Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-1 Chapter 4 Elasticity

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-2 Elasticity What do you think? –Could reducing the supply of illegal drugs cause an increase in drug-related burglaries? –How would reducing the supply of illegal drugs change total spending?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-3 The effect of extra border patrols on the market for illicit drugs Q(1000s of ounces/day) P($/ounce) 50 S D S’ Total expenditure = P x Q S $250 = $50 x 50 S’ $320 = $80 x 40

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-4 Price elasticity of demand Elasticity –A measure of the extent to which quantity demanded and quantity supplied respond to variations in price, income and other factors. –An important determinant for various policy issues.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-5 Price elasticity of demand Defined –Generally  A measure of the responsiveness of the quantity demanded of a good to a change in the price of that good. –Formally  The percentage change in the quantity demanded that results from a 1 per cent change in its price.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-6 Price elasticity of demand Measuring price elasticity of demand

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-7 Price elasticity of demand Assume –The price of pork falls by 2% and the quantity demanded increases by 6%.  Then the price elasticity of demand for pork is

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-8 Price elasticity of demand Measuring price elasticity of demand Observations Price elasticity of demand will always be negative (i.e. an inverse relationship between price and quantity). For convenience we drop the negative sign.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-9 Price elasticity of demand Measuring price elasticity of demand When is > 1: elastic < 1: inelastic = 1: unit elastic

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-10 Elastic and inelastic demand 3 Price elasticity of demand Inelastic Unit elastic Elastic 210

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-11 Price elasticity of demand What is the elasticity of demand for sushi? –Originally  Price = $2/piece  Quantity demanded = 400 pieces/day –New  Price = $1.94/piece  Quantity demanded = 404 pieces/day, then

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-12 Price elasticity of demand What is the elasticity of season ski passes? –Originally  Price = $1000  Quantity demanded = passes/year –New  Price = $950  Quantity demanded = passes/year, then

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-13 Price elasticity of demand Determinants of price elasticity of demand –Substitution possibilities  Elasticity of table salt and snake antivenom –Budget share  Elasticity of key rings and hot tub –Time  Elasticity of postage stamps today and tomorrow

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-14 Price elasticity estimates for selected products Good or servicePrice elasticity Green peas2.80 Restaurant meals1.63 Automobiles1.35 Electricity1.20 Beer1.19 Movies0.87 Air travel (foreign)0.77 Shoes0.70 Coffee0.25 Theatre, opera0.18

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-15 Price elasticity of demand What do you think? –Why is the price elasticity of demand more than 14 times larger for green peas than for theatre and opera performances? –Is it budget share or substitution possibilities?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-16 Price elasticity of demand Economic naturalist –How effective will a ‘fat tax’ be in solving the growing problem of obesity? –Will higher taxes on cigarettes curb teenage smoking? –Why was the luxury tax on yachts such a disaster?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-17 A graphical interpretation of price elasticity For small changes in price Where Q is the original quantity and P is the original price.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-18 A graphical interpretation of price elasticity Example –Originally  Price (P) = $100  Quantity (Q) = 20 –New  Price (P) = $105  Quantity (Q) = 15

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-19 A graphical interpretation of price elasticity of demand Quantity Price P D A Q P - P Q + Q Q P

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-20 Calculating price elasticity of demand 20 Quantity Price 1 D A

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-21 Calculating price elasticity of demand 20 Quantity Price D A Question: What is the price elasticity of demand when P = $4?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-22 D1D1 D2D Price elasticity and the steepness of the demand curve Quantity Price What is the price elasticity of demand when P = $4?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan D1D1 D2D For D 2 when P = $1 Price elasticity and the steepness of the demand curve Quantity Price

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-24 Price elasticity and the steepness of the demand curve 12 Quantity Price D1D1 D2D Observation If two demand curves have a point in common, the steeper curve must be less elastic with respect to price at that point.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-25 Price elasticity regions along a straight-line demand curve Quantity Price b/2 a/2 a b Observation Price elasticity varies at every point along a straight- line demand curve.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-26 Perfectly elastic demand curve Quantity Price

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-27 Perfectly inelastic demand curve Quantity Price

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan A B 3 P Q 6 12 Example: The price elasticity of demand at two different points on a demand curve Two points on a demand curve Quantity Price 0

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-29 A graphical interpretation of price elasticity The midpoint formula and

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-30 Two points on a demand curve Then the price elasticity of demand between A and B: Quantity Price A B 3 P Q

