Download Elasticity: measuring Responsiveness

ECONOMICS:
EXPLORE & APPLY
by Ayers and Collinge
Chapter 15
“Elasticity: Measuring
Responsiveness”
©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
1
Learning Objectives
1. Discuss how elasticity is used to
measure the responsiveness.
2. Compute the elasticity of demand.
3. Describe the conditions under which a
price change would increase, decrease,
or not change a firm’s revenue.
4. Discuss the significance of the income
elasticity of demand, the cross elasticity
of demand, and the elasticity of supply.
©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
2
Learning Objectives
5. Explain how elasticity determines who
ultimately pays a sales tax.
6. Discuss how the war on drugs increases
crime associated with drug use.
©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
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15.1
COMPUTING ELASTICITY
• Elasticity measures how one variable
changes as a result of another variable
changing.
• All elasticities arise from this same formula.
• Different elasticities merely name the variables
differently.
Elasticity = Percentage change in one variable (Y)
Percentage change in another variable (X)
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Computing Elasticity
Elasticity has a broad range of
applications.
Price elasticity of demand
Price elasticity of supply
Cross price elasticity
Income Elasticity
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Midpoints Formula
• The measure of percentage changes is
provided by the midpoints formula.
– The formula computes a percentage change
as the change in the variable divided by an
amount halfway between the starting and
ending amount.
Percentage change in Y= change in Y/Y midpoint
Divided by
Percentage change in X= change in X/X midpoint
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15.2
THE ELASTICITY OF DEMAND
o The elasticity of demand measures the responsiveness
of quantity demanded to changes in price.
o It is sometimes referred to as the price elasticity of
demand.
o Since price and quantity demanded are inversely
related, the computation of elasticity of demand will
always result in a negative value.
o For convenience, the elasticity of demand is stated as
an absolute value, meaning the minus sign is
ignored.
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The Elasticity of Demand
o The elasticity of demand is not the same as
the slope of demand.
o The slope of demand divides the change in
price by the change quantity, without
reference to percentages.
o The slope measures absolute changes, while
elasticity measures percentage changes.
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Classifying the Elasticity of
Demand
 Inelastic demand has an elasticity coefficient
whose value lies between 0 and 1.
 Unit elastic demand has an elasticity coefficient
whose value equals 1.
 Elastic demand has an elasticity coefficient
whose value is greater than 1.
 Other things being equal, the more substitutes
there are for a product, or the greater the
fraction a product takes of a person’s budget
to buy the product, the greater will be its
elasticity of demand.
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The Range of the Elasticity of Demand
This value can range
from zero to infinity
(in absolute value)
Unit
Elastic
Inelastic
0
Elastic
1
Elasticity of Demand
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Estimates of Demand Elasticities
Product
Elasticity of Demand
Beef
0.35
Fish
0.39
Public Transit
0.40
Peak use electricity
.47
Physician services
0.60
Poultry
0.64
Fruit
0.71
Peak use residential electricity
1.5
Restaurant meals
2.3
Kellogg’s Fruit Loops
2.3
Cheerios
3.6
Coke
3.8
Mountain Dew
4.4
Fresh Tomatoes
4.6
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Elasticity and Total Revenue
Total Revenue = Price  Quantity
When P
TR
TR constant
TR
Depending upon the elasticity
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Total Revenue
$
Total revenue = price x quantity
which is the area of the shaded
rectangle.
Price
Demand
Quantity
demanded
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Quantity
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The Effect of a Change in Total
Revenue
Change in Price
Effect on Total Revenue
Higher Price
If demand is inelastic, total revenue
rises.
If demand is unit elastic, total revenue
remains constant.
If demand is elastic, total revenue falls.
Lower price
If demand is inelastic, total revenue
falls.
If demand is unit elastic, total revenue
remains constant.
If demand is elastic, total revenue rises.
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Elasticity and Total Revenue
The longer the time period that quantity
demanded adjusts, the greater the elasticity of
demand.
Time lets people adjust, to substitute towards
goods that have become relatively less expensive
and away from those that become relatively more
expensive.
The elasticity of demand will vary along most
demand curves. Along a downward sloping,
straight line demand curve, demand is unit elastic
at the midpoint, elastic above the midpoint, and
inelastic below the midpoint.
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Price ($’s)
Elasticity Varies along Linear Demand
Curves
Elastic
Midpoint: Unit Elastic
Inelastic
Demand
Quantity
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Demand and Total Revenue
Data Point Price ($) Quantity Demanded Total Revenue = PxQ Marginal Revenue
A
5
0
0
Undefined
B
4
1
4
4
C
3
2
6
2
E
2
3
6
0
F
1
4
4
-2
G
0
5
0
-4
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Computing the Elasticity of
Demand
Between Points ΔP/(P0 + P1) ΔQ/(Q0 + Q1) Elasticity of Demand
A and B
0.111
1
9
B and C
0.143
0.33
2.33
C and E
0.2
0.2
1
E and F
0.33
0.143
0.429
F and G
1
0.111
0.111
Table 4A-2
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Dollars
Demand, Elasticity, Total Revenue,
and Marginal Revenue
5
A
Total Revenue
Elasticity =9
B
4
Elasticity =2.33
C
3
Elasticity =1
D
2
Elasticity =.43
E
1
Demand
0
1
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2
3
Elasticity =.11
F
Quantity
4
5
Marginal Revenue
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Dollars
Demand, Elasticity, Total Revenue,
and Marginal Revenue
Total revenue is maximized
when demand is unit elastic.
