2. 1 C H A P T E R 1 5 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin 1 Elasticity: A Measure of Responsiveness A Closer Look at Demand and Supply

3. 2 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Concept of Elasticity  How large is the response of producers and consumers to changes in price? Before business firms and the government decide to change prices and taxes, they must anticipate the magnitude of response by those affected.  Elasticity is a measure of the responsiveness of people to changes in economic variables.

4. 3 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Popular Elasticity Measures  Price elasticity of demand  Price elasticity of supply  Income elasticity—and the character of consumer goods  Cross elasticity of demand for related goods Popular measures of elasticity include:

5. 4 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Price Elasticity of Demand  Price elasticity of demand measures the response of consumers to changes in price.

6. 5 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Computing Price Elasticity of Demand

7. 6 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Using the Midpoint Formula to Compute Price Elasticity  The midpoint formula is a more accurate measure of percentage changes.

8. 7 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Interpreting the Value of Elasticity Response to Price Changes Responsive Unresponsive Proportional Value of Elasticity E d > 1 E d < 1 E d = 1 Demand Elasticity Elastic Inelastic Unitary elastic Magnitudes of Change %  Q D > %  P %  Q D < %  P %  Q D = %  P Type of Elasticity Elastic Inelastic Substitutes Available Many Few The main determinant of demand elasticity is the availability of substitutes for the good in question.

9. 8 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Interpreting the Value of Elasticity  The price elasticity for water (0.20) suggests that a 10% increase in the price of water would decrease the quantity demanded by only 2%.  The elasticity for specific brands of coffee (5.6) suggests that a 10% increase in the price of a specific brand would decrease its quantity demanded by 56%. Estimated price elasticities of demand for selected products Product Price elasticity of demand Salt0.1 Water0.2 Coffee0.3 Cigarettes0.3 Shoes and footwear0.7 Housing1.0 Automobiles1.2 Foreign travel1.8 Restaurant meals2.3 Air travel2.4 Motion pictures3.7 Specific brands of coffee5.6

10. 9 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Elasticity Along a Linear Demand Curve  Price elasticity of demand decreases as we move downward along a linear demand curve  Demand is elastic on the upper part of the demand curve and inelastic on the lower part. Percentage decrease in price Percentage increase in quantity Elasticity Point r to point s4/80 = 5%2/10 = 20%20%/5% = 4.0 Point t to point u4/50 = 8%2/25 = 8%8%/8% = 1 Point v to point w4/20 = 20%2/40 = 5%5%/20% = 0.25

11. 10 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Elasticity and Total Revenue  Elasticity of demand determines if an increase in price will cause the firm’s revenue to increase or decrease. Total Revenue = Price x Quantity sold

12. 11 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Elasticity and Total Revenue  The good news about an increase in price is that a higher price will increase the revenue obtained from each unit sold.  The bad news is that at a higher price, fewer units are sold. Elasticity of demand tells us whether the good news dominates over the bad news. Total Revenue = Price x Quantity sold

13. 12 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Predicting Changes in Total Revenue  Along the elastic range of the demand curve, an increase in price leads to a decrease in total revenue. This graph shows the relationship between elasticity along a linear demand curve and total revenue. Note the following:  Along the inelastic range, an increase in price leads to an increase in total revenue.  Revenue is maximum when E d =1.

14. 13 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Predicting Changes in Total Revenue Elasticity and Total Revenue Type of demandValue of E d Change in quantity versus change in price Effect of an increase in price on total revenue Effect of a decrease in price on total revenue ElasticGreater than 1.0 Larger percentage change in quantity Total revenue decreases Total revenue increases InelasticLess than 1.0Smaller percentage change in quantity Total revenue increases Total revenue decreases Unitary elastic Equal to 1.0Same percentage change in quantity and price Total revenue does not change

15. 14 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Price Elasticity of Supply  Price elasticity of supply is a measure of the responsiveness in quantity supplied to changes in price.

16. 15 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Computing Price Elasticity of Supply

17. 16 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Supply Elasticity and Time  Supply becomes more elastic over time. The increase in quantity supplied as a response to an increase in price is greater when supply is more elastic. Higher market prices give business firms an incentive to expand production and output. As time goes by, the ability of firms to expand productive capacity is greater, and supply becomes more elastic.

18. 17 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Predicting Price Changes Using Elasticities  The price-change formula can be used to predict the change in price resulting from a change in demand.  For changes in price resulting from a change in supply:

19. 18 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Predicting Price Changes Using Elasticities: an Example  Assume that E d =1.5 and E s =2.0, a rightward shift in demand by 35%, will increase price by the following percentage:

20. 19 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Income Elasticity  Income elasticity is a measure of the responsiveness of the quantity demanded to changes in consumer income.

21. 20 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Income Elasticity E i > 0 Normal E i < 0 Inferior E i > 1 Luxury %  Q D > %  I E i < 1 Necessity %  Q D < %  I Income ElasticityType of GoodResponsiveness Classification of Goods According to Income Elasticity

22. 21 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Cross Elasticity of Demand  Cross elasticity of demand is a measure of the responsiveness of the quantity demanded to changes in price of a related good.

23. 22 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Exy > 0 Substitutes  Py   Qx Cross Elasticity of Demand Exy < 0Complements  Py   Qx Classification of Goods According to Cross Elasticity Cross ElasticityResponsivenessType of Good