Lecture 4 Elasticity (continue…) Sources: http://www.arts.cornell.edu/econ/wissink/econ1110jpw/ http://www.investopedia.com/university/economics  http://ingrimayne.com/econ/ Case, Fair, Oster, Introduction to Microeconomics

Remember Demand Elasticity If price increases by 10% and consumers respond by decreasing purchases by 20% the elasticity is ? The result is (-/ +) ?? Why ??

Because the law of demand says it will always be negative…. So lets consider elasticity in absolute terms!!!

An elasticity coefficient of 2 shows that consumers respond a great deal to a change in price. If a 10% change in price causes only a 5% change in sales, the elasticity coefficient will be only 1/2. Economists would say in this case that demand is inelastic. Demand is inelastic whenever the elasticity coefficient is less than one. When it is greater than one, economists say that demand is elastic.

The demand curve is a negative slope, and if there is a large decrease in the quantity demanded with a small increase in price, the demand curve looks flatter, or more horizontal. This flatter curve means that the good or service in question is elastic.

  inelastic demand is represented with a much more upright curve (steeper) as quantity changes little with a large movement in price.

Supply Elasticity Extremely similar formulas are used to calculate the own price elasticity of supply: Point formula Just need to substitute in: Change in quantity supplied So…(dQS/dP) would refer to the supply function So…(1/slope) where slope refers to the slope of the graph of supply!

Supply Elasticity Definition: Point formula:

Example: Point Calculation of Own Price Elasticity of Supply Suppose you are given: QS = -10 + 4P Note, that’s the same as: PS = 2.50 +.25Q Suppose you want the exact own price elasticity of supply at P = $12 At P = $12, QS = -10 + 48 = 38 Note: (dQS/dP) = 4 (Slope of drawn supply curve = .25, so.... 1/slope = 4) So supply elasticity at P=$12 is... (4)•(12/38) = 48/38 = 1.26

Some Technical Definitions For Extreme Elasticity Values Perfectly elastic means the quantity demanded or supplied is as price sensitive as possible. a.k.a. completely elastic a.k.a. infinitely elastic Perfectly inelastic means that the quantity demanded or supplied has no price sensitivity at all. a.k.a. completely inelastic

Perfectly Elastic Demand Demand is perfectly elastic when a 1% change in the price would result in an infinite change in quantity demanded. Example: Price Quantity Perfectly Elastic Demand (elasticity = -¥) Your discussion from your lecture 6

Perfectly Inelastic Demand Price Quantity Perfectly Inelastic Demand (elasticity = 0) Demand is perfectly inelastic when a 1% change in the price would result in no change in quantity demanded. Example: ditto.

Perfectly Inelastic Supply Supply is perfectly inelastic when a 1% change in the price would result in no change in quantity supplied. Example: DaVinci painting Price Quantity Perfectly Inelastic Supply (elasticity = 0) ditto.

Perfectly Elastic Supply Supply is perfectly elastic when a 1% change in the price would result in an infinite change in quantity supplied. The key for perfectly elastic supply is that the good has a large number of very close substitutes-in-production readily available. Example: Sandwich with feta cheese (Very close Substitute: sandwich kasseri cheese) Price Quantity Perfectly Elastic Supply (elasticity = ¥) Your discussion from your lecture 6

Determinants of Elasticity Time plays an important role Time plays an important role in determining both consumer and producer responsiveness for many items. The longer people have to make adjustments, the more adjustments they will make. Example supply elasticity of apple? Short run? Long run?

Time plays an important role In the very short run, there may be no adjustments sellers can make, which would mean a perfectly vertical supply curve. For example, if on November 1 the price of apples doubles, there will be minimal effect on the number of apples available to the consumer. Producers cannot make adjustments until a new planting season begins. In the long run, (old) producers increase their production and also new producers may start to production.

Time plays an important role!!! When the price of gasoline rose rapidly in the late 1970s as a result of the OPEC cartel, the only adjustment consumers could initially make was to drive less. With time, they could also move closer to work or find jobs closer to home, and switch to more fuel-efficient cars.

Determinants of Elasticity What is a major determinant of the own price elasticity of demand? Availability of substitutes in consumption. What is a major determinant of the own price elasticity of supply? Availability of alternatives in production. (feta cheese sandwich vs kasseri )

Real World Example – Getting it Wrong Gas taxes in Washington DC, 1980 extra 6% tax imposed Aug 16, 1980 to raise government revenue As tax increased also the price increased (at pump) by 8¢ (a nearly 6% increase) By end of first month, QD down by 27.5%  elasticity = 27.5÷6 = 4.5  very elastic! Way off on expected revenue, too. By October, sales had dropped by 40% and 242 gas station workers were laid off. Tax lifted by Mayor Marion Barry on November 24, 1980 What went wrong? What didn’t they account for?

