Download Price elasticity of demand.

Elasticity
AP Economics
Mr. Bordelon
Why is the demand curve
sloped negatively?
• Substitution effect. The substitution effect of
a change in the price of a good is the change
in the quantity demanded of that good as the
consumer substitutes the good that has
become relatively cheaper for the good that
has become relatively more expensive.
– When the price of one increases, a substitute will
look more attractive. Consumer will buy less of
the original good.
Why is the demand curve
sloped negatively?
• Income effect. The income effect of a change
in the price of a good is the change in the
quantity of that good deamanded that results
from a change in the consumer’s purchasing
power when the price of the good changes.
– In this case, think of income not as a sum of
money, but what you can actually buy with that
sum. This “purchasing power” is referred to as
real income.
Why is the demand curve
negatively sloped?
• Normal goods. Goods for which demand
decreases when income falls.
• Inferior goods. Goods for which demand
increases when income falls.
Why is the demand curve
sloped negatively?
• For the majority of g/s, income effect is not
important and has no significant effect on
individual consumption.
• When the income effect matters, it reinforces the
substitution effect.
– When the price of a g/s absorbs a substantial share of
income, consumers of that good become poorer
because real income falls.
– Reduction in income leads to reduction in Qd and
reinforces substitution effect.
Why is the demand curve
sloped negatively?
• How does this affect the demand for normal
goods?
• How does this affect the demand for inferior
goods?
What is elasticity?
• Elasticity. Measures the responsiveness of
one variable to changes in another.
• Price elasticity of demand. Ratio of the
percent change in Qd to percent change in P
along the demand curve.
Calculating the
Price Elasticity of Demand
Q D
% Q D 
Initial Q D
P
%P 
Initial P
%Q D
Price Elasticity of Demand 
%P
Hmmm...
• Law of demand states that P and Qd will
always move in opposite directions.
– A positive %ΔP (a rise in price) leads to a
negative %ΔQd.
– A negative %ΔP (a fall in price) leads to a
positive %ΔQd.
• So what’s the problem?
Midpoint Method
Change in X
%change in X 
x 100
Average value of X
Starting value of X  Final value of X
Average value of X 
2
Q 2 - Q1
(Q1  Q 2 )/2
Price Elasticity of Demand 
P2 - P1
(P1  P2 )/2
Why do we use
the midpoint method?
• Suppose you have to measure the price
elasticity of demand for steak in two different
countries.
– Steak in the United States tends to be cheaper
than in Germany because of taxes. Steak in the
U.S. is $5/pound. Steak in Germany is $10/pound.
– Steak between Germany and the U.S. is 100%
higher. Steak between the U.S. and Germany is
50% cheaper.
– If you calculate it like this, you end up with two
different elasticities.
How do I interpret elasticity?
• Perfectly inelastic
– Price elasticity is = 0.25.
• Ed = %ΔQd/% ΔP = 0.25.
– Assume for a second that price increased by 1%.
What can we predict about Qd, given that Ed =
0.25?
How do I interpret elasticity?
• Perfectly inelastic
– Price elasticity is = 0.25. Ed = %ΔQd/% ΔP = 0.25.
– Assume for a second that price increased by 1%.
What can we predict about Qd, given that Ed =
0.25?
• Qd will decrease by only 0.25%. Why?
– Now, what would be the smallest response
possible to a price increase?
How do I interpret elasticity?
• Perfectly inelastic
– None, or rather 0. Ed = 0%/1% = 0.
– A product that is perfectly inelastic has an
elasticity of demand of 0, meaning that Qd does
not respond at all to a change in price.
• When the demand is perfectly inelastic, the demand
curve is a vertical line.
How do I interpret elasticity?
• Perfectly inelastic
– Assume that price elasticity is 10.
• Ed = %ΔQd/%ΔP = 10
– Assume that P increases by 1%. If Ed = % ΔQd/1%
=10, what can we predict about Qd?
How do I interpret elasticity?
• Perfectly inelastic
– Assume that price elasticity is 10.
• Ed = % ΔQd/% ΔP = 10
– Assume that P increases by 1%. If Ed = % ΔQd/1%
=10, what can we predict about Qd?
• Qd will decrease by 10%.
– What would be the largest response to a price
increase?
How do I interpret elasticity?
Perfectly inelastic
Consumers immediately reduce consumption to 0.
Ed = 0
How do I interpret elasticity?
• Perfectly elastic
– What would be the largest response to a price
decrease?
How do I interpret elasticity?
• Perfectly elastic
– What would be the largest response to a price
decrease?
– Consumers immediately increase consumption to
an infinitely large amount.
• If price increased 1%, and an enormous change to Qd,
then %ΔQd = ∞.
• So in that case, Ed = ∞.
How do I interpret elasticity?
Perfectly elastic. Ed = ∞
(Perfectly) Elastic and Inelastic
• If a demand curve is closer to vertical
(steeper), then this tends to be inelastic.
• If a demand curve is closer to horizontal
(flatter), then this tends to be elastic.
