Download Elastic Demand

Elasticity
THE LAW OF DEMAND SAYS...
Consumers will buy more when prices
go down and less when prices go up
HOW MUCH MORE OR LESS?
DOES IT MATTER?
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Elasticity
Elasticity shows how sensitive quantity is
to a change in price.
1. Elasticity of Demand
Elasticity of Demand• Measurement of consumers
responsiveness to a change in price.
• What will happen if price increase? How
much will it effect Quantity Demanded
Who cares?
• Used by firms to help determine prices
and sales
• Used by the government to decide how to
tax
Inelastic Demand
Inelastic Demand
INelastic = Quantity is
INsensitive to a change in price.
•If price increases, quantity
20%
demanded will fall a little
•If price decreases, quantity
demanded increases a little.
In other words, people will
continue to buy it.
5%
A INELASTIC demand curve is steep! (looks like an “I”)
Examples:
•Gasoline
•Milk
•Diapers
•Chewing Gum
•Medical Care
•Toilet paper
Inelastic Demand
General Characteristics
of INelastic Goods:
20%
•Few Substitutes
•Necessities
•Small portion of
income
•Required now, rather
than later
•Elasticity coefficient
less than 1
5%
PRICE ELASTICITY OF DEMAND
Extreme Case
Perfectly Inelastic Demand
P
D1
Ed = 0
Q
When a price change results in no change
whatsoever in the quantity demanded,
that good is said to be perfectly inelastic.
An example: A diabetics need for insulin.
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Elastic Demand
Elastic Demand
Elastic = Quantity is sensitive
to a change in price.
•If price increases, quantity
demanded will fall a lot
•If price decreases, quantity
demanded increases a lot.
In other words, the amount
people buy is sensitive to price.
An ELASTIC demand curve is flat!
Examples:
•Soda
•Boats
•Beef
•Real Estate
•Pizza
•Gold
Elastic Demand
General Characteristics
of Elastic Goods:
• Many Substitutes
• Luxuries
• Large portion of
income
• Plenty of time to
decide
• Elasticity coefficient
greater than 1
PRICE ELASTICITY OF DEMAND
Extreme Case
When a small price change causes buyers to increase or decrease
their purchases drastically the good is said to be perfectly
elastic. Foreign currency exchange. Example: If one firm
increased the price of dollars, above market equilibrium – no
one would buy from that firm. They would buy from cheaper
alternatives.
Perfectly Elastic Demand
P
Ed = 
0
D2
Q
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PRICE ELASTICITY OF DEMAND
Refinement –
The Midpoint Formula
Ed =
Change in
quantity
Sum of
Quantities/2

Change in
price
Sum of
prices/2
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Elastic or Inelastic?
BeefGasolineReal EstateMedical CareElectricityGold-
What about the
Elastic- 1.27
demand for insulin for
INelastic - .20
diabetics?
Elastic- 1.60
INelastic - .31
What if % change in
INelastic - .13 quantity demanded equals
% change in price?
Elastic - 2.6
Perfectly INELASTIC
(Coefficient = 0)
Unit Elastic (Coefficient =1)
45 Degrees
PRICE ELASTICITY & TOTAL REVENUE
Price Elasticity is...
Inelastic from 0 to 1
Typical of necessities one must have
Elastic from 1 to

