Ch_-_05_-_Elasticity1111111111111111.ppt

Elasticity

1. Elasticity

2. Elasticity . . .
… 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

3. THE ELASTICITY OF DEMAND
Price elasticity of demandis 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.

4. What determines price
elasticity?
To learn the determinants of price elasticity,
we look at a series of examples.
Each compares two common goods.
In each example:
–Suppose the prices of both goods rise by 20%.
–The good for which Q
d
falls the most (in percent) has
the highest price elasticity of demand.
Which good is it? Why?
–What lesson does the example teach us about the
determinants of the price elasticity of demand?

5. Determinants of Elasticity
Whether close substitutes are available
Broadly defined goods vs. narrowly
defined goods
Necessities vs. Luxuries
How much of the consumer’s budget is
spent on the good
Long run vs. Short run

6. EXAMPLE 1:
Rice Krispies vs. Sunscreen
The prices of both of these goods rise by 20%.
For which good does Q
d
drop the most? Why?
–Rice Krispies has lots of close substitutes
(e.g., Cap’n Crunch, Count Chocula),
so buyers can easily switch if the price rises.
–Sunscreen has no close substitutes,
so consumers would probably not
buy much less if its price rises.
Lesson: Price elasticity is higher when close
substitutes are available.

7. EXAMPLE 2:
“Blue Jeans” vs. “Clothing”
The prices of both goods rise by 20%.
For which good does Q
d
drop the most? Why?
–For a narrowly defined good such as
blue jeans, there are many substitutes
(khakis, shorts, Speedos).
–There are fewer substitutes available for broadly
defined goods.
(Can you think of a substitute for clothing,
other than living in a nudist colony?)
Lesson: Price elasticity is higher for narrowly
defined goods than broadly defined ones.

8. EXAMPLE 3:
Insulin vs. Caribbean Cruises
The prices of both of these goods rise by 20%.
For which good does Q
d
drop the most? Why?
–To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or no decrease in
demand.
–A cruise is a luxury. If the price rises,
some people will forego it.
Lesson: Price elasticity is higher for luxuries than for
necessities.

9. EXAMPLE 4: Gasoline in the Short
Run vs. Gasoline in the Long Run
The price of gasoline rises 20%. Does Q
d
drop more in
the short run or the long run? Why?
–There’s not much people can do in the
short run, other than ride the bus or carpool.
–In the long run, people can buy smaller cars
or live closer to where they work.
Lesson: Price elasticity is higher in the
long run than the short run.

10. How much of the consumer’s
budget is spent on the good
When a good represents a large share of a
consumer’s budget, a price increase importantly
reduces the amount of the good that a consumer
is able to buy
–The amount demanded will decrease significantly.
When the good represents a smaller share of
the consumer’s budget, the consumer’s overall
income and purchasing power are less effected
by an increase in price.
–Therefore, demand is less price elastic in these
cases.

11. Percentage of Income
The higher the percentage of the
consumer's income that the product's price
represents, the higher the elasticity tends
to be, as people will pay more attention
when purchasing the good because of its
cost. (Income effect)
When the goods represent only a small
portion of the budget the income effect will
be insignificant and demand inelastic

12. The Price Elasticity of Demand and Its
Determinants
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.
–Percentage of income

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

14. Example: If the price of an ice cream cone
increases from $2.00 to $2.20 and the
amount you buy falls from 10 to 8 cones,
then your elasticity of demand would be
calculated as:
Computing the Price Elasticity of
DemandPrice elasticity of demand=
Percentage change in quantity demanded
Percentage change in price ( )
(. .)
.
108
10
100
220200
200
100
20%
10%
2




 

15. The Midpoint 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.Price elasticity of demand =
( )/[( )/]
( )/[( )/]
QQ QQ
PPPP
2 1 2 1
2 1 2 1
2
2
 
 

16. The Midpoint Method: A Better Way to
Calculate Percentage Changes and
Elasticities
Example: If the price of an ice cream cone
increases from $2.00 to $2.20 and the
amount you buy falls from 10 to 8 cones,
then your elasticity of demand, using the
midpoint formula, would be calculated as:( )
( )/
(. .)
(. .)/
.
.
108
1082
220200
2002202
22%
95%
232




 

17. The Variety of Demand Curves
(summary)
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.

18. The Variety of Demand Curves
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.

19. The Variety of Demand Curves
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.

20. Figure 1 The Price Elasticity of Demand
Copyright©2003 Southwestern/Thomson Learning
(a) Perfectly Inelastic Demand: Elasticity Equals 0
$5
4
Quantity
Demand
1000
1. An
increase
in price . . .
2. . . . leaves the quantity demanded unchanged.
Price