Summary
Elastic, Inelastic, Unit Elastic
• Elastic. Ed > 1
• Inelastic. Ed < 1
• Unit elastic. Ed = 1
Elastic: Ed > 1
Inelastic: Ed < 1
Unit Elastic: Ed = 1
Who cares?
• Ashley asks, “Bordelon, thanks for sharing all
this crap about elasticity, but honestly, who
cares? Who cares, Bordelon? Why are you
doing this to us? Why? WHY?!?”
Businesses Care, Ashley
• Total Revenue. Total value of sales of a good
or service. Total revenue is equal to price
multiplied by quantity sold.
– TR = (P)(Q sold)
• “Great Bordelon, but that doesn’t answer my
question.”
• “No, I guess it doesn’t Ashley. I should be
ashamed of myself.”
Psych
• Actually, Ed affects how businesses set price.
• Suppose a business wants to increase TR by
increasing price. What can we expect to
happen? (Hint: think law of demand!)
Psych
• Actually, Ed affects how businesses set price.
• Suppose a business wants to increase TR by
increasing price. What can we expect to
happen? (Hint: think law of demand!)
– As the price increases, the quantity demanded will
decrease.
– Well, this affects TR. Up, down or remain the
same?
Total Revenue and Elasticity
• Ultimately, the effect on TR depends on which
is stronger, higher price or lower quantity.
– Price effect. After a price increase, each unit sold
sells at a higher price, which tends to raise
revenue.
– Quantity effect. After a price increase, fewer units
are sold, which tends to lower revenue.
Total Revenue and Elasticity
• P increases by 1%, Qd decreases by 5%.
Identify elasticity.
Total Revenue and Elasticity
• P increases by 1%, Qd decreases by 5%.
Elastic.
– TR decreases because decrease in quantity is
stronger than increase in price.
Total Revenue and Elasticity
• P increases 10%, Qd decreases 5%. Identify
elasticity.
Total Revenue and Elasticity
• P increases 10%, Qd decreases 5%. Inelastic.
– TR increases because decrease in quantity is
weaker than increase in price.
Total Revenue and Elasticity
• P increases by 10%, Qd decreases 10%.
Identify elasticity.
Total Revenue and Elasticity
• P increases by 10%, Qd decreases 10%. Unit
elastic.
– TR will not change because decrease in quantity is
equal to increase in price.
Total Revenue and Elasticity
• Suppose initial price of
slices of pizza is $2 and
50 slices are sold every
day (point A). Calculate
total revenue.
– TR = PQ
Total Revenue and Elasticity
• Suppose initial price of
slices of pizza is $2 and
50 slices are sold every
day (point A).
– TR = PQ
– TR = ($2)(50) = $100
– Represented by the TR +
L rectangle.
Total Revenue and Elasticity
• Assume pizzeria now
wishes to increase price
to $3 and estimates 40
slices will be sold per
day (point B). Calculate
total revenue.
Total Revenue and Elasticity
• Assume pizzeria now
wishes to increase price
to $3 and estimates 40
slices will be sold per
day (point B).
– TR = ($3)(40) = $120
– Represented by the TR +
G rectangle.
Total Revenue and Elasticity
• Area L represents
revenue lost due to
decreased quantity, loss
of $20. Loss of 10 slices
at $2 each.
• Area G represents
revenue gained due to
increased price, gain of
$40 in gained revenue.
Gain of 40 slices at $1
extra ($3-$2).
Total Revenue and Elasticity
• $40 - $20 = $20 total
revenue increase from
higher price.
• If increased price effect
is stronger than
downward quantity
effect, demand must be
inelastic.
• Converse is also true.
• Calculate elasticity
using midpoint formula.
Total Revenue and Elasticity
Total Revenue and Elasticity
Elasticity Along Demand Curve
Price
Qd
TR
$0
70
$0
1
60
60
2
50
100
3
40
120
4
30
120
5
20
100
6
10
60
7
0
0
Ed
.56
Calculate remaining elasticities using midpoint
formula.
Elasticity Along Demand Curve
Price
Qd
TR
Ed
$0
70
$0
--
1
60
60
.08
2
50
100
.27
3
40
120
.56
4
30
120
1
5
20
100
1.8
6
10
60
3.7
7
0
0
13
What happens to total revenue here as price increases?
How does this relate to elastic, inelastic and unit elastic?
Factors Determining
Price Elasticity of Demand
• Substitutes. The more substitutes, the more
elastic the demand. If a product has many
substitutes, and the price increases,
consumers will have an elastic response
because they can easily find alternatives.
• Necessity vs. Luxury. The less necessary the
item, the more elastic the demand. For
luxuries, if the price increases, consumers will
just do without and have an elastic response.
Factors Determining
Price Elasticity of Demand
• Share of income spent on g/s. The larger the
expenditure relative to one’s budget, the more
elastic the demand, because buyers notice the
change in price more. Real income.
• Time. The longer the time period involved,
the more elastic the demand becomes.
