Mr. Barnett University High AP Economics 2012-2013 Elasticity

Elasticity We already know that if the price of a good rises, consumers will buy less But….how much less? Economists measure the change through elasticity Elasticity: a measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants Basically, a measure of how much buyers and sellers respond to change in market conditions

Price Elasticity Remember the Law of demand…. A fall in the price of a good will raise the quantity demanded Price Elasticity – measures how much the quantity demanded responds to a change in price Demand is: Elastic – if quantity demanded responds substantially to a change in price Inelastic – if quantity demanded responds only slightly to a change in price

Influences on Price Elasticity of Demand Availability of close substitutes Goods with close substitutes tend to have more elastic demand because it is easier for consumer to switch from that good to another Example Butter goes up $0.15 in price Price of margarine stays the same Result: large drop in quantity of butter sold

Influences on Price Elasticity of Demand Necessities versus luxuries Necessities have _________ demands Luxuries have ___________demands Example: When the price of a dentist visit increases, people will not drastically reduce the # of visits When the price of video games rise, the quantity demanded of video games falls substantially Note: Whether a good is a necessity or a luxury depends on personal preference

Influences on Price Elasticity of Demand Definition of the market Elasticity of demand in a market depends on its definition (how we qualify it) Narrowly defined markets tend to have more elastic demand than broadly defined markets Because easier to find substitutes if more narrowly defined Food -> inelastic Ice Cream -> elastic Vanilla Ice Cream -> very elastic

Influences on Price Elasticity of Demand Time Horizon Goods have more elastic demand in the long term Example When the price of gasoline increases, the quantity of gasoline only falls slightly in the short term Long term, people will set up carpools, buy more fuel efficient cars, electric cars, ride buses, move closer to work

Influences on Price Elasticity of Demand Inexpensive vs expensive Expensive items tend to have elastic demand curve Inexpensive items tend to have inelastic demand curve A screw doubles in price from $0.05 to $0.10 A civic doubles in price from $20,000 to $40,000

Total Revenue = Price x Quantity TR = P x Q Price (P) Quantity (Q) TR Price (P) Quantity (Q) TR Price INC, Total Revenue INC Price INC, Total Revenue DEC Price DEC, Total Revenue DEC Price DEC, Total Revenue INC

Elasticity Coefficient Test The Elasticity Coefficient equals the percentage change in quantity demanded divided by the percentage change in price Butter goes from $1.00 to $1.20 Causes 40% drop in amount bought 40 percent/20 percent = 2.0 Elasticity coefficient = 2 Note: Use absolute values so all elasticities are positive numbers A larger price elasticity implies a greater responsiveness of quantity demanded to change in price

Computing the elasticity coefficient of demand Make sure to use positive numbers Make sure to start with original numbers

Figure out the elasticity of demand of both graphs above using the TR test Figure out the elasticity of demand of both graphs above by figuring out the of elasticity coefficient Inelastic Elastic Elasticity Coefficient Test Ed < 1 Ed > 1

Influences on Price Elasticity of Demand So 5 tests of Elasticity Tests Inelastic Elastic Substitutes Few Substitutes Many Substitutes Necessity v Luxury Necessity Luxury Cost Inexpensive Expensive Total Revenue P Inc, TR Inc P Dec, TR Dec P Inc, TR Dec P Dec, TR Inc Elasticity Coefficient Test Ed < 1 Ed > 1

Classification of Elasticity When the price elasticity of demand is greater than one, demand is defined to be elastic Percentage change in quantity demanded will be greater than the percentage change in price When the price elasticity of demand is less than one, demand is defined to be inelastic Percentage change in price will be greater than the percentage change in quantity demanded When the price elasticity of demand is equal to one , the demand is said to have unit elasticity Percentage change in price will be equal to the percentage change in quantity demanded

Elasticity of Demand Curves Most demand curves that have a downward slope have an elastic, inelastic and unit elastic portion

