Principles of Micro Chapter 5: “Elasticity and Its Application ” by Tanya Molodtsova, Fall 2005

We Will Learn: The Meaning of the Elasticity of Demand and Supply The Meaning of the Elasticity of Demand and Supply What Determines the Elasticity of Demand and Supply What Determines the Elasticity of Demand and Supply Elasticity: Elasticity: 1. allows us to analyze supply and demand with greater precision. 2. is a measure of how much buyers and sellers respond to changes in market conditions

I. The Elasticity of Demand price elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in the price of that good price elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in the price of that good How much consumers are willing to move away from the good when its price increases How much consumers are willing to move away from the good when its price increases It’s the percentage change in quantity demanded divided by the percentage change in price. It’s the percentage change in quantity demanded divided by the percentage change in price.

Determinants of Price Elasticity of Demand Availability of Close Substitutes: the more substitutes a good has, the more elastic its demand. Availability of Close Substitutes: the more substitutes a good has, the more elastic its demand. Necessities versus Luxuries: necessities are more price inelastic. Necessities versus Luxuries: necessities are more price inelastic. Definition of the market: narrowly defined markets (ice cream) have more elastic demand than broadly defined markets (food). Definition of the market: narrowly defined markets (ice cream) have more elastic demand than broadly defined markets (food). Time Horizon: goods tend to have more elastic demand over longer time horizons. Time Horizon: goods tend to have more elastic demand over longer time horizons.

Determinants of Price Elasticity of Demand Demand tends to be more elastic Demand tends to be more elastic (people can move away from the good when its price increases) (people can move away from the good when its price increases) 1. the larger the number of close substitutes 2. if the good is a luxury 3. the more narrowly defined the market 4. the longer the time period

Computing the Price Elasticity of Demand Price Elasticity of Demand = Price Elasticity of Demand = % change in quantity demanded % change in quantity demanded % change in price % change in price Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as: Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as:

Computing the Price Elasticity of Demand The Midpoint Method: A Better Way to Calculate % Changes and Elasticities The Midpoint Method: A Better Way to Calculate % Changes and Elasticities 1. it gives the same answer regardless of the direction of the change. 2. The midpoint method involves calculating the % changes by dividing the change in the variable by the midpoint between the initial and final levels rather than by the initial level itself.

Computing the Price Elasticity of Demand Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as: Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:

The Variety of Demand Curves Inelastic Demand Inelastic Demand - Quantity demanded does not respond strongly to price changes. - Quantity demanded does not respond strongly to price changes. - Price elasticity of demand < 1 - Price elasticity of demand < 1 Elastic Demand Elastic Demand - Quantity demanded responds strongly to changes in price. - Quantity demanded responds strongly to changes in price. - Price elasticity of demand > 1 - Price elasticity of demand > 1

Computing the Price Elasticity of Demand Demand is price elastic $5 4 Demand Quantity Price

The Variety of Demand Curves Perfectly Inelastic Perfectly Inelastic - Quantity demanded does not respond to price changes at all. - Quantity demanded does not respond to price changes at all. Perfectly Elastic Perfectly Elastic - Quantity demanded changes infinitely with any change in price. - Quantity demanded changes infinitely with any change in price. Unit Elastic Unit Elastic - Quantity demanded changes by the same percentage as the price. - Quantity demanded changes by the same percentage as the price.

The Variety of Demand Curves Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve. Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.

Perfectly Inelastic Demand: Elasticity =0 (a) Perfectly Inelastic Demand: Elasticity Equals 0 $5 4 Quantity Demand An increase in price leaves the quantity demanded unchanged. Price

Inelastic Demand: Elasticity < 1 (b) Inelastic Demand: Elasticity Is Less Than 1 Quantity 0 $5 90 Demand 1. A 22% increase in price... Price leads to an 11% decrease in quantity demanded

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

Elastic Demand: Elasticity > 1 (d) Elastic Demand: Elasticity Is Greater Than 1 Demand Quantity Price $ A 22% increase in price leads to a 67% decrease in quantity demanded.

Perfectly Elastic Demand: Elasticity = infinity (e) Perfectly Elastic Demand: Elasticity Equals Infinity Quantity 0 Price $4 Demand 2. At exactly $4, consumers will buy any quantity. 1. At any price above $4, quantity demanded is zero. 3. At a price below $4, quantity demanded is infinite.

Total Revenue and the Price Elasticity of Demand total revenue: the amount paid by buyers and received by sellers of a good total revenue: the amount paid by buyers and received by sellers of a good computed as the price of the good times the quantity sold. computed as the price of the good times the quantity sold. TR = P x Q TR = P x Q

Total Revenue Demand Quantity Q P 0 Price P × Q = $400 (revenue) $4 100

Elasticity of Demand and Total Revenue If a demand curve is inelastic, an increase in price leads to a decrease in quantity that is proportionately smaller. If a demand curve is inelastic, an increase in price leads to a decrease in quantity that is proportionately smaller.  total revenue increases when price rises

How Total Revenue Changes When Price Increases: Inelastic Demand Demand Quantity 0 Price Revenue = $100 Quantity 0 Price Revenue = $240 Demand $1 100 $3 80 An Increase in price from $1 to $3 … … leads to an Increase in total revenue from $100 to $240

Elasticity of Demand and Total Revenue If a demand curve is elastic, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. If a demand curve is elastic, an increase in the price leads to a decrease in quantity demanded that is proportionately larger.  total revenue decreases when price increases.

