Elasticity and Its Applications Chapter 5 Elasticity and Its Applications Ratna K. Shrestha 1 1 1 1 1 1 1

Overview Elasticity Elasticity of Demand Elasticity of Supply Cross Price Elasticity Income Elasticity of Demand Applications of Elasticity 2 2 2 2 2

Elasticity . . . Elasticity is a measure of how much buyers and sellers respond to changes in market conditions. This measure allows us to analyze supply and demand with greater precision. More precisely, it is the percentage (%) change in something. . . given a one percent (1%) change in something else. 3 2 3 3 3 3 3

(1) Price Elasticity of Demand ED = % change in the quantity demanded given a one % change in its price. A P1 B P2 Q1 Q2 Q 7 5 7 7 7 7 7

Ranges of Elasticity . . . Perfectly Inelastic (ED = 0): Consumers are “completely unresponsive” to price changes. Perfectly Elastic (ED = - ): Consumers are “infinitely responsive” to price changes. Unit Elastic (ED = -1): Consumer’s response is “equal to” change in price in percentage terms. 8 6 8 8 8 8 8

Elasticity of Demand Illustrated Perfectly Inelastic ED = 0 P2 Even if price increases a lot quantity demanded stays the same at Q1. P1 Q1 9 9 7 9 9 9 9

Elasticity of Demand Illustrated A small increase in price will cause demand to drop off completely. P P1 Perfectly Elastic ED = -  Q 10 7 10 10 10 10 10

Determinants of Price Elasticity of Demand Demand tends to be more elastic: if the good is a luxury; the longer the time period; the greater the number of close substitutes; the more narrowly defined the market. Ex: Demand for a car (broad market) vs. Toyota Corolla (narrowly market). Obviously demand for a Toyota car is more elastic than the demand for a car in general. Why? 11 8 11 11 11 11 11

Determinants of Price Elasticity of Demand Demand tends to be more inelastic: if the good is a necessity; the shorter the adjustment time; if there are few good substitutes; and the more broadly defined the market. 12 9 12 12 12 12 12

Short-Run Vs. Long-Run Elasticity In general, demand is much more price elastic in the long run. Consumers take time to adjust consumption habits. E.g.,if the price of gasoline increases, you cannot decrease your driving right away. It takes time for you to move closer to your school or work or switch to energy efficient vehicles. More substitutes are usually available in the long run. Moreover if the price of Toyota Corolla goes up you can switch to Honda Civic easily. But if the price of food goes up, is there anything you can switch to? 86

Short-Run and Long-Run Demand Curves People cannot easily adjust consumption in short run. In the long run, people tend to drive smaller and more fuel efficient cars. Alternative energy cars (e.g., battery operated) may also be available. Quantity of Gas Price DSR DLR 87

Computing Elasticity Coefficient Percentage Change in Quantity Demanded Price Elasticity of Demand, ED = Percentage Change in Price % Q Q/Q = = P/P % P (Q2 – Q1)/Q1 = (P2 – P1)/P1 13 13 10 13 13 13 13

Computing Elasticity Coefficient (8 - 10) / 10 Demand for Ice Cream ED = ($2.2 - $2.0)/$2.0 2.20 -(20%) -2.0 = = 2.00 (10%) Demand is Elastic because ED > 1 8 10 15 12 15 15 15 15 15

Elasticity and Total Revenue Over the Elastic Range of prices and quantity the relationship between price and total revenue (TR) is INDIRECT If ED  > 1 then Q and TR P 18 15 18 18 18 18 18

Elasticity and Total Revenue Over the Inelastic Range of prices and quantity the relationship between price and total revenue is DIRECT ED  < 1 then TR P Q and 20 17 20 20 20 20 20

Price Elasticity and a Linear Demand Curve Given a linear demand curve Elasticity (at a point) depends on slope and on the values of P and Q at that point. The top portion of demand curve is elastic. At the point where Q=0, you are not consuming anything so a small change in P can trigger you to buy a lot—perfectly elastic. The bottom portion of demand curve is inelastic. At the point where Q=8, you are already consuming the maximum you want and so a small change in P will not affect your demand at all—perfectly inelastic.

Price Elasticity of Demand ED = -1 ED = 0 ED = - Q Price 4 8 2 Elastic Demand Curve Q = 8 – 2P Inelastic 76

Price Elasticity of Demand The steeper the demand curve, the more inelastic the good. In this case, the change in your demand for a given price change is smaller. The flatter the demand curve, the more elastic the good. One interesting observation in the case of a linear demand curve is that even though its slope is constant the elasticity is not. Why??

Policy Questions As a curator of an art museum, would you raise or lower the admission fee if you are running short of funds? As the CEO of Telus, would you increase the price of local or international calls? Which policy: hike tax on basic cars or BMWs do you think is more effective in raising revenue?

