principles of economics

Principles of Economics

Session 2

Topics To Be Covered

Price Elasticity of DemandIncome Elasticity of DemandCross-Price Elasticity of DemandElasticity of SupplyApplication of ElasticityNetworks and Positive Feedback

Elasticity

Elasticity is a measure of how much buyers and sellers respond to changes in market conditions

It allows us to analyze supply and demand with greater precision.

Price Elasticity of Demand

Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.

It is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

Computing the Price Elasticity of Demand

The price elasticity of demand (Ed) is computed as the percentage change in the quantity demanded divided by the percentage change in price.

P/P

Q/Q

P%

Q%

Price inChange Percentage

Demanded Quantity inChange Percentage

=Ed

Computing the Price Elasticity of Demand

Example: If the price of an ice cream cone increases from $0.50 to $1.00 and the amount customers buy falls from 10 to 8 cones then the elasticity of demand would be calculated as:

2.0%100

%20

%10050.0

)50.000.1(

%10010

)810(

P

Q

%

%


DemandedQuantity inChange Percentage

=Ed

Computing the Arc Elasticity of Demand

$3.00

2.50

2.00

1.50

1.00

0.50

21 3 4 5 6 7 8 9 10 1211

P

Qd0

Ed=0.2


Example: If the price of an ice cream cone decreases from $1.00 to $0.50 and the amount customers buy increases from 8 to 10 cones then the elasticity of demand would be calculated as:

5.0%50

%25

%10000.1

)50.000.1(

%1008

)810(

P%

Q%


Demanded Quantity inChange Percentage

=Ed


$3.00

2.50

2.00

1.50

1.00

0.50

21 3 4 5 6 7 8 9 10 1211

P

Qd0

Ed=0.5

Computing the Arc Elasticity of Demand Using the Midpoint

Formula

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.

)/2]P)/[(PP(P

)/2]Q)/[(QQ(Q=Demand of ElasticityPrice

1212

1212


Example: If the price of an ice cream cone increases from 0.50 to $1.00 and the amount customers buy falls from 10 to 8 cones the your elasticity of demand, using the midpoint formula, would be calculated as:

33.0%6.66

%2.22

2/)50.000.1(

)50.000.1(2/)810(

)810(

)/2]P)/[(PP(P

)/2]Q)/[(QQ(Q=Demand of ElasticityPrice

1212

1212


$3.00

2.50

2.00

1.50

1.00

0.50

21 3 4 5 6 7 8 9 10 1211

P

Qd0

Ed=0.33

Ranges of Elasticity

Inelastic (E ＜ 1) Quantity demanded does not respond

strongly to price changes.

Elastic (E ＞ 1)Quantity demanded responds strongly to changes in price.


Unit Elastic (E= 1)Quantity demanded changes by the same percentage as the price.

Perfectly Inelastic (E = 0)Quantity demanded does not respond to price changes.

Perfectly Elastic (E =∞)Quantity demanded changes infinitely with any change in price.

Inelastic Demand

Quantity

Price

4

$51. A 22%increasein price...

Demand

100902. ...leads to a 11% decrease in quantity.

E ＜ 1

Elastic Demand

Quantity

Price

4


Demand


E ＞ 1

Unit Elastic Demand

Quantity

Price

4


Demand


E= 1

Perfectly Inelastic Demand

Quantity

Price

4

$5

Demand

1002. ...leaves the quantity demanded unchanged.

1. Anincreasein price...

E = 0

Perfectly Elastic Demand

Quantity

Price

Demand$4

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

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

E =∞


$3.00

2.50

2.00

1.50

1.00

0.50

21 3 4 5 6 7 8 9 10 1211

P

Qd0

Ed ＜ 1

Ed = ∞

Ed ＞ 1

Ed = 1

Ed = 0

Linear Demand Curve Qd = a + bP Qd =12 – 4P

Arc Elasticity vs. Point Elasticity

Arc ElasticityIt is calculated over a portion of demand curve.

Point ElasticityIt is computed at a point on demand curve.

