Download January 23

Elasticity
Today: Thinking like an economist
requires us to know how quantities
change in response to price
Unit 1 completed
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Demand
Supply
Surplus of both demanders and
suppliers
Utility
Begin Unit 2: Elasticity
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We use supply and demand as tools for
other topics
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Elasticity tells us how responsive quantity
is to changes in price
Price controls are often aimed to help
“poor” or “middle class” people, but
sometimes these people are made worse
off
Today
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Elasticity
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Calculated by the
percentage change in
quantity divided by
the percentage
change in price
Denominator could be
something else, but
for now think price
%Q
Elasticity 
%P
Elasticity
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Elasticity is most commonly associated
with demand
Percentage changes are typically small
when calculating elasticity
Note elasticity is negative, since price
and quantity move in opposite
directions
We will typically ignore negative sign
Elasticity
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Demand elasticity falls into three broad
categories
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Elastic, if elasticity is greater than 1
Unit elastic, if elasticity is equal to 1
Inelastic, if elasticity is less than 1
Economist questions of the
day (to be answered later)
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How can you maximize the total ticket
expenditures on the Santa Barbara
Foresters?
What happens to total expenditures
spent on strawberries (or total revenue
received by firms) when growing
conditions are good?
Inelastic demand
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When demand is inelastic, quantity
demanded changes less than price does
(in percentage terms)
What goods are unresponsive to price?
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Salt
Illegal Drugs?
Coffee
Salt, illegal drugs, and coffee
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Why are these goods price inelastic?
Some determinants of price elasticity of
demand
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Availability of good substitutes
Fraction of budget necessary to buy the
item
Age of currently-owned item when
considering replacement, if a durable good
Salt, illegal drugs, and coffee
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These items do not have good
substitutes
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Salt  Potassium chloride
Illegal drugs  Legal drugs?
Coffee  Tea, “energy” drinks
Caution
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Some economists use the reference
point in calculating percentage changes
to be the initial price
Other economists use the average of
the two prices involved
In this class, you can use either method
I will use the initial price
Example
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Suppose the price of apples falls from
$1.00/lb. to $0.90/lb.
This causes the number of apples
consumed in Santa Barbara to increase
from 2 tons/day to 2.1 tons/day
What is the price elasticity of apples at
this point?
Example
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%ΔQ
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%ΔP
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We will ignore the negative on %ΔP
Example
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The demand elasticity of apples in
Santa Barbara is thus 0.05/0.1 = 0.5
The demand of apples is inelastic
Algebra lesson for straight-line
demand curves
Q / Q P Q P
1
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 
 
P / P Q P Q slope
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Slope on straight line is ΔP/ΔQ
Along a straight line, elasticity is also equal to
P/Q times inverse of the slope (see above)
Why is studying elasticity
important?
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Suppose that you work for the Santa
Barbara Foresters, the local amateur
baseball team
Suppose that in a previous season, a
UCSB student studied demand and
elasticity of demand for tickets
You are asked to use this information to
maximize ticket expenditures
Some information lost
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The student from the previous season
only provided the following information
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Demand for tickets is nearly linear
A table of estimated elasticity at various
prices
You are asked to price tickets to
maximize expenditure
How do we solve this?
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We need two additional pieces of
information
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When demand is linear, total expenditure is
maximized at the midpoint of the demand
curve
We can prove that price elasticity is 1 at
the midpoint of the demand curve
Solution: Find the point with price
elasticity is 1
Solution: Find price elasticity
of 1
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Answer: Price each
ticket at $5
Is this table
consistent with a
linear demand
curve?
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Yes  Try
= 10 - Q
P
Price
($/ticket)
9
Price
elasticity
9
8
4
5
1
2
0.25
1
0.11
Some other important
elasticity facts
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On a linear demand curve
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Elasticity is greater than 1 on the upper
half of the curve
Elasticity is less than 1 on the lower half of
the curve
Exceptions
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Horizontal demand: Elasticity is always ∞
Vertical demand: Elasticity is always 0
Back to increasing expenditure
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This is an example of being able to control
price (more on this while studying monopoly)
When you can control price and you want to
increase expenditure, go in the direction of
the highest change
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When demand is elastic, %ΔQ is higher than %ΔP
 Decrease P to increase expenditures
Inelastic demand, the opposite occurs  Increase
P to increase expenditures
Back to our bumper crop of
strawberries
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Under normal
growing conditions,
suppose that S1 is
the supply curve
In the bumper crop
season, supply shifts
out to S2
What happens to
total expenditure?
Back to our bumper crop of
strawberries
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Normal growing
conditions: Total
expenditure is $56
million
However, look at
elasticity (note slope
is 1):
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ε = P/(Q  slope)
ε = 0.29  inelastic
Back to our bumper crop of
strawberries
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ε = 0.29  inelastic
Expenditure goes
DOWN moving from
S1 to S2
The bumper crop of
strawberries actually
hurts farmers
collectively
What is happening here?
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The price drops by 50%, while the %
increase in strawberries is small
Price change dominates
Assuming costs are the same in both
years, farmers will make less profit in
the bumper crop year
Elasticity of supply
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Supply has elasticity, too
Most of the math is the same or similar
to what we have talked about with
demand
Summary
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Elasticity tells us what happens to total
expenditure along the demand curve
On a straight line demand curve, total
expenditure is maximized halfway
between the vertical intercept and
horizontal intercept
Supply shift to the right does not
necessarily increase total expenditure
For Monday
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Do you think the imposition of rent
control in Isla Vista would be beneficial
to you?
Read pages 190-197