Download - Elasticity - A Measure of Response
Elasticity: A Measure of Response
Can anything be so elegant as to have few wants, and to serve them one's self?
-Ralph Waldo Emerson
Slide 1 of 50
Eab
Ey
Ed
Es
Elasticity can measure numerous things
Each of these concepts refers to how sensitive changes in one
variable are to changes in another variable.
Elasticity of Demand
Elasticity of Supply
Cross Elasticity
Income Elasticity
We’ll use these symbols as shorthand
In this presentation, we’ll look at four concepts related to elasticity.
They include:
Slide 2 of 50
So far, we have always looked at 45 degree demand curves
Elasticity of Demand
In reality, demand curves can change in slope
depending on how sensitive quantity demand is to price. That sensitivity is referred to
as elasticity of demand!
Slide 3 of 50
A demand curve that is more horizontal is referred to as ‘elastic’
P1
Qd1
P2
Qd2
That is typical of goods that have very elastic demand.
Consumers are sensitive to price changes. Even small
increases will scare away a lot of customers.
Elasticity of Demand
Have you ever changed travel dates or
destinations to save money on vacation air
fare? Probably so because
as a vacation air traveler, you were sensitive to price.
Consider this very elastic demand
curve for example.
At a price of P1, quantity demand is
Qd1.
Now imagine the price of this good goes up a little.
Look what happens to the quantity
demand!
Small changes in price result in big
changes in quantity demanded
Examples of goods that have elastic demand include:
Restaurant foodVacation air travel
Luxury goods
Slide 4 of 50
Now consider this very
inelastic demand curve.
A demand curve that is more vertical is referred to as ‘inelastic’
P1
Qd1
P2
Qd2
Examples:Milk & Salt
Business air travelHabit forming goods
Doctor/Medical Visits
Elasticity of Demand
Even big changes in price
result in only small changes in
quantity demanded.
Consultants are business air travelers. When they book plane tickets, they usually don’t care about
price. They want to be on time for the meeting!
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Real world example of an inelastic price elasticity of demand
Every year, we seem to see this outside of big box
stores.
People wait in line for days for a particular product.
Clearly, these folks are not sensitive to price.
If upon entering the store, they found the price to be higher, would they have
cared?
Elasticity of Demand
Based on this behavior, we’d probably classify their demand as: ______________.Inelastic!
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Price Elasticity of Demand- the technical definition
Elasticity of Demand
Price elasticity of demand (also simply called elasticity of demand) – The rate of response of quantity demanded
due to a change in price.
It is commonly referred to as Ed (as it is in this presentation) or eD (as it is in your
course reading material.Ed
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Price Elasticity of Demand- the technical definition seen graphically
Elasticity of Demand
When we talk about price elasticity of demand, we are asking how sensitive changes in quantity demand are…
…to changes in price.
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Individual exercises
1) Identify one item that you routinely buy that you would be
willing to pay a lot more for if you had to.
2) Now identify one item that you would not buy if the price were to
go up even only a little.
Elasticity of Demand
Here are mine:
I am insensitive to the price of ESPN. If it doubled, I’d still pay. My demand for ESPN is inelastic! Don’t tell
them that!
I like pineapples but they are $5 and they are a lot of work. I only buy them on sale. I am very sensitive to price- my
demand for pineapples is very elastic!
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Different elasticity of demand scenarios
Unit ElasticElastic Inelastic
Elasticity of Demand
Note how the horizontal demand curve looks like the middle flat part of the “E” for elastic!
Note how the vertical demand
curve looks like an “I” for inelastic!
This means a one unit change in price (i.e. 1%) results in a one unit change in Quantity demand
(i.e. 1%)Slide 10 of 50
We’ve reached a key learning outcome here. We are applying the concept of
elasticity of demand to consumer decisions.
When demand is very elastic, consumers are quite sensitive to price. When it is
very inelastic, they care much less about price…they are willing to pay more.
Why is this important?
Understanding elasticity is important for economists because it lets us measure
what the impact that a price change had, is having, or will have on the amount of
product that is demanded.
Elasticity of Demand
Let’s look at a case study on the next few slides to see how this can be applied.
Slide 11 of 50
Case study: the Dulles GreenwayElasticity of Demand
The Dulles Greenway is a 14 mile road that
opened in 1995.
It allowed people to avoid all the stoplights
on Route 7 as they made their way into Tyson’s Corner, the
nation’s tenth largest employment center.
They thought people would be willing to pay a big toll to avoid stoplights on alternate routes.
