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Principles of Microeconomics
4 and 5 Elasticity*
Akos Lada
July 24th and July 25th, 2014
* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint
Contents
1. Review
2. Elasticity of Demand
3. Elasticity and Revenue
4. Other Elasticities
5. Elasticity of Supply
1. Review
Equilibrium, surplus and
shortage
P
$6.00
D
Surplus
S
$5.00
$4.00
P*
$3.00
$2.00
$1.00
Shortage
$0.00
0
5
10 15 20 25 30 35
Q*
Q
Comparative statics
No change in
Supply
Increase in
Supply
Decrease in
Supply
No Change in
Demand
P same
Q same
P down
Q up
P up
Q down
Increase in
Demand
P up
Q up
P ambiguous
Q up
P up
Q ambiguous
Decrease in
Demand
P down
Q down
P down
Q ambiguous
P ambiguous
Q down
Three Steps to Analyzing Changes in
Equilibrium
To determine the effects of any event,
1. Decide whether event shifts S curve,
D curve, or both.
2. Decide in which direction curve shifts.
3. Use supply-demand diagram to see
how the shift changes equilibrium P and Q.
EXAMPLE: The Market for Hybrid Cars
P
price of
hybrid cars
S1
P1
D1
Q1
Q
quantity of
hybrid cars
EXAMPLE 1: A Shift in Demand
EVENT TO BE
ANALYZED:
P
Increase in price of gas.
STEP 1:
D curve shifts
because
STEP 2: price of gas
affects demand for
D shifts right
hybrids.
because
high gas price
STEP
3:
S
curvehybrids
does not
shift,
makes
more
The shiftprice
causes
an
because
of
attractive relativegas
to
increase
in
price
does
not
affect
cost of
other cars.
and quantity
of
producing
hybrids.
hybrid cars.
S1
P2
P1
D1
Q 1 Q2
D2
Q
EXAMPLE 1: A Shift in Demand
Notice:
When P rises,
producers supply
a larger quantity
of hybrids, even
though the S curve
has not shifted.
Always be careful to
distinguish be a shift
in a curve and a
movement along the
curve.
P
S1
P2
P1
D1
Q 1 Q2
D2
Q
EXAMPLE 2: A Shift in Supply
EVENT: New technology
reduces cost of producing P
hybrid cars.
S1
S2
STEP 1:
S curve shifts
because
STEP 2: event affects
cost of production.
S shifts right
D
curve does
not
shift,
because
event
reduces
STEP 3: production
because
cost,
The shift causes
price
technology
is
not
makes productionone
to fall
of
theprofitable
factors that
more
at any
and quantity
to rise.
affect
demand.
given price.
P1
P2
D1
Q 1 Q2
Q
EXAMPLE 3: A Shift in Both Supply
and
EVENTS:
price of gas rises AND
new technology reduces
production costs
STEP 1:
Both curves shift.
Demand
P
S1
S2
P2
P1
STEP 2:
Both shift to the right.
STEP 3:
Q rises, but effect
on P is ambiguous:
If demand increases more than
supply, P rises.
D1
Q1
Q2
D2
Q
EXAMPLE 3: A Shift in Both Supply
and
EVENTS:
price of gas rises AND
new technology reduces
production costs
STEP 3, cont.
But if supply
increases more
than demand,
P falls.
Demand
P
S1
S2
P1
P2
D1
Q1
Q2
D2
Q
STUDENTS’ TURN:
Shifts in Supply and Demand
Use the three-step method to analyze the effects of
each event on the equilibrium price and quantity of
music downloads.
Event A: A fall in the price of CDs
Event B:
Sellers of music downloads negotiate a
reduction in the royalties they must pay for
each song they sell.
Event C: Events A and B both occur.
A. Fall in price of CDs
STEPS
P
1. D curve shifts
2. D shifts left
3. P and Q both
fall.
The market for
music downloads
S1
P1
P2
D2
Q2 Q1
D1
Q
B. Fall in cost of royalties
STEPS
1. S curve shifts
(Royalties are part
of sellers’ costs)
2. S shifts right
3. P falls,
Q rises.
P
The market for
music downloads
S1
S2
P1
P2
D1
Q1 Q2
Q
C. Fall in price of CDs and
fall in cost of royalties
STEPS
1. Both curves shift (see parts A & B).
2. D shifts left, S shifts right.
3. P unambiguously falls.
Effect on Q is ambiguous:
The fall in demand reduces Q,
the increase in supply increases Q.
