CHAPTER 5. Elasticity

Chapter 5 Objectives/Key Topics Upon completion of this chapter, you should understand and be able to answer these questions: How is the responsiveness of consumers to changes in various demand factors measured? Elasticities – a. What are they? b. How are they calculated? c. What factors influence their values? d. How can they be used?

Question Suppose your cumulative GPA increases from 3.00 to 3.30 after this semester. What was the ‘percentage increase’ in your cumulative GPA?

Answer

Question What is likely to happen to the quantity demanded of gasoline if it were to increase in price by 20%?

Elasticity of D Definition (Meaning) = A measure of responsiveness of D to changes in a factor that influences D Two components Magnitude of change (number) Direction of change (sign) = The number shows the magnitude of how much D will change due to a 1% change in a D factor The sign shows whether the D factor and D are changing in the same or opposite directions +  same direction -  opposite direction

Elasticities of Demand  EQ,F = %ΔQdx/%ΔF = %ΔQ/%ΔF Where, Qdx = the quantity demanded of X F = a factor that affects Qdx Notes: sign > 0  Qdx & F, ‘directly’ related sign < 0  Qdx & F, ‘indirectly’ related number > 1  %ΔQd, >%ΔF

Measures of Responsiveness of D to P Changes Slope = unit ΔP/unit ΔQd → can be used to show unit Δ Qd caused by 1 unit ΔP → a problem with slope is that it depends on the ‘units’ of measurement Elasticity = % Δ Qd/% ΔP → shows % Δ Qd for each 1% ΔP → does NOT depend on ‘units’ of measurement

Alternative elasticity calculation ‘formulas’: 1. Point => calculate % changes as % of original values 2. Midpoint => Calculate % changes as % of average of original values and new values, = (original value + new value) / 2

Elasticity Calculation (point method)

Types of Elasticities Type F E0 = own P PX EC cross P PY EI Income I EA advertising A

Elasticity Value Meanings (e.g.) E0 = -2  for each 1% Px,Qd for X will  by 2% in opposite direction EC = +1/2  for each 1% PY,Qd for X will  by 1/2% in same direction EI = +.1  for each 1% I,Qd for X will  by .1% in same direction

Own Price Elasticity of Demand Negative according to the ‘law of demand’

Perfectly Elastic & Inelastic Demand

E0 Calculation (point formula)

E0 Calculation (example)

E0 and Linear D Curve P a E0>1 E0=1 1/2a E0<1 Q

Factors Affecting Own Price Elasticity Available Substitutes The more substitutes available for the good, the more elastic the demand. Time Demand tends to be more inelastic in the short term than in the long term. Time allows consumers to seek out available substitutes. Expenditure Share Goods that comprise a small share of consumer’s budgets tend to be more inelastic than goods for which consumers spend a large portion of their incomes.

Uses of E0 Calculate % change in P needed to bring about desired % change in Q sold Calculate % change in Q sold that will result from a given % change in P Predict how TR will Δ due to given % ΔP

Elasticity Equation => Note: this is an equation with 3 variables => given values for 2 variables, can solve for value of 3rd variable Example: %ΔQ = E0(%ΔP) Example: %ΔP = (%ΔQ)/E0

Use of E0 (Example) According to an FTC Report, AT&T’s own price elasticity of demand for long distance services is –8.64. If AT&T lowered price by 3 percent, what would happen to the volume of long distance telephone calls routed through AT&T?

Answer Calls would increase by 25.92 percent!

Question If a firm wants to increase its dollar sales of a product, should it P or P?

Quote of the Day “Students of Economics need to be taught, in business, sometimes you should raise your price, and sometimes you should lower your price.” - CEO of Casey’s

E0 and TR TR = P∙Q = total revenue (total $ sales) If E0 elastic (# > 1)  little P  BIG Q  TR  little P  BIG Q  TR* (P) If E0 inelastic (# < 1)  BIG P  little Q  TR* ( P)  BIG P  little Q  TR

Max TR Maximum R will be generated at midpoint of linear, down-sloping D curve P 5.00 Max TR 2.50 P=5-.5Q Q 5 10

E0 and TR (Example) Recall E0 = -.25 at P=1 and Q=8 for P=5 - .5Q Given E0 is inelastic  firm should be able to TR by P. P Qd TR ($) 1 8 8.00 2 6 12.00 2.50 5 12.50* (= max TR)

Cross Price Elasticity of Demand + Substitutes - Complements

Income Elasticity + Normal Good - Inferior Good

Elasticity of Supply

Elasticity Summary Elasticities can be used to estimate: