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eStudy.us Elasticity and its Application copyright © michael [email protected] 2010, All rights reserved eStudy.us Price Elasticity of Demand Price elasticity of demand measures how much quantity demand responds to a change in price measures the price sensitivity of consumers measures how willing consumers are to buy less of the good as its price rises Ed = Percentage change in quantity demanded Percentage change in price = %∆Qd %∆P copyright © michael [email protected] 2010, All rights reserved eStudy.us A B %∆Qd = 20% 10% = 2 = 5% 10% = .5 = 10% 10% = 1 %∆P %∆Qd %∆P %∆Qd C Price Elasticity of Demand %∆P copyright © michael [email protected] 2010, All rights reserved eStudy.us Price elasticity of demand Elastic demand - Quantity demanded responds substantially to a change in the price Ed 1 Ed 2 is Elastic Inelastic demand - Quantity demanded responds slightly to a change in the price Ed 1 Ed .5 is Inelastic Unit elastics - Quantity demanded responds by the same percentage change in the price Ed 1 copyright © michael [email protected] 2010, All rights reserved eStudy.us Price elasticity of demand Own Price Elasticity of Demand Product Gas A 0.5 Inelastic Luxury Car B 2.0 Elastic Steak C 8.0 Elastic Hamburger D 0.05 Inelastic copyright © michael [email protected] 2010, All rights reserved eStudy.us Midpoint Formula Midpoint is the number halfway between the start & end values or the mean of those values Use the following information to calculate the price elasticity of demand for hotel rooms: if P = $7, Qd = 50 if P = $9, Qd = 30 Price Calculates Ed at the midpoint $9 $7 30 50 Quantity copyright © michael [email protected] 2010, All rights reserved eStudy.us Midpoint Formula Use the following information to calculate the price elasticity of demand for hotel rooms: if P = $7, Qd = 50 then changes to P = $9, Qd = 30 q0 q1 q0 q1 2 %Q d Ed %P p0 p1 p0 p1 2 50 30 50 30 20 2 .50 40 2 .25 $2 $7 $9 $8 $7 $9 2 copyright © michael [email protected] 2010, All rights reserved eStudy.us Determinants Determinants of price elasticity of demand – Availability of close substitutes: goods with close substitutes are more elastic demand – Necessities vs. luxuries • Necessities are more inelastic demand • Luxuries are more elastic demand – Definition of the market • Narrowly defined markets are more elastic • Broadly defined market are more inelastic – Time horizon • More elastic over longer time horizons • More inelastic over shorter time horizons copyright © michael [email protected] 2010, All rights reserved eStudy.us Determinants Determinants of price elasticity of demand – Availability of close substitutes ½ ton pick-up trucks (GM, Ford, Chrysler) + Toyota the addition of Toyota increased demand elasticity – Necessities vs. luxuries (Toyota vs. Mercedes) Mercedes brand is more price elastic than Toyota – Definition of the market (Transportation vs. Automobiles) Automobiles are more elastic an transportation in general – Time horizon (running car vs. broken car) – with a broken car you have less time to shop, reducing elasticity copyright © michael [email protected] 2010, All rights reserved eStudy.us Elasticity of Gasoline Short Run vs. Long Run elasticity of Gasoline When price doubles: Purchase about the same amount – With in the next few months you may: • Purchase a more fuel efficient car • Car pool – Over the next few years you may: • Move closer to work • Find a job closer to home Increasingly Elasticity – Tomorrow you will: copyright © michael [email protected] 2010, All rights reserved eStudy.us Elasticity of Gasoline Available Gasoline Substitutes When price doubles: Purchase about the same amount – or you live in a small city: • Ride a bike • Car pool – or you live in a large city: • Car pool (HOV) • Train • Bus Increasingly Elasticity – and you live in the country: copyright © michael [email protected] 2010, All rights reserved eStudy.us Price Elasticity of Demand Price elasticity of demand is closely related to the slope of the demand curve – the flatter the demand curve, the greater the elasticity – the steeper the demand curve, the lower the elasticity Ed 2 is Elastic Ed .5 is Inelastic P P2 P1 D Q2 Q1 Q falls by 20% Q P rises by 10% P rises by 10% P P2 P1 D Q2 Q1 Q Q falls by 5% copyright © michael [email protected] 2010, All rights reserved eStudy.us Other Demand Elasticities ― Perfectly inelastic demand • Elasticity = 0 • Demand curve is vertical • Increase in price leaves the quantity demanded unchanged ― Demand is perfectly elastic • Elasticity = infinity • Demand curve is horizontal • At a given price, P0, consumers will buy any quantity Price Demand P1 P0 1. an 0 Q Quantity Price P0 0 1. an Demand Quantity copyright © michael [email protected] 2010, All rights reserved eStudy.us Total revenue Total revenue (TR) - price of the good times the quantity sold The total amount paid by buyers, and received as revenue by sellers, equals the area of the box under the demand curve, P × Q. At price equal $8, the quantity demanded is 100, and total revenue is $800. Price TR P Q $8 1. an $800 0 $800 $8 100 Demand 100 Quantity copyright © michael [email protected] 2010, All rights reserved eStudy.us Demand Curve Elasticity of a linear demand curve Price Elastic E>1 $7 6 𝐸𝑑 = 67% = 3.7 18% 18% 5 4 1. an 3 Inelastic E<1 𝐸𝑑 = 18% = 0.3 67% 2 67% Demand 1 0 2 4 67% 6 8 10 12 14 18% Quantity copyright © michael [email protected] 2010, All rights reserved eStudy.us Price Quantity Total revenue (Price ˣ Quantity) $7 0 $0 6 2 12 5 4 20 4 6 24 3 8 24 2 10 20 1 12 12 0 14 0 Demand Curve Percentage Change in Quantity 200% Percentage Change in Price ÷ 15% = Elasticity