5 Elasticity SLIDES CREATED BY ERIC CHIANG CHAPTER 5 SLIDE 1 iStock / Getty Images CHAPTER 5 SLIDE 1

CHAPTER OBJECTIVES Understand the concept of elasticity and why percentages are used to measure it. Describe the difference between elastic and inelastic demand. Describe the determinants of price elasticity of demand. Compute the price elasticity of demand using the base and midpoint methods. Describe the relationship between total revenue and price elasticity of demand.  CHAPTER 5 SLIDE 2

CHAPTER OBJECTIVES Describe cross elasticity of demand and use this concept to define substitutes and complements. Use income elasticity of demand to define normal, inferior, and luxury goods. Use the concept of price elasticity of supply to measure the relationship between changes in product price and quantity supplied. Describe the time periods economists use to study elasticity, and the variables that can be changed in each period. Describe the relationship between elasticity and the burden and incidence of taxes. CHAPTER 5 SLIDE 3

ELASTICITY MEASURES THE RESPONSIVENESS OF ONE VARIABLE TO CHANGES IN ANOTHER. EASTPHOTO/AGE FOTOSTOCK 10% PRICE CHAPTER 5 SLIDE 4

= % Δ QUANTITY % Δ PRICE PRICE ELASTICITY OF DEMAND, Ed Always a negative number, which is why we use the absolute value. Larger number (in absolute value) indicates greater elasticity. CHAPTER 5 SLIDE 5

INELASTIC ELASTIC UNITARY ELASTIC Ed < 1 Ed > 1 Ed = 1 DEFINING PRICE ELASTICITY OF DEMAND Ed < 1 INELASTIC Ed > 1 ELASTIC Ed = 1 UNITARY ELASTIC CHAPTER 5 SLIDE 6

DEMAND FOR ELASTIC GOODS IS SENSITIVE TO PRICE CHANGES. HUPEN/DREAMSTIME.COM CHAPTER 5 SLIDE 7

DEMAND FOR INELASTIC GOODS IS LESS SENSITIVE TO PRICE CHANGES. JOHNFOTO/DREAMSTIME.COM DEMAND FOR INELASTIC GOODS IS LESS SENSITIVE TO PRICE CHANGES. CHAPTER 5 SLIDE 8

THE SHAPE OF DEMAND CURVES Relatively elastic Relatively inelastic PRICE PRICE D D QUANTITY QUANTITY Unitary elastic PRICE D QUANTITY CHAPTER 5 SLIDE 9

THE SHAPE OF DEMAND CURVES Perfectly inelastic Perfectly elastic D PRICE D PRICE QUANTITY QUANTITY CHAPTER 5 SLIDE 10

    DETERMINANTS OF ELASTICITY Number of substitutes available The cost as a proportion of one’s budget Whether a good is a necessity or a luxury The period to respond to changes in price    Elastic goods have many substitutes, represent a large portion of one’s budget, tend to be luxury goods, and have a long time horizon for responses. CHAPTER 5 SLIDE 11

MAGICTORCH/IKON IMAGES/CORBIS THE MIDPOINT METHOD ALLOWS PERCENTAGE CHANGES TO BE THE SAME REGARDLESS OF THE DIRECTION OF THE CHANGE. CHAPTER 5 SLIDE 12

THE MIDPOINT METHOD USES THE AVERAGE OF TWO VALUES AS THE BASE: %ΔQ = (Q1 – Q0) / [(Q0 + Q1) / 2] EXAMPLE: Q increases from 10 to 12 %ΔQ = (12 – 10) / [10 + 12) / 2] = 2 / 11 = 18.2% CHAPTER 5 SLIDE 13

Total Revenue = Price  Quantity ELASTICITY AND TOTAL REVENUE Total Revenue = Price  Quantity TR = P × Q CHAPTER 5 SLIDE 14

= ELASTICITY AND TOTAL REVENUE P TR Q When demand is inelastic, price changes are larger than quantity changes (in percentage terms). An increase in price results in higher total revenue. = P TR Q A decrease in price results in lower total revenue. CHAPTER 5 SLIDE 15

= ELASTICITY AND TOTAL REVENUE TR P Q When demand is elastic, quantity changes are larger than price changes (in percentage terms). An increase in price results in lower total revenue. = TR P Q A decrease in price results in higher total revenue. CHAPTER 5 SLIDE 16

= ELASTICITY AND TOTAL REVENUE TR Q P When demand is unitary elastic, quantity changes are equal to price changes (in percentage terms). An increase in price does not change total revenue. = TR Q P A decrease in price does not change total revenue. CHAPTER 5 SLIDE 17

ELASTICITY AND TOTAL REVENUE Inelastic demand Elastic demand 5 5 4 4 Revenue gained 3 PRICE ($) 3 PRICE ($) Revenue gained 2 2 D Revenue lost Revenue lost 1 1 D 100 200 300 400 500 600 100 200 300 400 500 600 QUANTITY QUANTITY An increase in price causes a net increase in revenue. An increase in price causes a net decrease in revenue. CHAPTER 5 SLIDE 18

