Chapter 5 - Elasticity and Its Application

Chapter

Elasticity and Its Application

5

The Elasticity of Demand• Elasticity

– Measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants

– Measure of how much buyers and sellers respond to changes in market conditions

When price of a product changes, there are two things that we look at

1) Direction: Demand can rise or fall

2) Magnitude: Size of the decline

2

• Consumers usually buy more of a product when;

a. Price is lower

b. Income is higher

c. Price of substitutes for the good are higher

d. Price of complements of the good are lower

Our demand analysis discussion in chapter 4 only focused on the direction in which quantity demanded moved but not the size of the change.

3

The Elasticity of Demand

• Law of Demand: Decline in the price of a good raises its quantity demanded.

• Price elasticity of demand– Measure of how much quantity demanded of

a good responds to a change in the price of that good

– Measures how willing consumers are to buy less of the good as its price rises

4


• Price elasticity of demand

• Demand for a good is said to be – Elastic (Elastic demand)

• Quantity demanded responds substantially to changes in the price

– Inelastic (Inelastic demand)• Quantity demanded responds only slightly to

changes in the price

5


• Determinants of price elasticity of demand– Availability of close substitutes

• Goods with close substitutes are have more elastic demand

Why?

It is easier for consumers to switch from that good to others

• Butter Vs Salt

• Apple computers Vs Egg

• Burger King Vs Water

6

Determinants of price elasticity of demand

– Necessities vs. luxuries

Necessities tend to have inelastic demands, whereas luxuries have elastic demand• Necessities – inelastic demand

e.g. water, doctor’s visit, Food

• Luxuries – elastic demand

e.g. Cable or satellite, video games, movies at the theater

7

Determinants of price elasticity of demand

– Definition of the market

Elasticity of demand in any market depends on how we draw the boundaries of the market.• Narrowly defined markets – more elastic demand

• Broadly defined markets – Less elastic demand

Cloth (no close substitutes) Vs designer jeans

– Time horizon– Goods tend to be more elastic over longer time

horizons as compared to short time horizons. Over time, people find cheaper alternatives.

8


• Computing the price elasticity of demand

• Standard procedure– Percentage change in quantity demanded

• Divided by percentage change in price

– Use absolute value (drop the minus sign)

Problem:

When you calculate elasticity between two points say A to B, it will be different from that of B to A.

9

• Conventional methodPoint A: Price = $4 Quantity = 120

Point A: Price = $6 Quantity = 8

• From point A to B, Price rises by 50% and the quantity falls by 33%. Using conventional method, Price elasticity of demand is

33/50 = 0.66

• From point B to A, price falls by 33% and the quantity rises by 50%. Using conventional method, price elasticity of demand is

50/33 =1.5

The Elasticity of DemandMidpoint method

Two points: (Q1, P1) and (Q2, P2)

Because midpoint method gives the same answer regardless of the direction of change, it is often used

when calculating the price elasticity of demand between two points.

A larger price elasticity implies a greater responsiveness of quantity demanded to Price

11

])/P)/[(PP(P])/Q)/[(QQ(Q

22

1212

1212

+−+−

=demand of elasticity Price


• Variety of demand curves: Demand curves can be classified according to their elasticity. – Demand is elastic

• Elasticity > 1 : quantity moves proportionately more than the price

– Demand is inelastic• Elasticity < 1 :quantity moves proportionately less

than the price

– Demand has unit elasticity• Elasticity = 1 : quantity moves the same amount

proportionately as the price 12


• Variety of demand curves– Rule of thumb

The flatter the demand curve that passes through a given point, the greater the price elasticity

The steeper the demand curve that passes through a given point, the smaller the price elasticity of demand.