2. Elasticity of Demand
A scenario…
You design websites for local businesses.
You charge $200 per website,
and currently sell 12 websites per month.
Your costs are rising
(including the opportunity cost of your time),
so you consider raising the price to $250.
The law of demand says that you won’t sell as many
websites if you raise your price.
How many fewer websites? How much will your revenue
fall, or might it increase?
Elasticity
• Basic idea:
Elasticity measures how much one variable responds
to changes in another variable.
• One type of elasticity measures how much demand for
your websites will fall if you raise your price.
• Definition:
Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.
Price Elasticity of Demand
• Price elasticity of demand measures how much Qd
responds to a change in P.
Price elasticity
of demand
=
Percentage change in Qd
Percentage change in P
 Loosely speaking, it measures the price-sensitivity
of buyers’ demand.
Price Elasticity of Demand
Price elasticity
of demand
=
Percentage change in Qd
Percentage change in P
P
Example:
Price elasticity
of demand
equals
15%
= 1.5
10%
P rises
by 10%
P2
P1
D
Q2
Q falls
by 15%
Q1
Q
Price Elasticity of Demand
Price elasticity
of demand
=
Percentage change in Qd
Percentage change in P
Along a D curve, P and Q
move in opposite directions,
which would make price
elasticity negative.
We will drop the minus sign
and report all price elasticities
as positive numbers.
P
P2
P1
D
Q2
Q1
Q
Calculating Percentage
Changes
Standard method
of computing the
percentage (%) change:
Demand for
your websites
end value – start value
x 100%
start value
P
$250
B
Going from A to B,
the % change in P equals
A
$200
D
8
12
Q
($250–$200)/$200 = 25%
Calculating Percentage
Changes
Problem:
The standard method gives
different answers depending on
where you start.
Demand for
your websites
P
$250
From A to B,
P rises 25%, Q falls 33%,
elasticity = 33/25 = 1.33
B
A
$200
From B to A,
P falls 20%, Q rises 50%,
Q
elasticity = 50/20 = 2.50
D
8
12
Calculating Percentage
Changes
• So, we instead use the midpoint method:
end value – start value
x 100%
midpoint
 The midpoint is the number halfway between the
start & end values, the average of those values.
 It doesn’t matter which value you use as the
“start” and which as the “end” – you get the
same answer either way!
Calculating Percentage
Changes
• Using the midpoint method, the % change in P equals
$250 – $200
x 100% = 22.2%
$225
 The % change in Q equals
12 – 8
x 100% = 40.0%
10
 The price elasticity of demand equals
40/22.2 = 1.8
STUDENTS’ TURN:
Calculate an Elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:
if P = $70, Qd = 5000
if P = $90, Qd = 3000
Answers
Use midpoint method to calculate
% change in Qd
(5000 – 3000)/4000 = 50%
% change in P
($90 – $70)/$80 = 25%
The price elasticity of demand equals
50%
= 2.0
25%
The Variety of Demand
Curves
• The price elasticity of demand is closely related to
the slope of the demand curve.
• Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
• Five different classifications of D curves.…
“Perfectly inelastic demand” (one extreme case)
% change in Q
Price elasticity
=
=
of demand
% change in P
P
D curve:
vertical
10%
=0
D
P1
Consumers’
price sensitivity:
none
Elasticity:
0
0%
P2
P falls
by 10%
Q1
Q changes
by 0%
Q
“Inelastic demand”
% change in Q
< 10%
Price elasticity
<1
=
=
of demand
% change in P
10%
P
D curve:
relatively steep
P1
Consumers’
price sensitivity:
relatively low
Elasticity:
<1
P2
D
P falls
by 10%
Q1 Q2
Q rises less
than 10%
Q
“Unit elastic demand”
% change in Q
Price elasticity
=
=
of demand
% change in P
10%
=1
P
D curve:
intermediate slope
P1
Consumers’
price sensitivity:
intermediate
Elasticity:
1
10%
P2
P falls
by 10%
D
Q1
Q2
Q
Q rises by 10%
“Elastic demand”
% change in Q
> 10%
Price elasticity
>1
=
=
of demand
% change in P
10%
P
D curve:
relatively flat
P1
Consumers’
price sensitivity:
relatively high
Elasticity:
>1
P2
P falls
by 10%
D
Q1
Q2
Q rises more
than 10%
Q
“Perfectly elastic demand” (the other extreme)
% change in Q
any %
Price elasticity
=
=
=
of demand
0%
% change in P
infinity
P
D curve:
horizontal
Consumers’
price sensitivity:
extreme
Elasticity:
infinity
D
P2 = P1
P changes
by 0%
Q1
Q2
Q changes
by any %
Q
3. Elasticity and
Revenue
Effect of price increase on
revenue
Revenue = P x Q
• A price increase has two effects on revenue:
• Higher P means more revenue on each unit
you sell.
