1. Mr. Barnett University High AP Economics 2012-2013
Elasticity

2. Elasticity
We already know that if the price of a good rises, consumers will buy less
But….how much less?
Economists measure the change through elasticity
Elasticity: a measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants
Basically, a measure of how much buyers and sellers respond to change in market conditions

3. Price Elasticity Remember the Law of demand….
A fall in the price of a good will raise the quantity demanded
Price Elasticity – measures how much the quantity demanded responds to a change in price
Demand is:
Elastic – if quantity demanded responds substantially to a change in price
Inelastic – if quantity demanded responds only slightly to a change in price

4. Influences on Price Elasticity of Demand
Availability of close substitutes
Goods with close substitutes tend to have more elastic demand because it is easier for consumer to switch from that good to another
Example
Butter goes up $0.15 in price
Price of margarine stays the same
Result: large drop in quantity of butter sold

5. Influences on Price Elasticity of Demand
Necessities versus luxuries
Necessities have _________ demands
Luxuries have ___________demands
Example:
When the price of a dentist visit increases, people will not drastically reduce the # of visits
When the price of video games rise, the quantity demanded of video games falls substantially
Note: Whether a good is a necessity or a luxury depends on personal preference

6. Influences on Price Elasticity of Demand
Definition of the market
Elasticity of demand in a market depends on its definition (how we qualify it)
Narrowly defined markets tend to have more elastic demand than broadly defined markets
Because easier to find substitutes if more narrowly defined
Food -> inelastic
Ice Cream -> elastic
Vanilla Ice Cream -> very elastic

7. Influences on Price Elasticity of Demand
Time Horizon
Goods have more elastic demand in the long term
Example
When the price of gasoline increases, the quantity of gasoline only falls slightly in the short term
Long term, people will set up carpools, buy more fuel efficient cars, electric cars, ride buses, move closer to work

8. Influences on Price Elasticity of Demand
Inexpensive vs expensive
Expensive items tend to have elastic demand curve
Inexpensive items tend to have inelastic demand curve
A screw doubles in price from $0.05 to $0.10
A civic doubles in price from $20,000 to $40,000

9. Total Revenue = Price x Quantity TR = P x Q
Price (P)
Quantity (Q) TR
Price (P)
Quantity (Q) TR
Price INC, Total Revenue INC
Price INC, Total Revenue DEC
Price DEC, Total Revenue DEC
Price DEC, Total Revenue INC

10. Elasticity Coefficient Test
The Elasticity Coefficient equals the percentage change in quantity demanded divided by the percentage change in price
Butter goes from $1.00 to $1.20
Causes 40% drop in amount bought
40 percent/20 percent = 2.0
Elasticity coefficient = 2
Note: Use absolute values so all elasticities are positive numbers
A larger price elasticity implies a greater responsiveness of quantity demanded to change in price

11. Computing the elasticity coefficient of demand
Make sure to use positive numbers
Make sure to start with original numbers

12. Figure out the elasticity of demand of both graphs above using the TR test
Figure out the elasticity of demand of both graphs above by figuring out the of elasticity coefficient
Inelastic
Elastic
Elasticity Coefficient Test
Ed < 1
Ed > 1

13. Influences on Price Elasticity of Demand
So 5 tests of Elasticity
Tests
Inelastic
Elastic
Substitutes
Few Substitutes
Many Substitutes
Necessity v Luxury
Necessity
Luxury
Cost
Inexpensive
Expensive
Total Revenue
P Inc, TR Inc
P Dec, TR Dec
P Inc, TR Dec
P Dec, TR Inc
Elasticity Coefficient Test
Ed < 1
Ed > 1

14. Classification of Elasticity
When the price elasticity of demand is greater than one, demand is defined to be elastic
Percentage change in quantity demanded will be greater than the percentage change in price
When the price elasticity of demand is less than one, demand is defined to be inelastic
Percentage change in price will be greater than the percentage change in quantity demanded
When the price elasticity of demand is equal to one , the demand is said to have unit elasticity
Percentage change in price will be equal to the percentage change in quantity demanded

15. Elasticity of Demand Curves
Most demand curves that have a downward slope have an elastic, inelastic and unit elastic portion