• Variety of demand curves– Demand is perfectly inelastic

• Elasticity = 0

• Demand curve - vertical

– Demand is perfectly elastic• Elasticity = infinity

• Demand curve - horizontal

– The flatter the demand curve• The greater the price elasticity of demand

14

Figure

The price elasticity of demand (a, b)

1

15

(a) Perfectly inelastic demand: Elasticity = 0

1. an

Price

Quantity 0

Demand

100

$5

4

1. Anincreasein price…

2. …leavesthe quantitydemanded unchanged

(b) Inelastic demand: Elasticity < 1

1. an

Price

Quantity 0

$5

4

1. A 22%increasein price… 2. … leads to

an 11% decreasein quantitydemanded

Demand

10090

The price elasticity of demand determines whether the demand curve is steep or flat.Note that all percentage changes are calculated using the midpoint method.

Figure

The price elasticity of demand (c)

1

16

(c) Unit elastic demand: Elasticity = 1

1. an

Price

Quantity 0

$5

41. A 22%increasein price…

2. … leads toA 22% decreasein quantitydemanded

Demand

10080


Figure

The price elasticity of demand (d, e)

1

17

(d) Elastic demand: Elasticity > 1

1. an

Price

Quantity 0

$5

4


2. … leads toa 67% decreasein quantitydemanded

Demand

10050


(e) Perfectly elastic demand: Elasticity equals infinity

1. an

Price

Quantity 0

Demand $4

1. At any priceabove $4, quantitydemanded is zero 2. At exactly $4,

consumers willbuy any quantity

3. At any pricebelow $4, quantitydemanded is infinite


• Total revenue – Amount paid by buyers

– Received by sellers of a good

– Computed as: price of the good times the quantity sold (P ˣ Q)

18

Figure

Total revenue

2

19

1. an

P

Q

P ˣ Q=$400(revenue)

Quantity 0

Demand

Price

The total amount paid by buyers, and received as revenue by sellers, equals the area of the box under the demand curve, P × Q. Here, at a price of $4, the quantity demanded is 100, and total revenue is $400.

100

$4


• Total revenue and price elasticity of demand

• How does total revenue changes as one moves along the demand curve?

• Inelastic demand– An Increase in price causes an increase in

total revenue

• Elastic demand– An Increase in price causes a decrease in total

revenue

20

Figure

How total revenue changes when price changes (a)

3

21

1. an

Revenue=$100

Quantity 0

Demand

Price

100

$1

(a) The Case of Inelastic Demand

1. an

Revenue=$240

Quantity 0

Demand

Price

80

$3

The impact of a price change on total revenue (the product of price and quantity) depends on the elasticity of demand. In panel (a), the demand curve is inelastic. In this case, an increase in the price leads to a decrease in quantity demanded that is proportionately smaller, so total revenue increases. Here an increase in the price from $1 to $3 causes the quantity demanded to fall from 100 to 80. Total revenue rises from $100 to $240

Figure

How total revenue changes when price changes (b)

3

22

1. anRevenue

=$200

Quantity 0

Demand

Price

50

$4

(b) The Case of Elastic Demand

1. an

Demand

The impact of a price change on total revenue (the product of price and quantity) depends on the elasticity of demand. In panel (b), the demand curve is elastic. In this case, an increase in the price leads to a decrease in quantity demanded that is proportionately larger, so total revenue decreases. Here an increase in the price from $4 to $5 causes the quantity demanded to fall from 50 to 20. Total revenue falls from $200 to $100.

Revenue=$100

Quantity 0

Price

20

$5

The Elasticity of Demand• Rules

• When demand is inelastic– Price and total revenue move in the same

direction

• When demand is elastic– Price and total revenue move in opposite

directions

• If demand is unit elastic– Total revenue remains constant when the

price changes23

The Elasticity of Demand• Elasticity and total revenue along a linear demand

curve• Linear demand curve

– Constant slope

– Elasticity is not constant

1. Slope is the ratio of changes in the two variables

2. Elasticity is the ratio of percentage changes in the two variables

• Points with low price & high quantity

– Inelastic

• Points with high price & low quantity

–Elastic 24

Figure

Elasticity of a linear demand curve (graph)

4

25

1. an

Quantity 0

Price

Demand

$7

14

6

5

4

3

2

1

2 4 6 8 10 12

Elasticityis largerthan 1

Elasticityis smallerthan 1

The slope of a linear demand curve is constant, but its elasticity is not. The demand schedule in the table was used to calculate the price elasticity of demand by the midpoint method. At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic.