Drawbacks to Coefficient Test There are some drawbacks to using the coefficient of price elasticity of demand test As we have seen, the PED can vary at different points along a demand curve, due to its percentage nature Also, percentage changes are not symmetric; rather, the percentage change between any two values depends on which one is chosen as the starting value and which one as the ending value What if a company just wants to compare the results of two different possible pricings, instead of “starting” at one price and moving to another? If quantity demanded increases from 10 to 15 units, the percentage change is 50%...... (15-10)/10 If quantity demanded decreases from 15 to 10 units, the percentage change is 33.3%....(10-15)/10

Midpoint Method Thus, we can use the midpoint method to avoid those problems. Also known as Arc Elasticity Involves calculating the percentage change in either P or Qd by dividing the change in the variable by the midpoint between the initial and final levels rather than by the initial value itself Formula: Note: Use averages for quantities and prices. Avoids having to deal with beg and ending values Example: Price of hamburgers rise from $4 to $6 Quantity demanded falls from 120 to 80 % change in quantity demanded = (120-80)/100 = 40% % change in price = (6-4)/5 x 100% = 40% Price elasticity of demand = 40/40 = 1

Figure 1 The Price Elasticity of Demand (a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand 100 $5 1. An increase in price . . . 4 Quantity 2. . . . leaves the quantity demanded unchanged. Copyright©2003 Southwestern/Thomson Learning

Figure 1 The Price Elasticity of Demand (b) Inelastic Demand: Elasticity Is Less Than 1 Price Demand $5 90 1. A 22% increase in price . . . 4 100 Quantity 2. . . . leads to an 11% decrease in quantity demanded.

Figure 1 The Price Elasticity of Demand (c) Unit Elastic Demand: Elasticity Equals 1 Price Demand $5 80 1. A 22% increase in price . . . 4 100 Quantity 2. . . . leads to a 22% decrease in quantity demanded. Copyright©2003 Southwestern/Thomson Learning

Figure 1 The Price Elasticity of Demand (d) Elastic Demand: Elasticity Is Greater Than 1 Price Demand $5 50 1. A 22% increase in price . . . 4 100 Quantity 2. . . . leads to a 67% decrease in quantity demanded.

Figure 1 The Price Elasticity of Demand (e) Perfectly Elastic Demand: Elasticity Equals Infinity Price 1. At any price above $4, quantity demanded is zero. $4 Demand 2. At exactly $4, consumers will buy any quantity. 3. At a price below $4, quantity demanded is infinite. Quantity

Total Revenue = Amount paid by buyers and received by sellers of a good = price of the good times the quantity sold

Review Even though slope is constant, elasticity is not Slope is the ratio of changes in the 2 variables Elasticity is the ratio of percentage changes in the two variables At points with a high price and low quantity, the demand curve is ____ At points with a low price and high quantity, the demand curve is ____

Elasticity When the price is $1, demand is inelastic An increase in price to $2 will increase total revenue When the price is $5, demand is elastic, A price increase to $6 will reduce total revenue At $3.50, demand is unit elastic, and consumers will buy any quantity

Figure 3 How Total Revenue Changes When Price Changes: Inelastic Demand An Increase in price from $1 to $3 … … leads to an Increase in total revenue from $100 to $240 Demand Demand $3 80 Revenue = $240 $1 100 Revenue = $100 Quantity Quantity

Figure 4 How Total Revenue Changes When Price Changes: Elastic Demand An Increase in price from $4 to $5 … … leads to an decrease in total revenue from $200 to $100 $5 20 Demand Demand Revenue = $100 $4 50 Revenue = $200 Quantity Quantity

Midpoint Method

Midpoint example Example: If the price of Hello Kitty pencil toppers increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 toppers, then your elasticity of demand, using the midpoint formula, would be calculated as…

Income Elasticity Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income

Income Elasticity Normal goods have ______income elasticities Inferior goods have ______income elasticities Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods Necessities tend to have _____income elasticities, whereas luxuries tend to have ______income elasticities

Important Side Note We use the absolute value when figuring out price elasticity of demand because the value is always negative (because when price changes in one direction, quantity demanded always changes in the other). But this isn't true for income. When income changes, people might want to buy more or less of the good.

Income Elasticity After irrevocably destroying symbols borrowed from the American West, PSY’s income rises from $100,000 to 1,000,000. The quantity of hamburger he buys each week rises from two pounds to four pounds. What is PSY’s income elasticity? What kind of good is hamburger for PSY?