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-31 Elasticity and total expenditure Total expenditure = P x Q –Market demand measures the quantity (Q) at each price (P). Total expenditure = Total revenue

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-32 D A Total expenditure = $1000/day The demand curve for movie tickets 12 Quantity (100s of tickets/day) Price ($/ticket)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-33 D B Total expenditure = $1600/day The demand curve for movie tickets 12 Quantity (100s of tickets/day) Price ($/ticket)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-34 Elasticity and total expenditure What do you think? –Will increasing the market price always increase total revenue?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-35 D Total expenditure = $1600/day The demand curve for movie tickets 12 Quantity (100s of tickets/day) Price ($/ticket)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-36 D Total expenditure = $1000/day The demand curve for movie tickets 12 Quantity (100s of tickets/day) Price ($/ticket)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-37 Elasticity and total expenditure General rule –A price increase will increase total revenue when the % change in P is greater than the % change in Q.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-38 The demand curve for movie tickets 12 Quantity (100s of tickets/day) Price ($/ticket)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-39 Total expenditure as a function of price Price ($/ticket) Total expenditure ($/day)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-40 Total expenditure as a function of price 1800 Price ($/ticket) Total expenditure ($/day) Quantity (100s of tickets/day) Price ($/ticket) Total revenue is at a maximum at the midpoint on a straight-line demand curve.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-41 Elasticity and total expenditure What do you think? –Should a rock band raise or lower its price to increase total revenue? Assume

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-42 Elasticity and total expenditure What do you think? –Should a rock band raise or lower its price to increase total revenue? Then –Total revenue = $20 x 5000 = $ /week –If P is increased 10%, Q will decrease 30%  Total revenue = $22 x 3500 = $77 000/week –If P is lowered 10%, Q will increase 30%  Total revenue = $18 x 6500 = $ /week

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-43 Elasticity and total expenditure Rule –When price elasticity is greater than 1, changes in price and changes in total expenditures always move in opposite directions. –When price elasticity is less than 1, changes in price and changes in total expenditures always move in the same direction.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-44 Elasticity and total expenditure Measuring changes in quantity demanded for sausage rolls due to a change in –price of pies –price of sausage meat –income –income when sausage roll is a normal good –income when sausage roll is an inferior good.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-45 Elasticity and total expenditure Cross-price elasticity of demand –The percentage by which quantity demanded of the first good changes in response to a 1 per cent change in the price of the second good. Substitute goods  When the cross-price elasticity of demand is positive. –Complement goods  When the cross-price elasticity of demand is negative.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-46 Elasticity and total expenditure Income elasticity of demand –The percentage by which quantity demanded changes in response to a 1 per cent change in income. –Normal goods  Income elasticity is positive. –Inferior goods  Income elasticity is negative.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-47 The price elasticity of supply Price elasticity of supply –The percentage change in the quantity supplied that occurs in response to a 1 per cent change in price.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan B P Q S 12 4 A Calculating the price elasticity of supply graphically Quantity Price 0

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan A 3 5 B A supply curve for which price elasticity declines as quantity rises Quantity Price 0 S

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-50 A perfectly inelastic supply curve Quantity of land in New Zealand (1000s of hectares) Price ($/hectare) 0 S Elasticity = 0 at every point along a vertical supply curve What is the price elasticity of supply of lakefront land in Taupo, New Zealand?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-51 Quantity of lemonade (cups/day) Price (cents/cup) 0 14 S If MC is constant, then the price elasticity of supply at every point along a horizontal supply curve is infinite What is the price elasticity of supply of lemonade? A perfectly elastic supply curve

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-52 The price elasticity of supply Determinants of supply elasticity –Flexibility of inputs –Mobility of inputs –Ability to produce substitute inputs –Time

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-53 The price elasticity of supply Thinking as an economist –Why are petrol prices so much more volatile than car prices?  Differences in markets Demand for petrol is more inelastic. Petrol market has larger and more frequent supply shifts.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-54 Greater volatility in petrol prices than in car prices Quantity (millions of litres/day) Price ($/litre) S’ D S Petrol

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-55 Greater volatility in petrol prices than in car prices Price ($1000s/car) D 17 S’ 11 Quantity (1000s of cars/day) Cars S Cars

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-56 The price elasticity of supply What do you think? –How would elasticity of supply and fluctuating demand impact price volatility?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4-57 The price elasticity of supply Unique and essential inputs: The ultimate supply bottleneck –Why does Guus Hiddink get paid more than $20 million over a four-year contract?