Download Document

A Lecture Presentation
in PowerPoint
to accompany
Exploring Economics
Second Edition
by Robert L. Sexton
Copyright © 2002 Thomson Learning, Inc.
Thomson Learning™ is a trademark used herein under license.
ALL RIGHTS RESERVED. Instructors of classes adopting EXPLORING ECONOMICS, Second Edition by Robert L.
Sexton as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic
network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work
covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or
mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or
information storage and retrieval systems—without the written permission of the publisher.
Printed in the United States of America
ISBN 0030342333
Copyright © 2002 by Thomson Learning, Inc.
Chapter 5
Elasticities
Copyright © 2002 by Thomson Learning, Inc.
5.1 Price Elasticity of Demand




The law of demand establishes that
quantity demanded changes inversely
with changes in price, ceteris paribus.
But how much does quantity demanded
change?
This is very important to understand for
many economic issues.
This is what the price elasticity of
demand is designed to answer.
Copyright © 2002 by Thomson Learning, Inc.
5.1 Price Elasticity of Demand


The price elasticity of demand
measures how responsive consumer
behavior (quantity demanded) is due to
an incentive (price) change.
The price elasticity of demand is defined
as the percentage change in quantity
demanded divided by the percentage
change in price.
Copyright © 2002 by Thomson Learning, Inc.
5.1 Price Elasticity of Demand
Copyright © 2002 by Thomson Learning, Inc.
5.1 Price Elasticity of Demand



Following the law of demand, there is
an inverse relationship between price
and quantity demanded.
For this reason, price elasticity of
demand is, in theory, always negative.
In practice, however, this quantity is
always expressed in absolute value
terms, as a positive number, for
simplicity.
Copyright © 2002 by Thomson Learning, Inc.
5.1 Price Elasticity of Demand



The percentage changes in the
elasticity of demand formula are
measured using the average price and
average quantity.
This is so we do not get different values
for the elasticity of demand depending
on whether we moved up or down the
demand curve.
We are actually calculating the midpoint
elasticity.
Copyright © 2002 by Thomson Learning, Inc.
5.1 Price Elasticity of Demand

The basic intuition behind elasticities is
straightforward, using an analogy to a
rubber band.


If the quantity demanded (or length) is very
responsive to even a small change in price
(or pressure), we call it elastic.
If even a huge change in price (or
pressure) results in only a small change in
quantity demanded (or length), then
demand is said to be inelastic.
Copyright © 2002 by Thomson Learning, Inc.
5.1 Price Elasticity of Demand



A demand curve or a portion of a
demand curve can be relatively elastic,
unit elastic, or relatively inelastic.
A segment of a demand curve is elastic
(Ed > 1) if the percentage change in
quantity demanded is greater than the
percentage change in price that caused
it.
A perfectly elastic demand curve is the
limiting case.
Copyright © 2002 by Thomson Learning, Inc.
Price per CD
Exhibit 1: Elastic Demand
B
$21
Pave $20 P=$2
$19
ED = .5 at
midpoint
QD =
4 million
A
Demand
0
Copyright © 2002 by Thomson Learning, Inc.
78 80 82
Qave
Quantity of CDs
(millions per month)
5.1 Price Elasticity of Demand


A segment of a demand curve is
inelastic (Ed < 1) if the percentage
change in quantity demanded is less
than the percentage change in price
that caused it.
A perfectly elastic demand curve is the
limiting case.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 2: Elastic Demand
P1
P0
10%P
b. Perfectly Inelastic Demand
(ED = 0)
ED= %QD = .20 =2
%P
.10
D
Price
Price
a. Elastic Demand
(ED < 1)
P1
P0
P
QD
20%QD
0
Q1
Q0
Quantity
Copyright © 2002 by Thomson Learning, Inc.
D
0Q
1
Q0
Quantity
5.1 Price Elasticity of Demand

A segment of a demand curve is unit
elastic (Ed = 1) if the percentage change
in quantity demanded equals the
percentage change in the price that
caused it.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 4: Unit Elastic Demand
ED =
Price
P1
P0
10%P
%QD
=
%P
.10
=1
.10
D
10%
QD
0
Q1 Q0
Quantity
Copyright © 2002 by Thomson Learning, Inc.
5.1 Price Elasticity of Demand

At a given point, quantity demanded is
much more responsive to a given
change in price on a flatter, more elastic
demand curve.