Figure

Elasticity of a linear demand curve (schedule)

4

26

The slope of a linear demand curve is constant, but its elasticity is not. The demand schedule in the table was used to calculate the price elasticity of demand by the midpoint method. At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic.

Price Quantity Total revenue

(Price ˣ Quantity)

PercentageChangein Price

Percentage Change inQuantity Elasticity Description

$76543210

O2468

101214

The Elasticity of Demand• Income elasticity of demand

– Measure of how much the quantity demanded of a good responds• To a change in consumers’ income

– Percentage change in quantity demanded • Divided by the percentage change in income

– Normal goods: positive income elasticity. • Necessities: smaller income elasticities

• Luxuries: large income elasticities

– Inferior goods: negative income elasticities27


• Cross-price elasticity of demand– Measure of how much the quantity

demanded of one good (say good A) responds• To a change in the price of another good (say B)

– Percentage change in quantity demanded of the first good• Divided by the percentage change in price of the

second good

– Substitutes: Positive cross-price elasticity

– Complements: Negative cross-price elasticity28

The Elasticity of Supply

• Price elasticity of supply– Measure of how much the quantity supplied

of a good responds• To a change in the price of that good

– Percentage change in quantity supplied• Divided by the percentage change in price

– Price elasticity of supply depends on the flexibility of sellers to change the amount of the good they produce

29

The Elasticity of Supply• Price elasticity of supply

– Elastic supply

• Quantity supplied responds substantially to changes in the price

– Inelastic supply

• Quantity supplied responds only slightly to changes in the price

• Determinant of price elasticity of supply

– Time period

• Supply is more elastic in long run

• In short run, firms cannot easily change the size of their factories to make more/less of the product

30

The Elasticity of Supply

• Computing price elasticity of supply– Percentage change in quantity supplied

• Divided by percentage change in price

• Variety of supply curves– Supply is perfectly inelastic

• Elasticity =0

• Supply curve – vertical

– Supply is perfectly elastic• Elasticity = infinity

• Supply curve – horizontal31

The Elasticity of Supply• Suppose price of milk increases from $2.85 to $3.15

a gallon. Amount that dairy farmers produce changes from 9,000 to 11,000 gallons. Calculate elasticity of supply.

• Variety of supply curves– Unit elastic supply

• Elasticity =1

– Elastic supply• Elasticity >1

– Inelastic supply• Elasticity < 1

32

Figure

The price elasticity of supply (a, b)

5

33

(a) Perfectly inelastic supply: Elasticity = 0

1. an

Price

Quantity 0

Supply

100

$5

4

1. Anincreasein price…

2. …leavesthe quantitysupplied unchanged

(b) Inelastic supply: Elasticity < 1

1. an

Price

Quantity 0

$5

4

1. A 22%increasein price… 2. … leads to

a 10% increasein quantitysupplied

100 110

The price elasticity of supply determines whether the supply curve is steep or flat.Note that all percentage changes are calculated using the midpoint method.

Supply

Figure

The price elasticity of supply (c)

5

34

(c) Unit elastic supply: Elasticity =1

1. an

Price

Quantity 0

$5

4


2. … leads toa 22% increasein quantitysupplied

100 125


Supply

Figure

The price elasticity of supply (d, e)

5

35


(d) Elastic supply: Elasticity > 1

1. an

Price

Quantity 0

$5

4


2. … leads toa 67% increasein quantitysupplied

100 50

(e) Perfectly elastic supply: Elasticity equals infinity

1. an

Price

Quantity 0

Supply $4

1. At any priceabove $4, quantitysupplied is infinite

2. At exactly $4,producers willsupply any quantity

3. At any pricebelow $4, quantitysupplied is zero

Supply

Figure

How the price elasticity of supply can vary

6

36

1. an

Price

Quantity 0

$15

12

Supply

100 525

Because firms often have a maximum capacity for production, the elasticity of supply may be very high at low levels of quantity supplied and very low at high levels of quantity supplied. Here an increase in price from $3 to $4 increases the quantity supplied from 100 to 200. Because the 67 percent increase in quantity supplied (computed using the midpoint method) is larger than the 29 percent increase in price, the supply curve is elastic in this range. By contrast, when the price rises from $12 to $15, the quantity supplied rises only from 500 to 525. Because the 5 percent increase in quantity supplied is smaller than the 22 percent increase in price, the supply curve is inelastic in this range.

