1. Elasticity and its Applications

2. Learn the meaning of the elasticity of demand. Examine what determines the elasticity of demand. Learn the meaning of the elasticity of supply. Examine what determines the elasticity of supply. Apply the concept of elasticity in three different markets. Learn the meaning of the elasticity of demand. Examine what determines the elasticity of demand. Learn the meaning of the elasticity of supply. Examine what determines the elasticity of supply. Apply the concept of elasticity in three different markets. In this chapter you will…

3. … allows us to analyze supply and demand with greater precision. … 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. … is a measure of how much buyers and sellers respond to changes in market conditions THE ELASTICITY OF DEMAND

4. Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price. Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price. Price Elasticity of Demand

5. Availability of Close Substitutes Necessities versus Luxuries Definition of the Market Time Horizon Availability of Close Substitutes Necessities versus Luxuries Definition of the Market Time Horizon The Price Elasticity of Demand and Its Determinants

6. Demand tends to be more elastic: –the larger the number of close substitutes. –if the good is a luxury. –the more narrowly defined the market. –the longer the time period. Demand tends to be more elastic: –the larger the number of close substitutes. –if the good is a luxury. –the more narrowly defined the market. –the longer the time period. The Price Elasticity of Demand and Its Determinants

7. The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. Computing the Price Elasticity of Demand Price elasticity of demand= Percentage change in quantity demanded Percentage change in price

8. The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change. point Method: A Better Way to Calculate Percentage Changes and Elasticities The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change. point Method: A Better Way to Calculate Percentage Changes and Elasticities The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities (Q 2 - Q 1 ) /[(Q 2 + Q 1 ) / 2] (P 2 - P 1 ) /[(P 2 + P 1 ) / 2] Price elasticity of demand =

9. From Point A to Point B: Price rise = 50% and Quantity fall = 33% From Point B to Point A: Price fall = 33% and Quantity rise = 50% From Point A to Point B: Price rise = 50% and Quantity fall = 33% From Point B to Point A: Price fall = 33% and Quantity rise = 50% The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities (80 - 120) /[(80 + 120)/ 2] (6 - 4) /[(6 + 4)/ 2] Price elasticity of demand = Point A: Price = $4Quantity = 120 Point B: Price = $6Quantity = 80 Point A: Price = $4Quantity = 120 Point B: Price = $6Quantity = 80 = 1 Mid point method

10. Inelastic Demand –Quantity demanded does not respond strongly to price changes. –Price elasticity of demand is less than one. Elastic Demand –Quantity demanded responds strongly to changes in price. –Price elasticity of demand is greater than one. Inelastic Demand –Quantity demanded does not respond strongly to price changes. –Price elasticity of demand is less than one. Elastic Demand –Quantity demanded responds strongly to changes in price. –Price elasticity of demand is greater than one. A Variety of Demand Curves

11. Perfectly Inelastic –Quantity demanded does not respond to price changes. Perfectly Elastic –Quantity demanded changes infinitely with any change in price. Unit Elastic –Quantity demanded changes by the same percentage as the price. Perfectly Inelastic –Quantity demanded does not respond to price changes. Perfectly Elastic –Quantity demanded changes infinitely with any change in price. Unit Elastic –Quantity demanded changes by the same percentage as the price. A Variety of Demand Curves

12. Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve. A Variety of Demand Curves

13. E = 0 0 Quantity Price Demand 100 1. An increase in price… $4.00 $5.00 2. …leaves the quantity demanded unchanged. Figure 5-1 a): Perfectly Inelastic Demand

14. E < 1 0 Quantity Price 100 1. A 22% increase in price… $5.00 2. … Leads to a 11% decrease in quantity demanded. Demand $4.00 90 Figure 5-1 b): Inelastic Demand

15. E = 1 0 Quantity Price 100 1. A 22% increase in price… $5.00 2. … Leads to a 22% decrease in quantity demanded. Demand $4.00 80 Figure 5-1 c): Unit Elastic Demand

