Elasticity and Its Uses Chapter Four Elasticity and Its Uses

Why the Size of the Elasticity of Demand is Important Price Elasticity of Demand is a measure of the sensitivity of the quantity demanded of a good to the price of the good. Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 4.1: Comparing Different Sizes of the Price Elasticity of Demand Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Why the Size of Elasticity of Demand is Important – continued. In the first graph, the demand curve is relatively flat, the quantity demanded of oil is VERY sensitive to the price (HIGH ELASTICITY). When the price rises by $2, from $20 to $22 ($2/$20 = .10 or 10%), the quantity demanded falls by 12 million from 60 million to 48 million (12/60 = .20 or 20%). Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 4.1: Comparing Different Sizes of the Price Elasticity of Demand (cont’d) Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Why the Size of Elasticity of Demand is Important – Continued. In the second graph, the quantity demanded is not very sensitive to the price. The demand curve has a low elasticity and is relatively steep. When the price rises by $2 or 10% (again, from $20 to $22), the quantity demanded falls by 3 million barrels from 60 to 57 million (3/60 = .05 or 5%). When supply of oil shifted (i.e. from lower production in Iraq), we need to know elasticity of demand to be able to predict effect on price and quantity demanded. In previous example, had same shift but two dramatically different results. (Graphs on following two slides) Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 4.2: The Importance of the Sizes of the Price Elasticity of Demand Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 4.2: The Importance of the Sizes of the Price Elasticity of Demand (cont’d) Copyright © by Houghton Mifflin Company, Inc. All rights reserved

The Advantage of a Unit-Free Measure Elasticity is a unit-free measure because it uses percentage changes in price and quantity demanded. Provides a way to compare the price sensitivity of the demand for many different goods. Allows us to compare the price sensitivity of less expensive goods with that of more expensive goods. Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Elasticity versus Slope The elasticity of the demand curve is not the same as the slope of the demand curve. Slope is rise/run or ΔP/ΔQ and is not a unit-free measure. Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 4.3: Different Slopes and Same Elasticities Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 4.3: Different Slopes and Same Elasticities (cont’d) Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Elasticities Elastic demand is greater than 1 (quantity demanded decreases by more than 1 percent when price rises 1 percent). Inelastic demand is less than 1 (quantity demanded decreases by less than 1 percent when price rises 1 percent). A vertical demand curve is perfectly inelastic. No matter what the price, the same quantity will be demanded. A horizontal demand curve is perfectly elastic. Infinitely large movements of quantity demanded for small increases in price. Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 4.4: Perfectly Elastic and Perfectly Inelastic Demand Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Calculating the Elasticity with a Midpoint Formula The price elasticity of demand = ΔQ/Average Quantity ÷ ΔP/Average Price Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Revenue and the Price Elasticity of Demand If price increases, that increases payment per unit but also reduces the number of units. When price increases, people pay more for each item and this increases revenue; but they buy fewer items, and this decrease in the quantity demanded reduces revenue. Elasticity helps us decide which effect will dominate. Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 4.5: Revenue and Elasticity of a Straight-Line Demand Curve Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 4.5: Revenue and Elasticity of a Straight-Line Demand Curve (cont’d) Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 4.6: Effects of an increase in the Price of Oil on Revenue Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 4.6: Effects of an increase in the Price of Oil on Revenue (cont’d) Copyright © by Houghton Mifflin Company, Inc. All rights reserved

What Determines the Size of the Price Elasticity of Demand The Degree of Substitutability: If people can easily find a substitute, elasticity will be high. Luxury vs. Necessity Big-Ticket versus Little-Ticket Items: If a good represents a large fraction of people’s income, then the price elasticity will be high. Temporary versus Permanent Price Changes: If a change in price is known to be temporary, the price elasticity of demand will tend to be high. Copyright © by Houghton Mifflin Company, Inc. All rights reserved

What Determines the Size of the Price Elasticity of Demand - continued Difference in Preferences: Various groups of consumers may have different levels of elasticity. Example: 18 year-old smokers vs. 50 year-old smokers Long-Run versus Short-Run Elasticity: Short Run: Period of time before people have made all their adjustments or changed their habits Long Run: Period of time long enough for people to make such adjustments or change their habits. Price elasticity is low immediately after a price change but then increases after a period of time has passed. Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Income Elasticity of Demand Income Elasticity of Demand = Percentage change in quantity demanded ÷ percentage change in income Example: If incomes rise by 10 percent and as a result people purchase 15 percent more health care at a given price, the income elasticity of health care is 1.5. Normal good (incomes fall, demand falls) vs. Inferior good (incomes fall, demand rises): The income elasticity of demand for an inferior good is negative and is reported as a negative number. Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Working with Supply Elasticities Elasticity of supply = ΔQuantity supplied/Quantity supplied ÷ ΔPrice/Price Also a unit-free measure Also, elasticity of supply is NOT the same as slope of the supply line Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Perfectly Elastic and Perfectly Inelastic Supply Vertical Supply curve is perfectly inelastic Example: Mona Lisa Horizontal Supply curve is perfectly elastic Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 4.7: Perfectly Elastic and Perfectly Inelastic Supply Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 4.8: Comparing Different Sizes of the Price Elasticity of Supply Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 4.8: Comparing Different Sizes of the Price Elasticity of Supply (cont’d) Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 4.9: Importance of Knowing the Size of the Price Elasticity of Supply Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 4.9: Importance of Knowing the Size of the Price Elasticity of Supply (cont’d) Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Activities 17 18 19 20 21 23 Multiple Choice Questions, Short Free-Response Questions, Long Free-Response Questions Copyright © by Houghton Mifflin Company, Inc. All rights reserved