Lecture Week 05.pptzdhxjcgkjfchgjxjgjcjcjgj

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1. 1
Percentages and Elasticity
•Which of the following seem more serious:
–An increase of 50 cents or an increase of
50% in the price of a hamburger
–An increase of $100 or an increase of 1% in
the price of a new car
•Percentage changes are often more important
than the amount of change
–Therefore economists often use elasticities
to examine percentage change or
responsiveness

2. 2
Price Elasticity
•Price Elasticity of Demand (E
p)
–The responsiveness of quantity demanded
of a commodity to changes in its price
–Related to the slope, but concerned with
percentage changes

3. 3
Impact of a Change in Supply &
Therefore Price on the Quantity Demanded
S
1
Quantity (pizzas per hour)
P
r
ic
e

(
d
o
lla
r
s

p
e
r

p
iz
z
a
)
10.00
20.00
30.00
40.00
D
a
0 25510152013
5.00
S
0
Large price
change and
small quantity
change
An increase
in supply
brings ...
… and a small
increase in quantity
… a
large
fall in
price...

4. 4
Impact of a Change in Supply…
Quantity (pizzas per hour)
P
r
ic
e

(
d
o
lla
r
s

p
e
r

p
iz
z
a
)
10.00
20.00
30.00
40.00
D
b
0 25510152017
S
1
15.00
S
0
Small price
change and
large quantity
change
An increase
in supply
brings ...
… a small
fall in price...
… and a large
increase in quantity

5. 5
Price Elasticity

E
p
%Q
d
%P
Percentage change in price
Percentage change in quantity demanded

pE
The ratio of the two percentages is a
number without units.
Price Elasticity of Demand

6. 6
Price Elasticity
•Example
–Price of oil increases 10%
–Quantity demanded decreases 1%

E
p
-1%
10%
.1
When calculating the price elasticity of When calculating the price elasticity of
demand, we ignore the minus sign for demand, we ignore the minus sign for
% change in % change in QQ..

7. 7
TYPES OF ELASTICITY
Hypothetical Demand Elasticities for 4 Products
Product % Change in
price (%P)
% Change in
quantity
demanded
(%QD)
Elasticity
(%QD/%P)

Insulin

+ 10%

0%

0  Perfectly
inelastic
Basic
Telephone
service

+ 10% 

-1%

.1  Inelastic

Beef

+ 10% 

-10%

1.0 
Unitarily
elastic

Bananas

+ 10% 

-30%


3.0Elastic

8. 8
Price Elasticity Ranges: Extreme Price Elasticities
Quantity Demanded per Year
(millions of units)
P
r
ic
e

0
D
8
Perfect
inelasticity,
zero elasticity,
no matter how
much Price
changes,
Quantity
stays the
same;
insulin
P
0
P
1
Quantity Demanded per Year
(millions of units)
P
r
ic
e

0
Perfect
elasticity,
infinite
elasticity,
the slightest
increase
in price will
lead to
zero sales.
30
D
P
1
P
1 never touches
the demand curve

9. 9
Price Elasticity Ranges
Summary from Table

%Q%P; E
P1

%Q%P; E
P1

%Q%P; E
P1
Unit Elastic
Inelastic Demand
 Elastic Demand

10. 10
Elasticity of Demand
•Calculating elasticity

E
p

Change in Q
(Q
1
Q
2
)/2
Change in P
(P
1
P
2
)/2
or

E
p
Q
Avg.Q
P
Avg.P
or
Sum of prices/2
Change in P
Sum of quantities/2
Change in Q

p
E
Always use
the mid-point
formula

11. 11
Calculating the Elasticity of Demand
9 10 11
19.50
20.50
D
New
point
Quantity (pizzas/hour)
Price (dollars/pizza)
20.00
Original
point
Elasticity = = 4
Q/Q
ave
P/P
ave
2/10
1/20
=
ΔP=1
ΔQ=2
Q
ave
=1/2(11+9)=10
P
ave
=1/2(20.50+19.50)=20

12. 12
Elasticity of Demand (mid-point)
Ed =
P = $1.00
P
1 + P
2
($20.50 + $19.50)
2
P
=5% = $20
Q = 2
Q
1
+ Q
2
(9 + 11)
2
Q
=20%
= 10
Always use the mid-point formula for calculating elasticity
20%
5%
=4= Ed =
X 100
X 100

