1 Percentages and Elasticity Which of the following seem more serious: –An increase of 50 cents or an increase of 50% in the price of a hamburger –An increase of $100 or an increase of 1% in the price of a new car Percentage changes are often more important than the amount of change –Therefore economists often use elasticities to examine percentage change or responsiveness

2 Price Elasticity Price Elasticity of Demand (E p ) –The responsiveness of quantity demanded of a commodity to changes in its price –Related to the slope, but concerned with percentage changes

3 Impact of a Change in Supply & Therefore Price on the Quantity Demanded S1S1 Quantity (pizzas per hour) Price (dollars per pizza) DaDa S0S0 Large price change and small quantity change An increase in supply brings... … and a small increase in quantity … a large fall in price...

4 Impact of a Change in Supply… Quantity (pizzas per hour) Price (dollars per pizza) DbDb S1S S0S0 Small price change and large quantity change An increase in supply brings... … a small fall in price... … and a large increase in quantity

5 Price Elasticity Percentage change in price Percentage change in quantity demanded  p E The ratio of the two percentages is a number without units. Price Elasticity of Demand

6 Price Elasticity Example –Price of oil increases 10% –Quantity demanded decreases 1% When calculating the price elasticity of demand, we ignore the minus sign for % change in Q.

7 TYPES OF ELASTICITY Hypothetical Demand Elasticities for 4 Products

8 Price Elasticity Ranges: Extreme Price Elasticities Quantity Demanded per Year (millions of units) Price 0 D 8 Perfect inelasticity, zero elasticity, no matter how much Price changes, Quantity stays the same; insulin P0P0 P1P1 Quantity Demanded per Year (millions of units) Price 0 Perfect elasticity, infinite elasticity, the slightest increase in price will lead to zero sales. 30 D P1P1 P 1 never touches the demand curve

9 Price Elasticity Ranges Summary from Table Unit Elastic Inelastic Demand Elastic Demand

10 Elasticity of Demand Calculating elasticity or Sum of prices/2 Change in P Sum of quantities/2 Change in Q  p E Always use the mid-point formula

11 Calculating the Elasticity of Demand D New point Quantity (pizzas/hour) Price (dollars/pizza) Original point Elasticity = = 4 /Q ave /P ave 2/10 1/20 = ΔP=1 ΔQ=2 Q ave =1/2(11+9)=10 P ave =1/2( )=20

12 Elasticity of Demand (mid-point) Ed =  P = $1.00 P 1 + P 2 ( $ $19.50) 2  P =5% = $20  Q = 2 Q 1 + Q 2 ( ) 2  Q =20% = 10 Always use the mid-point formula for calculating elasticity 20% 5% = 4 = Ed = X 100

13 D Demand, or average revenue curve Quantity per Period (billions of minutes) Price per Minute ($) Elastic (E P > 1) Inelastic (E P < 1) Unit-elastic (E P = 1) Changes in Elasticity Along a Linear Demand

14 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service $ Quantity Total Elasticity Price Demanded Revenue E p Elastic Inelastic Unit-elastic

15 Total Revenue and Elasticity Total Revenue = Price Per Good X # of Goods Sold TR = P X Q Assumption : Costs are constant

(dollars) Maximum total revenue When demand is inelastic, price cut decreases total revenue Unit elastic Elastic demand Quantity Inelastic demand 0 When demand is elastic, price cut increases total revenue Total Revenue Price Elasticity and Total Revenue Quantity.80

17 Relationship Between Price Elasticity of Demand and Total Revenues Inelastic(E P < 1) TR  TR  Unit-elastic(E P = 1)No change  No change Elastic (E P > 1) TR  TR  Price ElasticityEffect of Price Change of Demandon Total Revenues (TR) Price Decrease Increase

18 Total Revenue and Elasticity Total Revenue Test: Estimate the price elasticity of demand by observing the change in total revenue that results from a change in price (ceteris paribus). Note that revenue is maximized when elasticity of demand = -1.

19 Question 2 drivers - Tom & Jerry each drive to to a gas station. Before looking at the price, each places an order. Tom says, “I’d like 10 litres of gas”. Jerry says, “I’d like $10 of gas”. What is each driver’s price elasticity of demand?

