Elasticity of Demand Measurement of a good’s responsiveness to a change in price The price effect is greater for some goods than for others Examples:

Elasticity of Demand Large Price Effect → Elastic Ex: Small Price Effect → Inelastic Other Examples?

Factors Affecting Elasticity of Demand Wants = more elastic, needs = more inelastic Time: Can purchase be delayed? Time to adjust… Longer price change persists = more elastic (long run) Immediately after price change = more inelastic (short run) Availability, Suitability, Price of Substitutes More/better/cheaper substitutes = more elastic Ex: Ibuprofen vs. Insulin Percentage of Budget Larger % = more elastic Ex: New Car for me vs. LeBron James

Testing for Elasticity of Demand Graphical Comparison The flatter the curve, the more Elastic the good. The steeper the curve, the more Inelastic the good. ***ONLY APPLICABLE WHEN COMPARING 2 CURVES Elastic Inelastic

Testing for Elasticity of Demand Total Revenue Test --- TR = P x Q Example: If P and TR move in the same direction, demand is inelastic If P and TR move in opposite directions, demand is elastic Hot Dogs? Gas?

The Total Revenue Test Lower price and elastic demand Blue gain exceeds gold loss $3 2 1 0 10 20 30 40 Q P a b D1 6-7

The Total Revenue Test Lower price and inelastic demand Gold loss exceeds blue gain $4 3 2 1 0 10 20 Q P c d D2 6-8

The Total Revenue Test Lower price and unit-elastic demand Blue gain equals yellow loss $3 2 1 0 10 20 30 Q P e f D3 6-9

As long as Total Revenue is increasing with every increase in price, Demand is elastic **Marginal Revenue is positive When Total Revenue begins to decrease with every increase in price, Demand becomes inelastic **Marginal Revenue is negative

Elasticity on a Linear Demand Curve (1) Total Quantity of Tickets Demanded Per Week, Thousands (3) Elasticity Coefficient (Ed) (4) Total Revenue (1) X (2) (5) Total-Revenue Test (2) Price Per Ticket 1 2 3 4 5 6 7 8 $8 7 6 5 4 3 2 1 $8,000 14,000 18,000 20,000 8,000 ] 5.00 2.60 1.57 1.00 0.64 0.38 0.20 ] Elastic Unit Elastic Inelastic 6-11

Elasticity and the TR Curve 1 2 3 4 5 6 7 8 Quantity Demanded Price (Thousands of Dollars) Total Revenue $20 18 16 14 12 10 $8 Elastic Ed > 1 a b c d e f g h Unit Elastic Ed = 1 Inelastic Ed < 1 D TR 6-12

Price Elasticity of Demand Price-elasticity coefficient and formula Percentage Change in Quantity Demanded of Product X Ed = Percentage Change in Price of Product X 6-13

Price Elasticity of Demand Calculate percentage change Restate formula Change in Quantity Demanded of X Ed = Original Quantity Demanded of X Change in Price of X ÷ Original Price of X 6-14

Price Elasticity of Demand Calculation problem $4-$5 is 25% increase $5-$4 is 20% decrease Starting point matters Midpoint formula Change in Quantity Ed = Sum of Quantities/2 ÷ Change in Price Sum of Prices/2 6-15

Price Elasticity of Demand Why use percentages? Unit free measure Dollars vs. pennies Compare responsiveness across products JBCs vs. Porsches Elimination of the (-) sign Extreme cases Perfectly inelastic demand Perfectly elastic demand 6-16

Interpretations of Elasticity Elastic Demand Ed = .04 .02 = 2 Inelastic Demand Ed = .01 .02 = .5 Unit Elasticity Ed = .02 = 1 6-17

Extending Elasticity of Demand How does elasticity of demand affect us? What do these have in common? Government taxes inelastic goods… Why? Why doesn’t govt. tend to tax elastic goods?

“Government's view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.” -Ronald Reagan

Elasticity of Supply Elastic – easy/quick to produce – lower marginal cost for each additional unit produced Inelastic – harder/slower to produce – higher marginal cost for each additional unit produced Elasticity of supply increases as producers have more time to adjust to a price change Ex: 1979 Today

Factors Affecting Elasticity of Supply Ease of Production easier = more elastic Responsiveness to price change quicker adjustment = more elastic Time more time to adjust = more elastic

Price Elasticity of Supply Responsiveness to price changes by producers Percentage Change in Quantity Supplied of Product X Es = Percentage Change in Price of Product X 6-22

Elasticity of Supply changes over time Market Period – immediately after a change in price Perfectly inelastic supply Short Run – up to a few months after a change in price Inelastic or somewhat elastic supply Fixed plant size Long Run – many months/years after a price change Perfectly Elastic supply Adjustable plant size

Price Elasticity of Supply The Market Period Perfectly inelastic supply P Q Sm Greatest Price Impact Pm P0 D1 D2 Q0 6-24

Price Elasticity of Supply The Short Run Inelastic supply P Q Ss Lower Price Impact Ps P0 Fixed land. Some fixed capital. More labor? More fertilizer? D1 D2 Q0 Qs 6-25

Price Elasticity of Supply The Long Run Elastic supply P Q Sl Least Price Impact Pl P0 D1 D2 Q0 Ql 6-26

Price Elasticity of Supply Applications Antiques and reproductions Limited, inelastic supply Strong demand Resulting high price Volatile gold prices Inelastic supply Shifting demand 6-27

Cross Elasticity of Demand Responsiveness of sales to change in price of another good Percentage Change in Quantity Demanded of Product X Exy = Percentage Change in Price of Product Y 6-28

Cross Elasticity of Demand Substitute goods Positive sign Complementary goods Negative sign Independent goods Zero or near zero Coke and Sprite Example Mergers 6-29

Practice Problem P₁ P₂ Q₁ Q₂ Widgets $3 $5 47 21 Wadgets $2 12 3 Let’s look at 2 goods, Widgets and Wadgets. Given the following information: 1. Calculate the price elasticity of demand for widgets. Is demand for widgets elastic, inelastic, or unit elastic? 2. Calculate the cross elasticity of demand for wadgets as they relate to widgets. Would wadgets be considered complements, substitutes, or independent of widgets? P₁ P₂ Q₁ Q₂ Widgets $3 $5 47 21 Wadgets $2 12 3

Income Elasticity of Demand Percentage Change in Quantity Demanded Ei = Percentage Change in Income Responsiveness of sales to change in income Normal goods – positive sign Inferior goods– negative sign How can this help you profit from a recession? 6-31