13. 13
D
Demand,
or average
revenue curve
Quantity per Period (billions of minutes)
P
r
ic
e

p
e
r

M
in
u
t
e

(
$
)
0
.10
.20
.30
.40
.50
.60
.70
.80
.90
1.00
1.10
1234567891011
Elastic (E
P
> 1)
Inelastic (E
P
< 1)
Unit-elastic (E
P = 1)
Changes in Elasticity Along a Linear
Demand

14. 14
The Relationship Between Price Elasticity of Demand and
Total Revenues for Cellular Phone Service
$1.10 0
1.00 1
.90 2
.80 3
.70 4
.60 5
.50 6
.40 7
.30 8
.20 9
.10 10
Quantity Total Elasticity
Price Demanded Revenue E
p
21.000
6.333
3.400
2.143
1.144
1.000
.692
.467
.294
.158
Elastic
Inelastic
Unit-elastic
00
1.01.0
1.81.8
2.42.4
2.82.8
3.03.0
3.03.0
2.82.8
2.42.4
1.81.8
1.01.0

15. 15
Total Revenue and Elasticity
Total Revenue
=
Price Per Good
X
# of Goods Sold
TR = P X Q
Assumption : Costs are constant

16. 16
5555 110110
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1.101.10
3.003.00
(
d
o
lla
r
s
)
(
d
o
lla
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)
Maximum
total revenue
When demand
is inelastic,
price cut decreases
total revenue
Unit
elastic
Elastic
demand
QuantityQuantity
Inelastic
demand
00
When demand is
elastic, price cut
increases total
revenue
T
o
t
a
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e
v
e
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u
e
T
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it
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QuantityQuantity
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17. 17
Relationship Between Price
Elasticity of Demand and Total Revenues
Inelastic(E
P < 1) TR  TR 
Unit-elastic(E
P = 1) No change  No change
Elastic (E
P
> 1) TR  TR 
Price Elasticity Effect of Price Change
of Demand on Total Revenues (TR)
Price Price
Decrease Increase

18. 18
Total Revenue and Elasticity
Total Revenue Test:
Estimate the price elasticity of
demand by observing the change in
total revenue that results from a
change in price (ceteris paribus).
Note that revenue is maximized
when elasticity of demand = -1.

19. 19
Question
•2 drivers - Tom & Jerry each drive to to a gas
station.
•Before looking at the price, each places an
order.
•Tom says, “I’d like 10 litres of gas”.
•Jerry says, “I’d like $10 of gas”.
•What is each driver’s price elasticity of
demand?

20. 20
Determinants of
Price Elasticity of Demand
•Existence of substitutes
•The length of time allowed for
adjustment
•More specifically a good is defined
(more specific = more substitutes)
•Necessity or not
•Share of budget

21. 21
D2
Quantity Supplied per Period
P
r
ic
e


p
e
r

U
n
it
D
1
P
e
P
1
As time passes, the
demand curve rotates
to D2 and then to D3
and quantity demanded
lowers first to Q1 and
then to Q2
Demand Elasticity and Time
D
3
Q2Q1Q3

22. 22
Elasticity: Example
•You are the consulting economist to the Guelph
transportation commission,
•The current fare is $.80
•There are 25,000 riders per day
•For each $.01 increase (decrease) in the fare, rider
ship decreases (increases) by 500 riders per day.
•What is the price elasticity of demand at the current
fare?
•Should fares be raised or lowered?
•What fare will maximize revenue?

23. 23
Elasticity of Supply
•Calculating elasticity

E
p
Change in Q
(Q
1Q
2)/2
Change in P
(P
1P
2)/2
or

E
p
Q
Avg.Q
P
Avg.P
or
Sum of prices/2
Change in P
Sum of quantities/2
Change in Q

p
E
Always use
the mid-point
formula

24. 24
How a Change in Demand Changes Price and Quantity
Quantity (pizzas per hour)
P
r
i
c
e

(
d
o
l
l
a
r
s

p
e
r

p
i
z
z
a
)
10.00
40.00
D
0
0 255101520
S
a
Large price change and
small quantity change
… a large
price rise...
20.00
D
1
30.00
13
An increase
in demand
brings ...
… and a small
quantity increase

25. 25
How a Change in Demand Changes Price and Quantity
Quantity (pizzas per hour)
P
r
ic
e