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Elasticity of demand, misread
$1.75
Elasticity of Demand
The Bryant’s hired a consultant to determine how much people would be willing to pay to use the road. In other words, they wanted to know the price elasticity of demand for
this road!
The consultants estimated that the demand curve would take the
following shape.
That meant that if the toll was set at $1.75, about 30,000 cars would
use the toll road every day.
The owners determined that would generate enough money to meet
their obligations…
In reality, the demand curve was much more elastic.
At $1.75 per trip, full time use would cost $910 per year.
People were sensitive to this price!
Instead of attracting 30,000 cars per day, they attracted about
10,000.
At least at first, the roadway lost money in what must have been a painful learning experience about
elasticity of demand!
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Factors that determine elasticity of demand
• Availability of close substitutes– Example: margarine and butter are close substitutes
so they are more elastic
• Necessity versus Luxury– Doctor’s costs are not likely to respond as much to
price increases as the cost of 60” plasma TV
• Definition of Market– Elasticity of demand for any market will depend on
how the market is defined. Broad definitions, such as food will have fewer substitutes and will be more inelastic. Conversely, snow peas, will have many substitutes and will be more elastic.
• Time Horizon– Goods tend to be more elastic over time as markets
adjust to changes in price
Elasticity of Demand
Slide 14 of 50
How can time impact elasticity?
Typical car in 1960 Typical car just 12 years later
Weighed up to 5,000 pounds
35 MPG
Elasticity of Demand
10 MPG
Weighed only 2,600 pounds
We are seeing another broad and dramatic change in our fleet now. A movement to electric and hybrid cars!
In the 1970s, the supply of oil was reduced for a
number of reasons and on a number of occasions.
At that time, what could we do? Not much. We still had to drive to work. So we still bought gas. Our
demand for gas was inelastic in the short run.
Over time, what could we do? Change our behavior so we demanded less gas.
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Calculating elasticity of demandElasticity of Demand
If a small change in price results in a big change in
quantity demand, then price elasticity of demand for that good is high - it is elastic!
-50%
+1%
= 50
If a BIG change in price results in a SMALL change in quantity demand, then price elasticity of demand for that
good is low- it is INELASTIC!
-1%
+50%
= .02
Note: this ratio will always be negative.
For this first example, -50%/1% is actually -50.
For this second example, -1%/50% is actually -.02.
Since we know the sign will always be negative, we ignore it.
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Here are some possible price elasticity of demand scenarios
Elasticity of Demand
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Examples of some elasticity's for selected goods
Source: Mackinac Center for Public Policy
Elasticity of Demand
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A closer look at the demand curve
Elasticity's differ at different points along the demand curve
Elasticity of Demand
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The demand schedule and curveElasticity of Demand
Let’s start with the demand schedule and curve shown
here:
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Calculating Elasticity
Assume price falls from $9 to $8, what is the elasticity of demand?
• Step 1: Calculate the percent change in Quantity Demanded (Qd)– Quantity demanded increases from 1 to 2.– The percent change in Qd = change/first or
1/1=100%• Step 2: Calculate the percent change in
Price – The price decreased by 1– The percent change in price = change/first or
(-1)/9 or -11.1%• Step 3: Calculate Elasticity
– Divide the percent change in Qd by the percent change in price
– Ed = 100%/11% = 9• Step 4: Interpret the results
– This is elastic! (it is greater than one) Note: we dropped the negative sign. Since the demand curve
represents a negative relationship, this figure is always negative. The negative sign is
understood and is therefore ignored!
Elasticity of Demand
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Calculating Elasticity
Assume price falls from $8 to $7, what is the elasticity?
• Step 1: Calculate the percent change in Quantity Demanded (Qd)– Quantity demanded increases from 2 to 3.– The percent change in Qd = change/first or
1/2=50%• Step 2: Calculate the percent change in
Price – The percent change in price = change/first or
(-1)/8 or -12.5%• Step 3: Calculate Elasticity
– Divide the percent change in Qd by the percent change in price
– Ed = 50%/12.5% = 4• Step 4: Interpret the results
– This is elastic! (it is greater than one)
Elasticity of Demand
Slide 22 of 50
Calculating Elasticity
Assume price falls from $2 to $1, what is the elasticity?
• Step 1: Calculate the percent change in Quantity Demanded (Qd)– Quantity demanded increases from 8 to 9.– The percent change in Qd = change/first or
1/8=12.5%• Step 2: Calculate the percent change in
Price – The percent change in price = change/first or
(-1)/2 or -50%• Step 3: Calculate Elasticity
– Divide the percent change in Qd by the percent change in price
– Ed = 12.5%/50% = .25• Step 4: Interpret the results
– This is inelastic! (it is less than one)
Elasticity of Demand
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Lets look more closely at the demand curve
This portion of the demand curve is elastic.
