©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 1 Chapter 15 “Elasticity: Measuring Responsiveness”

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 2 Learning Objectives 1.Discuss how elasticity is used to measure the responsiveness. 2.Compute the elasticity of demand. 3.Describe the conditions under which a price change would increase, decrease, or not change a firm’s revenue. 4.Discuss the significance of the income elasticity of demand, the cross elasticity of demand, and the elasticity of supply. 1.Discuss how elasticity is used to measure the responsiveness. 2.Compute the elasticity of demand. 3.Describe the conditions under which a price change would increase, decrease, or not change a firm’s revenue. 4.Discuss the significance of the income elasticity of demand, the cross elasticity of demand, and the elasticity of supply.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 3 Learning Objectives 5.Explain how elasticity determines who ultimately pays a sales tax. 6.Discuss how the war on drugs increases crime associated with drug use. 5.Explain how elasticity determines who ultimately pays a sales tax. 6.Discuss how the war on drugs increases crime associated with drug use.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e COMPUTING ELASTICITY Elasticity measures how one variable changes as a result of another variable changing.Elasticity measures how one variable changes as a result of another variable changing. All elasticities arise from this same formula.All elasticities arise from this same formula. Different elasticities merely name the variables differently.Different elasticities merely name the variables differently. Elasticity measures how one variable changes as a result of another variable changing.Elasticity measures how one variable changes as a result of another variable changing. All elasticities arise from this same formula.All elasticities arise from this same formula. Different elasticities merely name the variables differently.Different elasticities merely name the variables differently. Elasticity = Percentage change in one variable (Y) Percentage change in another variable (X) Percentage change in another variable (X)

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 5  Elasticity has a broad range of applications.  Price elasticity of demand  Price elasticity of supply  Cross price elasticity  Income Elasticity  Elasticity has a broad range of applications.  Price elasticity of demand  Price elasticity of supply  Cross price elasticity  Income Elasticity Computing Elasticity

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 6 Midpoints Formula The measure of percentage changes is provided by the midpoints formula.The measure of percentage changes is provided by the midpoints formula. –The formula computes a percentage change as the change in the variable divided by an amount halfway between the starting and ending amount. Percentage change in Y= change in Y/Y midpoint Divided by Percentage change in X= change in X/X midpoint The measure of percentage changes is provided by the midpoints formula.The measure of percentage changes is provided by the midpoints formula. –The formula computes a percentage change as the change in the variable divided by an amount halfway between the starting and ending amount. Percentage change in Y= change in Y/Y midpoint Divided by Percentage change in X= change in X/X midpoint

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e THE ELASTICITY OF DEMAND oThe elasticity of demand measures the responsiveness of quantity demanded to changes in price. oIt is sometimes referred to as the price elasticity of demand. oSince price and quantity demanded are inversely related, the computation of elasticity of demand will always result in a negative value. oFor convenience, the elasticity of demand is stated as an absolute value, meaning the minus sign is ignored. oThe elasticity of demand measures the responsiveness of quantity demanded to changes in price. oIt is sometimes referred to as the price elasticity of demand. oSince price and quantity demanded are inversely related, the computation of elasticity of demand will always result in a negative value. oFor convenience, the elasticity of demand is stated as an absolute value, meaning the minus sign is ignored.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 8 The Elasticity of Demand oThe elasticity of demand is not the same as the slope of demand. oThe slope of demand divides the change in price by the change quantity, without reference to percentages. oThe slope measures absolute changes, while elasticity measures percentage changes. oThe elasticity of demand is not the same as the slope of demand. oThe slope of demand divides the change in price by the change quantity, without reference to percentages. oThe slope measures absolute changes, while elasticity measures percentage changes.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 9 Classifying the Elasticity of Demand  Inelastic demand has an elasticity coefficient whose value lies between 0 and 1.  Unit elastic demand has an elasticity coefficient whose value equals 1.  Elastic demand has an elasticity coefficient whose value is greater than 1.  Other things being equal, the more substitutes there are for a product, or the greater the fraction a product takes of a person’s budget to buy the product, the greater will be its elasticity of demand.  Inelastic demand has an elasticity coefficient whose value lies between 0 and 1.  Unit elastic demand has an elasticity coefficient whose value equals 1.  Elastic demand has an elasticity coefficient whose value is greater than 1.  Other things being equal, the more substitutes there are for a product, or the greater the fraction a product takes of a person’s budget to buy the product, the greater will be its elasticity of demand.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 10 The Range of the Elasticity of Demand 0 InelasticElastic Elasticity of Demand 1 Unit Elastic This value can range from zero to infinity (in absolute value)