How Total Revenue Changes When Price Increases: Elastic Demand Demand Quantity 0 Price Revenue = $200 $4 50 Demand Quantity 0 Price Revenue = $100 $5 20 An Increase in price from $4 to $5 … … leads to an decrease in total revenue from $200 to $100

Other Demand Elasticities income elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in consumers’ income, income elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in consumers’ income, the percentage change in quantity demanded divided by the percentage change in income. the percentage change in quantity demanded divided by the percentage change in income.

Income Elasticity Income Elasticity of Demand = Income Elasticity of Demand = % change in quantity demanded % change in quantity demanded % change in income % change in income Types of Goods Types of Goods Normal Goods: Income Elasticity > 0 Normal Goods: Income Elasticity > 0 Inferior Goods: Income Elasticity < 0 Inferior Goods: Income Elasticity < 0 Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods

Income Elasticity Goods consumers regard as necessities tend to be income inelastic Goods consumers regard as necessities tend to be income inelastic Examples: food, fuel, clothing, utilities, and medical services. Examples: food, fuel, clothing, utilities, and medical services. Goods consumers regard as luxuries tend to be income elastic. Goods consumers regard as luxuries tend to be income elastic. Examples: sports cars, furs, and expensive foods. Examples: sports cars, furs, and expensive foods.

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 of demand: a measure of how much the quantity demanded of one good responds to a change in the price of another good computed as the percentage change in the quantity demanded of the 1st good divided by the percentage change in the price of the 2nd good. computed as the percentage change in the quantity demanded of the 1st good divided by the percentage change in the price of the 2nd good. Cross-Price Elasticity of Demand = Cross-Price Elasticity of Demand = % change in quantity demanded of good 1 % change in price of good 2 % change in price of good 2

The Elasticity of Supply price elasticity of supply: 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: a measure of how much the quantity supplied of a good responds to a change in the price of that good computed as the percentage change in quantity supplied divided by the percentage change in price. computed as the percentage change in quantity supplied divided by the percentage change in price. Price Elasticity of Supply = Price Elasticity of Supply = % change in quantity supplied % change in quantity supplied % change in price % change in price

The Elasticity of Supply Elastic Supply

Extreme Cases

Determinants of Price Elasticity of Supply Flexibility of sellers: goods that are somewhat fixed in supply (beachfront property) have inelastic supplies. Flexibility of sellers: goods that are somewhat fixed in supply (beachfront property) have inelastic supplies. Time horizon: supply is more elastic in the long run Time horizon: supply is more elastic in the long run

The Elasticity of Supply Example: the price of 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. Example: the price of 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. % change in price = (3.15 – 2.85)/3.00 × 100% = 10% % change in price = (3.15 – 2.85)/3.00 × 100% = 10% % change in quantity supplied = (11, ,000)/10,000 × 100% = 20% % change in quantity supplied = (11, ,000)/10,000 × 100% = 20% Price elasticity of supply = (20%)/(10%) = 2 Price elasticity of supply = (20%)/(10%) = 2

Three Applications of Supply, Demand, and Elasticity New hybrid of wheat is more productive than those in the past. What happens? New hybrid of wheat is more productive than those in the past. What happens? Supply increases, price falls, and quantity demanded rises. Supply increases, price falls, and quantity demanded rises. If demand is inelastic, the fall in price is greater than the increase in quantity demanded and total revenue falls. If demand is inelastic, the fall in price is greater than the increase in quantity demanded and total revenue falls. If demand is elastic, the fall in price is smaller than the rise in quantity demanded and total revenue rises. If demand is elastic, the fall in price is smaller than the rise in quantity demanded and total revenue rises.

An Increase in Supply in the Market for Wheat Quantity of Wheat 0 Price of Wheat and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220. Demand S1S1 S2S leads to a large fall in price When demand is inelastic, an increase in supply $3 100

Compute the Price Elasticity of Demand Supply is inelastic

Why Did OPEC Fail to Keep the Price of Oil High? 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? 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? The demand and supply of oil are much more inelastic in the short run than the long run. The demand and supply of oil are much more inelastic in the short run than the long run.

Short Run Long Run

Summary Price elasticity of demand measures how much the quantity demanded responds to changes in the price. Price elasticity of demand measures how much the quantity demanded responds to changes in the price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price It is calculated as the percentage change in quantity demanded divided by the percentage change in price If a demand curve is elastic, total revenue falls when the price rises. If a demand curve is elastic, total revenue falls when the price rises. If it is inelastic, total revenue rises as the price rises. If it is inelastic, total revenue rises as the price rises.

Summary The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income. The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good. The price elasticity of supply measures how much the quantity supplied responds to changes in the price. The price elasticity of supply measures how much the quantity supplied responds to changes in the price.

Summary In most markets, supply is more elastic in the long run than in the short run. In most markets, supply is more elastic in the long run than in the short run. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price.