21. Figure 1 The Price Elasticity of Demand
(b) Inelastic Demand: Elasticity Is Less Than 1
Quantity0
$5
90
Demand1. A 22%
increase
in price . . .
Price
2. . . . leads to an 11% decrease in quantity demanded.
4
100
ΔQ<ΔP

22. Figure 1 The Price Elasticity of Demand
Copyright©2003 Southwestern/Thomson Learning
2. . . . leads to a 22% decrease in quantity demanded.
(c) Unit Elastic Demand: Elasticity Equals 1
Quantity
4
1000
Price
$5
80
1. A 22%
increase
in price . . .
Demand

23. Figure 1 The Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Demand
Quantity
4
1000
Price
$5
50
1. A 22%
increase
in price . . .
2. . . . leads to a 67% decrease in quantity demanded.
ΔQ>ΔP

24. Figure 1 The Price Elasticity of Demand
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Quantity0
Price
$4 Demand
2. At exactly $4,
consumers will
buy any quantity.
1. At any price
above $4, quantity
demanded is zero.
3. At a price below $4,
quantity demanded is infinite.

25. Total Revenue and the Price Elasticity
of Demand
Total revenueis 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

26. Figure 2 Total Revenue
Copyright©2003 Southwestern/Thomson Learning
Demand
Quantity
Q
P
0
Price
P×Q= $400
(revenue)
$4
100

27. Elasticity and Total Revenue along a
Linear Demand Curve
With an inelastic demand curve, an
increase in price leads to a decrease in
quantity that is proportionately smaller.
Thus, total revenue increases.

28. Figure 3 How Total Revenue Changes When Price
Changes: Inelastic Demand
Copyright©2003 Southwestern/Thomson Learning
Demand
Quantity0
Price
Revenue = $100
Quantity0
Price
Revenue = $240
Demand
$1
100
$3
80
An Increase in price from $1 to $3 … … leads to an Increase in total revenue from
$100 to $240

29. Elasticity and Total Revenue along a
Linear Demand Curve
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.

30. Figure 4 How Total Revenue Changes When Price
Changes: Elastic Demand
Copyright©2003 Southwestern/Thomson Learning
Demand
Quantity0
Price
Revenue = $200
$4
50
Demand
Quantity0
Price
Revenue = $100
$5
20
An Increase in price from $4
to $5 …
… leads to an decrease in
total revenue from $200 to
$100

31. Elasticity & Total Revenue Test
Elastic > 1 if P decreases
=> TR increases; if P
increases TR decreases
Unit elastic = 1 if ΔP => no
ΔTR
Inelastic < 1 if P decreases
=> TR decreases; if P
increases TR increases

32. Figure 19-2 The Relationship Between Price Elasticity of
Demand and Total Revenues for Cellular Phone Service,
Panel (b)

33. Figure 19-2 The Relationship Between Price Elasticity of
Demand and Total Revenues for Cellular Phone Service,
Panel (c)

34. Relationship Between Price Elasticity of Demand
and Total Revenues

35. Income Elasticity of Demand
Income elasticity of demandmeasures
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.

36. Computing Income ElasticityIncome elasticity of demand=
Percentage change
in quantity demanded
Percentage change
in income

37. Income Elasticity
Types of Goods
–Normal Goods
–Inferior Goods
Higher income raises the quantity
demanded for normal goods but lowers
the quantity demanded for inferior goods.

38. Income Elasticity
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.

40. ELASTICITY AND ITS APPLICATION 40
Other Elasticities
Income elasticity of demand: measures the response of
Q
d
to a change in consumer income
Income elasticity
of demand
=
Percent change in Q
d
Percent change in income
Recall from Chapter 4: An increase in income
causes an increase in demand for a normalgood.
Hence, for normal goods, income elasticity > 0.
For inferiorgoods, income elasticity < 0.

41. ELASTICITY AND ITS APPLICATION 41
Other Elasticities
Cross-price elasticity of demand:
measures the response of demand for one good to
changes in the price of another good
Cross-price elast.
of demand
=
% change in Q
d
for good 1
% change in price of good 2
For substitutes, cross-price elasticity > 0
(e.g., an increase in price of beef causes an
increase in demand for chicken)
For complements, cross-price elasticity < 0
(e.g., an increase in price of computers causes
decrease in demand for software)

42. Cross-Price Elasticities in the News
“As Gas Costs Soar, Buyers Flock to Small Cars”
-New York Times,5/2/2008
“Gas Prices Drive Students to Online Courses”
-Chronicle of Higher Education, 7/8/2008
“Gas prices knock bicycle sales, repairs into higher gear”
-Associated Press, 5/11/2008
“Camel demand soars in India”
(as a substitute for “gas-guzzling tractors”)
-Financial Times, 5/2/2008
“High gas prices drive farmer to switch to mules”
-Associated Press, 5/21/2008
ELASTICITY AND ITS APPLICATION 42