Elasticity of Demand
Slide 24 of 50
Lets look more closely at the demand curve
This portion of the demand curve is inelastic.
Elasticity of Demand
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Lets look more closely at the demand curve
This portion of the demand curve is referred to as “Unit Elastic”. A
change in price results in an equal percentage change in quantity
demanded.
Percent change in quantity demand = (6-5)/5 = 20%
Percent change in price = (4-5)/5 = 20%
20% / 20% = 1.0. This is unit elastic!
Elasticity of Demand
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Note an annoying problem when calculating Ed
• Elasticities will change in the same portion of the demand curve depending on whether prices are increasing or decreasing
?
Elasticity of Demand
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Calculating elasticity, again
Assume price falls from $9 to $8, what is the elasticity?
• Step 1: Calculate the percent change in Quantity Demanded (Qd)– Quantity demanded increases by 1.– The percent change in Qd = change/first or
1/1=100%• Step 2: Calculate the percent change in
Price – The price decreased by 1– The percent change in price = change/first or
(-1)/9 or -11.1%• Step 3: Calculate Elasticity
– Divide the percent change in Qd by the percent change in price
– Ed = 100%/11% = 9• Step 4: Interpret the results
– This is elastic! (it is greater than one) Note: We previously determined that Ed is 9
Elasticity of Demand
Slide 28 of 50
Calculating Elasticity, the other direction
Assume price rises from $8 to $9, what is the elasticity?
• Step 1: Calculate the percent change in Quantity Demanded (Qd)– Quantity demanded decreases by 1.– The percent change in Qd = change/first or
(-1)/2=-50%• Step 2: Calculate the percent change in
Price – The price increased by 1– The percent change in price = change/first or
(1)/8 or 12.5%• Step 3: Calculate Elasticity
– Divide the percent change in Qd by the percent change in price
– Ed = -50%/12.5% = 4• Step 4: Interpret the results
– This is elastic! (it is greater than one) Note: We now determine that Ed is 4…along the
same part of the demand curve!
Elasticity of Demand
Slide 29 of 50
Calculations of elasticity will change depending on direction
We should be careful…
As we just saw a price decrease from $9 to $8 gave us an Ed of 9…
very elastic.
But an increase in price from $8 to $9 gave us an Ed of 4…still elastic
but not as much as before.
Using the midpoint formula can help solve this problem.
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The midpoint formula
As you’ll probably note, the midpoint formula gets around this problem by taking an average of these
starting points using the formula below.
Let’s try an example.
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The midpoint formula
Regardless of direction, if price moved from 8 to 9 we could use the midpoint formula to get Ed
• Step 1: Calculate the change in quantity demanded divided by the average of the two quantities Demanded (Qd)– Change in Qd is 1.– The average of the Qd’s is 1.5– This ratio is 1/1.5 or 66.6%
• Step 2: Calculate the change in price divided by the average of the two prices The price increased by 1– Change in P is 1.– The average of the P’s is 8.5– This ratio is 1/8.5 or 11.7%
• Step 3: Calculate Elasticity– Divide the results from step one by the results
from step two– Ed = 66.6%/11.7% = 5.7
• Step 4: Interpret the results– This is elastic! (it is greater than one)
Elasticity of Demand
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WHEW!
• I know that the material related to calculating elasticity of demand was heavy. In addition, having two methodologies to calculate it that are closely related makes it confusing.
• On a test, be prepared to calculate elasticity of demand using either formula (you don’t need to know both).
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Part II - Income Elasticity of Demand
Income Elasticity - A measure of how sensitive quantity demand is to changes in income
It is commonly referred to as Ey
Normal Goods (Like this steak)
Inferior Goods (like this Spam?)
Income Elasticity
When we discuss income elasticity, we are talking about normal versus inferior goods
Slide 34 of 50
Calculating Income ElasticityIncome Elasticity
Notice: as your income goes up,
you may demand more normal goods
Let’s assume your income increases by 10%
Let’s assume that in response, your demand for steaks increases by 10%
10%
10%
Ey would equal one (10%/10% = 1)
Slide 35 of 50
Calculating Income ElasticityIncome Elasticity
Notice: as your income goes up,
you may demand less inferior goods
Let’s assume your income increases by 10%
Let’s assume that in response, your demand for SPAM falls by 10%
10%
-10%
Ey would equal one (-10%/10% = -1)
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Interpreting Income Elasticity
• If income elasticity of demand is greater than zero, than goods are normal– i.e., as you make more money, you demand
more of these goods– Example: your income goes up so you buy
more clothes• If income elasticity of demand is less
than zero, than goods are inferior– i.e. as your income goes down, you buy more of
these goods– Example: your income goes down so you buy
Raman noodles
Income Elasticity
Slide 37 of 50
Inferior goods…a subjective classification
Keep in mind that your perceptions of normal and inferior goods may differ. You may love Spam!