500200

43

Elasticity is small(less than 1).

Elasticity is large(greater than 1).

Applications of Supply, Demand, & Elasticity

• Can good news for farming be bad news for farmers?– New hybrid of wheat – increase production

per acre 20%• Supply curve changes

• Supply curve shifts to the right

• Higher quantity; lower price

• Demand – inelastic– Total revenue falls

– Paradox of public policy• Induce farmers not to plant crops 37

Figure

An increase in supply in the market for wheat

7

38

S1

S2

When an advance in farm technology increases the supply of wheat from S1 to S2, the price of wheat falls. Because the demand for wheat is inelastic, the increase in the quantity sold from 100 to 110 is proportionately smaller than the decrease in the price from $3 to $2. As a result, farmers’ total revenue falls from $300 ($3 × 100) to $220 ($2 × 110).

Price ofWheat

Quantity of Wheat0 110

$3

2

100

Demand

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

2. … leadsto a large fallin price. . .

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


• Why did OPEC fail to keep the price of oil high? – 1970s: OPEC reduced supply of oil

• Increase in prices 1973-1974 and 1971-1981

• Short-run: supply is inelastic– Decrease in supply: large increase in price

– 1982-1990 – price of oil decreased• Long-run: supply is elastic

– Decrease in supply: small increase in price

39

Figure

1. an

Price

1. an

Price

A reduction in supply in the world market for oil

8

40

Demand

P2

(a) The Oil Market in the Short Run

Demand

When the supply of oil falls, the response depends on the time horizon. In the short run, supply and demand are relatively inelastic, as in panel (a). Thus, when the supply curve shifts from S1 to S2, the price rises substantially. By contrast, in the long run, supply and demand are relatively elastic, as in panel (b). In this case, the same size shift in the supply curve (S1 to S2) causes a smaller increase in the price.

(b) The Oil Market in the Long Run

S1S2

P1

1. In the short run, when supply and demand are inelastic, a shift in supply. . .

2. … leads to alarge increasein price

P2

S1S2

P1

1. In the long run, when supply and demand are elastic, a shift in supply. . .

2. … leads to asmall increasein price

Quantity 0 Quantity 0


• Does drug interdiction increase or decrease drug-related crime?– Government increases the number of federal

agents devoted to the war on drugs• Illegal drugs - Supply curve shifts left

– Higher price; lower quantity

– Amount of drug-related crimes• Inelastic demand for drugs

• Higher drugs price – higher total revenue

• Increase drug-related crime

41


• Does drug interdiction increase or decrease drug-related crime?– Policy of drug education

• Reduce demand for illegal drugs

• Left shift of demand curve

• Lower quantity; lower price

• Reduce drug-related crime

42

Figure

Policies to reduce the use of illegal drugs

9

43

1. an

Price

1. an

Price

Demand

P2

(a) Drug Interdiction

D1

Drug interdiction reduces the supply of drugs from S1 to S2, as in panel (a). If the demand for drugs is inelastic, then the total amount paid by drug users rises, even as the amount of drug use falls. By contrast, drug education reduces the demand for drugs from D1 to D2, as in panel (b). Because both price and quantity fall, the amount paid by drug users falls

(b) Drug Education

S1S2

P1

1. Drug interdiction reduces the supply of drugs. . .

2. … whichraises theprice . . .

P2

Supply

P1

1. Drug education reducesthe demand for drugs . . .

2. . . . whichreduces theprice . . .

Quantity 0 Quantity 0Q1Q2

3. … and reduces the quantity sold

D2

Q1Q2

3. … and reducesthe quantity sold

Chapter 5 - Elasticity and Its Application

Documents

Transcript of Chapter 5 - Elasticity and Its Application