IB-SL Economics Mr. Messere - CIA 4U7 Victoria Park S.S. Elasticity IB-SL Economics Mr. Messere - CIA 4U7 Victoria Park S.S. 1
Outline I. Introduction II. Elasticity of Demand A. Definition B. Degrees of Elasticity of Demand C. Relationship between Ed and Total Revenue D. Determinants of Elasticity of Demand III. Other Elasticities A. Income Elasticity of Demand B. Cross Price Elasticity of Demand C. Elasticity of Supply D. Determinants of Elasticity of Supply 2
Coffee Question Consider the following: An economist was called in to consult for a coffee shop that was losing money. One manager thought they needed to raise prices in order to make more money on each coffee sold. The other manager thought that lowering prices would make more money because a lot more coffee could be sold. Who was right? 4
Coffee Question The answer is - it depends. On what? If you lower the price - will the new sales offset the loss in revenue on each coffee? If you raise your price - will the loss in sales be offset by the increase in price of coffee? In other words, how much will the quantity demanded change when price changes?
Demand We know, from the Law of Demand, that price and quantity demanded are inversely related. Now, we are going to get more specific in defining that relationship We want to know just how much will quantity demanded change when price changes? That is what elasticity of demand measures.
Elasticity of Demand Elasticity of Demand (Ed) measures the responsiveness of the quantity demanded (Qd) of a good to a changein its price (P). Ed = % in Qd (Note that means “change”) % in P Ed = [(Q2-Q1)/Q1] ÷ [(P2-P1)/P1] Also note that the law of demand implies Ed is negative. We will ignore the negative sign when discussing price elasticity of demand. 7
Calculating Elasticity of Demand There are two methods for calculating elasticity - point and arc methods. We will be examining the point method.
Point Elasticity P Qd Consider the following Demand Curve: 6 5 2 D 1 2 Qd 2 3 6 7
Point Elasticity P Qd A …and let’s say we want to find the Elasticity of Demand as we move from point A to Point B... 6 B 5 2 D 1 Qd 2 3 6 7
Point Elasticity We know Ed = % in Qd or Ed = [(Q2-Q1)/Q1] ÷ [(P2-P1)/P1] % in P To calculate Ed from point A to B: [(3-2)/2] [(5-6)/6] 1/2 ÷ -1/6 3 (since negative sign ignored) Calculate Ed from point C to D on the same curve
Point Elasticity P 6 5 C 2 D 1 Qd 2 3 7 8
Point Elasticity Recall: Ed = % in Qd or Ed = [(Q2-Q1)/Q1] ÷ [(P2-P1)/P1] % in P To calculate Ed from point C to D: [(8-7)/7] [(1-2)/2] 1/7 ÷ -1/2 2/7 or 0.29 (since negative sign ignored)
Point Elasticity Note that Ed is different at different places along the curve. Specifically, it gets smaller as you move down the curve Note that elasticity and slope are NOT the same thing. One last calculation - let’s find the elasticity of demand going from point D to point C on the same curve
Point Elasticity Recall: Ed = % in Qd or Ed = [(Q2-Q1)/Q1] ÷ [(P2-P1)/P1] % in P To calculate Ed from point D to C: [(7-8)/8] [(2-1)/1] -1/8 ÷ 1 1/8 or 0.13 (since negative sign ignored)
How Do We Interpret Elasticity? The number we get from computing the elasticity is a percentage - there are no units. We can read it as the percentage change in quantity for a 1% change in price
How Do We Interpret Elasticity? Thus, if Ed = 2, that means on that part of the demand curve, a 1% change in price will cause a 2% change in quantity demanded. Or if we extrapolate, a 10% change in price will cause a 20% change in quantity demanded, and so on.
