Download Price elasticity of demand

ELASTICITY
Economics 101
ELASTICITY

… is a measure of how much buyers and sellers
respond to changes in market conditions
THE ELASTICITY OF DEMAND


Price elasticity of demand is a measure of how
much the quantity demanded of a good responds
to a change in the price of that good.
Price elasticity of demand is the percentage
change in quantity demanded given a percent
change in the price.
DETERMINANTS OF PRICE
ELASTICITY OF DEMAND


Availability of Close Substitutes:
More close substitutes=More elastic
Example: Butter vs Egg
Necessities versus Luxuries:
inelastic versus elastic
Example: visit a doctor vs sailboat
DETERMINANTS OF PRICE
ELASTICITY OF DEMAND


Definition of the Market:
Narrowly defined market– more elastic
Broadly defined market – less elastic
Example: Food vs Ice Cream
Time Horizon
Longer time horizon– more elastic
Shorter time horizon– less elastic
SUMMARY

Demand tends to be more elastic :
the larger the number of close substitutes.
 if the good is a luxury.
 the more narrowly defined the market.
 the longer the time period.


The (own) price elasticity of demand is computed
as the percentage change in the quantity
demanded divided by the percentage change in
price.
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
CALCULATING ELASTICITY
1.1
1.0
1.44
1.5
CALCULATING ELASTICITY: POINT
ELASTICITY
Point Elasticity={[Q2-Q1]/Q1}/{[P2-P1]/P1}
Case 1: Price rises from 1 to 1.1
% change in qty = (1.44-1.5)/1.5= -4%
% change in price = (1.10-1)/1= 10%
Elasticity=-4%/10%=-0.4
CALCULATING ELASTICITY: POINT
APPROACH
Case 2: Price falls from 1.1 to 1.
% change in qty = (1.5-1.44)/1.44= 4.16%
% change in price = (1-1.10)/1.10= -9.09%
Elasticity=4.16%/-9.09%=-0.457
POTENTIAL PROBLEM OF POINT
ELASTICITY

(Point) Elasticity level in case 1 is different from
(point) elasticity level in case 2
MIDPOINT METHOD (ARC ELASTICITY)

The midpoint formula is preferable when
calculating the price elasticity of demand because
it gives the same answer regardless of the
direction of the change.
MIDPOINT METHOD FORMULA
(Q2  Q1 ) / [(Q2  Q1 ) / 2]
Price elasticity of demand =
(P2  P1 ) / [(P2  P1 ) / 2]
ARC ELASTICITY
(MIDPOINT METHOD)
Case 1: Price rises from 1 to 1.1.
 % change in qty = (1.44-1.5)/1.47 = -4.1%
 % change in price = (1.10-1)/1.05 = 9.5%
 Elasticity=-4.1%/9.5%
=-0.432
Case 2: Price falls from 1.1 to 1.
 % change in qty = (1.5-1.44)/1.47 = 4.1%
 % change in price = (1-1.10)/1.05 = -9.5%
 Elasticity=4.1%/-9.5%
=-0.432
ELASTIC OR INELASTIC?

Inelastic Demand



Quantity demanded does not respond strongly to
price changes.
Price elasticity of demand is less than one.
Elastic Demand


Quantity demanded responds strongly to changes in
price.
Price elasticity of demand is greater than one.
OTHER TYPES

Perfectly Inelastic


Perfectly Elastic


Quantity demanded does not respond to price
changes.
Quantity demanded changes infinitely with any
change in price.
Unit Elastic

Quantity demanded changes by the same
percentage as the price.
SUMMARY
|E|=0, perfectly inelastic
 0<|E|<1, inelastic
 |E|=1, unit elastic
 |E|>1, elastic
 |E|=infinity, perfectly elastic

OWN-PRICE ELASTICITIES
Product
Automobiles
Chevette
Civic
Consumer products
music CDs
cigarettes
liquor
football games
Utilities
electricity (residential)
telephone service
water (residential)
water (industrial)
Market
Elasticity
U.S.
U.S.
-3.2
-4
Aus
U.S.
U.S.
U.S.
-1.83
-0.3
-0.2
-0.275
Quebec
Spain
U.S.
U.S.
-0.7
-0.1
-0.25
-0.85
SLOPE AND ELASTICITY
Because the price elasticity of demand measures
how much quantity demanded responds to the
price, it is closely related to the slope of the
demand curve.
 Higher slope, lower elasticity

(a) Perfectly Inelastic Demand: Elasticity Equals 0
Price
Demand
$5
4
1. An
increase
in price . . .
0
100
Quantity
2. . . . leaves the quantity demanded unchanged.
Copyright©2003 Southwestern/Thomson Learning
(b) Inelastic Demand: Elasticity Is Less Than 1
Price
$5
4
1. A 22%
increase
in price . . .
Demand
0
90
100
Quantity
2. . . . leads to an 11% decrease in quantity demanded.
(c) Unit Elastic Demand: Elasticity Equals 1
Price
$5
4
Demand
1. A 22%
increase
in price . . .
0
80
100
Quantity
2. . . . leads to a 22% decrease in quantity demanded.
Copyright©2003 Southwestern/Thomson Learning
(d) Elastic Demand: Elasticity Is Greater Than 1
Price
$5
4
Demand
1. A 22%
increase
in price . . .
0
50
100
Quantity
2. . . . leads to a 67% decrease in quantity demanded.
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Price
1. At any price
above $4, quantity
demanded is zero.
$4
Demand
2. At exactly $4,
consumers will
buy any quantity.
0
3. At a price below $4,
quantity demanded is infinite.
Quantity
LINEAR DEMAND CURVE
Vertical intercept: perfectly elastic
 Upper segment: elastic
 Middle: Unit elastic
 Lower segment: inelastic
 Horizontal intercept: perfectly inelastic

TOTAL REVENUE AND ELASTICITY
Total revenue is the amount paid by buyers and
received by sellers of a good.
 Computed as the price of the good times the
quantity sold.

