Micro Ch 05 Lecture

7/29/2019 Micro Ch 05 Lecture

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What do you do when the price

of gasoline rises?


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5When you have completed your

study of this chapter, you will be able to

1 Define the price elasticity of demand, and explain thefactors that influence it and how to calculate it.

2 Define the price elasticity of supply, explain the factorsthat influence it and how to calculate it.

3 Define the cross elasticity of demand and the incomeelasticity of demand, and and explain the factors that

influence them.

CHAPTER CHECKLIST

Elasticities ofDemand and Supply


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5.1 THE PRICE ELASTICITY OF DEMAND

Price elasticity of demand is a measure of the

extent to which the quantity demanded of a good

changes when the price of the good changes.

To determine the price elasticity of demand, we

compare the percentage change in the quantity

demanded with the percentage change in price.


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Percentage Change in Price

Percent change in price =New price Initial price

Initial Pricex 100

Percent change in price =$5 $3

$3x 100 = 66.67 percent

Suppose Starbucks raises the price of a latte from $3

to $5 a cup. What is the percentage change in price?


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Suppose Starbucks cuts the price of a latte from $5 to

$3 a cup. What is the percentage change in price?

Percent change in price =New price Initial price

Initial Pricex 100

Percent change in price =$3 $5

$5x 100 = 40 percent


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The Midpoint Method

x 100Percent change in price =New price Initial price

(New Price + Initial Price) 2

To calculate the percentage change in the price dividethe change in the price by the average price and then

multiply by 100.The average price is at the midpoint between theinitial price and the new price, hence the namemidpoint method.


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The percentage change in price calculated by the midpointmethod is the same for a price rise and a price fall.

x 100Percent change in price =$5 $3

($5 + $3) 2

Percent change in price = 50 percent.


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Percentage Change in Quantity Demanded

x 100Percent changein quantity =

New quantity Initial quantity

(New quantity + Initial quantity)2

x 100Percent changein quantity =

5 15

(5 + 15) 2= 100 Percent

If Starbucks raises the price of a latte, the quantity oflatte demanded decreases.


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When the price rises, the quantity demanded decreasesalong the demand curve.

Similarly, when the price falls, the quantity demandedincreases along the demand curve.

Price and quantity always change in opposite directions.

So to compare the percentage change in the price and thepercentage change in the quantity demanded, we ignorethe minus sign and use the absolute values.


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Elastic and Inelastic Demand

Demand is elastic if the percentage change in the

quantity demanded exceeds the percentage change inprice.

Demand is unit elastic if the percentage change inthe quantity demanded equals the percentage change

in price.


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Demand is inelastic if the percentage change in thequantity demanded is less than the percentage change

in price.

Demand is perfectly elastic if the quantitydemanded changes by a very large percentage in

response to an almost zero percentage change in price.

Demand is perfectly inelastic if the quantitydemanded remains constant as the price changes.


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Figure 5.1(a) shows aperfectly elastic demand.

1. For a small change in theprice of spring water,

2. The quantity of spring water

demanded changes by alarge amount.

3. The demand for springwater is perfectly elastic.



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Figure 5.1(b) shows anelastic demand.

1. When the price of aSony PlayStation risesby 10%,

2. The quantity of PlayStations

demanded decreases by 20%.

3. Demand for SonyPlaystations is elastic.



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Figure 5.1(c) shows a unitelastic demand.

1. When the price of a triprises by 10%,

3. The demand for trips isunit elastic.


2. The quantity of trips demandeddecreases by 10%.


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Figure 5.1(d) shows aninelastic demand.

1. When the price of gumrises by 20%,

2. The quantity of gum

demanded decreases by 10%.

3. The demand for gum isinelastic.



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Figure 5.1(e) shows aperfectly inelastic demand.

1. When the price of adose rises,

2. The quantity of dosesdemanded does not change.

3. Demand for doses isperfectly inelastic.



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Influences on the Price Elasticity of Demand

Influences on the price elasticity of demand fall into twocategories:

Availability of substitutes

Proportion of income spent

Availability of Substitutes

The demand for a good is elastic if a substitute for it iseasy to find.

The demand for a good is inelastic if a substitute for it is

hard to find.


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Three main factors influence the ability to find asubstitute for a good:

Luxury Versus Necessity

A necessity has poor substitutes, so the demand fora necessity is inelastic. Food is a necessity.

A luxury has many substitutes, so the demand for aluxury is elastic. Exotic vacations are luxuries.

Narrowness of Definition

The demand for a narrowly defined good is elastic.

The demand for a broadly defined good is inelastic.


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Time Elapsed Since Price Change

The longer the time elapsed since the price change, the

more elastic is the demand for the good.Proportion of Income Spent

A price rise, like a decrease in income, means that

people cannot afford to buy the same quantities.

The greater the proportion of income spent on a good,

the more elastic is the demand for the good.


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Computing the Price Elasticity of Demand

If the price elasticity of demand is greater than 1,demand is elastic.

If the price elasticity of demand equals 1, demand isunit elastic.

If the price elasticity of demand is less than 1, demandis inelastic.

Price elasticity

of demand

Percentage change in quantity demanded

Percentage change in the price

=


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Figure 5.2 shows theprice elasticity ofdemand calculation.

The percentage changein the price equals$2/$4 100, or 50%.

The percentage changein the quantity equals 10cups/10 cups 100, or100%.



