ECO1000 Economics Semester One, 2004 Lecture Four

Class test 1 reminder (for internals) April 7 Test open from 5 pm-8pm 25 questions Based on lectures & all workshop activities Make sure you have Graph paper Rulers and pens Calculator Text book etc.

Lecture 6 Room Change The week after next, we miss a Friday due to Good Friday. To minimise disruption we have moved the lecture to Thursday April 8 in L209 at 10 am for 1 hour. This is the morning after your class test, and will allow you the chance to let me know how you went.

Outline or Plan of the Lecture Material Covered: Module Two, Part Two Reading: Text Chapter 5 plus Study Guide Chapter 5 Topics Considered: Elasticity

Purpose or Objectives of the Lecture You will learn about: What elasticity is The determinants of elasticity of demand The determinants of elasticity of supply The application of the concept

Relevant Economic Principles 3. Rational People Think at the Margin 4. People Respond to Incentives 6. Markets Are Usually a Good Way to Organise Activity

Revenue Total amount from the sale of a good or service Calculated as price/unit x quantity sold Profit = revenue - costs Economic profit = total revenue - explicit and implicit costs

Revenue in a Competitive Market Price Quantity S0S0 P0P0 Q0Q0 D0D0 = Revenue = P 0 x Q 0

A Change in Demand & Revenue Price Quantity S0S0 P0P0 Q0Q0 D0D0 = Revenue 0 = P 0 x Q 0 = Revenue 1 = P 1 x Q 1 Q1Q1 P1P1 D1D1 0

A Change in Supply & Revenue Price Quantity S0S0 P0P0 Q0Q0 D0D0 = Revenue 0 = P 0 x Q 0 = Revenue 1 = P 1 x Q 1 Q1Q1 P1P1 S1S1

The size of revenue change depends on the responsiveness of quantity demanded or quantity supplied to one of its determinants. QD not very responsive to change in Price QD very responsive* P0P0 P1P1 Increase in QD very small Increase in QD very large Price Quantity Q0Q0 Q1Q1 Q0*Q0* Q1*Q1*

Elasticity

Elasticity of Demand Elasticity of demand is a measure of responsiveness of the quantity demanded of a good to a change in: price of that good (own price elasticity) income (income elasticity) the price of another good (cross-price elasticity)

Why Economists Are Interested In Elasticity Elasticity allows us to compare two different markets. We can quantify differences in markets for different goods even if the units of measurement are different. Eg. We can say that oil demand is twice as sensitive to price changes as wheat demand even though oil is measured in gallons and wheat in tonnes.

Calculating Elasticity Basic Terms/Notation: Change in own price of good:  P Change in quantity:  Q Change in income:  I Change in the price of another good:  P other good

Basic Formula Own-Price Elasticity: %ΔQ ÷ %ΔP Income Elasticity: %ΔQ ÷ %ΔI Applications of these formulae are presented in the following slides.

Own Price Elasticity If the price of a good increases by 10% and the quantity demanded decreases by 20% The own price elasticity of demand = Number is always negative because of the law of demand

What does the Result Mean? Inelastic { Elastic This good is relatively elastic (responsive to changes in price) Elasticity (2) is greater than 1 (ignore the sign when considering relative elasticity) Change in qty greater than change in price

To Help Interpret the Result… Inelastic { Elastic Notice: there are no negative values. This is because we always view our elasticity number as an absolute value.

Income Elasticity If average income increases by 8% and the quantity demanded decreases by 2% Then income elasticity of demand = Number is negative. Therefore, the good must be inferior.

What Does the Result Mean? This good is relatively income inelastic because the elasticity is less than 1 (not very responsive to changes in income) 0.25 lies here in the inelastic section (remember to ignore the negative sign)

Another Example If average income decreases by 4% and the quantity demanded decreases by 6% Then the income elasticity of demand = This good is relatively income elastic because elasticity is greater than 1 (responsive) Number is positive. Therefore, it must be a normal good.

What Happens When You Are Given Prices and Quantities Rather Than Percentage Changes? Answer: You must first work out the percentage changes, then calculate the elasticity.

Suppose We Have the Following Changes: Price ($) Quantity/wk The price increases by $20/unit D The quantity demanded decreases by 400/wk

Calculating the Percentage Change in Price:  P = P 1 - P 0 = = +20 % Change =  P/P 0 x 100 = (20/80) x 100 = 0.25 x 100 = 25% The price has increased by 25% in relation to the initial price

Calculating the percentage change in quantity  Q = Q 1 - Q 0 = = % Change in Q =  Q/Q o = - 400/1200 x 100 = x 100 = - 33% Quantity has decreased by 33 percent

Calculating Final Elasticity Elasticity =  Q/  P = / 25 = The percentage change in quantity was larger than the percentage change in price. The good is relatively elastic because elasticity is greater than 1 The quantity demanded is quite responsive to the change in price.