16. Drawbacks to Coefficient Test
There are some drawbacks to using the coefficient of price elasticity of demand test
As we have seen, the PED can vary at different points along a demand curve, due to its percentage nature
Also, percentage changes are not symmetric; rather, the percentage change between any two values depends on which one is chosen as the starting value and which one as the ending value
What if a company just wants to compare the results of two different possible pricings, instead of “starting” at one price and moving to another?
If quantity demanded increases from 10 to 15 units, the percentage change is 50% (15-10)/10
If quantity demanded decreases from 15 to 10 units, the percentage change is 33.3%....(10-15)/10

17. Midpoint Method
Thus, we can use the midpoint method to avoid those problems. Also known as Arc Elasticity
Involves calculating the percentage change in either P or Qd by dividing the change in the variable by the midpoint between the initial and final levels rather than by the initial value itself
Formula:
Note: Use averages for quantities and prices. Avoids having to deal with beg and ending values
Example:
Price of hamburgers rise from $4 to $6
Quantity demanded falls from 120 to 80
% change in quantity demanded = (120-80)/100 = 40%
% change in price = (6-4)/5 x 100% = 40%
Price elasticity of demand = 40/40 = 1

18. Figure 1 The Price Elasticity of Demand
(a) Perfectly Inelastic Demand: Elasticity Equals 0
Price
Demand
100 $5
1. An
increase
in price . . . 4
Quantity
leaves the quantity demanded unchanged.
Copyright©2003 Southwestern/Thomson Learning

19. Figure 1 The Price Elasticity of Demand
(b) Inelastic Demand: Elasticity Is Less Than 1
Price
Demand $5 90
1. A 22%
increase
in price . . . 4
100
Quantity
leads to an 11% decrease in quantity demanded.

20. Figure 1 The Price Elasticity of Demand
(c) Unit Elastic Demand: Elasticity Equals 1
Price
Demand $5 80
1. A 22%
increase
in price . . . 4
100
Quantity
leads to a 22% decrease in quantity demanded.
Copyright©2003 Southwestern/Thomson Learning

21. Figure 1 The Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Price
Demand $5 50
1. A 22%
increase
in price . . . 4
100
Quantity
leads to a 67% decrease in quantity demanded.

22. Figure 1 The Price Elasticity of Demand
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Price
1. At any price
above $4, quantity
demanded is zero. $4
Demand
2. At exactly $4,
consumers will
buy any quantity.
3. At a price below $4,
quantity demanded is infinite.
Quantity

23. Total Revenue = Amount paid by buyers and received by sellers of a good
= price of the good times the quantity sold

24. Review Even though slope is constant, elasticity is not
Slope is the ratio of changes in the 2 variables
Elasticity is the ratio of percentage changes in the two variables
At points with a high price and low quantity, the demand curve is ____
At points with a low price and high quantity, the demand curve is ____

25. Elasticity When the price is $1, demand is inelastic
An increase in price to $2 will increase total revenue
When the price is $5, demand is elastic,
A price increase to $6 will reduce total revenue
At $3.50, demand is unit elastic, and consumers will buy any quantity

26. Figure 3 How Total Revenue Changes When Price Changes: Inelastic Demand
An Increase in price from $1
to $3 …
… leads to an Increase in total revenue from $100 to $240
Demand
Demand $3 80
Revenue = $240 $1
100
Revenue = $100
Quantity
Quantity

27. Figure 4 How Total Revenue Changes When Price Changes: Elastic Demand
An Increase in price from $4
to $5 …
… leads to an decrease in total revenue from $200 to $100 $5 20
Demand
Demand
Revenue = $100 $4 50
Revenue = $200
Quantity
Quantity

28. Midpoint Method

29. Midpoint example
Example: If the price of Hello Kitty pencil toppers increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 toppers, then your elasticity of demand, using the midpoint formula, would be calculated as…

30. Income Elasticity Income elasticity of demand
measures how much the quantity demanded of a good responds to a change in consumers’ income

31. Income Elasticity Normal goods have ______income elasticities
Inferior goods have ______income elasticities
Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods
Necessities tend to have _____income elasticities, whereas luxuries tend to have ______income elasticities

32. Important Side Note
We use the absolute value when figuring out price elasticity of demand because the value is always negative (because when price changes in one direction, quantity demanded always changes in the other).
But this isn't true for income. When income changes, people might want to buy more or less of the good.

34. Income Elasticity
After irrevocably destroying symbols borrowed from the American West, PSY’s income rises from $100,000 to 1,000,000. The quantity of hamburger he buys each week rises from two pounds to four pounds.
What is PSY’s income elasticity?
What kind of good is hamburger for PSY?

