Elasticity and its implications Lecture 2 – academic year 2014/15 Introduction to Economics Fabio Landini

Where we are… Lect. 1: Demand and supply Lect. 1: Market equilibrium Lect. 1: Market adjustment processes Lect. 2: Elasticity 2

What do we do today? The concept of elasticity The elasticity of demand with respect to prices Elasticity and total revenue Elasticity of demand with respect to income Elasticity of supply with respect to prices Examples 3

Elasticity It measures the sensibility of buyers and sellers to variations in the market conditions. It allows one to study demand and supply with greater precision. 4

Three types of elasticity Elasticity of demand with respect to prices Elasticity of demand with respect to income Elasticity of supply with respect to prices 5

Elasticity of demand with respect to prices The elasticity of demand with respect to prices E D (p) measures how the quantity demanded respond to variations in market prices. 6

Elastic and inelastic demand Inelastic demand The quantity demanded does not significantly react to variations in market prices Elastic demand The quantity demanded significantly react to variations in market prices Limit cases: perfectly inelastic, elastic and unitary. 7

Perfectly inelastic demand Demand Quantity …leaves the quantity demanded unaltered. Price 1. An increase in price...

Perfectly elastic demand 9 4 Quantity0 Demand 2. When the price is equal to 4 euro consumers are available to buy any quantity Price 1. For any price greater than 4 euro the quantity demanded in null 3. For any price smaller than 4 euro the quantity demanded in infinite

Demand with unitary elasticity Demand Quantity A 25% increase in price... Price 2. …causes a 25% reduction in the quantity demanded

Elastic demand Demand Quantity1000 Price …causes a 50% decrease in the quantity demanded 1. A 25% increase in price...

Inelastic demand Demand Quantity1000 Price …causes a 10% decrease in the quantity demanded 1. A 25% increase in price...

When is E D (p) high? Demand tends to be elastic.... for luxury goods.. in the long period.. in general, for goods that have close substitutes. 13

When is E D (p) low? Demand tends to be inelastic... … for primary goods … in the short period … in general, for goods that have no substitutes 14

Low elasticity : Oil 15

How to compute E D (p) E D (p) is computed as the ratio between the percentage variation in the quantity demanded and the percentage variation in price. E D (p) = – [Δ q / q 0 ] / [Δ p / p 0 ] = = – [(q 1 – q 0 ) / q 0 ] / [(p 1 – p 0 ) / p 0 ] Notice: E D (p) is a positive number. 16

How to compute E D (p) Demand Quantity1000 Price 50

How to compute E D (p) Demand Quantity1000 Price 50 Demand is elastic with respect to price

Elasticity and total revenue Total revenue is the total expenses of consumers and the total proceeds for producers It is computed as the product of price and quantity sold TR = p X q Total revenue varies along the demand curve depending on the degree of elasticity. 19

Elasticity and total revenue 20 4 Demand Quantity P 0 Price P · Q = 400 (Total revenue) 100 Q

Elasticity and total revenue If the demand is elastic, an in price (more than proportional decrease) in the quantity demanded: total revenue If the demand is inelastic, an in price (less than proportional decrease) in the quantity demanded: total revenue 21

Elasticity and total revenue Example: Inelastic demand 22 3 Quantity0 Price 80 Revenue = 240 Demand 1 Quantity0 Revenue = Price 1 100

Elasticity of demand with respect to income The elasticity of demand with respect to income E D (Y) measures how the quantity demanded respond to changes in income It is computed as the ratio between the percentage variation in the quantity demanded and the percentage variation in income 23

How to compute E D (Y) 24

When is E D (Y) low? When the good is necessary, such as clothes, food, fuel, drugs, but also cigarettes for a heavy smoker 25

When is E D (R) high? When the good is luxury, such as sport cars, caviar, fur coat, etc. 26

Cross elasticity of demand The cross elasticity of demand with respect to price E(p) measures the responsiveness of the demand for a good to a change in the price of another good. 27

28 We can consider two goods, such as sugar (S) and coffee (C) : Cross elasticity of demand

29 Complementary goods (coffee and sugar): cross elasticity with negative sign: as the price of coffee rises, the demand for sugar falls. Substitute goods (tea and coffee): cross elasticity with positive sign: as the price of tea rises, the demand for coffee rises. Cross elasticity of demand

Elasticity of supply with respect to price Elasticity of supply with respect to price E S (p) is measured as the ratio between the percentage change in the quantity supplied and the percentage change in price. 30

Values of E S (p) Perfectly elastic E S (p) =∞ Elastic E S (p) >1 Unitary elasticity E S (p) =1 Inelastic E S (p) <1 Perfectly inelastic E S (p) =0 31

Perfectly inelastic supply Supply Quantity …leaves the quantity supplied unaltered. Price 1. An increase in price…

Perfectly elastic supply 33 4 Quantity0 Offerta 2. At the price of 4 euro sellers are willing to sell any quantity. 1.For any price greater than 4 euro the quantity supplied is infinite 3. For any price greater than 4 euro the quantity supplied is null Price

When is E S (p) high? When producers enjoy some flexibility in the use of resources: – Residential zonings close to the sea have low elasticity of supply; – Books, cars, TVs, have high elasticity of supply. In the long-run. 34

Elasticity of demand: An application Ascertain whether the demand curve or the supply curve shifts. In which direction? Draw the S-D graph to see how the market equilibrium and total revenue change. 35

Elasticity of demand: An application Can good news for agriculture be bad news for farmers? What does it happen to a wheat farmer and to the wheat market if some university researchers discover a new variety of wheat that is more productive than the varieties presently available? 36

An increase of supply in the market for wheat Check whether the event affects both supply and demand. Ascertain the directions of the shifts Draw the supply-demand graph to identify the new market equilibrium 37

38 3 Quantity of wheat1000 Price of wheat Demand S1S1 An increase of supply in the market for wheat

39 3 Quantity of wheat1000 Price of wheat Demand S1S1 An increase of supply in the market for wheat 1. If the demand is inelastic an increase of supply… S2S2

40 3 Quantity of wheat1000 Price of wheat Demand S1S1 An increase of supply in the market for wheat S2S2 2. …causes a significant drop in price If the demand is inelastic an increase of supply…

41 3 Quantity of wheat1000 Price of wheat Demand S1S1 An increase of supply in the market for wheat 1. If the demand is inelastic an increase of supply… S2S2 2. …causes a significant drop in price … and a less than proportional increase in the quantity sold. As a consequence the total revenue falls (from 300 to 220 €).

42 TR1= 3·100= Quantity of wheat Price of wheat Demand S1S1 S2S2 An increase of supply in the market for wheat

43 TR 2 = 2·110= Quantity of wheat Price of wheat Demand S1S1 S2S2 An increase of supply in the market for wheat

Conclusion The elasticity of demand with respect to price measures the responsiveness of demand to price changes If the demand is elastic, an increase in price causes a reduction in total revenue If the demand is inelastic, the total revenue increases as the price rises 44

Conclusion The elasticity of supply with respect to price measures the responsiveness of supply to price changes Usually, both demand and supply are more elastic in the long-run than in the short-run 45

Next week Demand, supply and elasticity: applications and exercises 46