When a demand curve is relatively steep,
ceteris paribus, its price elasticity of
demand is relatively low (more inelastic).
When the demand curve is relatively flat,
its price elasticity of demand is relatively
high (more elastic).
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 5: Slope and Relative
Elasticity
P1
P0
Price
D1
(relatively
elastic)
D0
(relatively
inelastic)
0
Q2
Q1 Q0
Quantity
Copyright © 2002 by Thomson Learning, Inc.
5.1 Price Elasticity of Demand

The price elasticity of demand depends
on



the availability of close substitutes,
the proportion of income spent on the
good, and
the amount of time people have to adapt to
a price change.
Copyright © 2002 by Thomson Learning, Inc.
5.1 Price Elasticity of Demand

Substitutes



Goods with close substitutes tend to have
more elastic demands.
Goods without close substitutes tend to
have less elastic demand.
Example: the elasticity of demand for a
Ford, Toyota, or a Honda is more elastic
than the demand for a car because there
are more and better substitutes for a
certain type of car than for a car itself.
Copyright © 2002 by Thomson Learning, Inc.
5.1 Price Elasticity of Demand


The fewer the number of close substitutes,
the less elastic the demand curve.
Examples: insulin for diabetics, heroin for
an addict, and emergency medical care
have few, if any, close substitutes.
Copyright © 2002 by Thomson Learning, Inc.

The smaller the proportion of income
spent on a good, the lower its elasticity
of demand.

If the amount spent on a good relative to
income is small (example: salt), then the
impact of a change in its price on one's
budget will also be small.
Copyright © 2002 by Thomson Learning, Inc.
5.1 Price Elasticity of Demand

Consumers will respond less to price
changes for these goods than for similar
percentage changes in large-ticket
items (example: textbooks), where a
price change could have a potentially
large impact on the consumer's budget.
Copyright © 2002 by Thomson Learning, Inc.
5.1 Price Elasticity of Demand

The more time that people have to
adapt to a new price change, the
greater the elasticity of demand.

The more time that passes, the more time
consumers have to find or develop suitable
substitutes and to plan and implement
changes in their patterns of consumption.
Copyright © 2002 by Thomson Learning, Inc.
5.1 Price Elasticity of Demand

Hence, the short-run demand curve is
generally less elastic than the long-run
demand curve.
Copyright © 2002 by Thomson Learning, Inc.
5.2 Total Revenue and Price
Elasticity of Demand


When demand is relatively price elastic
(Ed > 1), total revenues will rise as the
price declines.
This occurs because the percentage
increase in the quantity demanded is
greater than the percentage reduction in
price.
Copyright © 2002 by Thomson Learning, Inc.
5.2 Total Revenue and Price
Elasticity of Demand


If the price rises and the quantity
demanded falls, then total revenue falls.
This occurs because the percentage
decrease in the quantity demanded is
greater than the percentage increase in
price.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 1: Elastic Demand and Total
Revenue
A
Price
$10
a
B
$5
b
0
20
Copyright © 2002 by Thomson Learning, Inc.
DELASTIC
c
40
60
80 100
Quantity
5.2 Total Revenue and Price
Elasticity of Demand


When demand is relatively price
inelastic (Ed < 1), total revenues will fall
as the price declines.
Total revenues fall because the
percentage increase in the quantity
demanded is less than the percentage
reduction in price.
Copyright © 2002 by Thomson Learning, Inc.
5.2 Total Revenue and Price
Elasticity of Demand