Cross-Price Elasticity Cross-Price Elasticity of demand: A measure of how much the quantity demanded of one good responds to a change in the price of another good Cross-Price Elasticity = % change in quantity demanded of good 1 ___________________________________ % change in price of good 2 Substitutes have ______ cross price elasticities, whereas complements have ________cross-price elasticities

The sign matters for cross-price elasticity. When the price of one good changes, people might want to buy more of the other good, or less.

Cross Price Elasticities The price of Kris-Kross cassette tapes rise from $8 to $10. As a result, the quantity of Kris-Kross trading cards demanded falls from 8,000 per week to 9,500. What is the cross-price elasticity? What is the relationship between the two goods?

Elasticity of Supply Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good. Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price

Figure 6 The Price Elasticity of Supply (a) Perfectly Inelastic Supply: Elasticity Equals 0 Price Supply $5 1. An increase in price . . . 4 100 Quantity 2. . . . leaves the quantity supplied unchanged. Copyright©2003 Southwestern/Thomson Learning

Figure 6 The Price Elasticity of Supply (b) Inelastic Supply: Elasticity Is Less Than 1 Price Supply 110 $5 1. A 22% increase in price . . . 100 4 Quantity 2. . . . leads to a 10% increase in quantity supplied. Copyright©2003 Southwestern/Thomson Learning

Figure 6 The Price Elasticity of Supply (c) Unit Elastic Supply: Elasticity Equals 1 Price Supply 125 $5 1. A 22% increase in price . . . 100 4 Quantity 2. . . . leads to a 22% increase in quantity supplied. Copyright©2003 Southwestern/Thomson Learning

Figure 6 The Price Elasticity of Supply (d) Elastic Supply: Elasticity Is Greater Than 1 Price Supply $5 200 1. A 22% increase in price . . . 4 100 Quantity 2. . . . leads to a 67% increase in quantity supplied. Copyright©2003 Southwestern/Thomson Learning

Figure 6 The Price Elasticity of Supply (e) Perfectly Elastic Supply: Elasticity Equals Infinity Price 1. At any price above $4, quantity supplied is infinite. $4 Supply 2. At exactly $4, producers will supply any quantity. 3. At a price below $4, quantity supplied is zero. Quantity Copyright©2003 Southwestern/Thomson Learning

Determinants of Price Elasticity of Supply Flexibility of Sellers Goods that are somewhat fixed in supply have inelastic supplies Goods that are not (books, cars, tamagotchi pets) have elastic supplies

Determinants of Price Elasticity of Supply Time Period Supply is usually more inelastic in the short run Supply is usually more elastic in the long run

The price of chocolate milk increases from $2. 85 per gallon to $3 The price of chocolate milk increases from $2.85 per gallon to $3.15 per gallon and the quantity supplied rises from 9,000 to 11,000 gallons per month Price elasticity of supply is ?

APPLICATION of ELASTICITY Can good news for farming be bad news for farmers? What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties?

THE APPLICATION OF SUPPLY, DEMAND, AND ELASTICITY Examine whether the supply or demand curve shifts. Determine the direction of the shift of the curve. Use the supply-and-demand diagram to see how the market equilibrium changes.

Figure 8 An Increase in Supply in the Market for Wheat Price of Wheat 1. When demand is inelastic, an increase in supply . . . 2. . . . leads to a large fall in price . . . S1 S2 Demand $3 100 2 110 Quantity of 3. . . . and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220. Wheat Copyright©2003 Southwestern/Thomson Learning

Compute the Price Elasticity of Supply Supply is inelastic

Supply Supply _____, price _____, quantity demanded ______ If demand is ineastic, the fall in price is greater than the increase in quantity demanded and total revenue ______ Demand for basic foodstuffs is usually inelastic Less revenue for farmers Because farmers are price takers they still have incentive to adopt new hybrid so they can produce and sell more wheat Explains why number of farms has declined so much over the past 200 years Also explains why some gov policies encourage farmers to decrease the amuont of crops planted

In the 1970s and 1980s, OPEC reduced the amount of oil it was willing to supply to world markets. The decrease in supply led to an increase in the price of oil and a decrease in quantity demanded. The increase in price was much larger in the short run than the long run. Why?