Typical of luxuries one wants
Unit elastic when exactly = 1
Price change does not reduce total
revenue
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Total Revenue Test
Uses elasticity to show how changes in price will
affect total revenue (TR).
(TR = Price x Quantity)
Elastic Demand• Price increase causes TR to decrease
• Price decrease causes TR to increase
Inelastic Demand• Price increase causes TR to increase
• Price decrease causes TR to decrease
Unit Elastic• Price changes and TR remains unchanged
Ex: If demand for milk is INelastic, what will happen to
expenditures on milk if price increases?
PRICE ELASTICITY & TOTAL REVENUE
When prices are low,
TR So is total revenue
Quantity Demanded
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PRICE ELASTICITY & TOTAL REVENUE
Total revenue rises
with price to a
point...
P
TR
D
Q
Quantity Demanded
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PRICE ELASTICITY & TOTAL REVENUE
P
Total revenue rises
with price to a
point...
then declines
D
Q
Quantity Demanded
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PRICE ELASTICITY & TOTAL REVENUE
P
Total revenue rises
with price to a
point...
D
Q
then declines
Quantity Demanded
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PRICE ELASTICITY & TOTAL REVENUE
P
Total revenue
rises
with price to a
point...
then declines
TR
Total Revenue Test
D
Q
Quantity Demanded
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PRICE ELASTICITY & TOTAL REVENUE
P
Total revenue rises
with price to a
point...
Inelastic
Demand
then declines
TR
D
Q
Inelastic
Demand
Quantity Demanded
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PRICE ELASTICITY & TOTAL REVENUE
P
Total revenue rises
with price to a
point...
then declines
TR
Elastic
Demand
Inelastic
Demand
D
Q
Elastic Inelastic
Demand Demand
Quantity Demanded
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PRICE ELASTICITY & TOTAL REVENUE
P
Total revenue rises
with price to a
TR
point...
then declines
Unit
Elastic
Elastic
Demand
Inelastic D
Demand
Q
Elastic Inelastic
Demand Demand
Quantity Demanded
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Is the range between A and B, elastic,
inelastic, or unit elastic?
10 x 100 =$1000 Total Revenue
5 x 225 =$1125 Total Revenue
A
50%
B
125%
Price decreased and TR increased,
so…
Demand is ELASTIC
Elastic, Inelastic, or Unit Elastic?
Price
D
$30
S
20
T
10
0
U
7
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D
U'
Quantity Demanded
(d)
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Elasticity Practice
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a) Calculate the producer surplus
before the tax.
.
Producer surplus is the area above the supply curve and below the
horizontal line indicating the price the producers receive. It represents the
difference between the minimum price that producers are willing to accept
and the price they actually receive summed over all units sold. Prior to the
imposition of the tax, the price the producers receive is the market price of
$5. As a result, producer surplus is equal to:
($5-$2)*90*1/2 = 135
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(b) Now assume a per-unit tax of
$2 is imposed whose impact is
shown in the graph above.
(i) Calculate the amount of tax revenue.
Tax revenue is equal to the per unit tax amount ($2) multiplied by the
number of units sold under the tax (60 calculators). So the tax revenue is
equal to $120.
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(b) Now assume a per-unit tax of
$2 is imposed whose impact
is shown in the graph
above.
(ii) What is the after-tax price that the sellers now keep?
The price that consumers will pay after the imposition of the tax is $6.
Net of the $2 tax, producers will receive $4 per unit sold.
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(b) Now assume a per-unit tax of
$2 is imposed whose impact is
shown in the graph above.
(iii) Calculate the producer surplus after the tax.
As before, producer surplus is the area above the supply curve and below
the horizontal line indicating the price the producers receive. Following
the imposition of the tax, however, the price producers receive is $4 and
the number of units sold is 60. As a result, producer surplus is equal to:
($4-$2)*60*1/2 = 60
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(c) Is the demand price elastic, inelastic, or unit
elastic between the prices of $5 and $6?
Explain.
An increase in price from $5 to $6
represents a percentage change of
($6-$5)/$5.50 = 18.18181%
The resulting change in quantity
demanded is a reduction from 90 units
to 60 units, representing a percentage
change of
(60-90)/75 = -40%
The demand elasticity over this range is then calculated as the ratio
of the % change in quantity over the % change in price, or
-40%/18.18181% = -2.2
Since the absolute value of elasticity is greater than 1, demand is
considered elastic.
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(d) Assuming no externalities,
how does the tax affect
allocative efficiency? Explain.
In the absence of externalities, the tax will lead to allocative inefficiency.
Prior to the tax, the sum of consumer and producer surplus was 270.
Following the tax, the sum of consumer and producer surplus is 120, plus
government revenues of 120, for a total surplus of 240. So the tax results in a
reduction of total surplus of 30. As a result, the outcome is no longer
allocatively efficient.
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2. Price Elasticity of Supply
Elasticity of Supply• Elasticity of supply shows how sensitive producers
are to a change in price.
Elasticity of supply is based on time limitations.
Producers need time to produce more.
INelastic = Insensitive to a change in price (Steep curve)
• Most goods have INelastic supply in the short-run
Elastic = Sensitive to a change in price (Flat curve)
• Most goods have elastic supply in the long-run
Perfectly Inelastic = Q doesn’t change (Vertical line)
• Set quantity supplied
The formula is for Price Elasticity of
Supply
Es =
Change in
quantity
Sum of
Quantities/2

Change in
price
Sum of
prices/2
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3. Cross-Price Elasticity of Demand
• Cross-Price elasticity shows how sensitive a product
is to a change in price of another good
• It shows if two goods are substitutes or complements
Exy = % change in quantity demanded of product “B”
% change in price of product “A”
P increases 20%
Q decreases 15%
• If coefficient is negative (shows inverse relationship)
then the goods are complements
• If coefficient is positive (shows direct relationship)
then the goods are substitutes
4. Income-Elasticity of Demand
• Income elasticity shows how sensitive a product is to
a change in INCOME
• It shows if goods are normal or inferior
Ei =
% change in quantity demanded
% change in income
Income increases 20%, and quantity decreases 15%
then the good is a… INFERIOR GOOD
• If coefficient is negative (shows inverse relationship)
then the good is inferior
• If coefficient is positive (shows direct relationship)
then the good is normal
Ex: If income falls 10% and quantity falls 20%…
1996 Micro FRQ #2
The Toledo arena holds a maximum of 40,000 people.
Each year the circus performs in front of a sold out crowd.
(a) Analyze the effect on each of the following of the
addition of a fantastic new death-defying trapeze act that
increases the demand for tickets.
(i)The price of tickets
(ii)The quantity of tickets sold
(b) The city of Toledo institutes an effective price ceiling on
tickets. Explain where the price ceiling would be set.
Explain the impact of the ceiling on each of the following.
(i) The quantity of tickets demanded
(ii) The quantity of tickets supplied
(c) Will everyone who attends the circus pay the ceiling
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price set by the city of Toledo. Why or why not?