If the price rises and the quantity
demanded falls, then total revenue
rises.
Total revenue rises because the
percentage decrease in the quantity
demanded is less than the percentage
increase in price.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 2: Inelastic Demand and
Total Revenue
A
Price
$10
a
B
$5
b
c
DINELASTIC
0
10
Copyright © 2002 by Thomson Learning, Inc.
20
30
40
Quantity
Exhibit 3: Total Revenue & Inelastic
Demand:A Reduction in Supply
S1
S0
Price
P1
a
(gain)
P0
b
0
Copyright © 2002 by Thomson Learning, Inc.
c
(loss)
Q1
Quantity
Q0
D
Exhibit 3: Total Revenue & Inelastic
Demand: An Increase in Supply
Price of Wheat
S0
S1
P0
a
(loss)
P1
b
0
Copyright © 2002 by Thomson Learning, Inc.
c
(gain)
Q0
Q1
Quantity of Wheat
D
5.2 Total Revenue and Price
Elasticity of Demand

A straight-line demand curve (having a
constant slope) will change price
elasticity continuously as you move up
or down it.

When the price falls on the upper half of
the demand curve, there is a negative
relationship between price and total
revenue.

Demand is relatively price elastic.
Copyright © 2002 by Thomson Learning, Inc.
5.2 Total Revenue and Price
Elasticity of Demand

When the price falls on the lower half of the
demand curve, there is a positive
relationship between price and total
revenue.

Demand is relatively price inelastic.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 4: Price Elasticity Along a
Linear Demand Curve
a. Elastic Range
ED > 1 = Elastic
b
Midpoint
ED = 1
P2
c
D
0
Q 0 Q1
Quantity
Copyright © 2002 by Thomson Learning, Inc.
Midpoint
ED = 1
Price
Price
P0
a
P1
b. Inelastic Range
P3
0
d
e
ED < 1
= Inelastic
f
Q2 Q3
Quantity
D
5.3 Price Elasticity of Supply



According to the law of supply, there is
a positive relationship between price
and quantity supplied, ceteris paribus.
But by how much does quantity
supplied change as price changes?
The price elasticity of supply measures
how responsive the quantity sellers are
willing to sell is to changes in the price.
Copyright © 2002 by Thomson Learning, Inc.
5.3 Price Elasticity of Supply


In other words, price elasticity of supply
measures the relative change in the
quantity supplied that results from a
change in price.
The price elasticity of supply (Es) is
defined at the percentage change in the
quantity supplied divided by the
percentage change in price.
Copyright © 2002 by Thomson Learning, Inc.
5.3 Price Elasticity of Supply
Copyright © 2002 by Thomson Learning, Inc.
5.3 Price Elasticity of Supply



Goods with a supply elasticity that is
greater than 1 (Es > 1 ) are relatively
elastic in supply.
With that, a 1 percent change in price
will result in a greater than 1 percent
change in quantity supplied.
The extreme case is perfectly elastic
supply, where Es = infinity.
Copyright © 2002 by Thomson Learning, Inc.
5.3 Price Elasticity of Supply



Goods with a supply elasticity that is
less than 1 (Es < 1) are relatively
inelastic in supply.
This means that a 1 percent change in
the price of these goods will induce a
proportionately smaller change in the
quantity supplied.
The extreme case is perfectly inelastic
supply, where Es = 0.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 1: The Price Elasticity of
Supply
a. Elastic Supply (ES > 1)
Price
S
P1
P0
5%P
20%QS
0
Copyright © 2002 by Thomson Learning, Inc.
Q0
ES = %QS = .20 = 4
%P .05
Q1
Quantity
Exhibit 1: The Price Elasticity of
Supply
b. Inelastic Supply (ES < 1)
S
Price
P1
20%P
%QS .05
ES =
=
%P .20 = .25
P0
5%
QS
0
Copyright © 2002 by Thomson Learning, Inc.
Q 0 Q1
Quantity
Exhibit 1: The Price Elasticity of
Supply
c. Perfectly Inelastic Supply (ES = 0)
S
Price
P1
20%P
P0
0
Copyright © 2002 by Thomson Learning, Inc.
Q0 = Q1
Quantity
Exhibit 1: The Price Elasticity of
Supply
Price
d. Perfectly Elastic supply (ES = )
P1
P0
S
P
0
Copyright © 2002 by Thomson Learning, Inc.
Q0
Quantity
5.3 Price Elasticity of Supply