ELASTICITYAND TOTAL REVENUE ALONG A LINEAR DEMAND CURVE 12 Elastic Moving down a linear demand curve, elasticity falls from elastic to inelastic. 10 Unitary elastic 8 PRICE ($) 6 4 Inelastic 2 20 40 60 80 100 120 500 400 Total revenue is maximized when demand is unitary elastic. 300 TOTAL REVENUE ($) 200 TR 100 20 40 60 80 100 120 QUANTITY CHAPTER 5 SLIDE 19

OTHER ELASTICITIES OF DEMAND PRICE CROSS INCOME CHAPTER 5 SLIDE 20

UPPERCUT IMAGES/ALAMY CROSS ELASTICITY OF DEMAND RESPONSIVENESS OF DEMAND FOR ONE GOOD TO CHANGES IN THE PRICE OF ANOTHER GOOD CHAPTER 5 SLIDE 21

= % Δ Qa % Δ Pb CROSS ELASTICITY OF DEMAND, Eab Unlike for price elasticity, the sign (+ or −) matters. The sign determines whether goods are substitutes or complements. CHAPTER 5 SLIDE 22

SUBSTITUTES Eab > 0 A PRICE INCREASE FOR GOOD A… …INCREASES DEMAND ERIC CHIANG A PRICE INCREASE FOR GOOD A… ERIC CHIANG …INCREASES DEMAND FOR GOOD B. CHAPTER 5 SLIDE 23

IF THE PRICE OF GASOLINE RISES, DEMAND FOR CARS FALLS. COMPLEMENTS Eab < 0 HUPEN/DREAMSTIME.COM + PETER ALBREKTSEN | DREAMSTIME.COM IF THE PRICE OF GASOLINE RISES, DEMAND FOR CARS FALLS. CHAPTER 5 SLIDE 24

AXX-STUDIO/SHUTTERSTOCK MEASURES CONSUMERS’ RESPONSIVENESS TO CHANGES IN INCOME INCOME ELASTICITY CHAPTER 5 SLIDE 25

= % Δ QUANTITY % Δ INCOME INCOME ELASTICITY OF DEMAND, EY The sign of EY (+ or −) also matters. The sign determines whether goods are normal, luxury, or inferior with respect to income. CHAPTER 5 SLIDE 26

0 < EY < 1 NORMAL GOODS ERIC CHIANG AS INCOME RISES, CONSUMERS BUY MORE NORMAL GOODS. AS INCOME FALLS, CONSUMERS BUY FEWER NORMAL GOODS. 0 < EY < 1 CHAPTER 5 SLIDE 27

LUXURY GOODS DANIEL GILBEY/DREAMSTIME.COM AS INCOME RISES, PURCHASES OF LUXURY GOODS RISE BY MORE THAN THE CHANGE IN INCOME. EY > 1 CHAPTER 5 SLIDE 28

INFERIOR GOODS ERIC CHIANG AS INCOME RISES, CONSUMERS BUY FEWER INFERIOR GOODS. AS INCOME FALLS, CONSUMERS BUY MORE INFERIOR GOODS. EY < 0 CHAPTER 5 SLIDE 29

ERIC CHIANG ELASTICITY OF SUPPLY MEASURES RESPONSIVENESS OF SUPPLIERS TO CHANGES IN PRICE. CHAPTER 5 SLIDE 30

= % Δ QUANTITY % Δ PRICE ELASTICITY OF SUPPLY, ES ES is always a positive number because of the law of supply. ES increases over time as suppliers adjust. CHAPTER 5 SLIDE 31

INELASTIC ELASTIC UNITARY ELASTIC Es < 1 Es > 1 Es = 1 DEFINING ELASTICITY OF SUPPLY INELASTIC Es < 1 Es > 1 ELASTIC Es = 1 UNITARY ELASTIC CHAPTER 5 SLIDE 32

ELASTICITY OF SUPPLY RISES OVER TIME AS BUSINESSES ADJUST PRODUCTION. KRIS TRIPPLAAR/TRIPLAAR KRISTOFFER/SIPA/NEWSCOM ELASTICITY OF SUPPLY RISES OVER TIME AS BUSINESSES ADJUST PRODUCTION. CHAPTER 5 SLIDE 33

   TIME PERIODS AND ELASTICITY MARKET PERIOD: PERIOD SO SHORT THAT OUTPUT AND NUMBER OF FIRMS ARE FIXED. SHORT RUN: PERIOD IN WHICH THE NUMBER OF FIRMS DOES NOT CHANGE BUT EACH FIRM CAN ADJUST OUTPUT LEVELS. LONG RUN: PERIOD LONG ENOUGH FOR NEW FIRMS TO ENTER.   CHAPTER 5 SLIDE 34

ELASTICITY OF SUPPLY OVER TIME SMP P SSR Supply becomes more elastic (flatter) over time from the short run to the long run. SLR P1 P2 P3 PRICE P0 D1 D0 Q Q0 Q2 Q3 QUANTITY CHAPTER 5 SLIDE 35

