Chapter 4: Elasticity Copyright © 2014 Pearson Canada Inc.

Chapter Outline/Learning Objectives Section Learning Objectives After studying this chapter, you will be able to 4.1 Price Elasticity of Demand explain what price elasticity of demand is and how it is measured. explain the relationship between total expenditure and price elasticity of demand. 4.2 Price Elasticity of Supply explain what price elasticity of supply is and how it is measured. 4.3 An Important Example Where Elasticity Matters see how elasticity of demand and supply determine the effects of an excise tax. 4.4 Other Demand Elasticities measure the income elasticity of demand and be able to distinguish between normal and inferior goods. measure cross elasticity of demand and be able to distinguish between substitute and complement goods. Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

4.1 Price Elasticity of Demand Demand is said to be elastic when quantity demanded is very responsive to a change in the products own price. Demand is inelastic if quantity demanded is very unresponsive to changes in its price. Elasticity is related to the slope of the demand curve, but it is not exactly the same. Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

Fig. 4-1(i) Elastic Demand Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

Fig. 4-1(ii) Inelastic Demand Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

The Measurement of Price Elasticity Elasticity (Greek letter eta:) is defined as: Demand elasticity is negative, but economists usually emphasize the absolute value. Elasticity usually measures the change in p and Q relative to some "base" values of p and Q.  =  QD / QD  p / p percentage change in quantity demanded percentage change in price Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

Demand elasticity between point "0" and point "1" on some demand curve is: where p and Q are the average price and average quantity, respectively. Thus p = (p1+p0)/2 and Q = (Q1+Q0)/2. After a little simplifying, we get:  = (Q1 - Q0)/Q (p1 - p0)/p  = (Q1 - Q0)/(Q1 + Q0) (p1 - p0)/(p1 + p0) Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

A Numerical Example of Price Elasticity Product Original Price New Price Average Price Original Quantity New Quantity Average Quantity Corona Beer (6-pack) $9.00 $8.00 $8.50 2000 3000 2500  = (3000 - 2000)/(3000 + 2000)/2 (8 - 9)/(8 + 9)/2 (1000)/(2500)  = (1)/(8.5) 0.4  = = 3.40 0.1176 Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

Price Elasticity of Demand LO1 Elasticity Coefficient a number that measures the responsiveness of quantity demanded to a change in price If coefficient is: Demand is: Greater than 1 Elastic Less than 1 Inelastic Equal to 1 Unitary © 2012 McGraw-Hill Ryerson Limited

Price Elasticity of Demand LO1 Inelastic Demand quantity demanded that is not very responsive to a change in price Elastic Demand quantity demanded that is quite responsive to a change in price © 2012 McGraw-Hill Ryerson Limited

Fig. 4-2 Elasticity Along a Linear Demand Curve  > 1 Inelastic  < 1 Perfectly Inelastic  = 0 Unit Elastic  = 1  =  Perfectly Elastic Elasticity falls as you move down a linear demand curve. Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

What Determines Elasticity of Demand? Demand elasticity tends to be high when there are many close substitutes. The availability of substitutes is determined by: the length of the time interval considered whether the good is a necessity or a luxury how specifically the product is defined Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

Self-Test a) Calculate the elasticity coefficients for each set. LO1 a) Calculate the elasticity coefficients for each set. b) In each set the change in price is $1 and the change in quantity is 1 unit. Why aren’t the coefficients the same? Price Quantity Set I $9 1 8 2 Set II 9 © 2012 McGraw-Hill Ryerson Limited

Fig. 4-3 Three Demand Curves with Constant Elasticity D1 is perfectly inelastic D2 is perfectly elastic at p0 D3 is unit elastic Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

Fig. 4-4 Short-Run and Long-Run Equilibrium Following an Increase in Supply The changes depend on the time that consumers have to respond. In the long run, demand is more elastic. Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

Fig. 4-5 Total Expenditure and Quantity Demanded When demand is elastic, TE increases when price falls. When demand is inelastic, TE decreases when price falls. TE reaches a maximum when demand is unit elastic. Example: What happens when OPEC's output restrictions raise the world price of oil? Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