Degrees of Demand Elasticity Perfectly Inelastic Demand Ed = % in Qd % in P Ed = 0 % in P Ed = 0 No matter how much price changes, consumers purchase the same amount of the good. Example: Insulin 22
Elasticity P Qd Perfectly Inelastic Demand ED = 0 28
Degrees of Ed Inelastic Demand Ed = % in Qd % in P Ed < 1 (in absolute value) % in Qd < % in P For every 1% change in P, Qd changes by less than 1% 23
Elasticity Relatively Inelastic P Qd 31
Degrees of Ed Unitary Elastic Demand Ed = % in Qd % in P Ed = 1 (in absolute value) % in Qd = % in P For every 1% change in P, Qd changes by 1% (in opposite direction) 24
Unitary Elastic Demand P Unitary Elastic QD 30
Degrees of Ed Elastic Demand Ed = % in Qd % in P Ed > 1 (in absolute value) % in Qd > % in P For every 1% change in P, Qd changes by more than 1% (in opposite direction) 25
Elasticity P Qd Relatively Elastic 30
Degrees of Ed Perfectly Elastic Demand Ed = % in Qd % in P Ed = % in Qd 0 Ed = infinity The price of the good never changes, no matter how much consumers purchase of the good. 26
Elasticity P Perfectly Elastic Demand ED = œ Qd 27
Generalizing about Elasticity Notice that the vertical (perfectly inelastic) demand curve has an elasticity of zero and the flat (perfectly elastic) demand curve has an elasticity of infinity. As the demand curve goes from vertical to horizontal the elasticity is going from 0 to infinity In other words, the flatter the demand curve, the greater the elasticity or if the curve becomes more vertical, then demand becomes more inelastic
The Coffee Problem Back to the Coffeehouse question - should they raise or lower price? We said that depended on how much sales will change when they change price In other words, it depends on the elasticity
Total Revenue & Elasticity Total Revenue = Price (p) x Quantity (q) The coffeehouse is interested in how TR (total revenue) changes as p and q change 33
Total Revenue Calculation - Example Price $1 Qd = 100 TR = $100 Price $3 Qd = 90 TR = $270 Price $4 Qd = 50 TR = $200 Price $5 Qd = 30 TR = $150 34
Total Revenue and Elasticity Let’s say demand is inelastic. Then if the coffeehouse raises prices 10%, the sales will drop by less than 10% In other words, the gain in revenue from higher prices is greater than the loss in revenue from lost sales. Therefore, Total Revenue will rise P Qd 10% TR DCoffee
Total Revenue and Elasticity If they lowered prices, though, the loss of revenue from higher prices would be greater than the gain from increased sales, so Total Revenue will fall P Qd 10% TR DCoffee
Total Revenue and Elasticity Let’s say demand is elastic. Then if the coffeehouse raises prices 10%, the sales will drop by more than 10% In other words, the gain in revenue from higher prices is less than the loss in revenue from lost sales. Therefore, Total Revenue will fall TR P Qd 10% DCoffee
Total Revenue and Elasticity If they lowered prices, though, the loss of revenue from higher prices would be less than the gain in revenue from increased sales, so Total Revenue will rise P 10% DCoffee TR Qd
Total Revenue and Demand So we can look at what happens to total revenue as we move down a demand curve As we move down a demand curve we know that demand is elastic and as we lower price further demand becomes less elastic until we hit unit elasticity, at which point total revenue begins to fall and demand becomes more inelastic
Total Revenue and Demand ED = infinite $ Unitary Elastic Ed = 1 Elastic Ed >1 Inelastic Ed < 1 ED = 0 Q Ed = 1 $ Ed > 1 Ed < 1 Total Revenue Q
Total Revenue Test 41
Total Revenue Test If P and Total Revenue Move Together Demand is Inelastic If Qd and TR Move Together Demand is Elastic If changes in P or Qd Don’t Change TR Demand is Unitary Elastic 42
Determinants of Ed Availability of Substitutes As there are more substitutes, demand is more elastic With fewer substitutes, demand is more inelastic Example: Coca-Cola has many substitutes and hence, demand is very elastic Insulin has no substitutes for diabetic and hence, demand is very inelastic. 43
Determinants of Ed Percentage of Income Spent on Commodity The less expensive a good is as a fraction of our total budget, the more inelastic the demand for the good is (and vice versa). Example: Price of cars go up 10% (from $20,000 to $22,000) Price of toothpicks rise by 10% (from $2 to $2.20) Demand is more (elastic) affected by the price of cars increasing vs. the increase in the price of toothpicks (price inelastic). 44