35. Cross-Price Elasticity
Cross-Price Elasticity of demand: A measure of how much the quantity demanded of one good responds to a change in the price of another good
Cross-Price Elasticity = % change in quantity demanded of good 1
___________________________________
% change in price of good 2
Substitutes have ______ cross price elasticities, whereas complements have ________cross-price elasticities

36. The sign matters for cross-price elasticity.
When the price of one good changes, people might want to buy more of the other good, or less.

37. Cross Price Elasticities
The price of Kris-Kross cassette tapes rise from $8 to $10. As a result, the quantity of Kris-Kross trading cards demanded falls from 8,000 per week to 9,500.
What is the cross-price elasticity?
What is the relationship between the two goods?

38. Elasticity of Supply
Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good.
Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price

39. Figure 6 The Price Elasticity of Supply
(a) Perfectly Inelastic Supply: Elasticity Equals 0
Price
Supply $5
1. An
increase
in price . . . 4
100
Quantity
leaves the quantity supplied unchanged.
Copyright©2003 Southwestern/Thomson Learning

40. Figure 6 The Price Elasticity of Supply
(b) Inelastic Supply: Elasticity Is Less Than 1
Price
Supply
110 $5
1. A 22%
increase
in price . . .
100 4
Quantity
leads to a 10% increase in quantity supplied.
Copyright©2003 Southwestern/Thomson Learning

41. Figure 6 The Price Elasticity of Supply
(c) Unit Elastic Supply: Elasticity Equals 1
Price
Supply
125 $5
1. A 22%
increase
in price . . .
100 4
Quantity
leads to a 22% increase in quantity supplied.
Copyright©2003 Southwestern/Thomson Learning

42. Figure 6 The Price Elasticity of Supply
(d) Elastic Supply: Elasticity Is Greater Than 1
Price
Supply $5
200
1. A 22%
increase
in price . . . 4
100
Quantity
leads to a 67% increase in quantity supplied.
Copyright©2003 Southwestern/Thomson Learning

43. Figure 6 The Price Elasticity of Supply
(e) Perfectly Elastic Supply: Elasticity Equals Infinity
Price
1. At any price
above $4, quantity
supplied is infinite. $4
Supply
2. At exactly $4,
producers will
supply any quantity.
3. At a price below $4,
quantity supplied is zero.
Quantity
Copyright©2003 Southwestern/Thomson Learning

44. Determinants of Price Elasticity of Supply
Flexibility of Sellers
Goods that are somewhat fixed in supply have inelastic supplies
Goods that are not (books, cars, tamagotchi pets) have elastic supplies

46. Determinants of Price Elasticity of Supply
Time Period
Supply is usually more inelastic in the short run
Supply is usually more elastic in the long run

47. The price of chocolate milk increases from $2. 85 per gallon to $3
The price of chocolate milk increases from $2.85 per gallon to $3.15 per gallon and the quantity supplied rises from 9,000 to 11,000 gallons per month
Price elasticity of supply is ?

48. APPLICATION 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?

49. THE APPLICATION OF SUPPLY, DEMAND, AND ELASTICITY
Examine whether the supply or demand curve shifts.
Determine the direction of the shift of the curve.
Use the supply-and-demand diagram to see how the market equilibrium changes.

50. Figure 8 An Increase in Supply in the Market for Wheat
Price of
Wheat
1. When demand is inelastic,
an increase in supply
. . .
leads
to a large fall
in price . . . S1 S2
Demand $3
100 2
110
Quantity of
and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
Wheat
Copyright©2003 Southwestern/Thomson Learning

51. Compute the Price Elasticity of Supply
Supply is inelastic

52. Supply Supply _____, price _____, quantity demanded ______
If demand is ineastic, the fall in price is greater than the increase in quantity demanded and total revenue ______
Demand for basic foodstuffs is usually inelastic
Less revenue for farmers
Because farmers are price takers they still have incentive to adopt new hybrid so they can produce and sell more wheat
Explains why number of farms has declined so much over the past 200 years
Also explains why some gov policies encourage farmers to decrease the amuont of crops planted

53. In the 1970s and 1980s, OPEC reduced the amount of oil it was willing to supply to world markets. The decrease in supply led to an increase in the price of oil and a decrease in quantity demanded. The increase in price was much larger in the short run than the long run. Why?