• But you sell fewer units (lower Q),
due to Law of Demand.
• Which of these two effects is bigger?
It depends on the price elasticity of demand.
Price Elasticity and Total
Revenue
Price elasticity
of demand
=
Percentage change in Q
Percentage change in P
Revenue = P x Q
• If demand is elastic, then
price elast. of demand > 1
% change in Q > % change in P
• If demand is inelastic, then
price elast. of demand < 1
% change in Q < % change in P
• The fall in revenue from lower Q is • The fall in revenue from lower Q is
smaller than the increase in
greater than the increase in revenue
revenue from higher P,
from higher P,
so revenue rises.
so revenue falls.
4. Other elasticities of
demand
Income elasticity of demand
Measures the response of Qd to a change in consumer
income
d
Percent
change
in
Q
Income elasticity
=
of demand
Percent change in income
 Recall : An increase in income causes
an increase in demand for a normal
good.
 Hence, for normal goods, income
elasticity > 0.
 For inferior goods, income elasticity < 0.
Cross-price elasticity of demand
Measures the response of demand for one good to changes
in the price of another good
Cross-price elast.
=
of demand
% change in Qd for good 1
% change in price of good 2
 For substitutes, cross-price elasticity > 0
(e.g., an increase in price of beef causes an increase in
demand for chicken)
 For complements, cross-price elasticity < 0
(e.g., an increase in price of computers causes decrease in
demand for software)
STUDENTS’ TURN:
Calculate other elasticities of demand
Refer to Questions 2 and 3 of the
market demand experiments
Remember that you can calculate
percentage changes using
end value – start value
midpoint
x 100%
Or…
end value – start value
end value + start value
2
x 100%
The formulas for
income elasticity of
demand and cross-price
elasticity of demand
are on your handout!
5. Elasticity of Supply
Price Elasticity of Supply
Price elasticity
of supply
=
Percentage change in Qs
Percentage change in P
P
Example:
Price
elasticity
of supply
equals
16%
= 2.0
8%
P rises
by 8%
S
P2
P1
Q1
Q rises
by 16%
Q2
Q
Different types of Supply Curves
• The slope of the supply curve is
closely related to price elasticity
of supply.
• Rule of thumb:
The flatter the curve, the bigger
the elasticity.
The steeper the curve, the
smaller the elasticity.
• Five different classifications.…
“Perfectly inelastic” (one extreme)
% change in Q
Price elasticity
=
=
of supply
% change in P
P
S curve:
vertical
10%
=0
S
P2
Sellers’
price sensitivity:
none
Elasticity:
0
0%
P1
P rises
by 10%
Q1
Q changes
by 0%
Q
“Inelastic”
% change in Q
< 10%
Price elasticity
<1
=
=
of supply
% change in P
10%
P
S curve:
relatively steep
P2
Sellers’
price sensitivity:
relatively low
Elasticity:
<1
S
P1
P rises
by 10%
Q 1 Q2
Q rises less
than 10%
Q
“Unit elastic”
% change in Q
Price elasticity
=
=
of supply
% change in P
10%
=1
P
S curve:
intermediate slope
S
P2
Sellers’
price sensitivity:
intermediate
Elasticity:
=1
10%
P1
P rises
by 10%
Q1
Q2
Q rises
by 10%
Q
“Elastic”
% change in Q
> 10%
Price elasticity
>1
=
=
of supply
% change in P
10%
P
S curve:
relatively flat
S
P2
Sellers’
price sensitivity:
relatively high
Elasticity:
>1
P1
P rises
by 10%
Q1
Q2
Q rises more
than 10%
Q
“Perfectly elastic” (the other extreme)
any %
% change in Q
Price elasticity
=
=
of supply
0%
% change in P
P
S curve:
horizontal
Sellers’
price sensitivity:
extreme
Elasticity:
infinity
= infinity
S
P 2 = P1
P changes
by 0%
Q1
Q2
Q changes
by any %
Q
The 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
supply of new cars.
• For many goods, price elasticity
of supply is greater in the long
run than in the short run, because
firms can build new factories,
or new firms may be able to enter
the market.