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 11 Estimates of Demand Elasticities ProductElasticity of Demand Beef0.35 Fish0.39 Public Transit0.40 Peak use electricity.47 Physician services0.60 Poultry0.64 Fruit0.71 Peak use residential electricity1.5 Restaurant meals2.3 Kellogg’s Fruit Loops2.3 Cheerios3.6 Coke3.8 Mountain Dew4.4 Fresh Tomatoes4.6

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 12 Elasticity and Total Revenue Total Revenue = Price  Quantity When P  TR  TR constant TR  Depending upon the elasticity

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 13 Total Revenue Quantity $ Price Quantity demanded Total revenue = price x quantity which is the area of the shaded rectangle. Demand

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 14 The Effect of a Change in Total Revenue Change in Price Effect on Total Revenue Higher Price If demand is inelastic, total revenue rises. If demand is unit elastic, total revenue remains constant. If demand is elastic, total revenue falls. Lower price If demand is inelastic, total revenue falls. If demand is unit elastic, total revenue remains constant. If demand is elastic, total revenue rises.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 15  The longer the time period that quantity demanded adjusts, the greater the elasticity of demand.  Time lets people adjust, to substitute towards goods that have become relatively less expensive and away from those that become relatively more expensive.  The elasticity of demand will vary along most demand curves. Along a downward sloping, straight line demand curve, demand is unit elastic at the midpoint, elastic above the midpoint, and inelastic below the midpoint.  The longer the time period that quantity demanded adjusts, the greater the elasticity of demand.  Time lets people adjust, to substitute towards goods that have become relatively less expensive and away from those that become relatively more expensive.  The elasticity of demand will vary along most demand curves. Along a downward sloping, straight line demand curve, demand is unit elastic at the midpoint, elastic above the midpoint, and inelastic below the midpoint. Elasticity and Total Revenue

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 16 Elasticity Varies along Linear Demand Curves Midpoint: Unit Elastic Demand Quantity Price ($’s) Elastic Inelastic

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 17 Demand and Total Revenue

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 18 Computing the Elasticity of Demand Table 4A-2

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 19 Demand, Elasticity, Total Revenue, and Marginal Revenue Total Revenue Marginal Revenue Demand Quantity Dollars A B C D E F Elasticity =9 Elasticity =2.33 Elasticity =.43 Elasticity =1 Elasticity =.11

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 20 Demand, Elasticity, Total Revenue, and Marginal Revenue Elastic Inelastic Unit Elastic Elastic Total Revenue Marginal Revenue Demand Quantity Dollars Total revenue is maximized when demand is unit elastic. Each firm produces in the elastic range of its demand curve.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 21 The Extremes of Elasticity Quantity Quantity Quantity Demand Demand Demand Dollars Dollars Dollars Perfectly Inelastic Elasticity = 0 2. Unit Elastic Elasticity =1 3. Perfectly Elastic Elasticity = 

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e INCOME AND CROSS ELASTICITIES OF DEMAND  The income elasticity of demand measures how demand responds to income.  It is computed by dividing the percentage change in quantity demanded, by the percentage in income.  A positive income elasticity indicates the good is a normal good.  A negative income elasticity of demand indicates the good is inferior.  The income elasticity of demand measures how demand responds to income.  It is computed by dividing the percentage change in quantity demanded, by the percentage in income.  A positive income elasticity indicates the good is a normal good.  A negative income elasticity of demand indicates the good is inferior.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 23 Income and Cross Elasticities of Demand  The cross elasticity of demand measures how the demand for one good responds to changes in the price of another good.  It is computed by dividing the percentage change in quantity demanded of one good, by the percentage in the price of another good.  A positive cross elasticity indicates the goods are substitutes  A negative cross elasticity of demand indicates the goods are complements.  The cross elasticity of demand measures how the demand for one good responds to changes in the price of another good.  It is computed by dividing the percentage change in quantity demanded of one good, by the percentage in the price of another good.  A positive cross elasticity indicates the goods are substitutes  A negative cross elasticity of demand indicates the goods are complements.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e THE ELASTICITY OF SUPPLY  The elasticity of supply measures the responsiveness of quantity supplied to price. Elasticity of supply can fall within the following three ranges: Inelastic Supply:  Inelastic Supply: Elasticity of supply lies between 0 and 1. Unit Elastic Supply:  Unit Elastic Supply: Elasticity of supply = 1. Elastic Supply:  Elastic Supply: Elasticity of supply is greater than 1.  The elasticity of supply measures the responsiveness of quantity supplied to price. Elasticity of supply can fall within the following three ranges: Inelastic Supply:  Inelastic Supply: Elasticity of supply lies between 0 and 1. Unit Elastic Supply:  Unit Elastic Supply: Elasticity of supply = 1. Elastic Supply:  Elastic Supply: Elasticity of supply is greater than 1.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 25 The Extremes of Supply Elasticity Quantity Supply Supply Dollars 1. Perfectly Inelastic Elasticity = 0 2. Unit Elastic Elasticity =1 3. Perfectly Elastic Elasticity =  Supply