(
d
o
lla
r
s

p
e
r

p
iz
z
a
)
10.00
30.00
40.00
D
0
0 255101520
S
b
Small price
change and
large quantity
change
… a small
price rise...
20.00
D
1
An increase
in demand
brings ...
21.00
… and a large
quantity increase

26. 26
Elasticity of Supply
•Elasticity of supply ranges
–(from) Perfectly Elastic Supply
•Quantity supplied falls to 0 when there is
any decrease in price
–(to) Perfectly Inelastic Supply
•Quantity supplied is constant no matter
what happens to price
Notice: There is no total revenue test for supply
since price and quantity are directly related

27. 27
Supply Elasticity Ranges
P
r
ic
e
Quantity
S
Elasticity of
supply = 0
0
Quantity supplied is
the same for any
price!
P
r
ic
e
P
r
ic
e
QuantityQuantity
SS
Elasticity of
supply = 
00
Suppliers will offer
ANY quantity at this
price

28. 28
Elasticity of Supply: Depends On:
1.Resource substitution possibilities,
-The more unique the resource, the more
inelastic the supply.
2.Time frame for the supply decision,
Momentary supply
Long-run supply
Short-run supply
- The longer producers have to adjust to a price
change, the more elastic is supply.

29. 29
S2
Quantity Supplied per Period
P
r
ic
e


p
e
r

U
n
it
S1
Q
e
P
e
P
1
As time passes, the
supply curve rotates
to S2 and then to S3
and quantity supplied
rises first to Q1 and
then to Q2
Supply Elasticity and Time
S
3
Q2Q1

30. 30
Elasticity: example-Tax Burden
•Government levies a tax on a good:
–who actually pays the tax,
– what is the incidence of the tax,
•who bears the burden of the tax.
•Suppose that the tax is levied on the seller;
i.e., the seller has to pay the tax
Supply is affected

31. 31
Explain the Effects of the Sales Tax
•A $10 sales (excise) tax per MP3 player is imposed
on the sellers of MP3 players.
•There are now two “prices” for MP3 players: an after-
tax price faced by buyers, and an after-tax price faced
by sellers.
•Will the price faced by buyers increase $10 after
introducing the sales tax? By how much?
•Will the price faced by sellers change? By how
much?

32. 32
S + tax
Sales Tax Imposed on the Sellers
Quantity (thousands of MP3 players per week)
P
r
ic
e

(
d
o
lla
r
s

p
e
r

p
la
y
e
r
)
3 4 5 6
95
100
105
110 S
D
A
Tax
revenue
$10 tax
After Tax
Market Price
Supply is affected

33. 33
S + tax
Sales Tax: Who Pays?
Quantity (thousands of MP3 players per week)
P
r
ic
e

(
d
o
lla
r
s

p
e
r

p
la
y
e
r
)
3 4 5 6
95
100
105
110 S
D
A
$10 tax
Original Market Price
Buyer pays
After Tax
Market Price
Seller pays
After Tax
Price to Seller
t
a
x
Tax Wedge

34. 34
Summary:
•Taxes discourage market activity
•Burden is shared, buyers pay more,
sellers receive less,
and
•Tax burden falls most heavily on the
side of the market that is least elastic
in its response to a price change.

35. 35
S + tax
The Sales Tax: Who Pays?
Demand Relatively Inelastic
Quantity (thousands of MP3 players per week)
P
r
ic
e

(
d
o
lla
r
s

p
e
r

p
la
y
e
r
)
3 4 5 6
95
100
105
110 S
D
A
98
108 $10 tax

36. 36
S + tax
The Sales Tax: Who Pays? Demand
Relatively More Elastic.
Quantity (thousands of MP3 players per week)
P
r
ic
e

(
d
o
lla
r
s

p
e
r

p
la
y
e
r
)
3 4 5 6
95
100
105
110 S
D
A
$10 tax
Original Market Price
103
93
Tax Wedge

37. 37
D-tax
Sales Tax: Who Pays When Tax
Is Imposed on the Buyer?
Quantity (thousands of MP3 players per week)
P
r
ic
e

(
d
o
lla
r
s

p
e
r

p
la
y
e
r
)
3 4 5 6
95
100
105
110 S
D
A
$
1
0

t
a
x
Original Market Price