Computing the Point Elasticity of a Linear Demand Curve

$3.00

2.50

2.00

1.50

1.00

0.50

21 3 4 5 6 7 8 9 10 1211

P

Qd0

Ed = ∞

Ed=5

Ed = 1

Ed = 0

Ed=2

Ed=0.5

Ed=0.2

Q

P

P

Q

PP

QQ

P

Q

/

/

%

%=Ed

4

412

P

QPQd

Computing the Point Elasticity of a Linear Demand Curve

A

B

D E

P

QdO

COD

DE

AC

CE

AB

BOOD

BO

AB

BC

OD

BO

AO

OE

Q

P

P

Q

=Ed

Elasticity vs. Slope

$3.00

2.50

2.00

1.50

1.00

0.50

21 3 4 5 6 7 8 9 10 1211

P

Qd0

Ed=1 Ed=0.43

Computing the Point Elasticity of a Curvilinear Demand

$3.00

2.50

2.00

1.50

1.00

0.50

21 3 4 5 6 7 8 9 10 1211

P

Qd0

A Ed=2●

●B Ed=1

Elasticity and Total Revenue

Total revenue is 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

$4

Demand

Quantity

P

0

Price

P x Q = $400 (total revenue)

100Q



$3.00

2.50

2.00

1.50

1.00

0.50

21 3 4 5 6 7 8 9 10 1211

P

Qd0

TRA=0.5×10=5

TRB=1.0×8=8Ed ＜ 1

With inelastic demand (Ed ＜ 1), an increase in price leads to an

increase in total revenue.

A

B TR=P ×Q


$3.00

2.50

2.00

1.50

1.00

0.50

21 3 4 5 6 7 8 9 10 1211

P

Qd0

TRA=2×4=8

TRB=2.5×2=5

Ed ＞ 1

With elastic demand (Ed ＞ 1), an increase

in price leads to a decrease in total

revenue.

A

B TR=P ×Q


$3.00

21 3 4 5 6 7 8 9 10 1211

P

Qd0

TRA=1.25×7=8.75

TRB=1.75×5=8.75

Ed=1

With unit-elastic demand (Ed=1), an increase in price leads to no

change in total revenue.

1.25 A

1.75B

TR=P ×Q

Determinants of Price Elasticity of Demand

Necessities versus Luxuries

Availability of Close Substitutes

Definition of the Market

Time Horizon

Determinants of Price Elasticity of Demand

Demand tends to be more elastic :

if the good is a luxury. the longer the time period. the larger the number of close

substitutes. the more narrowly defined the market.

Price Elasticity of Demand

Beef 0.956

Eggs 0.263

Fruit 3.021

GM Pontiac Catalina 16.99

Gasoline (short run) 0.43

Gasoline (long run) 1.50

Income Elasticity of Demand

Income elasticity of demand measures 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.

Computing Income Elasticity

Income Elasticity

of Demand

Percentage Change in Quantity Demanded

Percentage Change in Income

=

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.

Income Elasticity- Types of Goods -

Goods consumers regard as necessities tend to be income inelasticExamples 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.

Income Elasticity of Demand

Automobiles 2.50

Furniture 0.53

Books 1.40

Clothing 1.00

Tobacco 0.64

Eggs 0.37

Cross-Price Elasticity of Demand

The cross-price elasticity of a good measures the

responsiveness of quantity demanded of one good to

changes in the price of another good.

Computing Cross-Price Elasticity of Demand

X

Y

Y

X

YY

XX

Y

XXY Q

P

P

Q

PP

QQ

P

QE

/

/

%

%

Cross-Price Elasticity of Demand

Beef and Chicken 0.350

Margarine and Butter 1.526

Catalinas and Impalas 19.3

Price Elasticity of Supply

Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price.

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


Relatively Inelastic

ES < 1

Relatively Elastic

ES > 1

Unit Elastic

ES = 1


Perfectly Elastic

ES = Perfectly Inelastic

ES = 0

Inelastic Supply

Quantity

Price

4


110100

Supply

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

E ＜ 1

Elastic Supply

Quantity

Price

4


200100

Supply


E ＞ 1

Unit Elastic Supply

Quantity

Price

4


125100

Supply


E= 1

Perfectly Elastic Supply

Quantity

Price

Supply$4

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

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

E =∞

Perfectly Inelastic Supply

Quantity

Price

4

$5

Supply

1002. ...leaves the quantity supplied unchanged.

1. Anincreasein price...

E = 0

Determinants of Elasticity of Supply

Ability of sellers to change the amount ofthe good they produce.Beach-front land is inelastic.Books, cars, or manufactured goods are elastic.

Time period. Supply is more elastic in the long run.

Computing the Price Elasticity of Supply

The price elasticity of supply is computed as the percentage change in the quantity supplied divided by

the percentage change in price.


SuppliedQuantity inChange Percentage

=Supply of Elasticity

Application of 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.

Bumper Harvest and 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?