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e TAX SHIFTING AND THE ELASTICITIES OF SUPPLY AND DEMAND  When a product is taxed, how much of that tax will the buyers pay, and how much of the tax will the sellers pay? The answer to that question of who ultimately shoulders the tax burden depends upon the demand and supply elasticities of the product taxed.  Usually the tax burden is shared between producers and consumers.  Consumers pay more of the tax if demand is relatively less elastic than supply.  Producers pay more of the tax if demand is relatively more elastic than supply.  When a product is taxed, how much of that tax will the buyers pay, and how much of the tax will the sellers pay? The answer to that question of who ultimately shoulders the tax burden depends upon the demand and supply elasticities of the product taxed.  Usually the tax burden is shared between producers and consumers.  Consumers pay more of the tax if demand is relatively less elastic than supply.  Producers pay more of the tax if demand is relatively more elastic than supply.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 27 Partial Tax Shifting Demand Cigarettes Supply Tax Supply plus Tax #1 The tax changes the market equilibrium to a higher price and a lower quantity. #2 sellers receive less. #2 Consumers pay more. Dollars

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e EXPLORE & APPLY CRIME AND THE MARKET FOR DRUGS Supply in Free Market Supply with Drug War Demand P fm P dw Q dw Q fm #1 The drug war changes the market equilibrium, causing a higher price and lower quantity of output. Dollars #2 The revenue increases from the higher price #3 far exceeds the revenue decreases from the lower quantity

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 29 Terms along the Way  elasticity  elasticity of demand  inelastic  unit elastic demand  elastic demand  total revenue  perfectly inelastic  unit elastic throughout  perfectly elastic  elasticity  elasticity of demand  inelastic  unit elastic demand  elastic demand  total revenue  perfectly inelastic  unit elastic throughout  perfectly elastic  income elasticity of demand  cross elasticity of demand  elasticity of supply  inelastic supply  unit elastic supply  elastic supply  tax burden  tax shifting  income elasticity of demand  cross elasticity of demand  elasticity of supply  inelastic supply  unit elastic supply  elastic supply  tax burden  tax shifting

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 30 Test Yourself 1.The formula for all elasticities is the a.change in one variable divided by the change in another variable. b.change in one variable minus the change in another variable. c.percentage change in one variable divided by the percentage change in another variable. d.percentage change in one variable minus the percentage change in another variable. 1.The formula for all elasticities is the a.change in one variable divided by the change in another variable. b.change in one variable minus the change in another variable. c.percentage change in one variable divided by the percentage change in another variable. d.percentage change in one variable minus the percentage change in another variable.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 31 Test Yourself 2.Which of the following price elasticities of demand illustrates elastic demand? a.0.6 b.0.85 c.1.0 d Which of the following price elasticities of demand illustrates elastic demand? a.0.6 b.0.85 c.1.0 d.1.2

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 32 Test Yourself 3.The responsiveness of quantity demanded to changes in price a.increases over time. b.decreases over time. c.is not affected by passage of time. d.first decreases, but then increases over time. 3.The responsiveness of quantity demanded to changes in price a.increases over time. b.decreases over time. c.is not affected by passage of time. d.first decreases, but then increases over time.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 33 Test Yourself 4.If consumers buy 9 gizmos at a price of $9, and 10 gizmos at a price of $8, then demand is a.elastic. b.unit elastic. c.inelastic. d.proto-elastic 4.If consumers buy 9 gizmos at a price of $9, and 10 gizmos at a price of $8, then demand is a.elastic. b.unit elastic. c.inelastic. d.proto-elastic

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 34 Test Yourself 5.An income elasticity of demand that is positive indicates a good that is a.normal. b.inferior. c.a substitute. d.a complement. 5.An income elasticity of demand that is positive indicates a good that is a.normal. b.inferior. c.a substitute. d.a complement.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 35 Test Yourself 6.A cross elasticity of demand that is negative indicates that a.two goods are substitutes. b.two goods are complements. c.one good is a substitute and the other is a complement. d.both goods are normal. 6.A cross elasticity of demand that is negative indicates that a.two goods are substitutes. b.two goods are complements. c.one good is a substitute and the other is a complement. d.both goods are normal.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 36 The End! Next Chapter 16 “Consumer Behavior"