20 Determinants of Price Elasticity of Demand Existence of substitutes The length of time allowed for adjustment More specifically a good is defined (more specific = more substitutes) Necessity or not Share of budget

21 D2 Quantity Supplied per Period Price per Unit D1 PePe P1P1 As time passes, the demand curve rotates to D2 and then to D3 and quantity demanded lowers first to Q1 and then to Q2 Demand Elasticity and Time D3 Q2Q1Q3

22 Elasticity: Example You are the consulting economist to the Guelph transportation commission, The current fare is $.80 There are 25,000 riders per day For each $.01 increase (decrease) in the fare, rider ship decreases (increases) by 500 riders per day. What is the price elasticity of demand at the current fare? Should fares be raised or lowered? What fare will maximize revenue?

23 Elasticity of Supply Calculating elasticity or Sum of prices/2 Change in P Sum of quantities/2 Change in Q  p E Always use the mid-point formula

24 How a Change in Demand Changes Price and Quantity Quantity (pizzas per hour) Price (dollars per pizza) D0D SaSa Large price change and small quantity change … a large price rise D1D An increase in demand brings... … and a small quantity increase

25 How a Change in Demand Changes Price and Quantity Quantity (pizzas per hour) Price (dollars per pizza) D0D SbSb Small price change and large quantity change … a small price rise D1D1 An increase in demand brings … and a large quantity increase

26 Elasticity of Supply Elasticity of supply ranges –(from) Perfectly Elastic Supply Quantity supplied falls to 0 when there is any decrease in price –(to) Perfectly Inelastic Supply Quantity supplied is constant no matter what happens to price Notice: There is no total revenue test for supply since price and quantity are directly related

27 Supply Elasticity Ranges Price Quantity S Elasticity of supply = 0 0 Quantity supplied is the same for any price! Price Quantity S Elasticity of supply = 0 Suppliers will offer ANY quantity at this price

28 Elasticity of Supply: Depends On: 1.Resource substitution possibilities, - The more unique the resource, the more inelastic the supply. 2.Time frame for the supply decision, Momentary supply Long-run supply Short-run supply - The longer producers have to adjust to a price change, the more elastic is supply.

29 S2 Quantity Supplied per Period Price per Unit S1 QeQe PePe P1P1 As time passes, the supply curve rotates to S2 and then to S3 and quantity supplied rises first to Q1 and then to Q2 Supply Elasticity and Time S3 Q2 Q1

30 Elasticity: example-Tax Burden Government levies a tax on a good: –who actually pays the tax, – what is the incidence of the tax, who bears the burden of the tax. Suppose that the tax is levied on the seller; i.e., the seller has to pay the tax Supply is affected

31 Explain the Effects of the Sales Tax A $10 sales (excise) tax per MP3 player is imposed on the sellers of MP3 players. There are now two “prices” for MP3 players: an after- tax price faced by buyers, and an after-tax price faced by sellers. Will the price faced by buyers increase $10 after introducing the sales tax? By how much? Will the price faced by sellers change? By how much?

32 S + tax Sales Tax Imposed on the Sellers Quantity (thousands of MP3 players per week) Price (dollars per player) S DADA Tax revenue $10 tax After Tax Market Price Supply is affected

33 S + tax Sales Tax: Who Pays? Quantity (thousands of MP3 players per week) Price (dollars per player) S DADA $10 tax Original Market Price Buyer pays After Tax Market Price Seller pays After Tax Price to Seller taxtax Tax Wedge

34 Summary: Taxes discourage market activity Burden is shared, buyers pay more, sellers receive less, and Tax burden falls most heavily on the side of the market that is least elastic in its response to a price change.

35 S + tax The Sales Tax: Who Pays? Demand Relatively Inelastic Quantity (thousands of MP3 players per week) Price (dollars per player) S DADA $10 tax

36 S + tax The Sales Tax: Who Pays? Demand Relatively More Elastic. Quantity (thousands of MP3 players per week) Price (dollars per player) S DADA $10 tax Original Market Price Tax Wedge

37 D-tax Sales Tax: Who Pays When Tax Is Imposed on the Buyer? Quantity (thousands of MP3 players per week) Price (dollars per player) S DADA $10 tax Original Market Price