A Good Way to Remember How to Calculate Percentage Change (New Price or Quantity – Old Price or Quantity) Old Price or Quantity Line means “divided by” X 100

The Full Elasticity Formula (long version)

Simplifying Yields… When dividing a fraction you take the reciprocal and multiply yielding a simpler formula:

What Causes Elasticity to Differ Across Goods? Some goods & services tend to have greater changes in quantity in response to price changes usually things people can do without Others have relatively small changes in quantity in response to price changes essential, highly desired or addictive things

The Same Price Change With Two Different Levels of Elasticity Price ($) Quantity/wk D0D D1D

Comparing the Elasticity of Two Goods Elasticity of D 0 = (from earlier calculation) For D 1 elasticity equals: = = ==

Points to Note The steeper curve generally indicates relative inelasticity The quantity of goods/services demanded are less responsive to changes in price However, elasticity also changes along a demand curve.

Why Elasticity Changes Along a Line Price ($) Quantity/wk Same price change of $20/unit D Same change in quantity demanded of 400/wk

Comparing the Elasticity Elasticity when P goes from 30 to 50 = 0.25 Elasticity when P goes from 80 to 100 = 1.33 (calculated using the formula below)

Comparing the Two Scenario 1 vs Scenario 2 Relatively large change in quantity in response to a relatively small change in price Comparatively responsive Somewhat elastic Relatively small change in quantity despite the relatively large in price Comparatively unresponsive Much more inelastic

Points to Note Even though the price and quantity changed by the same amounts (400 units and $20) the elasticity is different. This is because elasticity is based on relative changes to both price and quantity. That is, percentage changes. When quantities are high, the relative change will be smaller and vice versa

This Can Be Shown on the Following Demand Curve: Price Quantity Elasticity equals 1 (unit elastic) Elasticity less than 1 (inelastic) Elasticity greater than 1 (elastic) D

What Makes Goods More Inelastic? Uniqueness (few substitutes) Necessity (versus discretionary spending) Non-durables (hard to postpone consumption) Account for small proportion of household incomes (people keep buying them) Little time to adjust to price changes

The Effect on Revenue

The Change in Revenue for an Elastic Good (assume supply has shifted) Price ($) Quantity/wk D0D Revenue 1 = 1200 x 80 = $96,000/wk Revenue 2 = 100 x 800 = $80,000 Change in revenue = -$16,000/wk

The Change in Revenue for an Inelastic Good Price ($) Quantity/wk D0D D1D1 Revenue 1 = $96,000 Revenue 2 = 1080 x 100 = $108,000 Change in revenue = + $12,000/wk

Revenue and Elasticity If a good or service is relatively inelastic, then an increase in the price will lead to an increase in revenue If a good or service is relatively elastic, then an increase in price will lead to a decrease in revenue

Elasticity of Supply Calculated in the same way as own- price elasticity

Elasticity of Supply is Affected by… Whether firms are operating at full capacity (can’t respond to price increases) Whether firms can switch to other products Assessment of whether price change is long term or short term (should they bother?) Ease of storage of product (stockpiling) Time lag from decision to actual production

A Change in Quantity & Price Price ($) Quantity/wk The price increases by $20/unit S The quantity supplied increases by 200/wk

Elasticity of Supply = = 0.8 =

Points to Note Elasticity of supply is always positive increase in price is associated with increase in quantity In this case elasticity is relatively inelastic The percentage change in price was much greater than the consequent percentage change in quantity At lower quantities, the outcome would be different, as in the demand example

Conclusions Elasticity is a measure of the responsiveness of demand and supply to changes in their determinants. A good that has elasticity < 1 is inelastic A good that has elasticity > 1 is elastic We ignore the negative sign and treat the result of our elasticity calculation as an absolute number

In Light of the Objectives for this Lecture… We now know: That elasticity is a measure of responsiveness or sensitivity That elasticity of demand and supply is determined by certain factors (eg. few substitutes may cause demand to be inelastic) That elasticity is an additional analytical tool that may be added to our supply and demand model developed last week.

Next Week Next Week’s Lecture: Material Covered: Module Two, Part Three Reading: Text Chapter 6 Plus Hakes and Parry Chapter 6 Topics: Markets and Government Policy

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