Introduction to Elasticity How much of a difference does price make? (And why would we want to know?) Price of gasoline $1.00 $1.20 Quantity demanded 100 90 gallons What is the slope, and what does it show? So: (inverted) slope isn’t enough!)

Elasticities of Demand and Supply I. The basic idea of elasticity: ratio of proportionate changes. II. [Own] price elasticity of demand A. Review of basic concepts, math B. Uses 1. Where to set your price 2. Effects of price changes 3. Effects of economic policies

Elasticity is a ratio of proportionate changes! Prop. change in quantity = DQ/Q = -10/100 = -0.1 Prop. Change in price = DP/P = .20/1.00 = +0.2 Elasticity = (DQ/Q)/(DP/P) = -0.1/0.2 = -0.50 The simplified “starting point” formula is

The Midpoint Method of Calculating Elasticity Midpoint quantity = (100 + 90)/2 = 95 Midpoint price = (1.00 +1.20)2 = 1.1 Prop. quantity change = -10/95 = -1.05 Prop. price change = -0.2/1.1 = - 0.182 Revised elasticity = -0.105/0.182 = -0.58 The simplified “midpoint” or “arc” formula:

II. Price Elasticity of Demand C. Elasticity, expenditure, and revenue 1. Meaning of “elastic” vs. “inelastic” 2. Revenue = price x quantity = Expenditure 3. Workin’ on the railroad: NS’ diesel fuel 4. Linear demand curve example a. Changing values of elasticity and TR b. Slope is the same, but elasticity isn’t 5. Parallel shifts: the holiday turkey

Linear demand curve example [Note inverted slope is a constant (5/0 Price Quantity TR, TX Elasticity .60 5 3 .50 10 5 .40 15 6 .30 20 6 .20 25 5 .10 30 3

II. Price elasticity of demand D. What determines elasticity? 1. Number and closeness of substitutes a. Definition of the market b. Firm demand vs. market demand 2. Fraction of income spent on the good 3. Time for adjustment 4. “Necessities vs. luxuries” E. Back to the arithmetic

III. Other elasticities of demand A. Income elasticity of demand 1. Meaning 2. Sign and significance B. Cross elasticity of demand C. Back to the math

IV. Price elasticity of supply A. Def.: Proportionate change in Q-supplied Proportionate change in price B. Major determinants 1. General: flexibility in hiring and using inputs. 2. Including, especially “length of run,” i.e., time available for adjustment and change.

V. Elasticity and policies A. Business pricing policies 1. Changing your price 2. Price levels and margins

V. Elasticity and policies B. Government policies 1. Price ceilings and adjustments 2. Price floors and adjustments 3. Taxes and adjustments 4. Tax levels and elasticity differences