10)/((10+8)/2), and y=(2.20- 2.00)/((2.00+2.20)/2)= -2.32 © 2007 Thomson South-Western The Variety of Demand Curves Inelastic Demand Quantity demanded does not respond strongly to price changes. Absolute Value of Price elasticity of demand is between zero and one. Elastic Demand Quantity demanded responds strongly to changes in price. Absolute Value of Price elasticity of demand is greater than one. © 2007 Thomson South-Western Computing the Price Elasticity of Demand (100 − 50) (100 + 50)/2 ED = (4.00 − 5.00) Price (4.00 + 5.00)/2 $5 67 percent 4 = = −3 Demand − 22 percent 0 50 100 Quantity Demand is price elastic. © 2007 Thomson South-Western The Variety of Demand Curves Perfectly Inelastic Quantity demanded does not respond to price changes. Perfectly Elastic Quantity demanded changes infinitely with any change in price. Unit Elastic Quantity demanded changes by the same percentage as the price. © 2007 Thomson South-Western Figure 1 The Price Elasticity of Demand (a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand $5 4 1. An increase in price... 0 100 Quantity 2.... leaves the quantity demanded unchanged. © 2007 Thomson South-Western The Variety of Demand Curves Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve. But it is not the same thing as the slope! © 2007 Thomson South-Western Own-Price Elasticity of Demand p1 p1 slope slope 10 =-2 10 = - 0.2 5 X1* 50 X * 1 In which case is the quantity demanded X1* more sensitive to changes to p1? © 2007 Thomson South-Western Own-Price Elasticity of Demand p1 p1 slope slope 10 =-2 10 = - 0.2 5 X1* 50 X * 1 In which case is the quantity demanded X1* more sensitive to changes to p1? © 2007 Thomson South-Western Own-Price Elasticity of Demand 10-packs Single Units p1 p1 slope slope 10 =-2 10 = - 0.2 5 X1* 50 X * 1 In which case is the quantity demanded X1* more sensitive to changes to p1? © 2007 Thomson South-Western Own-Price Elasticity of Demand 10-packs Single Units p1 p1 slope slope 10 =-2 10 = - 0.2 5 X1* 50 X * 1 In which case is the quantity demanded X1* more sensitive to changes to p1? It is the same in both cases. © 2007 Thomson South-Western Own-Price Elasticity of Demand Q: Why not just use the slope of a demand curve to measure the sensitivity of quantity demanded to a change in a commodity’s own price? A: Because the value of sensitivity then depends upon the (arbitrary) units of measurement used for quantity demanded. © 2007 Thomson South-Western Own-Price Elasticity of Demand * %  x1  x* ,p = 1 1 % p1 is a ratio of percentages and so has no units of measurement. Hence own-price elasticity of demand is a sensitivity measure that is independent of units of measurement. © 2007 Thomson South-Western Figure 1 The Price Elasticity of Demand (b) Inelastic Demand: Absolute value of Elasticity Is Between 0 and 1 Price $5 4 1. A 22% Demand increase in price... 0 90 100 Quantity 2.... leads to an 11% decrease in quantity demanded. © 2007 Thomson South-Western Figure 1 The Price Elasticity of Demand (c) Unit Elastic Demand: Absolute value of Elasticity Equals 1 Price $5 4 1. A 22% Demand increase in price... 0 80 100 Quantity 2.... leads to a 22% decrease in quantity demanded. © 2007 Thomson South-Western Figure 1 The Price Elasticity of Demand (d) Elastic Demand: Absolute value of Elasticity Is Greater Than 1 Price $5 4 Demand 1. A 22% increase in price... 0 50 100 Quantity 2.... leads to a 67% decrease in quantity demanded. © 2007 Thomson South-Western Figure 1 The Price Elasticity of Demand (e) Perfectly Elastic Demand: Absolute value of Elasticity Equals Infinity Price 1. At any price above $4, quantity demanded is zero. $4 Demand 2. At exactly $4, consumers will buy any quantity. 0 Quantity 3. At a price below $4, quantity demanded is infinite. © 2007 Thomson South-Western Total Revenue and the Price Elasticity of Demand Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold. TR = P  Q © 2007 Thomson South-Western  Figure 2 Total Revenue Price When the price is $4, consumers will demand 100 units, and spend $400 on this good. $4 P × Q = $400 P (revenue) Demand 0 100 Quantity Q © 2007 Thomson South-Western Elasticity and Total Revenue along a Linear Demand Curve With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases. © 2007 Thomson South-Western  Figure 3 How Total Revenue Changes When Price Changes: Inelastic Demand Price Price An Increase in price from $1 … leads to an Increase in to $3 … total revenue from $100 to $240 $3 Revenue = $240 $1 Revenue = $100 Demand Demand 0 100 Quantity 0 80 Quantity © 2007 Thomson South-Western Elasticity and Total Revenue along a Linear Demand Curve With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases. © 2007 Thomson South-Western  Figure 3 How Total Revenue Changes When Price Changes: Elastic Demand Price Price An Increase in price from $4 … leads to an decrease in to $5 … total revenue from $200 to $100 $5 $4 Demand Demand Revenue = $200 Revenue = $100 0 50 Quantity 0 20 Quantity Note that with each price increase, the Law of Demand still holds – an increase in price leads to a decrease in the quantity demanded. It is the change in TR that varies! © 2007 Thomson South-Western Elasticity of a Linear Demand Curve © 2007 Thomson South-Western Figure 4 Elasticity of a Linear Demand Curve Demand is elastic; When price increases from Price demand is responsive to $4 to $5, TR declines from $7 changes in price. $24 to $20. 6 Absolute value of Elasticity is > 1 in this range. 5 4 Absolute value of Elasticity is < 1 in this range. Demand is inelastic; demand is 3 not very responsive to changes 2 in price. When price increases from 1 $2 to $3, TR increases from $20 to $24. 0 2 4 6 8 10 12 14 Quantity © 2007 Thomson South-Western Other Demand Elasticities Income Elasticity of Demand Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income. © 2007 Thomson South-Western  Other Demand Elasticities Computing Income Elasticity Percentage change in quantity demanded Income elasticity of demand = Percentage change in income Remember, all elasticities are measured by dividing one percentage change by another © 2007 Thomson South-Western Other Demand Elasticities Income Elasticity Types of Goods Normal Goods: Income elasticity is positive Inferior Goods: Income elasticity is negative Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. © 2007 Thomson South-Western Other Demand Elasticities Income Elasticity Goods consumers regard as necessities tend to be income inelastic Examples include food, fuel, clothing, utilities, and medical services. Goods consumers regard as luxuries tend to be income elastic. Examples include sports cars, furs, and expensive foods. © 2007 Thomson South-Western Other Demand Elasticities Cross-price elasticity of demand A measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good For complements, cross price elasticity is negative For substitutes, cross price elasticity is positive %change in quantity demanded of good 1 Cross - price elasticity of demand = %change in price of good 2 © 2007 Thomson South-Western  Summary Price elasticity of demand measures how much the quantity demanded responds to changes in the price. Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. – If a demand curve is elastic, total revenue falls when the price rises. – If it is inelastic, total revenue rises as the price rises. © 2007 Thomson South-Western  Summary The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good. The price elasticity of supply measures how much the quantity supplied responds to changes in the price. © 2007 Thomson South-Western  Summary In most markets, supply is more elastic in the long run than in the short run. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. The tools of supply and demand can be applied in many different types of markets. © 2007 Thomson South-Western