1. 1 of 45 SUMMARY chapter: 6 >> Krugman/Wells ©2009  Worth Publishers Elasticity

2. 2 of 45 WHAT YOU WILL LEARN IN THIS CHAPTER  What is the definition of elasticity?  What is the meaning of  price elasticity of demand  income elasticity of demand  price elasticity of supply  What factors influence the size of elasticities?  How is the size of price elasticity of demand related to total revenue?

3. 3 of 45 Defining and Measuring Elasticity  The price elasticity of demand is the ratio of the percent change in the quantity demanded to the percent change in the price.  The law of demand says that price and quantity demanded move in opposite directions. This means that the price elasticity of demand is a negative number. However, economists report the absolute value of the elasticity.

4. 4 of 45 The Price Elasticity of Demand

5. 5 of 45 Interpreting the Price Elasticity of Demand Two Extreme Cases of Price Elasticity of Demand:  Demand is perfectly inelastic when the quantity demanded does not respond at all to changes in the price. When demand is perfectly inelastic, the demand curve is a vertical line.  Demand is perfectly elastic when any price increase will cause the quantity demanded to drop to zero. When demand is perfectly elastic, the demand curve is a horizontal line.

6. 6 of 45 Two Extreme Cases of Price Elasticity of Demand D 1 … leaves the quantity demanded unchanged. An increase in price… 10 Quantity of shoelaces (billions of pairs per year) (a)Perfectly Inelastic Demand: Price Elasticity of Demand = 0 $3 $2 Price of shoelaces (per pair)

7. 7 of 45 Two Extreme Cases of Price Elasticity of Demand At any price above $5, quantity demanded is zero At exactly $5, consumers will buy any quantity At any price below $5, quantity demanded is infinite D 2 (b) 0 Price Elastic Demand: Price Elasticity of Demand = ∞ $5 Price of pink tennis balls (per dozen) Quantity of tennis balls (dozens per year)

8. 8 of 45 Interpreting the Price Elasticity of Demand  Demand is elastic if the price elasticity of demand > 1.  Demand is inelastic if the price elasticity of demand < 1.  Demand is unit-elastic if the price elasticity of demand = 1.  Demand is perfectly elastic if the price elasticity of demand = ∞.(horizontal demand curve)  Demand is perfectly inelastic if the price elasticity of demand = 0.(vertical demand curve)

9. 9 of 45 Unit Elasticity of Demand A 20% increase in the price... D 1... generates a 20% decrease in the quantity of crossings demanded. (a) Unit-Elastic Demand: Price Elasticity of Demand = 1 9001,1000 $1.10 0.90 Price of crossing Quantity of crossings (per day) A B

10. 10 of 45 Inelastic Demand D 2... generates a 10% decrease in the quantity of crossings demanded. (b) Inelastic Demand: Price Elasticity of Demand = 0.5 9501,0500 $1.10 0.90 Price of crossing Quantity of crossings (per day) A 20% increase in the price... A B

11. 11 of 45 Elastic Demand … generates a 40% decrease in the quantity of crossings demanded. D 3 (c) Elastic Demand: Price Elasticity of Demand = 2 8001,2000 $1.10 0.90 Quantity of crossings (per day) Price of crossing A 20% increase in the price... B A In this case, the demand curve is flatter.

12. 12 of 45 Some Estimated Price Elasticities of Demand Good Price elasticity Inelastic demand  Eggs 0.1  Beef 0.4  Stationery0.5  Gasoline 0.5 Elastic demand  Housing 1.2  Restaurant meals 2.3  Airline travel 2.4  Foreign travel 4.1 Price elasticity of demand<1 Price elasticity of demand>1

13. 13 of 45 Price Elasticity of Demand & Total Revenue  This classification predicts how changes in the price of a good will affect the total revenue.  The total revenue is defined as the total value of sales of a good or service, i.e.  Total Revenue = Price × Quantity Sold

14. 14 of 45 Total Revenue by Area D Total revenue = price x quantity = $990 1,1000 $0.90 Price of crossing Quantity of crossings (per day)

15. 15 of 45 Elasticity and Total Revenue  When a seller raises the price of a good, there are two countervailing effects in action (except in the rare case of a good with perfectly elastic or perfectly inelastic demand):  A price effect: After a price increase, each unit sold sells at a higher price, which tends to raise revenue.  A quantity effect: After a price increase, fewer units are sold, which tends to lower revenue.