(2) Income Elasticity = = The percentage change in the quantity demanded given a one percent change in income. % Change in Demand Income Elasticity of Demand, YD = %Change in Income Q/Q = I /I 23 20 23 23 23 23 23

Income Elasticity... Types YD > 0 Normal Goods YD < 0 Inferior Goods YD = 0 Income-neutral Goods Most of the goods are normal goods. But there are some goods which are inferior. If you income goes up, will you consider to purchase a car and hence make less bus rides. What kind of goods do people buy especially during recession when their income go down? 24 21 24 24 24 24 24

Income Elasticity... Types Goods consumers regard as “necessities” tend to be income inelastic... Examples include: food, fuel, clothing, utilities, & medical services. Goods consumers regard as “luxuries” tend to be income elastic... Examples include: Sports cars, furs, and expensive foods. 25 22 25 25 25 25 25

(3) Cross-Price Elasticity of Demand Measures the % change in the quantity demanded of one good (good b) that results from a one % change in the price of another good (m). Depending on how this relationship exists, the two goods may be complements or substitutes. 81

Cross-Price Elasticity of Demand Complements: Cars and Tires Cross-price elasticity of demand is negative If price of cars increases, quantity demanded of tires decreases (due to shift in D curve to the left) Substitutes: Butter and Margarine Cross-price elasticity of demand is positive If price of butter increases, quantity of margarine demanded increases 83

(4) Price Elasticity of Supply The % change in quantity supplied resulting from a one % change in price. B P2 A P1 Q1 Q2 Q 29 25 29 29 29 29 29

Ranges of Elasticity Perfectly Elastic, E = infinite Relatively Elastic, E > 1 Unit Elastic, E = 1 Relatively Inelastic, E < 1 Perfectly Inelastic, E = 0 30 26 30 30 30 30 30

Elasticity of Supply Illustrated Perfectly Inelastic Perfectly Elastic Q 31 27 31 31 31 31 31

Determinants of Elasticity of Supply Flexibility or ability of sellers to change the amount of the good they produce. Beachfront land vs. books, cars, manufactured goods, etc. The supply of beachfront land is obviously fixed. More elastic in the long run. For example agricultural production. It takes time for the farmers to respond (by producing more) to an increase in price. 32 28 32 32 32 32 32

Computing Elasticity Coefficient % Q Supplied Elasticity of Supply = % P Explain why the price elasticity of supply might be different in the long run than in the short run. 33 33 29 33 33 33 33

Applications of Elasticity “Can Good News for Farming Be Bad News For Farmers?” What happens to wheat farmers and the market for wheat when UBC agronomists discover a new wheat hybrid that is more productive than existing varieties? 31 36 36 36

Examine whether the supply or demand curve shifts due to UBC’s discovery. Price SA $4.00 DA Quantity of Wheat 2000 38 33 38 38 38 38 38

Consider which direction the curve shifts. SA Price SB Technology causes an increase in supply. $4.00 DA Quantity 2000 39 39 34 39 39 39 39

Use Supply-and-Demand diagram to see how the market changes. SA Price SB $4.00 $2.60 DA Quantity 2000 2400 40 35 40 40 40 40 40

Compute Elasticity (2400 - 2000) / (2000) ED = ($2.60 - $4.00) /($4.00) = 0.57 (Inelastic) Recall that in the inelastic range, P and TR move in the same direction. 41 36 41 41 41 41 41

Observe the Change in Total Revenue SA Price SB TRSA = $8,000 $4.00 TRSB = $5,760!  Bad news for the farmers $2.60 DA 2000 2400 Quantity 42 42 37 42 42 42 42

Applications of Elasticity “Does a War on Drug Dealers Reduce Drug-Related Crime?” What happens to drug-related crime such as theft and violent behavior when police and custom officers impose higher penalties and stricter enforcement on drug dealers? 36 31 43 43 43 43 43

Apply Comparative Statics Going after drug dealers reduces supply of drugs such as heroin (shift left). The price of illegal drugs will increase. Since the demand for addictive drugs is inelastic, drug users will need to spend more in total dollars on drugs.  Drug-related crime will increase! 37 32 45 45 45 45 45

Drug Education Policy? Educating the public with regard to the bad effects of drug use will shifts demand for illegal drugs to the left. As a result, the price of illegal drugs will decrease. Since the demand for addictive drugs is inelastic, drug users spend less in total dollars on drugs.  Drug-related crime will decrease! 36 31 46 46 46 46 46

Applications of Elasticity “Why did OPEC fail to keep the price of oil high in the long run?” While the OPEC cartel has been successful in achieving short run bursts in oil prices, over the long run these high oil prices have not been maintained. 36 31 47 47 47 47 47

Apply Comparative Statics OPEC’s cartel policy consists of restricting the supply of oil, shifting the supply for crude oil to the left. This will increase the price of oil. In the short run, the demand for oil is inelastic.  A higher price for oil will increase the total revenue of OPEC. 37 32 49 49 49 49 49

Apply Comparative Statics In the long run, the demand for oil and the supply of oil becomes more elastic. This will tend to dampen oil prices. Why is oil inelastic in the short run? oil is a necessity item adding to the supply of oil is difficult Over time elasticity increases due to conservation, alternate energy sources... 37 32 50 50 50 50 50