Elasticity of Demand AP Econ 9/15

Warm Up You’re driving a used car that has worn paint (possibly a little bit of rust), has a few dings from your “learning experiences”. And has a very slow oil leak. Your sneakers are worn down and one of them has a tear at the toe. If the average price of sneakers and automobiles each increased by 20%, which of the two would you be least likely to replace? Why? Your family loves to eat chicken. And what is the best way to finish it off then with some tasty ice cream. If all chicken products and ice cream were to increase in price to 25%, which of the two is your family most likely to do without? Why?

Price Elasticity of Demand Responsiveness of consumers to a change in price How much will demand rise (fall) if the price falls (increases) if price changes, how drastic will the change be to quantity demanded? Ed = Elasticity of demand

Calculating Price Elasticity of Demand ***Since demand is downward sloping, Ed will always be negative ***Negative sign is ignored

Example Problem 1. As the price of cheese increases by 30%, the quantity demanded decreases by 15%. Ed= 15/30= 0.5 2. Price of a good increases from $20 to $21 and quantity falls from 10 to 8. % change in quantity demanded= 2/10 = 0.2 x 100= 20% % change in price= $1/$20= .05 x 100= 5% Ed= 20/5= 4

Midpoint Method Sometimes issues occur with the previous method (regional differences in currency or values) so we use the midpoint method. ***Since demand is downward sloping, Ed will always be negative ***Negative sign is ignored ***MOST OF THE HOMEWORK/PRACTICE PROBLEMS WILL USE THE MIDPOINT METHOD!!

Midpoint Method Example

Interpreting Price Elasticity of Demand Demand is elastic if the price elasticity of demand is greater than 1. Demand is inelastic if the price elasticity of demand is less than 1. Demand is unit-elastic if the price elasticity of demand is exactly 1.

Elastic Demand (c) Elastic Demand: Price Elasticity of Demand = 2 Price of broccoli (per pound) B $1.10 A A 20% increase in the price . . . 0.90 D 3 800 1,200 Quantity of broccoli (in lbs) … generates a 40% decrease in the quantity of broccoli demanded.

Inelastic Demand (b) Inelastic Demand: Price Elasticity of Demand = 0.5 Price of salt B A 20% increase in the price . . . $1.10 A 0.90 D 2 950 1,050 Quantity of salt (in lbs) . . . generates a 10% decrease in the quantity of salt demanded.

Unit Elasticity of Demand (a) Unit-Elastic Demand: Price Elasticity of Demand = 1 Price of coffee (per cup) B $1.10 A 20% increase in the price . . . A 0.90 D 1 900 1,100 Quantity of cups of coffee (in cups) . . . generates a 20% decrease in the quantity of cups of coffee demanded.

Two Extreme Cases: Perfectly Inelastic Perfectly Inelastic Demand: Price Elasticity of Demand = 0 Price of shoelaces (per pair) Perfectly inelastic: any change in price has no effect on quantity demanded D 1 $3 An increase in price… $2 … leaves the quantity demanded unchanged. 1 Quantity of shoelaces (billions of pairs per year)

Two Extreme Cases: Perfectly Elastic (b) Price Elastic Demand: Price Elasticity of Demand = ∞ Perfectly elastic: price increase causes quantity demanded to drop to zero Price of pink tennis balls (per dozen) At exactly $5, consumers will buy any quantity At any price above $5, quantity demanded is zero $5 D 2 At any price below $5, quantity demanded is infinite Quantity of tennis balls (dozens per year)

Determinants of Price Elasticity of Demand Price Elasticity of Demand is determined by: Substitutability Proportion of Income The higher the price of the good relative to income, the higher the elasticity Luxuries vs. Necessities Time the longer the time consideration the greater the demand

Applications of Price Elasticity of Demand Large crop yields: Demand for most farm products is highly inelastic As yield rises, price and total revenue fall Excise Taxes: Government won’t impose or raise excise taxes on goods that have highly elastic demand Decriminalization of Illegal Drugs: Proponents believe it can be taxed because demand is inelastic reduce profit motive to reduce crime, illegal sales Opponents believe that a portion of demand is elastic