16. E > 1 0 Quantity Price 100 1. A 22% increase in price… $5.00 2. … Leads to a 67% decrease in quantity demanded. Demand $4.00 50 Figure 5-1 d): Elastic Demand

17. E =  0 Quantity Price 2. At exactly $4, consumers will buy any quantity. $4.00 Demand 1. At any price above $4, quantity demanded is zero. 3. At any price below $4, quantity demanded is infinite. Figure 5-1 e): Perfectly Elastic Demand

18. Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold. TR = P x Q Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold. TR = P x Q Total Revenue and the Price Elasticity of Demand

19. Price Quantity 0 100 Demand P x Q = $400 (revenue) $4.00 Figure 5-2: Total Revenue

20. Price Quantity 0 80 Demand $3.00 P x Q = $400 (revenue) P x Q = $100 (revenue) $1.00 100 Figure 5-3: How Total Revenue Changes When Prices Changes: Inelastic Demand

21. Price Quantity Change in Total Revenue when Price Changes 0 50 Demand $4.00 $5.00 20 Revenue = $100 Revenue = $200 Figure 5-4: How Total Revenue Changes When Prices Changes: Elastic Demand

22. With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases. Elasticity and Total Revenue along a Linear Demand Curve

23. Table 5-1. Elasticity and Total Revenue along a Linear Demand Curve

24. Price Quantity 2 4 6 8 10 12 0 6 5 4 3 2 1 7 14 Elasticity is larger than 1. Elasticity is smaller than 1. Figure 5-5: A Linear Demand Curve

25. Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income. Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income. Other Demand Elasticities

26. Types of Goods –Normal Goods –Inferior Goods Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. Types of Goods –Normal Goods –Inferior Goods Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. Other Demand Elasticities

27. Goods consumers regard as necessities tend to be income inelastic –Examples include food, fuel, clothing, utilities, and medical services. Goods consumers regard as luxuries tend to be income elastic. –Examples include sports cars, furs, and expensive foods. Goods consumers regard as necessities tend to be income inelastic –Examples include food, fuel, clothing, utilities, and medical services. Goods consumers regard as luxuries tend to be income elastic. –Examples include sports cars, furs, and expensive foods. Other Demand Elasticities

28. Cross-Price elasticity of demand measures how much the quantity demanded of a good responds to a change in the price of another good. It is computed as the percentage change in the quantity demanded divided by the percentage change in the price of the second good. Cross-Price elasticity of demand measures how much the quantity demanded of a good responds to a change in the price of another good. It is computed as the percentage change in the quantity demanded divided by the percentage change in the price of the second good. Other Demand Elasticities Income elasticity of demand= Percentage change in quantity demanded Percentage change in the price of good 2.

29. 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 given a percent change in the price. 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 given a percent change in the price. PRICE ELASTICITY OF SUPPLY

30. Ability of sellers to change the amount of the good they produce. –Beach-front land is inelastic. –Books, cars, or manufactured goods are elastic. Time period. –Supply is more elastic in the long run. Ability of sellers to change the amount of the good they produce. –Beach-front land is inelastic. –Books, cars, or manufactured goods are elastic. Time period. –Supply is more elastic in the long run. The Price Elasticity of Supply and Its Determinants

31. The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price. Computing the Price Elasticity of Supply

32. … using the midpoint method, we calculate the percent change in the price as (2.10 - 1.90) / 2.00 x 100 = 10% Similarly, we calculate the percent change in the quantity supplied as (11 000 - 9000) / 10 000 x 100 = 20% … using the midpoint method, we calculate the percent change in the price as (2.10 - 1.90) / 2.00 x 100 = 10% Similarly, we calculate the percent change in the quantity supplied as (11 000 - 9000) / 10 000 x 100 = 20% 20% Price elasticity of supply = Suppose an increase in the price of milk from $1.90 to $2.10 a litre raises the amount that dairy farmers produce from 9000 to 11 000 L per month… = 2.0 Computing the Price Elasticity of Supply 10%

