1. 1 Microeconomics – 2008 Topic 3 Chapter 6 Elasticity and its Applications

2. 2 Learning Objectives Introduce the concept of price elasticity of demand and discuss its determinants. Relate price elasticity of demand to the changes in total revenue that result from a change in market price.

3. 3 Learning Objectives (cont.) Introduce the concept of the elasticity of supply and its relationship to time. Define the cross-price and income elasticities of demand. Survey some applications of supply and demand analysis.

4. 4 Price Elasticity of Demand The price elasticity of demand is the measure of the responsiveness of the quantity demanded to a change in price of a product

5. 5 Price Elasticity is... Q P P1P1 P2P2 Q1Q1 Q2Q2 D As price increases from P 1 to P 2, quantity decreases from Q 1 to Q 2

6. 6 Price Elasticity is... (cont.) Q P P2P2 P1P1 Q2Q2 Q1Q1 D As price decreases from P 1 to P 2, quantity increases from Q 1 to Q 2

7. 7 Q P P1P1 P2P2 Q1Q1 Q2Q2 D But what percentage did price change and what percentage did quantity change?

8. 8 Formula for Elasticity Original quantity demanded E d = Change in quantity Change in price Original price The percentage change in price The percentage change in quantity EdEd = ÷

9. 9 Price Elasticity of Demand Use of percentages choice of units product comparison Ignore the minus sign the absolute value of the coefficient is what is important

10. 10 Price Elasticity of Demand (cont.) Elastic Demand a given percentage change in price results in a larger percentage change in quantity demanded E d > 1

11. 11 Price Elasticity of Demand (cont.) Inelastic Demand a given percentage change in price results in a relatively smaller percentage change in quantity demanded E d < 1

12. 12 Price Elasticity of Demand (cont.) Unit elasticity a given percentage change in price results in an equal percentage change in quantity demanded E d = 1

13. 13 Perfectly Inelastic Demand Q P D1D1D1D1 Perfectly inelastic demand

14. 14 Perfectly Elastic Demand Q P D1D1D1D1 Perfectly inelastic demand D2D2D2D2 Perfectly elastic demand

15. 15 Midpoints Formula EdEd= Change in quantity Sum of Quantities/2 Change in price Sum of prices/2 

16. 16 4 0 2 4 6 7 8 10 12 14 1 2 3 4 5 Price (per unit) 0 2 4 6 7 8 10 12 14 Total Revenue Units of X (thousands per week) Price Elasticity of Demand and Revenue 8 12 16 20 TR E d > 1 16

17. 17 4 0 2 4 6 7 8 10 12 14 1 2 3 4 5 Price (per unit) 0 2 4 6 7 8 10 12 14 Total Revenue Units of X (thousands per week) Price Elasticity of Demand and Revenue 8 12 16 20 E d > 1 E d = 1 17

18. 18 4 0 2 4 6 7 8 10 12 14 1 2 3 4 5 Price (per unit) 0 2 4 6 7 8 10 12 14 Total Revenue Units of X (thousands per week) Price Elasticity of Demand and Revenue 8 12 16 20 TR E d < 1 E d > 1 E d = 1 18

19. 19 Total Revenue Test Elastic demand a change in price will cause total revenue to change in the opposite direction Inelastic demand a change in price will cause total revenue to change in the same direction Unit elasticity a change in price leaves total revenue unchanged

20. 20 Determinants of Price Elasticity of Demand Substitutability Proportion of income Luxuries versus necessities Time

21. 21 Elasticity of Demand: Some Applications Bumper crops Automation Excise taxes Heroin and crime

22. 22 Price Elasticity of Supply Es=Es= Percentage change in quantity supplied of product X Percentage change in the price of product X

23. 23 Price Elasticity of Supply (cont.) Immediate market period PoPoPoPo P Q D1D1D1D1 SmSmSmSm PmPmPmPm D1D1D1D1 D2D2D2D2 D2D2D2D2 QoQo

24. 24 D2D2D2D2 Price Elasticity of Supply (cont.) PoPoPoPo PsPsPsPs P Q D1D1D1D1 QoQo SsSsSsSs Short run QsQs

25. 25 Price Elasticity of Supply (cont.) PoPoPoPo PLPLPLPL P Q D1D1D1D1 QoQo SLSLSLSL Long run D2D2D2D2 S′LS′LS′LS′L S′LS′LS′LS′L QoQo QLQL Q′LQ′L

26. 26 E xy = Percentage change in quantity demanded of good X Percentage change in the price of good Y Substitute goods—Positive sign Complementary goods—Negative sign Independent goods—Zero or near-zero value Cross Elasticity of Demand

27. 27 Income Elasticity of Demand E i = Percentage change in quantity demanded Percentage change in in income Normal goods—Positive sign

28. 28 Income Elasticity of Demand (cont.) E i = Percentage change in quantity demanded Percentage change in income Normal goods—Positive sign Inferior goods—Negative sign