mr. barnett university high ap economics 2012-2013

Elasticity

Mr. BarnettUniversity HighAP Economics2012-2013

Elasticity

We already know that if the price of a good rises, consumers will buy less But….how much less? Economists measure the change through elasticity

Elasticity: a measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants

Basically, a measure of how much buyers and sellers respond to change in market conditions

Price Elasticity

Remember the Law of demand…. A fall in the price of a good will raise

the quantity demanded

Price Elasticity – measures how much the quantity demanded responds to a change in price

Demand is: Elastic – if quantity demanded

responds substantially to a change in price

Inelastic – if quantity demanded responds only slightly to a change in price

Influences on Price Elasticity of Demand

Availability of close substitutes Goods with close substitutes tend to have

more elastic demand because it is easier for consumer to switch from that good to another

Example▪ Butter goes up $0.15 in price▪ Price of margarine stays the same▪ Result: large drop in quantity of butter sold


Necessities versus luxuries Necessities have _________ demands Luxuries have ___________demands

Example: When the price of a dentist visit

increases, people will not drastically reduce the # of visits

When the price of video games rise, the quantity demanded of video games falls substantially

Note: Whether a good is a necessity or a luxury depends on personal preference


Definition of the market Elasticity of demand in a market depends on its

definition (how we qualify it) Narrowly defined markets tend to have more

elastic demand than broadly defined markets ▪ Because easier to find substitutes if more narrowly

defined

Food -> inelastic Ice Cream -> elastic Vanilla Ice Cream -> very elastic

Influences on Price Elasticity of Demand Time Horizon

Goods have more elastic demand in the long term

Example When the price of gasoline

increases, the quantity of gasoline only falls slightly in the short term

Long term, people will set up carpools, buy more fuel efficient cars, electric cars, ride buses, move closer to work

Influences on Price Elasticity of Demand Inexpensive vs

expensive Expensive items tend to

have elastic demand curve

Inexpensive items tend to have inelastic demand curve

A screw doubles in price from $0.05 to $0.10

A civic doubles in price from $20,000 to $40,000

Total Revenue = Price x Quantity TR = P x Q

Price (P) Quantity (Q)

TR Price (P) Quantity (Q)

TR

Price INC, Total Revenue INC Price INC, Total Revenue DEC

Price DEC, Total Revenue DEC Price DEC, Total Revenue INC

Elasticity Coefficient Test

The Elasticity Coefficient equals the percentage change in quantity demanded divided by the percentage change in price

▪ Butter goes from $1.00 to $1.20▪ Causes 40% drop in amount bought ▪ 40 percent/20 percent = 2.0 ▪ Elasticity coefficient = 2

▪ Note: Use absolute values so all elasticities are positive numbers

▪ A larger price elasticity implies a greater responsiveness of quantity demanded to change in price

Computing the elasticity coefficient of demand

Make sure to use positive numbersMake sure to start with original numbers

Figure out the elasticity of demand of both graphs above using the TR test

Figure out the elasticity of demand of both graphs above by figuring out the of elasticity coefficient

Inelastic Elastic


Ed < 1 Ed > 1

Influences on Price Elasticity of Demand So 5 tests of Elasticity

Tests Inelastic Elastic

Substitutes Few Substitutes Many Substitutes

Necessity v Luxury Necessity Luxury

Cost Inexpensive Expensive

Total Revenue P Inc, TR IncP Dec, TR Dec

P Inc, TR DecP Dec, TR Inc


Ed < 1 Ed > 1

Classification of Elasticity When the price elasticity of demand is greater than

one, demand is defined to be elastic Percentage change in quantity demanded will be greater

than the percentage change in price

When the price elasticity of demand is less than one, demand is defined to be inelastic Percentage change in price will be greater than the

percentage change in quantity demanded

When the price elasticity of demand is equal to one , the demand is said to have unit elasticity Percentage change in price will be equal to the percentage

change in quantity demanded

Elasticity of Demand Curves

Most demand curves that have a downward slope have an elastic, inelastic and unit elastic portion

Drawbacks to Coefficient Test There are some drawbacks to using the coefficient of

price elasticity of demand test As we have seen, the PED can vary at different points along

a demand curve, due to its percentage nature Also, percentage changes are not symmetric; rather, the

percentage change between any two values depends on which one is chosen as the starting value and which one as the ending value