Some stores however specialize in the sale of what most of us consider inferior goods. Can you name one?
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Part III - Cross Elasticity of Demand
Cross Elasticity - A measure of how sensitive quantity demand is to price changes for related goods
Commonly referred to as Ea,b
Cross Elasticity
For example, if the price of this goes up, do you buy more of this?
Slide 39 of 50
Calculating Cross Elasticity
Notice: as price of B (Pepsi) goes up,
you may demand more of A (Coke)
Cross Elasticity
Let’s assume Pepsi prices go up by 10%
Let’s assume that in response, demand for Coke increased by 10%
10%
10%
Ea,b would equal one (10%/10% = 1)Slide 40 of 50
Interpreting Cross Elasticity (part 1)
• If cross elasticity of demand is greater than zero, than goods are substitutes– Example: Price of DVDs goes up so you
demand more Blu-ray Discs
Cross Elasticity of Blu-ray and DVDs
Price of DVDs increases 100%
Change in quantity of Blu-ray discs demanded increases 20%
Cross elasticity of demand = 20%/100% = +0.2
These goods are substitutes!
Cross Elasticity
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Interpreting Cross Elasticity (part 2)
• If cross elasticity of demand is less than zero, than goods are compliments– Price of ketchup goes up so you demand
fewer french fries
Cross Elasticity of french fries and ketchup
Price of ketchup increases 300%
Change in quantity of french fries demanded decreases 10%
Cross elasticity of demand = -10%/300% = -0.03
These goods are compliments!
Cross Elasticity
Slide 42 of 50
Part IV – Elasticity of Supply
For this one, Imagine that you
are a tomato farmer….
Lastly, let’s turn to the fourth and final elasticity
Elasticity of Supply
Slide 43 of 50
First a definition: what is price elasticity of supply
Price Elasticity of Supply (Es)- A measure of how sensitive quantity supplied is to price
In other words, how do changes in price effect the amount of a product (for you, that means tomatoes)
that suppliers will provide?
That depends a lot on the time.
Elasticity of Supply
Slide 44 of 50
What does “That depends a lot on the time” mean?
We’ll analyze three time periods:
Market Period: a time where producers are unable to change supply given a change in price. In other words, right now.
Short run: a time horizon where plant capacity cannot be changed but the intensity to which that capacity is used can be. In other words, this season.
Long run: a time horizon where plant size can be adjusted, firms can enter and exit market.In other words, next season or beyond.
A plant is a physical establishment that
performs one or more functions in the
production of goods or services. For you, the
tomato farmer, it is your farm.
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In the “market period”, there is no time to change output
• In the market period: You’re truck is loaded with tomatoes and you are on the way to sell them. You can either sell the tomatoes or let them spoil.
• Supply is perfectly inelastic
Note how Qs does not change regardless of price! The production
decision has been made and is irreversible.
Qs
Elasticity of Supply
Slide 46 of 50
In the “short run”, output can be changed a little
• Short run: you’ve planted the crops. All you can do now is perhaps adjust the fertilizers or hire more crop pickers to maximize your harvest.
• Supply is more elastic but is still pretty inelastic
Note how Qs changes only slightly with a change in price. The “plant” (or
farm) decision has been made and only the intensity with which it is
worked can be altered.
QsQs2
Elasticity of Supply
Slide 47 of 50
In the “long run”, output can be changed a lot
• Long run: You could buy more land. You could alter crops to more productive produce.
• Supply is more much elastic
Note how Qs changes significantly with a change in price. The “plant” (or farm) decision has not been made and
can be significantly altered.
Qs Qs2
Elasticity of Supply
That is what I mean by “the price elasticity of supply has a lot to do with
time.”
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Interpreting Elasticity of Supply
Market Period
Short run
Long run
Elasticity of Supply
Slide 49 of 50
In Summary
We’ve learned that an elasticity refers to a sensitivity
We’ve studied four of those here – elasticity to price, elasticity to income, elasticity to prices of other goods, and
elasticity of supply.
These are important concepts, particularly for a business owner considering a change in price.
Depending on how sensitive consumers are, price changes could drastically change quantity demand!
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