TR = P x Q
Price
$4
P × Q = $400
(revenue)
P
0
Demand
100
Quantity
Q
Copyright©2003 Southwestern/Thomson Learning
TOTAL REVENUE AND ELASTICITY
With an elastic demand curve, an increase in the
price leads to a decrease in quantity demanded
that is proportionately larger. Thus, total revenue
decreases.
 With an inelastic demand curve, an increase in
the price leads to a decrease in quantity
demanded that is proportionately smaller. Thus,
total revenue increases.

INCOME ELASTICITY OF DEMAND
Income elasticity of demand measures how much
the quantity demanded of a good responds to a
change in consumers’ income.
 It is computed as the percentage change in the
quantity demanded divided by the percentage
change in income.

NORMAL OR INFERIOR?

Types of Goods
Normal Goods
 Inferior Goods

Higher income raises the quantity demanded for
normal goods but lowers the quantity demanded
for inferior goods.
 Normal goods: Positive income elasticity
 Inferior goods: Negative income elasticity

NECESSITY OR LUXURY?

Goods consumers regard as necessities tend to be
income inelastic


Examples include food, fuel, clothing, utilities, and
medical services.
Goods consumers regard as luxuries tend to be
income elastic.

Examples include sports cars, furs, and expensive
foods.
INCOME ELASTICITY
I >0, Normal good
 I <0, Inferior good
 Among normal goods:
0<I<1, necessity
I>1, luxury

INCOME ELASTICITY
Item
Consumer products
cigarettes
liquor
food
clothing
newspapers
Utilities
electricity (residential)
telephone service
Market
Elasticity
U.S.
U.S.
U.S.
U.S.
U.S.
0.1
0.2
0.8
1
0.9
Quebec
Spain
0.1
0.5
PRICE ELASTICITY OF SUPPLY
Price elasticity of supply is a measure of how
much the quantity supplied of a good responds to
a change in the price of that good.
 Price elasticity of supply is the percentage change
in quantity supplied resulting from a percent
change in price.

FORMULA

The price elasticity of supply is computed as the
percentage change in the quantity supplied
divided by the percentage change in price.
Percentage change
in quantity supplied
Price elasticity of supply =
Percentage change in price
SUMMARY
S=0, perfectly inelastic
 0<S<1, inelastic
 S=1, unit elastic
 S>1, elastic
 S=infinity, perfectly elastic

SLOPE AND ELASTICITY
Because the price elasticity of supply measures
how much quantity supplied responds to the
price, it is closely related to the slope of the
supply curve.
 Higher slope, lower elasticity

(a) Perfectly Inelastic Supply: Elasticity Equals
0
Price
Supply
$5
4
1. An
increase
in price . . .
0
100
Quantity
2. . . . leaves the quantity supplied unchanged.
Copyright©2003 Southwestern/Thomson Learning
(b) Inelastic Supply: Elasticity Is Less Than 1
Price
Supply
$5
4
1. A 22%
increase
in price . . .
0
100
110
Quantity
2. . . . leads to a 10% increase in quantity supplied.
Copyright©2003 Southwestern/Thomson Learning
(c) Unit Elastic Supply: Elasticity Equals
1
Price
Supply
$5
4
1. A 22%
increase
in price . . .
0
100
125
Quantity
2. . . . leads to a 22% increase in quantity supplied.
Copyright©2003 Southwestern/Thomson Learning
(d) Elastic Supply: Elasticity Is Greater Than 1
Price
Supply
$5
4
1. A 22%
increase
in price . . .
0
100
200
Quantity
2. . . . leads to a 67% increase in quantity supplied.
Copyright©2003 Southwestern/Thomson Learning
(e) Perfectly Elastic Supply: Elasticity Equals Infinity
Price
1. At any price
above $4, quantity
supplied is infinite.
$4
Supply
2. At exactly $4,
producers will
supply any quantity.
0
3. At a price below $4,
quantity supplied is zero.
Quantity
Copyright©2003 Southwestern/Thomson Learning
DETERMINANTS OF PRICE
ELASTICITY OF SUPPLY

Ability of sellers to change the amount of the
good they produce.
Beach-front land is inelastic.
 Books, cars, or manufactured goods are elastic.


Time period.

Supply is more elastic in the long run.
PRICE ELASTICITIES OF SUPPLY
Item
distillate
gasoline
pork
tobacco
housing
Horizon
short run
short run
long run
long run
long run
Price Elasticity
1.57
1.61
0.23
7
1.6 - 3.7
APPLICATION OF ELASTICITY
Can good news for farming be bad news for
farmers?
 What happens to wheat farmers and the market
for wheat when university agronomists discover a
new wheat hybrid that is more productive than
existing varieties?

Price of
Wheat
2. . . . leads
to a large fall
in price . . .
1. When demand is inelastic,
an increase in supply . . .
S1
S2
$3
2
Demand
0
100
110
Quantity of
Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
Copyright©2003 Southwestern/Thomson Learning
OTHER APPLICATIONS
A reduction in supply in the world market for oil:
the response depends on the time horizon.
 Policies to Reduce the Use of Illegal Drugs:
Drug interdiction
Drug education

QUIZ 1
Beachfront resorts: inelastic supply
 Automobile: elastic supply
 Suppose a rise in population doubles the demand
for both products.
 Price? Quantity? Consumer spending?

QUIZ 2
Why? Why?
 A drought around the world:
Total revenue that farmers received from sale of
grain rises. However, a drought in Kansas
reduces total revenue that Kansas farmers
receive.