What if a company just wants to compare the results of two different possible pricings, instead of “starting” at one price and moving to another?▪ If quantity demanded increases from 10 to 15 units, the percentage

change is 50%...... (15-10)/10▪ If quantity demanded decreases from 15 to 10 units, the percentage

change is 33.3%....(10-15)/10

Midpoint Method Thus, we can use the midpoint method to avoid those

problems. Also known as Arc Elasticity Involves calculating the percentage change in either P or Qd by

dividing the change in the variable by the midpoint between the initial and final levels rather than by the initial value itself

Formula:

Note: Use averages for quantities and prices. Avoids having to deal with beg and ending values

Example: Price of hamburgers rise from $4 to $6 Quantity demanded falls from 120 to 80

▪ % change in quantity demanded = (120-80)/100 = 40%▪ % change in price = (6-4)/5 x 100% = 40%▪ Price elasticity of demand = 40/40 = 1

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. Anincreasein price . . .

2. . . . leaves the quantity demanded unchanged.

Price


(b) Inelastic Demand: Elasticity Is Less Than 1

Quantity0

$5

90

Demand1. A 22%increasein price . . .

Price

2. . . . leads to an 11% decrease in quantity demanded.

4

100



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%increasein price . . .

Demand

Copyright © 2004 South-Western/Thomson Learning


(d) Elastic Demand: Elasticity Is Greater Than 1

Demand

Quantity

4

1000

Price

$5

50


2. . . . leads to a 67% decrease in quantity demanded.

Copyright © 2004 South-Western/Thomson Learning


(e) Perfectly Elastic Demand: Elasticity Equals Infinity

Quantity0

Price

$4 Demand

2. At exactly $4,consumers willbuy any quantity.

1. At any priceabove $4, quantitydemanded is zero.

3. At a price below $4,quantity demanded is infinite.

Total Revenue = Amount paid by buyers and received by sellers of a good

= price of the good times the quantity sold

Review

Even though slope is constant, elasticity is not Slope is the ratio of

changes in the 2 variables Elasticity is the ratio of

percentage changes in the two variables

At points with a high price and low quantity, the demand curve is ____

At points with a low price and high quantity, the demand curve is ____

Elasticity

When the price is $1, demand is inelastic An increase in price to $2 will increase total revenue

When the price is $5, demand is elastic, A price increase to $6 will reduce total revenue

At $3.50, demand is unit elastic, and consumers will buy any quantity

Figure 3 How Total Revenue Changes When Price Changes: Inelastic Demand

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

Figure 4 How Total Revenue Changes When Price Changes: Elastic Demand

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

Midpoint Method

P rice e las tic ity o f d em an d =( ) / [( ) / ]

( ) / [( ) / ]

Q Q Q QP P P P2 1 2 1

2 1 2 1

2

2

Midpoint example

Example: If the price of Hello Kitty pencil toppers increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 toppers, then your elasticity of demand, using the midpoint formula, would be calculated as…

( )( ) /

( . . )( . . ) /

..

1 0 81 0 8 2

2 2 0 2 0 02 0 0 2 2 0 2

2 2 %

9 5 %2 3 2

Income Elasticity

In co m e e la stic ity o f d em an d =

P ercen tag e ch an g e in q u an tity d em an d ed

P ercen tag e ch an g e in in co m e

Income elasticity of demandmeasures how much the quantity demanded of a good responds to a change in consumers’ income

Income Elasticity

Normal goods have ______income elasticities Inferior goods have ______income elasticities

Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods

Necessities tend to have _____income elasticities, whereas luxuries tend to have ______income elasticities

Important Side Note

We use the absolute value when figuring out price elasticity of demand because the value is always negative (because when price changes in one direction, quantity demanded always changes in the other).

But this isn't true for income. When income changes, people might want to buy more or less of the good.

Income Elasticity

After irrevocably destroying symbols borrowed from the American West, PSY’s income rises from $100,000 to 1,000,000. The quantity of hamburger he buys each week rises from two pounds to four pounds. What is PSY’s income elasticity? What kind of good is hamburger

for PSY?

