Elasticity: A Measure of Response Chapter 5 Elasticity: A Measure of Response

1. THE PRICE ELASTICITY OF DEMAND Learning Objectives Explain the concept of price elasticity of demand and its calculation. Explain what it means for demand to be price inelastic, unit price elastic, price elastic, perfectly price inelastic, and perfectly price elastic. Explain how and why the value of the price elasticity of demand changes along a linear demand curve. Understand the relationship between total revenue and price elasticity of demand. Discuss the determinants of price elasticity of demand.

1. THE PRICE ELASTICITY OF DEMAND The price elasticity of demand is the percentage change in quantity demanded of a particular good or service divided by the percentage change in the price of that good or service, all other things unchanged. eD = % change in quantity demanded % change in price

1.1 Computing the Price Elasticity of Demand arc elasticity is a measure of elasticity based on percentage changes relative to the average value of each variable between two points. EQUATION 1.2

Responsiveness and Demand Movement from Point A to B (or B to A) shows that a $.10 change in price changes the number of rides per day by 20,000. A B

1.2 Price Elasticities Along a Linear Demand Curve eD = -3.00 eD = -1.00 eD = -.33

1.3 The Price Elasticity of Demand and Changes in Total Revenue Total Revenue (TR=P*Q) is a firm’s output multiplied by the price at which it sells that output. Price elastic refers to a situation in which the absolute value of the price elasticity of demand is greater than 1. Unit price elastic refers to a situation in which the absolute value of the price elasticity of demand is equal to 1. Price inelastic refers to a situation in which the absolute value of the price of elasticity of demand is less than 1.

Changes in Total Revenue and a Linear Demand Curve Elastic Region Unit elastic A B Inelastic Region E F

1.3 The Price Elasticity of Demand and Changes in Total Revenue An increase in price ... reduces total revenue. A reduction in price... Increases total revenue. Total revenue moves in the direction of the quantity change. Price Inelastic An increase in price… A reduction in price… Reduces total revenue. Total revenue moves in the direction of the price change. Unit price Elastic No change in total revenue. Total revenue does not change as price changes.

1.4 Constant Price Elasticity of Demand Curves Perfectly inelastic (insensitive to price changes) refers to a situation in which the price elasticity of demand is zero. Perfectly elastic (sensitive to price changes) refers to a situation in which the price elasticity of demand is infinite.

Demand Curves with Constant Price Elasticity

1.5 Determinants of the Price Elasticity of Demand Availability of substitutes If there are lots of close substitute goods to choose from consumers can switch easily Importance in household budgets Price of good relative to income Time In the short run it is often difficult to find substitutes.

2. RESPONSIVENESS OF DEMAND TO OTHER FACTORS Learning Objectives Explain the concept of income elasticity of demand and its calculation. Classify goods as normal or inferior depending on their income elasticity of demand. Explain the concept of cross price elasticity of demand and its calculation. Classify goods as substitutes or complements depending on their cross price elasticity of demand.

2.1 Income Elasticity of Demand Income elasticity of demand is the percentage change in quantity demanded at a specific price divided by the percentage change in income that produced the demand change, all other things unchanged. EQUATION 2.1

2.1 Income Elasticity of Demand Normal Good (e.g. DVD’s) An increase in income… Increases demand. A decrease in income… Decreases demand. Inferior Good (e.g. used clothing)

2.2 Cross Price Elasticity of Demand Cross price elasticity of demand is the percentage change in the quantity demanded of one good or service at a specific price divided by the percentage change in the price of a related good or service. EQUATION 2.2

2.2 Cross Price Elasticity of Demand Normal Good (e.g. DVD’s) An increase in PB… Increases demand for good A. A decrease in PB… Decreases demand for good A. Inferior Good (e.g. used clothing)

3. PRICE ELASTICITY OF SUPPLY Learning Objectives Explain the concept of elasticity of supply and its calculation. Explain what it means for supply to be price inelastic, unit price elastic, price elastic, perfectly price inelastic, and perfectly price elastic. Explain why time is an important determinant of price elasticity of supply. Apply the concept of price elasticity of supply to the labor supply curve.

3. PRICE ELASTICITY OF SUPPLY Price elasticity of supply is the ratio of the percentage change in quantity supplied of a good or service to the percentage change in its price, all other things unchanged. EQUATION 3.1

Increase in Apartment Rents Depends on How Responsive Supply Is Q0 Q1 Q2

Increase in Apartment Rents Depends on How Responsive Supply Is

3.1 Time: An Important Determinant of the Elasticity of Supply In the short run supply is likely to be inelastic. In the long run supply is likely to be more elastic.

Selected Elasticity Estimates Product Price elasticity Income elasticity Cross price elasticity Food (long-run) -2.58 0.20 Alcohol with respect to the price of heroin -0.05 Beer -0.90 to -1.50 0.40 Fuel with respect to the price of transport -0.48 Heroin -1.00 0.00 Beer with respect to the price of wine Coke -1.90 0.60 Poultry with respect to the price of ground beef 0.23 Pepsi -2.22 1.72 Coke with respect to the price of Pepsi 0.61 Gasoline (short-run) -0.10 ----- Pepsi with respect to the price of Coke 0.80 Transportation (long-run) -2.08

Selected Elasticity Estimates Product Price elasticity of supply Physicians (specialist) -0.30 Physicians (primary care) 0.00 Physician (young male) 0.20 Physicians (young female) 0.50 Milk (short run) 0.36 Milk (long run) Child care labor 2.00