33. E = 0 0 Quantity Price Supply 1. An increase in price… $5.00 2. …leaves the quantity supplied unchanged. 100 $4.00 Figure 5-6 a): Perfectly Inelastic Supply

34. E < 0 0 Quantity Price Supply 100 1. A 22% increase in price… $5.00 2. …leads to a 10% increase in quantity supplied. $4.00 110 Figure 5-6 b): Inelastic Supply

35. E = 1 0 Quantity Price Supply 100 1. A 22% increase in price… $5.00 2. …leads to a 22% increase in quantity supplied. $4.00 125 Figure 5-6 c): Unit Elastic Supply

36. E > 1 0 Quantity Price Supply 100 1. A 22% increase in price… $5.00 2. …leads to a 67% increase in quantity supplied. $4.00 200 Figure 5-6 d): Elastic Supply

37. E =  0 Quantity Price 2. At exactly $4, producers will supply any quantity. $4.00 Supply 1. At any price above $4, quantity supplied is infinite. 3. At any price below $4, quantity supplied is zero. Figure 5-6 e): Perfectly Elastic Supply

38. 0 Quantity Price $3 100 $4 200 $12 500 $15 525 Elasticity is greater than 1 Elasticity is less than 1 Figure 5-7: How the price elasticity of supply can vary

39. Good news bad news for farmers OPEC Drugs and crime Good news bad news for farmers OPEC Drugs and crime THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITY

40. Increase in Supply Demand S1S1 $3 Quantity of Wheat Price of Wheat S2S2 2. … leads to a fall in price… 3. …and a proportionately smaller increase in quantity sold. As a result revenue falls from $300 to $220. 1. When demand is inelastic, an increase in supply… 110 100 $2 Figure 5-8: An Increase in Supply in the Market for Wheat

41. Demand S1S1 Quantity of Oil Price of Oil S2S2 1. In the short run, when supply and demand are inelastic, a shift in supply… 2. … leads to a large increase in price… P1P1 P2P2 Demand S1S1 Quantity of Oil S2S2 1. In the long run, when supply and demand are elastic, a shift in supply… 2. … leads to a small increase in price… P1P1 P2P2 Price of Oil (a) Oil Market in the Short Run (b) Oil Market in the Long Run Figure 5-9: A Reduction in Supply in the World Market for Oil

42. Demand S1S1 Quantity of Drugs Price of Drugs S2S2 1. Drug interdiction reduces the supply of drugs… 2. … which raises the price… P1P1 P2P2 D1D1 Supply 1. Drug education reduces the demand for drugs… 2. … which reduces the price… (a) Drug Interdiction (b) Drug Education Q1Q1 Q2Q2 3. … and reduces the quantity sold. Q2Q2 Quantity of Drugs Price of Drugs D2D2 P1P1 Q1Q1 P2P2 Figure 5-10: Policies to Reduce the of Illegal Drugs

43. Price elasticity of demand measures how much the quantity demanded responds to changes in the price. Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. If a demand curve is elastic, total revenue falls when the price rises. If it is inelastic, total revenue rises as the price rises. Price elasticity of demand measures how much the quantity demanded responds to changes in the price. Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. If a demand curve is elastic, total revenue falls when the price rises. If it is inelastic, total revenue rises as the price rises. SummarySummary

44. The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good. The price elasticity of supply measures how much the quantity supplied responds to changes in the price. The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good. The price elasticity of supply measures how much the quantity supplied responds to changes in the price. SummarySummary

45. In most markets, supply is more elastic in the long run than in the short run. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. The tools of supply and demand can be applied in many different types of markets. In most markets, supply is more elastic in the long run than in the short run. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. The tools of supply and demand can be applied in many different types of markets. SummarySummary

46. The End