Cross-Price Elasticity

Cross-Price Elasticity of demand: A measure of how much the quantity demanded of one good responds to a change in the price of another good

Cross-Price Elasticity = % change in quantity demanded of good 1 ___________________________________

% change in price of good 2

Substitutes have ______ cross price elasticities, whereas complements have ________cross-price elasticities

The sign matters for cross-price elasticity.

When the price of one good changes, people might want to buy more of the other good, or less.

Cross Price Elasticities

The price of Kris-Kross cassette tapes rise from $8 to $10. As a result, the quantity of Kris-Kross trading cards demanded falls from 8,000 per week to 9,500.

What is the cross-price elasticity?

What is the relationship between the two goods?

Elasticity of Supply

Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good.

Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in priceP rice e las tic ity o f su p p ly =

P ercen tag e ch an g e in q u an tity su p p lied

P ercen tag e ch an g e in p rice

Figure 6 The Price Elasticity of Supply


(a) Perfectly Inelastic Supply: Elasticity Equals 0

$5

4

Supply

Quantity1000

1. Anincreasein price . . .

2. . . . leaves the quantity supplied unchanged.

Price



(b) Inelastic Supply: Elasticity Is Less Than 1

110

$5

100

4

Quantity0


Price

2. . . . leads to a 10% increase in quantity supplied.

Supply



(c) Unit Elastic Supply: Elasticity Equals 1

125

$5

100

4

Quantity0

Price



Supply



(d) Elastic Supply: Elasticity Is Greater Than 1

Quantity0

Price



4

100

$5

200

Supply



(e) Perfectly Elastic Supply: Elasticity Equals Infinity

Quantity0

Price

$4 Supply

3. At a price below $4,quantity supplied is zero.

2. At exactly $4,producers willsupply any quantity.

1. At any priceabove $4, quantitysupplied is infinite.

Determinants of Price Elasticity of Supply

Flexibility of Sellers Goods that are somewhat fixed in supply

have inelastic supplies Goods that are not (books, cars,

tamagotchi pets) have elastic supplies

Determinants of Price Elasticity of Supply

Time Period Supply is usually more inelastic in the

short run Supply is usually more elastic in the long

run

The price of chocolate milk increases from $2.85 per gallon to $3.15 per gallon and the quantity supplied rises from 9,000 to 11,000 gallons per month

Price elasticity of supply is ?

APPLICATION of ELASTICITY

Can good news for farming be bad news for farmers?

What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties?

THE APPLICATION OF SUPPLY, DEMAND, AND ELASTICITY

Examine whether the supply or demand curve shifts.

Determine the direction of the shift of the curve.

Use the supply-and-demand diagram to see how the market equilibrium changes.

Figure 8 An Increase in Supply in the Market for Wheat


Quantity ofWheat

0

Price ofWheat

3. . . . and a proportionately smallerincrease in quantity sold. As a result,revenue falls from $300 to $220.

Demand

S1 S2

2. . . . leadsto a large fallin price . . .

1. When demand is inelastic,an increase in supply . . .

2

110

$3

100

Compute the Price Elasticity of Supply

ED

1 0 0 11 01 0 0 11 0 2

3 0 0 2 0 03 0 0 2 0 0 2

0 0 9 5

0 40 2 4

( ) /. .

( . . ) /

.

..Supply is inelastic

Supply

Supply _____, price _____, quantity demanded ______

If demand is ineastic, the fall in price is greater than the increase in quantity demanded and total revenue ______

Demand for basic foodstuffs is usually inelastic Less revenue for farmers Because farmers are price takers they still have

incentive to adopt new hybrid so they can produce and sell more wheat

Explains why number of farms has declined so much over the past 200 years

Also explains why some gov policies encourage farmers to decrease the amuont of crops planted

In the 1970s and 1980s, OPEC reduced the amount of oil it was willing to supply to world markets. The decrease in supply led to an increase in the price of oil and a decrease in quantity demanded. The increase in price was much larger in the short run than the long run. Why?

mr. barnett university high ap economics 2012-2013

Documents

price demand

price slide

elasticity elasticity

price price of margarine

price inelastic

larger price elasticity

price elasticity measures

price butter