Time is usually critical in supply
elasticities because it is more costly for
producers to bring forth and release
resources in shorter periods of time.
Hence, supply tends to be more elastic
in the long run than the short run.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 2: Short-run and Long-run
Supply Curves
Price
SSR
SLR
P1
P0
0
Copyright © 2002 by Thomson Learning, Inc.
Q0 QSR
Quantity
QLR
5.3 Price Elasticity of Supply


The relative elasticity of supply and
demand determines the distribution of
the tax burden for a good.
If demand has a lower elasticity than
supply in the relevant tax region, the
largest portion of the tax is paid by the
consumer.
Copyright © 2002 by Thomson Learning, Inc.
5.3 Price Elasticity of Supply


However, if demand is relatively more
elastic than supply in the relevant tax
region, the largest portion of the tax is
paid by the producer.
In general, the tax burden falls on the
side of the market that is less elastic,
which has nothing to do with who
actually pays the tax at the time of the
purchase.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 3: Elasticity and the Burden
of Taxation
a. Demand Is Relatively Less Elastic than Supply
S + $.50 tax
Tax Paid
by Consumer
S
Price
$1.40
1.00
.90
$.50
Tax Paid
by Producer
0
Copyright © 2002 by Thomson Learning, Inc.
D
QAT QBT
Quantity
Exhibit 3: Elasticity and the Burden
of Taxation
b. Demand Is Relatively More Elastic than Supply
Tax Paid
by Consumer
S + $.50 tax
S
Price
$1.10
1.00
$.50
.60
D
Tax Paid
by Producer
0
Copyright © 2002 by Thomson Learning, Inc.
QAT QBT
Quantity
5.4 Other Types of Elasticities

The cross-price elasticity of demand
measures both the direction and
magnitude of the impact that a price
change for one good will have on the
quantity of another good demanded at a
given price.
Copyright © 2002 by Thomson Learning, Inc.
5.4 Other Types of Elasticities

The cross-price elasticity of demand is
defined as the percentage change in
quantity demanded of one good at a
given price divided by the percentage
change in price of another good.
Copyright © 2002 by Thomson Learning, Inc.
5.4 Other Types of Elasticities
Copyright © 2002 by Thomson Learning, Inc.
5.4 Other Types of Elasticities


If the cross-price elasticity of demand
between two goods is positive, they are
substitutes because the price of one
good and the demand for the other
move in the same direction.
If the cross-price elasticity of demand
between two goods is negative, they are
complements because the price of one
good and the demand for the other
move in opposite directions.
Copyright © 2002 by Thomson Learning, Inc.
5.4 Other Types of Elasticities


The income elasticity of demand is a
measure of the relationship between a
relative change in income and the
consequent relative change in quantity
demanded, ceteris paribus.
The income elasticity of demand
coefficient expresses the degree of the
connection between the two variables,
and it also indicates whether the good in
question is normal or inferior.
Copyright © 2002 by Thomson Learning, Inc.
5.4 Other Types of Elasticities

The income elasticity of demand is
defined as the percentage change in
quantity demanded at a given price
divided by the percentage change in
income.
Copyright © 2002 by Thomson Learning, Inc.
5.4 Other Types of Elasticities
Copyright © 2002 by Thomson Learning, Inc.
5.4 Other Types of Elasticities


If the income elasticity is positive, then
the good in question is a normal good
because the change in income and the
change in quantity demanded move in
the same direction.
If the income elasticity is negative, then
the good in question in an inferior good
because the change in income and the
change in quantity demanded move in
opposite directions.
Copyright © 2002 by Thomson Learning, Inc.