16. 16 of 45 Effect of a Price Increase on Total Revenue Price effect of price increase: higher price for each unit sold D Quantity effect of price increase: fewer units sold B C A 9001,1000 $1.10 0.90 Quantity of crossings (per day) Price of crossing

17. 17 of 45 Elasticity and Total Revenue  If demand for a good is elastic (Ep>1), an increase in price reduces total revenue. (P↑  TR↓)  In this case, the quantity effect is stronger than the price effect.  If demand for a good is inelastic (Ep<1), a higher price increases total revenue. (P↑  TR↑)  In this case, the price effect is stronger than the quantity effect.  If demand for a good is unit-elastic (the price elasticity of demand is 1), an increase in price does not change total revenue. (P↑  TR no change)  In this case, the sales effect and the price effect exactly offset each other.

18. 18 of 45 What Factors Determine the Price Elasticity of Demand? Price Elasticity of Demand is determined by:  Whether Close Substitutes Are Available  If there are other goods that consumers regard as similar and would be willing to consume instead, the price elasticity of demand tends to be high.  Whether the Good Is a Necessity or a Luxury  If a good is something you must have, the price elasticity of demand tends to be low. If the good is a luxury, the price elasticity of demand tends to high.  Time  In general, the price elasticity of demand tends to increase as consumers have more time to adjust to a price change.

19. 19 of 45 Cross-Price Elasticity  The cross-price elasticity of demand between two goods is the percent change in the quantity demanded of good A divided by the percent change in good B’s price. The Cross-Price Elasticity of Demand between Goods A and B

20. 20 of 45 Cross-Price Elasticity  Goods are substitutes when the cross-price elasticity of demand is positive.  Goods are complements when the cross-price elasticity of demand is negative.

21. 21 of 45 The Income Elasticity of Demand  The income elasticity of demand is the percent change in the quantity of a good demanded divided by the percent change in the consumer’s income.

22. 22 of 45 The Income Elasticity of Demand  When the income elasticity of demand is positive, the good is a normal good - that is, the quantity demanded at any given price increases as income increases.  When the income elasticity of demand is negative, the good is an inferior good - that is, the quantity demanded at any given price decreases as income increases.

23. 23 of 45 The Price Elasticity of Supply  The price elasticity of supply is the ratio of the percent change in the quantity supplied to the percent change in the price.

24. 24 of 45 Two Extreme Cases of Price Elasticity of Supply (b) Perfectly Elastic Supply: Price Elasticity of Supply = ∞ 0 Quantity of pizzas $12 Price of pizza S 1 (a) Perfectly Inelastic Supply: Price Elasticity of Supply = 0 1000 Quantity of cell phone frequencies $3,000 2,000 Price of cell phone frequency … leaves the quantity supplied unchanged S 2 At any price above $12, quantity supplied is infinite. At exactly $12, producers will produce any quantity At any price below $12, quantity supplied is zero. An increase in price…

25. 25 of 45 The Price Elasticity of Supply  Supply is elastic if the price elasticity of supply > 1.  Supply is inelastic if the price elasticity of supply < 1.  Supply is unit-elastic if the price elasticity of supply = 1.  Supply is perfectly elastic if the price elasticity of supply = ∞.(horizontal supply curve)  Supply is perfectly inelastic if the price elasticity of supply = 0.(vertical supply curve)

26. 26 of 45 What Factors Determine the Price Elasticity of Supply?  The Availability of Inputs  The price elasticity of supply tends to be small when inputs are difficult to obtain.  Time  The price elasticity of supply tends to grow larger as producers have more time to respond to a price change.  This means that the long-run price elasticity of supply is often higher than the short-run elasticity.

27. 27 of 45 Quiz  True or false? If the demand for milk rose, then, in the long run, milk-drinkers would be better off if supply was elastic rather than inelastic.  True or false? Long-run price elasticities of supply are generally larger than short-run price elasticities of supply. As a result, the short-run supply curves are generally flatter than the long-run supply curves.  True or false? When supply is perfectly elastic, changes in demand have no effect on price.  As the price of margarine rises by 20%, a manufacturer of baked goods increases its quantity of butter demanded by 5%. Are butter and margarine substitutes or complements for this manufacturer?

28. 28 of 45 Summary

29. 29 of 45 Summary

30. 30 of 45 The End of Chapter 6 Coming attraction: Chapter 7: Taxes