Answer could be a substitute of gas!!! LPG Consider Turkey, a country sells a pump of gasoline at highest price!!! What is the new trend? Buying a car with that consumes normal gasoline Buying a car with diesel motor Buying a car with LPG motor

Using The Own Price Elasticity of Demand Question: What happens to total expenditures (TE) on a product when its price increases? Note: TE = P•Q P↑ tends to increase TE, but it also decreases Q Q↓ tends to decreases TE So what happens to TE? Knowing own price elasticity will help! If demand is price ELASTIC, then TE ↓ If demand is price INELASTIC, then TE ↑ Set-up slide

Real World Example – Getting it Wrong Gas taxes in Washington DC, 1980 extra 6% tax imposed Aug 16, 1980 to raise government revenue As tax increased also the price increased (at pump) by 8¢ (a nearly 6% increase) By end of first month, QD down by 27.5%  elasticity = 27.5÷6 = 4.5  very elastic! Way off on expected revenue, too. By October, sales had dropped by 40% and 242 gas station workers were laid off. Tax lifted by Mayor Marion Barry on November 24, 1980 What went wrong? What didn’t they account for?

If a bus company decides it needs more revenue and tries to get it by raising fares, its revenues may decrease rather than increase. For the bus company, the key is that how much demand is elastic. For example, suppose that the demand elasticity is 1.5. Then, if price is raised by 10%, quantity (ridership) must drop by 15%. But the drop in ridership more than offsets the increase in price, …and so revenue will drop.

Bridge Toll Example Suppose: Current toll for the Bogaziçi Bridge is $6.00/trip. Suppose: The quantity demanded at $6.00/trip is 100,000 trips/hour. So: TE per hour = $600,000 If the own price elasticity of demand for bridge trips is known to be -2.0, what is the effect of a 10% toll increase? Note: since demand is price ELASTIC  TE↓ If η=-2, a toll increase of 10% implies a 20% decline in the quantity demanded. Say that price increase 10%, so what is new price and quantity demanded? Trips fall to 80,000/hour. Total expenditure falls to $528,000/hour (= 80,000 x $6.60). $528,000 < $600,000 Your example.

Cross-Price Elasticity of Demand Elasticity of demand with respect to the price of a complementary good (cross-price elasticity) This elasticity is negative because as the price of a complementary good rises, the quantity demanded of the good itself falls. Example: software is complementary with computers. When the price of software rises the quantity demanded of computers falls. Example: sugar and tea If you don’t like my example, which they have seen before, use your own.

Cross-Price Elasticity of Demand Elasticity of demand with respect to the price of a substitute good (also a cross-price elasticity) This elasticity is positive because as the price of a substitute good rises, the quantity demanded of the good itself rises. Example: tea is substitute for coffee. When the price of a cup of tea rises the quantity demanded of cups of coffee rises.

Cross-Price Elasticity of Demand Definition: Point Formula: If you don’t like my example, which they have seen before, use your own.

Income Elasticity of Demand The elasticity of demand with respect to a consumer’s income is called the income elasticity. When the income elasticity of demand is positive (normal good), consumers increase their purchases of the good as their incomes rise (e.g. automobiles, food). When the income elasticity of demand is greater than 1 (luxury good), consumers increase their purchases of the good more than proportionate to the income increase (e.g. ski vacations, haute cuisine). When the income elasticity of demand is positive but less than 1 (a necessity), consumers increase their purchases of the good less than proportionate to the income increase (e.g. socks, bread).

Income Elasticity of Demand When the income elasticity of demand is negative (inferior good), consumers reduce their purchases of the good as their incomes rise (e.g. spam, potatoes, bread).

Income Elasticity of Demand Definition: Point Formula: If you don’t like my example, which they have seen before, use your own.

The Four Elasticities You Need to Know Own Price Elasticity of Demand Cross Price Elasticity of Demand Income Elasticity of Demand Own Price Elasticity of Supply

Perfectly Elastic if η = ∞ Relatively Elastic if 1 < η < ∞ Unit Elastic if η = 1 Relatively Inelastic if 0 < η < 1 Perfectly Inelastic if η = 0