An Increase in Supply in the Market for Wheat

$3

Quantity of Wheat1000

Price ofWheat

Demand

S1

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

An Increase in Supply in the Market for Wheat

$3

Quantity of Wheat1000

Price ofWheat 1. When demand is inelastic,

an increase in supply...

Demand

S1 S2

2

110

2. ...leadsto a large fall in price...

Compute Elasticity

-0.240.4

0.095-

2.00)/2(3.002.00-3.00

110)/2(100110-100

=ED

Compute Elasticity

-0.240.4

0.095-

2.00)/2(3.002.00-3.00

110)/2(100110-100

=ED

Demand is inelastic

Taxes and Elasticity

Governments levy taxes to raise revenue for public

projects.

Taxes

Tax incidence is the study of who bears the burden of a tax.

Taxes result in a change in market equilibrium.

Buyers pay more and sellers receive less, regardless of whom the tax is levied on.

3.00

Quantity ofIce-Cream Cones

0

Price ofIce-Cream

Cone

10090

D1

D2

Supply, S1

Impact of Tax Levied on Buyers

A tax on buyersshifts the demandcurve downwardby the size ofthe tax ($0.50).

3.00


0

Price ofIce-Cream

Cone

10090

$3.30

Pricebuyers

pay

D1

D2

Equilibriumwith tax

Supply, S1

Equilibrium without tax

Impact of Tax Levied on Buyers

2.80

Pricesellersreceive

Pricewithout

tax

Tax ($0.50)

What was the impact of tax?

Taxes discourage market activity. When a good is taxed, the quantity sold

is smaller. Buyers and sellers share the tax

burden.

3.00


0

Price ofIce-Cream

Cone

10090

S1

S2

Demand, D1

Impact of Tax Levied on Sellers

Price without tax

2.80

Price sellers receiv

e

$3.30

Price buyers

pay

Equilibrium without tax

A tax on sellers shifts the supply

curve upward by the

amount of the tax ($0.50).

Tax ($0.50)

Equilibriumwith tax

Tax reduces

labor supply

A Payroll Tax

Quantity ofLabor

0

Wage

Wage without

tax

Labor demand

Labor supply

Tax wedge

Wage firms pay

Wage workers receive

The Incidence of Tax

In what proportions is the burden of the tax divided?

How do the effects of taxes on sellers compare to those levied on buyers?

The answers to these questions depend on the elasticity of demand

and the elasticity of supply.

Tax reduces

labor supply

Elastic Supply, Inelastic Demand

Quantity0

Price

Demand

Supply

Tax

1. When supply is moreelastic than demand...

2. ...theincidence of thetax falls moreheavily onconsumers...

3. ...than onproducers.

Price without tax

Price buyers pay

Price sellers receive

Tax reduces

labor supply

Inelastic Supply, Elastic Demand

Quantity0

Price

Demand

Supply

Price without tax

Tax

1. When demand is moreelastic than supply...

2. ...theincidence of the tax falls more heavily on producers...

3. ...than on consumers.

Price buyers pay

Price sellers receive

S’

$1.0 of Tax on Gasoline

Quantity0

Retail Price

D

S

0.8

1.0

0.8

2.0

1.8

90 100

0.2

So, how is the burden of the tax divided?

The burden of a tax falls more

heavily on the side of the market that

is less elastic.

Networks and Positive Feedback

Positive Feedback

Strong get stronger, weak get weaker

Negative feedback: stabilizing

Makes a market “tippy”

Examples: VHS v. Beta, Wintel v. Apple

“Winner take all markets”

Sources of Positive Feedback

Supply side economies of scale Declining average cost Marginal cost less than average cost Example: information goods

Demand side economies of scale Network effects In general: fax, email, Web In particular: Sony v. Beta, Wintel v. Apple

Network Effects

Real networksVirtual networksNumber of users

Metcalfe’s Law: Value of network of size n proportional to n2

Importance of expectations

Lock-In and Switching Costs

Network effects lead to substantial collect

ive switching costs

Even worse than individual lock-in

Due to coordination costs

Example: QWERTY

Chicken & Eggs

Fax and fax machines

VCRs and tapes

Internet browsers and Java

Historical Examples ofPositive Feedback

RR gauges

AC v. DC

Telephone networks

Color TV

HD TV

Assignment

Review Chapter 4Answer questions on P78-79Preview Chapter 5

Thanks

principles of economics

Documents

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price changes

point elasticityarc

portion of demand curve

linear demand curve

percentage change

percent change

inelastic demandquantitypricee