JAMES NAZZ/CORBIS INCIDENCE OF A TAX DESCRIBES WHO BEARS THE ECONOMIC BURDEN OF A TAX. THIS IS INFLUENCED BY ELASTICITY. CHAPTER 5 SLIDE 36

TYPES OF TAXES  PROGRESSIVE: AS INCOME RISES, INCOME IS TAXED AT A HIGHER PERCENTAGE. (EXAMPLE: FEDERAL INCOME TAX) FLAT: TAX IS A FIXED PERCENTAGE REGARDLESS OF INCOME. (EXAMPLE: MEDICARE TAX = 2.9%) REGRESSIVE: TAX BECOMES A SMALLER PERCENTAGE AS INCOME RISES. (Example: FICA payroll tax, which is capped—at $118,500 of income in 2016)   CHAPTER 5 SLIDE 37

TAXES AND ELASTICITY An excise tax on a good shifts the supply curve to the left, resulting in a higher price. But the prices rise by less than the full amount of the tax. Part of the burden is shifted to consumers, and the rest is borne by producers. CHAPTER 5 SLIDE 38

TAXES AND DEADWEIGHT LOSS S0 + tax New price paid by consumers S0 PRICE ($) The tax burden is shared by consumers and producers. Pc P0 Pp D New price received by producers Q1 Q0 Quantity QUANTITY CHAPTER 5 SLIDE 39

DEADWEIGHT LOSS THE LOSS IN CONSUMER AND PRODUCER SURPLUS BECAUSE SOME TRANSACTIONS CANNOT BE MADE AND THEREFORE THEIR VALUE TO SOCIETY IS LOST. CHAPTER 5 SLIDE 40

ELASTICITY AND DEADWEIGHT LOSS Consumer surplus The more elastic the demand and supply curves, the stronger the response to the tax and the larger the deadweight loss. PRICE ($) S0 + tax S0 Deadweight loss Pc Tax revenue P0 Pp D Q1 Q0 Quantity Producer surplus QUANTITY CHAPTER 5 SLIDE 41

ELASTICITY AND TAX BURDENS Elasticity of demand The more inelastic the demand, the greater the tax burden on consumers. The more elastic the demand, the greater the tax burden on producers. Elasticity of supply The more inelastic the supply, the greater the tax burden on producers. The more elastic the supply, the greater the tax burden on consumers. CHAPTER 5 SLIDE 42

KEY CONCEPTS Price elasticity of demand Inelastic supply Elastic demand Unitary elastic supply Inelastic demand Market period Unitary elastic demand Short run Total revenue Long run Cross elasticity of demand Progressive tax Substitutes Flat tax Complements Regressive tax Income elasticity of demand Lump-sum tax Normal goods Incidence of taxation Luxury goods Inferior goods Price elasticity of supply Elastic supply CHAPTER 5 SLIDE 43

IF THE PRICE OF SUSHI DROPS FROM $8 TO $4 AND SALES RISE FROM 20 TO 40, WHAT IS Ed (USING THE MIDPOINT METHOD)? 0.5 A 0.66 B 1 C Answer: C 2 D 2.5 E CHAPTER 5 SLIDE 44

EASTPHOTO/AGE FOTOSTOCK PRACTICE QUESTION IF RESTAURANT DEMAND IS INELASTIC, HOW WOULD A 10% INCREASE IN PRICE AFFECT REVENUES? 10% Answer: Increasing the price on an inelastic good increases revenues. PRICE CHAPTER 5 SLIDE 45

IF YOUR SALARY INCREASES BY 30%, AND IN RESPONSE YOU INCREASE YOUR CLOTHING PURCHASES BY 20%, INCOME ELASTICITY EQUALS ___ AND CLOTHING IS ___. 0.67; A NORMAL GOOD A 0.67; AN INFERIOR GOOD B Answer: A 1.5; A NORMAL GOOD C 1.5; A LUXURY GOOD D CHAPTER 5 SLIDE 46

PRACTICE QUESTION WHY DO OFFICE SUPPLY STORES OFFER DISCOUNTS ON INELASTIC GOODS SUCH AS PEN AND PAPER AT THE START OF EACH SCHOOL TERM? BARBARA HELGASON/DREAMSTIME.COM Answer: They are trying to attract customers into the store to buy higher-priced items such as computers and printers, goods that are complementary to school supplies. CHAPTER 5 SLIDE 47

THE TAX INCIDENCE OF ITEMS SUCH AS GASOLINE, TOBACCO, AND ALCOHOL TENDS TO FALL HEAVILY ON _____ BECAUSE THESE GOODS HAVE A _____. PRODUCERS; RELATIVELY ELASTIC DEMAND A PRODUCERS; RELATIVELY INELASTIC DEMAND B Answer: D CONSUMERS; RELATIVELY ELASTIC DEMAND C CONSUMERS; RELATIVELY INELASTIC DEMAND D CHAPTER 5 SLIDE 48

5 END OF CHAPTER SLIDES CREATED BY ERIC CHIANG CHAPTER 5 SLIDE 49 Tshooter/Shutterstock; Anton Balazh/Shutterstock CHAPTER 5 SLIDE 49