Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Chapter 5 Elasticity and Its Applications © 2002 by Nelson, a division of Thomson Canada Limited

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Overview  Elasticity  Elasticity of Demand  Elasticity of Supply  Applications of Elasticity

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Elasticity... … is a measure of how much buyers and sellers respond to changes in market conditions... … allows us to analyze supply and demand with greater precision.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Elasticity: A General Definition: The percentage (%) change in something given a one percent (1%) change in something else.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Three Types of Elasticities...  Price Elasticity of Demand  Income Elasticity  Price Elasticity of Supply Price Quantity

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Overview Elasticity  Elasticity of Demand  Elasticity of Supply  Applications of Elasticity

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Price Elasticity of Demand The percentage change in the quantity demanded given a one percent change in the price. A B Demand P Q

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Ranges of Elasticity...  Perfectly Inelastic Consumers are “completely unresponsive” to price changes.  Perfectly Elastic Consumers are “infinitely responsive” to price changes.  Unit Elastic Consumer’s response is “equal to” change in price.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Elasticity of Demand Illustrated Perfectly Inelastic P2P2 P1P1 Even if price increases a lot quantity demanded stays the same.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Elasticity of Demand Illustrated Perfectly Elastic P1P1 A small increase in price will cause demand to drop off completely.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition 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; and – the more narrowly defined the market.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition 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.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Computing Elasticity Coefficient  Computed as the percentage change in the quantity demanded divided by the percentage change in price. Price Elasticity of Demand = Percentage Change in Quantity Demanded Percentage Change in Price

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Computing Elasticity Coefficient Demand for Ice Cream EDED ($ $2.00) / $2.00 (8 - 10) / 10 =

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Computing Elasticity Coefficient Demand for Ice Cream EDED (10%) (20%) =

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Computing Elasticity Coefficient Demand for Ice Cream EDED = 2

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Computing Elasticity Coefficient Demand for Ice Cream EDED = 2 Demand is Elastic

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Elasticity and Total Revenue Over the Elastic Range of prices and quantity the relationship between price and total revenue is INDIRECT or OPPOSITE

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Elasticity and Total Revenue E D > 1 then P QTR and

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Elasticity and Total Revenue Over the Inelastic Range of prices and quantity the relationship between price and total revenue is DIRECT or THE SAME

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Elasticity and Total Revenue E D < 1 then P QTR and

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Income Elasticity of Demand The percentage change in the quantity demanded given a one percent change in income.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Computing Income Elasticity  Computed as the percentage change in demand divided by the percentage change in Income. Income Elasticity of Demand = Percentage Change in Demand Percentage Change in Income

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Income Elasticity... Types Y D > 0 Normal Goods Y D < 0 Inferior Goods Y D = 0 Income-neutral Goods

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Income Elasticity... Types  Goods consumers regard as “necessities” tend to be income inelastic... – Examples include: food, fuel, clothing, utilities, & medical services.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Income Elasticity... Types  Goods consumers regard as “luxuries” tend to be income elastic... – Examples include: Sports cars, furs, and expensive foods.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Quick Quiz!  Define the price elasticity of demand.  Explain the relationship between total revenue and elasticity of demand

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Overview Elasticity Elasticity of Demand  Elasticity of Supply  Applications of Elasticity

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Price Elasticity of Supply The percentage change in quantity supplied resulting from a one (1) percent change in price. Price Quantity A B

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Ranges of Elasticity  Perfectly Elastic infinite  Relatively Elastic >1  Unitary or Unit =1  Relatively Inelastic <1  Perfectly Inelastic = 0

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Elasticity of Supply Illustrated Perfectly Inelastic Perfectly Elastic P Q

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition 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. – More elastic in the long run.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Computing Elasticity Coefficient  Computed as the percentage change in the quantity supplied divided by the percentage change in price. Elasticity of Supply = Percentage Change in Quantity Supplied Percentage Change in Price

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Quick Quiz!  Define the elasticity of supply.  Explain why the price elasticity of supply might be different in the long run than in the short run.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Overview Elasticity Elasticity of Demand Elasticity of Supply  Applications of Elasticity

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Applications of Elasticity “Can Good News for Farming Be Bad News For Farmers?” What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties?

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Apply Comparative Statics  Examine whether the supply or demand curve shifts.  Consider the direction the curve shifts.  Use supply-and-demand diagrams to see how the market equilibrium changes. Consider the state of elasticity.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Examine whether the supply or demand curve shifts. SASA DADA Price Quantity $

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Consider which direction the curve shifts. SASA DADA Price Quantity $ SBSB Technology causes an increase in supply.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Use Supply-and-Demand diagram to see how the market changes. SASA DADA Price Quantity $ SBSB 2400 $2.60

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Compute Elasticity E D = ( ) / (2000) ($ $4.00) / ($4.00) E D = 0.57 (Inelastic)

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Observe the Change in Total Revenue SASA DADA Price Quantity $ SBSB 2400 $2.60 TR SA = $8,000 TR SB = $5,760!

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Applications of Elasticity “Does a War on Drug Dealers Reduce Drug-Related Crime?” What happens to drug-related crime such as theft and violent behaviour when police and custom officers impose higher penalties and stricter enforcement on drug dealers?

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Apply Comparative Statics  Examine whether the supply or demand curve shifts.  Consider the direction the curve shifts.  Use supply-and-demand diagrams to see how the market equilibrium changes. Consider the state of elasticity.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Apply Comparative Statics  Going after drug dealers affects the supply of drugs such as heroin.  This policy reduces supply.  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!

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Drug Education Policy?  Educating the public with regard to the bad effects of drug use will affect the demand for illegal drugs.  This policy reduces demand.  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!

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition 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.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Apply Comparative Statics  Examine whether the supply or demand curve shifts.  Consider the direction the curve shifts.  Use supply-and-demand diagrams to see how the market equilibrium changes. Consider the state of elasticity.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Apply Comparative Statics  OPEC’s cartel policy consists of restricting the supply of oil.  The supply for oil will decrease.  The price of oil will increase.  In the short run, the demand for oil is inelastic. A higher price for oil will increase the total revenue of OPEC.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition 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...

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Conclusion  Elasticity is defined as...  Price Elasticity of demand is...  Income Elasticity of demand is...  Price Elasticity of supply is...  What are the relationships between elasticity and total revenue or total consumer expenses?

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition Overview Elasticity Elasticity of Demand Elasticity of Supply Applications of Elasticity