chapter four elasticity and its uses. copyright © by houghton mifflin company, inc. all rights...

Chapter FourElasticity and Its

Uses

Copyright © by Houghton Mifflin Company, Inc. All rights reserved 4 - 2

Why the Size of the Elasticity of Demand is Important

• Price Elasticity of Demand is a measure of the sensitivity of the quantity demanded of a good to the price of the good.


Figure 4.1: Comparing Different Sizes of the Price Elasticity of Demand


Why the Size of Elasticity of Demand is Important – continued.• In the first graph, the demand curve is relatively flat,

the quantity demanded of oil is VERY sensitive to the price (HIGH ELASTICITY).

• When the price rises by $2, from $20 to $22 ($2/$20 = .10 or 10%), the quantity demanded falls by 12 million from 60 million to 48 million (12/60 = .20 or 20%).


Figure 4.1: Comparing Different Sizes of the Price Elasticity of Demand (cont’d)


Why the Size of Elasticity of Demand is Important – Continued.• In the second graph, the quantity demanded is not very

sensitive to the price. The demand curve has a low elasticity and is relatively steep.

• When the price rises by $2 or 10% (again, from $20 to $22), the quantity demanded falls by 3 million barrels from 60 to 57 million (3/60 = .05 or 5%).

• When supply of oil shifted (i.e. from lower production in Iraq), we need to know elasticity of demand to be able to predict effect on price and quantity demanded. In previous example, had same shift but two dramatically different results. (Graphs on following two slides)


Figure 4.2: The Importance of the Sizes of the Price Elasticity of Demand


Figure 4.2: The Importance of the Sizes of the Price Elasticity of Demand (cont’d)


The Advantage of a Unit-Free Measure

• Elasticity is a unit-free measure because it uses percentage changes in price and quantity demanded.

• Provides a way to compare the price sensitivity of the demand for many different goods.

• Allows us to compare the price sensitivity of less expensive goods with that of more expensive goods.


Elasticity versus Slope

• The elasticity of the demand curve is not the same as the slope of the demand curve.

• Slope is rise/run or ΔP/ΔQ and is not a unit-free measure.


Figure 4.3: Different Slopes and Same Elasticities


Figure 4.3: Different Slopes and Same Elasticities (cont’d)


Elasticities

• Elastic demand is greater than 1 (quantity demanded decreases by more than 1 percent when price rises 1 percent).

• Inelastic demand is less than 1 (quantity demanded decreases by less than 1 percent when price rises 1 percent).

• A vertical demand curve is perfectly inelastic. No matter what the price, the same quantity will be demanded.

• A horizontal demand curve is perfectly elastic. Infinitely large movements of quantity demanded for small increases in price.


Figure 4.4: Perfectly Elastic and Perfectly Inelastic Demand


Calculating the Elasticity with a Midpoint Formula

•The price elasticity of demand = ΔQ/Average Quantity ÷ ΔP/Average Price


Revenue and the Price Elasticity of Demand

• If price increases, that increases payment per unit but also reduces the number of units.

• When price increases, people pay more for each item and this increases revenue; but they buy fewer items, and this decrease in the quantity demanded reduces revenue.

• Elasticity helps us decide which effect will dominate.


Figure 4.5: Revenue and Elasticity of a Straight-Line Demand Curve


Figure 4.5: Revenue and Elasticity of a Straight-Line Demand Curve (cont’d)


Figure 4.6: Effects of an increase in the Price of Oil on Revenue


Figure 4.6: Effects of an increase in the Price of Oil on Revenue (cont’d)


What Determines the Size of the Price Elasticity of Demand• The Degree of Substitutability: If people can easily

find a substitute, elasticity will be high.– Luxury vs. Necessity

• Big-Ticket versus Little-Ticket Items: If a good represents a large fraction of people’s income, then the price elasticity will be high.

• Temporary versus Permanent Price Changes: If a change in price is known to be temporary, the price elasticity of demand will tend to be high.


What Determines the Size of the Price Elasticity of Demand - continued• Difference in Preferences: Various groups of

consumers may have different levels of elasticity. – Example: 18 year-old smokers vs. 50 year-old smokers

• Long-Run versus Short-Run Elasticity: – Short Run: Period of time before people have made all

their adjustments or changed their habits– Long Run: Period of time long enough for people to

make such adjustments or change their habits.– Price elasticity is low immediately after a price change

but then increases after a period of time has passed.


Income Elasticity of Demand

• Income Elasticity of Demand = Percentage change in quantity demanded ÷ percentage change in income

• Example: If incomes rise by 10 percent and as a result people purchase 15 percent more health care at a given price, the income elasticity of health care is 1.5.

• Normal good (incomes fall, demand falls) vs. Inferior good (incomes fall, demand rises): The income elasticity of demand for an inferior good is negative and is reported as a negative number.


Working with Supply Elasticities

• Elasticity of supply = ΔQuantity supplied/Quantity supplied ÷ ΔPrice/Price

• Also a unit-free measure

• Also, elasticity of supply is NOT the same as slope of the supply line


Perfectly Elastic and Perfectly Inelastic Supply

•Vertical Supply curve is perfectly inelastic–Example: Mona Lisa

•Horizontal Supply curve is perfectly elastic


Figure 4.7: Perfectly Elastic and Perfectly Inelastic Supply


Figure 4.8: Comparing Different Sizes of the Price Elasticity of Supply


Figure 4.8: Comparing Different Sizes of the Price Elasticity of Supply (cont’d)


Figure 4.9: Importance of Knowing the Size of the Price Elasticity of Supply


Figure 4.9: Importance of Knowing the Size of the Price Elasticity of Supply (cont’d)


Activities

• 17• 18• 19• 20• 21• 23• Multiple Choice Questions, Short Free-Response

Questions, Long Free-Response Questions

chapter four elasticity and its uses. copyright © by houghton mifflin company, inc. all rights...

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