Questions
1. There is a 10% rise in the price of bottled
water. This creates a 40% change in the
quantity demanded. The demand for bottled
water is considered to be
a.
b.
c.
d.
e.
perfectly inelastic.
elastic
inelastic
perfectly elastic
none of the above
Questions
1. There is a 10% rise in the price of bottled
water. This creates a 40% change in the
quantity demanded. The demand for bottled
water is considered to be
a.
b.
c.
d.
e.
perfectly inelastic.
elastic
inelastic
perfectly elastic
none of the above
Questions
2. If a 30% rise in gas prices creates a 0%
decrease in the quantity demanded, the
demand is said to be
a.
b.
c.
d.
e.
inelastic
perfectly elastic
elastic
perfectly inelastic
none of the above
Questions
2. If a 30% rise in gas prices creates a 0%
decrease in the quantity demanded, the
demand is said to be
a.
b.
c.
d.
e.
inelastic
perfectly elastic
elastic
perfectly inelastic
none of the above
Questions
3. All of the following are factors affecting the
elasticity of demand EXCEPT
a. availability of substitute goods
b. necessity versus luxury goods
c. how much of a consumer’s budget goes to the
good
d. the time horizon in which a change in price is
considered
e. the percentage change in the quantity
demanded
Questions
3. All of the following are factors affecting the
elasticity of demand EXCEPT
a. availability of substitute goods
b. necessity versus luxury goods
c. how much of a consumer’s budget goes to the
good
d. the time horizon in which a change in price is
considered
e. the percentage change in the quantity
demanded
Cross-Price Elasticity of Demand
• Effect of a change in a product’s price on the
quantity demanded for another product.
– Think complements and substitutes. This
elasticity measures how much that demand curve
shifts.
Cross-Price Elasticity of Demand
Substitutes. If Exy is positive, then X and Y are
substitutes.
• P of Nikes increases 2% and Qd of Converse
increases 4%.
• Econverse,nike = 4%/2% = 2.
•
Cross-Price Elasticity of Demand
Complements. If Exy is negative, then X and Y are
complements.
• P of gasoline increases 20% and Qd of SUVs
decreases by 5%.
• Egas,SUV = -5%/20% = -0.25
•
Cross-Price Elasticity of Demand
Unrelated products. If Exy = 0, then X and Y are
unrelated products.
• If P of Cinnamon Toast Crunch increased, it’s a
good bet there would be no impact on the quantity
demanded of New Orleans Saints season tickets.
•
Income Elasticity of Demand
• Percentage change in quantity demanded
which results from some percentage change in
consumer incomes.
– Think changes in income as it relates to demand,
particularly normal and inferior goods.
Income Elasticity of Demand
• Normal good. Positive income elasticity.
• American consumer income falls by 2%
and quantity of flights to Europe declines
by 8%.
• Ei = 8%/2% = 4.
• Income-elastic response. True of most
goods considered luxuries.
Income Elasticity of Demand
• Normal good. Positive income elasticity.
• Consumer income increases by 4% and
quantity of fresh vegetables purchased
increases by 1%.
• Ei = 1%/4% = 0.25
• Income-inelastic response. Typical for
food and other necessities.
Income Elasticity of Demand
• Inferior good. Negative income elasticity.
• Consumer income decreases by 5% and
consumers increase consumption of Spam
by 4%.
• Ei = 4%/-5% = -0.80
• Is there a difference between necessity
and luxury when talking about inferior
goods?
Price Elasticity of Supply
• When the price of g/s increases, businesses
will increase Qs. Here, we’re concerned with
how much quantity will increase in response
to the higher price.
Price Elasticity of Supply
Elastic: Es > 1
Inelastic: Es < 1
Unit elastic: Es = 1
Price Elasticity of Supply
• S1 is just a typical
supply curve.
• S2 is a perfectly elastic
curve. Even the
smallest increase in
price would
dramatically increase
quantity supplied. A
small decrease in the
price would decrease
quantity supplied to
zero.
Price Elasticity of Supply
• S3 is perfectly inelastic.
Even at the highest of
prices, there is
something that
prevents firms from
increasing the quantity
that they supply.
– Technology limitation
– Seasonal
– Agriculture
Factors Determining
Price Elasticity of Supply
• Availability of inputs. If a business can get
inputs into and out of production quickly, Es
will be more elastic. If not, inelastic.
Factors Determining
Price Elasticity of Supply
• Time (MOST IMPORTANT).
– Market period is so short that elasticity of supply
is perfectly inelastic (vertical).
– Short-run supply elasticity is more elastic than
market period and depends on ability of
producers to respond to price changes as to how
elastic it is.
– Long-run supply elasticity is most elastic because
more adjustments can be made over time and
quantity can be changed more relative to a small
change in price.
Factors Determining
Elasticity of Supply
• It is July 2010 and the price of oranges is
soaring. Farmers would love to supply more
oranges at the higher price, but orange crops
have already been planted. The quantity of
oranges that will be supplied at harvest 2010
(December) was determined months ago
during the planting season. The immediate
orange supply curve is inelastic or nearly
vertical and farmers are incapable of
responding to higher price.
Factors Determining
Elasticity of Supply
• If high prices continue into early 2011, farmers
will plant more acres of oranges next year and
supply more oranges. Increase in quantity
supplied is greater as more time passes and
farmers are able to respond.