Determinants of Ed Time The longer the time frame is, the more elastic the demand for a good is (and vice versa). Example - Price of Gasoline Increases Immediately: can’t do much, still need to get to work, school, etc. Short-run: find a car pool, ride bike, public transit Long-run: next car you buy uses less gas. 45
Determinants of Ed Nature of the Product - Necessities vs. Luxuries The more necessary a good is, the more inelastic the demand for the good (and vice versa). Example: Insulin 46
Income Elasticity of Demand Income Elasticity of Demand (Ey) - measures the responsiveness of quantity demanded to changes in income (Y). Ey = % in Qd % in Y Ey = ( Q/Q) ÷ ( Y/Y) Note that the negative sign is important! 47
Normal Goods Typically, if our income rises, we buy more and vice versa. These types of goods are called normal goods. EdY > 0 - normal good
Inferior Goods There are some goods we buy less of as our income grows and more of as our income falls. For instance, in university you’ll probably eat Macaroni & Cheese. But when you get a high paying job (as all V.P. grads do) you will probably buy less Mac and Cheese. If a good’s elasticity is EdY < 0 it is an inferior good
Cross Price Elasticity of Demand Another type of elasticity is the Cross Price Elasticity. This measures how changes in the price of one good can affect the quantity demanded of another Cross Price Elasticity of Demand (EAPB) - measures the responsiveness of quantity demanded of good A when the price of good B changes. 52
Cross Price Elasticity of Demand EAPB = % in Qd of Good A % in P of Good B EAPB = (QA / QA ) (PB / PB) Note that the sign DOES matter for this elasticity also!
Substitute Goods Consider Coke and Pepsi. If the price of Coke goes up, what would you expect to happen to the demand for Pepsi? It will rise, since people will buy less Coke and more Pepsi. Thus the Demand for Pepsi will rise. So the bottom of the elasticity fraction is positive and top of the elasticity fraction is positive.
Substitute Goods This relationship is called substitutes and can be seen when EA,B> 0.
Complement goods Consider Washing Machines and Dryers. If the price of Washing Machines rises, what would you expect to happen to the demand for Dryers? It will fall, since people will buy less washers at the new price, they will need less dryers. So the bottom of the elasticity fraction is positive and top of the elasticity fraction is negative.
Complement Goods This relationship is called complements and can be seen when EA,B < 0
Elasticity of Supply This is similar to price elasticity of demand, except we substitute the word supply for demand. It is measured the same and is inelastic, elastic, and unit elastic. Elasticity of Supply (Es) - measures the responsiveness of quantity supplied to changes in price of the good. 58
Elasticity of Supply Es = % in Qs % in P ES = (Q/Q) ÷ (P/P) or ES = [(Q2-Q1)/Q1]÷ [(P2-P1)/P1] Law of Supply tells us this number is generally positive.
Determinants of Elasticity of Supply If supply is getting more (or less) elastic, we are saying that the firms can change supply in larger (or smaller) quantities when price changes. Generally, anything that can affect a firm’s ability to change production easily will affect the elasticity of supply.
Determinants of Elasticity of Supply Time if time period very short, then an increase in price does not significantly affect the quantity offered for sale as the time period becomes longer, supply tends to become more elastic sellers are able to respond more easily to changes in the prices of their products
Determinants of Elasticity of Supply Storage Cost non-perishable goods (sunglasses) can be stored at low costs and thus supply elasticity is greater than perishable goods (vegetables) with high storage costs with changes in price for non-perishable goods that can be stored cheaply producers can release some extra quantities when price rises and withdraw item from market when price falls above option may not be possible with high storage costs
Elasticity of Supply Cases Q Perfectly Elastic Supply P Q Elastic Supply P Q Unitary Elastic Supply Inelastic Supply P Q P Q Perfectly Inelastic Supply
Examples of Elasticity of Supply To consider: How would the supply curve of NHL players differ from the supply curve of bakers? What would the supply curve of Picasso paintings look like?