Total Revenue
Elastic
Unit
Elastic
Each firm produces in
the elastic range of its
demand curve.
Inelastic
Demand
Marginal Revenue
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Quantity
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The Extremes of Elasticity
6
Demand
Demand
Demand
3
1
Quantity
1. Perfectly Inelastic
Elasticity = 0
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2
4
Quantity
2. Unit Elastic
Elasticity =1
12
Quantity
3. Perfectly Elastic
Elasticity = 
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15.3
INCOME AND CROSS ELASTICITIES OF
DEMAND
The income elasticity of demand measures how
demand responds to income.
It is computed by dividing the percentage
change in quantity demanded, by the
percentage in income.
A positive income elasticity indicates the good is
a normal good.
A negative income elasticity of demand
indicates the good is inferior.
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Income and Cross Elasticities of
Demand
The cross elasticity of demand measures how the
demand for one good responds to changes in
the price of another good.
It is computed by dividing the percentage
change in quantity demanded of one good, by
the percentage in the price of another good.
A positive cross elasticity indicates the goods
are substitutes
A negative cross elasticity of demand indicates
the goods are complements.
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15.4
THE ELASTICITY OF SUPPLY
The elasticity of supply measures the
responsiveness of quantity supplied to price.
Elasticity of supply can fall within the following three ranges:
 Inelastic Supply:
Elasticity of supply lies between 0 and 1.
 Unit Elastic Supply:
Elasticity of supply = 1.
 Elastic Supply:
Elasticity of supply is greater than 1.
©2004 Prentice Hall Publishing
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The Extremes of Supply Elasticity
Supply
Supply
Supply
Quantity
Quantity
1. Perfectly Inelastic
Elasticity = 0
2. Unit Elastic
Elasticity =1
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Quantity
3. Perfectly Elastic
Elasticity = 
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15.5
TAX SHIFTING AND THE ELASTICITIES
OF SUPPLY AND DEMAND
 When a product is taxed, how much of that tax will the
buyers pay, and how much of the tax will the sellers pay?
The answer to that question of who ultimately shoulders
the tax burden depends upon the demand and supply
elasticities of the product taxed.
 Usually the tax burden is shared between producers and
consumers.
 Consumers pay more of the tax if demand is relatively less
elastic than supply.
 Producers pay more of the tax if demand is relatively more
elastic than supply.
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Partial Tax Shifting
#2 Consumers
pay more.
Supply
plus Tax
Supply
Tax
#2 sellers
receive less.
#1 The tax changes the
market equilibrium to a
higher price and a lower
quantity.
Demand
Cigarettes
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15.6 EXPLORE & APPLY
CRIME AND THE MARKET FOR
DRUGS
Supply with Drug War
Pdw
#1 The drug war changes the
market equilibrium, causing
a higher price and lower
quantity of output.
#2 The revenue
increases from
the higher price
Supply in Free Market
Pfm
Demand
Qdw
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Qfm
#3 far exceeds
the revenue
decreases from
the lower
quantity
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Terms along the Way
 elasticity







elasticity of demand
inelastic
unit elastic demand
elastic demand
total revenue
perfectly inelastic
unit elastic
throughout
 perfectly elastic
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 income elasticity of
demand
 cross elasticity of
demand
 elasticity of supply
 inelastic supply
 unit elastic supply
 elastic supply
 tax burden
 tax shifting
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Test Yourself
1. The formula for all elasticities is the
a. change in one variable divided by the change
in another variable.
b. change in one variable minus the change in
another variable.
c. percentage change in one variable divided by
the percentage change in another variable.
d. percentage change in one variable minus the
percentage change in another variable.
©2004 Prentice Hall Publishing
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Test Yourself
2. Which of the following price elasticities of
demand illustrates elastic demand?
a. 0.6
b. 0.85
c. 1.0
d. 1.2
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Test Yourself
3. The responsiveness of quantity
demanded to changes in price
a. increases over time.
b. decreases over time.
c. is not affected by passage of time.
d. first decreases, but then increases over
time.
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Test Yourself
4. If consumers buy 9 gizmos at a price of
$9, and 10 gizmos at a price of $8, then
demand is
a. elastic.
b. unit elastic.
c. inelastic.
d. proto-elastic
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Test Yourself
5. An income elasticity of demand that is
positive indicates a good that is
a. normal.
b. inferior.
c. a substitute.
d. a complement.
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Test Yourself
6. A cross elasticity of demand that is
negative indicates that
a. two goods are substitutes.
b. two goods are complements.
c. one good is a substitute and the other is
a complement.
d. both goods are normal.
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The End!
Next Chapter 16
“Consumer
Behavior"
©2004 Prentice Hall Publishing
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