Elasticity and Total Revenue LO1 If demand is elastic, an increase in price will decrease revenue If demand is inelastic, an increase in price will increase revenue Vancouver to Edmonton Vancouver to Calgary Price Quantity Total Revenue: C Total Revenue: D $650 1000 $650 000 750 900 675 000 562 500 inelastic elastic © 2012 McGraw-Hill Ryerson Limited

4.2 Price Elasticity of Supply Price elasticity of supply measures the responsiveness of the quantity supplied to a change in the product's own price. It is denoted by s and is defined as: S = percentage change in quantity supplied percentage change in price  QS / QS  p / p Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

Determinants of Supply Elasticity The elasticity of supply depends on how easily firms can increase output in response to an increase in the product’s price. This depends on: the technical ease of substitution in production the nature of production costs the time span under consideration Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

Fig. 4-6 Computing Price Elasticity of Supply Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

4.3 An Important Example Where Elasticity Matters Fig. 4-8 The Effect of a Cigarette Excise Tax An excise tax raises the price paid by consumers but reduces the price received by producers. Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

Fig. 4-9 Elasticity and the Incidence of an Excise Tax The burden of an excise tax is independent of who actually remits the tax to the government—it depends only on the relative elasticities of demand and supply. Fig. 4-9 Elasticity and the Incidence of an Excise Tax Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

4.4 Other Demand Elasticities Income Elasticity of Demand percentage change in quantity demanded Y = percentage change in income If Y > 0, the good is said to be normal If Y < 0, the good is said to be inferior Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

Luxuries Versus Necessities The more necessary an item is in the consumption pattern of consumers, the lower its income elasticity. Income elasticities for any one product also vary with the level of a consumer’s income. The distinction between luxuries and necessities also helps to explain differences in income elasticities between countries. Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

Income Elasticity If coefficient is: Type of Good: Demand is: LO5 If coefficient is: Type of Good: Demand is: Greater than 1 Normal – Luxury good Income elastic Less than 1 but greater than 0 Normal – Necessity Income inelastic Less than 0 Inferior good Negative income elasticity © 2012 McGraw-Hill Ryerson Limited

Self-Test LO5 You are given the following data. Assume that the prices of X and Y do not change:   a) Calculate the income elasticity for products X and Y. b) Are products X and Y normal goods? Income Quantity Demanded of X Quantity Demanded of Y $10 000 200 50 15 000 350 54 © 2012 McGraw-Hill Ryerson Limited

Cross Elasticity of Demand percentage change in quantity demanded of good X XY = percentage change in price of good Y If XY > 0, then X and Y are substitutes If XY < 0, then X and Y are complements EXTENSIONS IN THEORY 4-2 The Terminology of Elasticity Copyright © 2014 Pearson Canada Inc. Chapter 4, Slide

Quantity Demanded per Week (lb.) Cross Elasticity LO5 Margarine Butter Price Quantity Demanded per Week (lb.) $1.50 5000 $3.00 1000 2.10 3200 3.00 2000 © 2012 McGraw-Hill Ryerson Limited

Cross Elasticity If coefficient is: Goods are: Positive Substitutes LO5 If coefficient is: Goods are: Positive Substitutes Negative Complements © 2012 McGraw-Hill Ryerson Limited

(thousands of person-visits per year) Review – Chapter 4 Refer to Table. Between the prices of $8 and $10, the elasticity of demand is A) 2. B) 1. C) 2/3. D) 3. E) 1/3. Price (per visit per person) Quantity Demanded (thousands of person-visits per year) $10 2 $ 8 4 $ 6 6 $ 4 8 $ 2 10 © McGraw Hill Publishing Co, 2011

Tax Incidence Consumers will bear a larger burden of an excise tax if A) demand is relatively elastic and supply is relatively inelastic. B) the tax is collected by firms rather than remitted directly to the government by consumers. C) both demand and supply are relatively inelastic. D) both demand and supply are relatively elastic. E) demand is relatively inelastic and supply is relatively elastic. © 2014 Pearson Education Canada Inc.

Elasticity and Slope Which of the following statements is correct?  A. Demand curve D3 is the most inelastic demand. B. Equilibrium price must be $50. C. If price is $30 and demand is D3 then the quantity demanded is 720 units per day. D. Demand curve D1 is more inelastic than D3. E. Demand curve D1 is perfectly elastic. © McGraw Hill Publishing Co, 2011