Description 13.0 Elastic 67% 18% 3.7 Elastic 40% 22% 1.8 Elastic 29% 29% 1.0 Unit elastic 22% 40% 0.6 Inelastic 18% 67% 0.3 Inelastic 15% 200% 0.1 Inelastic Using the midpoint formula copyright © michael [email protected] 2010, All rights reserved eStudy.us Demand Curve When demand is elastic: an increase in price will decrease total revenue a decrease in price will increase total revenue When demand is inelastic: an increase in price will increase total revenue a decrease in price will decrease total revenue copyright © michael [email protected] 2010, All rights reserved eStudy.us Drug Interdiction The United States, Mexico, and most of South American have been fighting a “Drug War” for several decades. This example illustrates two different interdiction methods used during the fight. Assume the demand for illegal drugs is perfectly inelastic, due to addiction copyright © michael [email protected] 2010, All rights reserved eStudy.us Interdiction reduces the supply of drugs. Since demand for drugs is perfectly inelastic, price rises Resulting in increased spending for drugs, and in drug-related crime Supply Interdiction Price D1 P1 S1 S0 P0 Q Drug Quantity copyright © michael [email protected] 2010, All rights reserved eStudy.us Education reduces the demand for drugs. Both price and quantity fall. Resulting in a decreased spending for drugs, which makes drug smuggling less desirable Demand Interdiction Price D1 D0 S0 P0 P1 Q1 Q0 Drug Quantity copyright © michael [email protected] 2010, All rights reserved eStudy.us Income elasticity of demand Income elasticity of demand: measures the response of demand to a change in consumer income %∆Qd EI = %∆ I ― For normal goods, income elasticity (EI) > 0 ― For inferior goods, income elasticity (EI) < 0 Hamburgers EI = %∆Qd %∆ I = Inferior Good 8% = 0.8 Income Inelastic 10% copyright © michael [email protected] 2010, All rights reserved eStudy.us Cross-price elasticity of demand Cross-price elasticity of demand: measures the response of demand for one good to changes in the price of another good %∆Qx Ex/y = %∆Py %∆Q %∆Q 20% 4% hamburger peanut butter = %∆P %∆P = chicken jelly 10% 2.0 = 0.4 — For substitutes, cross-price elasticity > 0 (an increase in the price of chicken causes an increase in demand for hamburger) ― For complements, cross-price elasticity < 0 (an increase jelly price causes decrease in demand for peanut butter) copyright © michael [email protected] 2010, All rights reserved eStudy.us Price Elasticity of Supply Price elasticity of supply measures how much quantity supplied, Qs, responds to a change in price Price elasticity of supply measures sellers’ price-sensitivity. Es = Percentage change in Qs Percentage change in P = %∆Qs %∆P copyright © michael [email protected] 2010, All rights reserved eStudy.us Elasticity of Supply Price elasticity of supply – Elastic supply - Quantity supplied responds substantially to changes in the price • Elasticity >1 – Inelastic supply - Quantity supplied responds only slightly to changes in the price • Elasticity < 1 – Unit elastic supply - Quantity supplied responds only equally to changes in the price • Elasticity =1 copyright © michael [email protected] 2010, All rights reserved eStudy.us Price Elasticity of Supply P S P rises by 8% P1 16% = 2.0 Es = 8% P0 Which is elastic Q0 Q1 Q rises by 16% Q copyright © michael [email protected] 2010, All rights reserved eStudy.us Supply Curves The slope of the supply curve is closely related to price elasticity of supply • The flatter the curve, the bigger the elasticity • The steeper the curve, the smaller the elasticity more elastic P more inelastic S P P1 P1 P0 P0 Q0 Q1 Q S Q0 Q1 Q copyright © michael [email protected] 2010, All rights reserved eStudy.us Elasticity of Supply ― Perfectly Inelastic Supply • Sellers’ are not price sensitive • Es = 0, supply curve is vertical • An increase in price leaves Price P1 P0 Supply 1. an quantity supplied unchanged 0 ― Perfectly Elastic Supply • At a given price, P0, producers will supply any quantity • Es = infinity • Supply curve is horizontal Q0 Quantity Price P0 0 1. an Supply Quantity copyright © michael [email protected] 2010, All rights reserved eStudy.us Determinants of Supply Elasticity — The more easily sellers can change the quantity they produce, the greater the price elasticity of supply. Example: Supply of beachfront property is harder to vary and thus less elastic than the supply of new cars. — Time period: Price elasticity of supply is greater in the longer a firm has to make changes, because firms can build new factories, or new firms may be able to enter the market over long time period Example: Supply of classrooms are generally fixed in the short run but schools can build a new facility with more time copyright © michael [email protected] 2010, All rights reserved eStudy.us A winning football team Your football team trades for an all pro quarterback • The supply of seats and the supply curve remain fixed • More wins leads to higher demand (higher attendance) • which leads to much higher ticket prices Price P1 Supply 1. an P0 0 D1 D0 Q0 Quantity copyright © michael [email protected] 2010, All rights reserved eStudy.us Good news for farmers? A new corn technology increases production per acre • Supply curve shifts to the right • Higher production quantity leads to lower price • Demand is inelastic so total revenue falls 1. When demand is inelastic, an increase in supply. Price S0 2. Which leads to a large fall in price. S1 P0 3. A proportionately smaller increase in quantity sold. As a result, revenue falls. P1 Demand 0 Q0 Q1 Quantity copyright © michael [email protected] 2010, All rights reserved