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The price elasticity ofdemand is 2.

The price elasticity ofdemand equalsPercentage change in

quantityPercentage change inprice.

The price elasticity of

demand equals 100%divided by 50%.



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Computing the Price Elasticity of Demand

We can use this formula to calculate the priceelasticity of demand for a Starbucks latte:

Price elasticity

of demand


Percentage change in the price

=

Price elasticity of demand100%

50%= 2=


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Interpreting the Price Elasticity of DemandNumber

The elasticity of demand for a Starbucks latte of 2 tells

us three things:1. The demand for Starbucks lattes is elasticit has

substitutes and the proportion of a buyers incomespent is small.

2. If Starbucks raised its price, revenue per cup will risebut it will lose potential business.

3. Even a slightly lower price could bring in morerevenue.


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Figure 5.3 shows that theelasticity decreases along alinear demand curve as theprice falls.

1.At any price above themidpoint, demand is elastic.

3. At any price below themidpoint, demand isinelastic.

2. At the midpoint, demand

is unit elastic.



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Total Revenue and the Price Elasticity of

Demand

Total revenue is the amount spent on a good andreceived by its sellers and equals the price of the good

multiplied by the quantity of the good sold.

Total revenue test is a method of estimating the price

elasticity of demand by observing the change in totalrevenue that results from a price change.


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If demand is elastic:

A given percentage rise in price brings a largerpercentage decrease in the quantity demanded.

Total revenue decreases.

If demand is inelastic:

A given percentage rise in price brings a smallerpercentage decrease in the quantity demanded.

Total revenue increases.


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Total revenue test:

If price and total revenue change in the oppositedirections, demand is elastic.

If a price change leaves total revenue unchanged,demand is unit elastic.

If price and total revenue change in the same

direction, demand is inelastic.


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Figure 5.4(a) shows totalrevenue and elastic demand.

At $3 a cup, the quantitydemanded is 15 cups an hour.

Total revenue is $45 an hour.

Total revenue decreases to$25 an hour.

When the price rises to $5 acup, the quantity demanded

decreases to 5 cups an hour.

Demand is elastic.



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Figure 5.4(b) shows totalrevenue and inelastic demand.

At $50 a book, the quantitydemanded is 5 million books.

Total revenue is $250 million.

Total revenue increases to$300 million.

When the price rises to $75 abook, the quantity demanded

decreases to 4 million books.

Demand is inelastic.



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Applications of the Price Elasticity of Demand

Orange Prices and Total Revenue

Price elasticity of demand for agricultural products(oranges) is 0.4.

So if a frost cuts the supply of oranges (and demand

doesnt change), a 1 percent decrease in the quantityharvested will lead to a 2.5 percent rise in the price.

Demand is inelastic and farmers total revenue willincrease.


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Addiction and Elasticity

Nonusers demand for addictive substances is elastic.

A moderately higher price will lead to a substantiallysmaller number of people trying a drug.

Existing users demand for addictive substances is

inelastic.

So even a substantial price rise brings only a modest

decrease in the quantity demanded.


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5.2 THE PRICE ELASTICITY OF SUPPLY

Price elasticity of supplyis a measure of the extent

to which the quantity supplied of a good changes when

the price of the good changes.

To determine the price elasticity of supply, we compare

the percentage change in the quantity supplied with the

percentage change in price.


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Supply is unit elastic if the percentage change in thequantity supplied equals the percentage change in

price.

Supply is inelastic if the percentage change in thequantity supplied is less than the percentage change in

price.

Supply is perfectly inelastic if the percentagechange in the quantity supplied is zero when the price

changes.


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Figure 5.5(a) shows perfectlyelastic supply.

1. A small rise in the price,

2. Increases the quantitysupplied by a very large

amount,

3. Supply is perfectly elastic.



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Figure 5.5(b) shows anelastic supply.

1. A 10% rise in the priceof a book,

2. Increases the quantity ofbooks supplied by 20%.

3. The supply of books iselastic.



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Figure 5.5(d) shows aninelastic supply.

1. A 20% rise in the price ofa hotel room,

2. Increases the quantity of hotelrooms supplied by 10%.

3. The supply of hotel rooms isinelastic.


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Figure 5.5(e) shows aperfectly inelastic supply.

1. A small rise in the price ofa beachfront lot,

2. The quantity of beachfront lotssupplied increases by 0%.

3. The supply of beachfrontlots is perfectly inelastic.


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Influences on the Price Elasticity of Supply

The two main influences are:

Production possibilities

Storage possibilities

Production Possibilities

Goods that can be produced at a constant (or verygently rising) opportunity cost have an elastic supply.

Goods that can be produced in only a fixed quantity

have a perfectly inelastic supply.


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Time Elapsed Since Price Change

As time passes after a price change, producers find it

easier to change their production plans, so supply

becomes more elastic.

Storage Possibilities

The supply of a storable good is highly elastic.

The cost of storage is the main influence on the

elasticity of supply of a storable good.


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Computing the Price Elasticity of Supply

Price elasticity

of supply

Percentage change in quantity supplied

Percentage change in quantity price=

If the price elasticity of supply is greater than 1,supply is elastic.

If the price elasticity of supply equals 1, supply isunit elastic.

If the price elasticity of supply is less than 1, supply

is inelastic.


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Figure 5.6 shows howto calculate the priceelasticity of supply.

Percentage change in theprice equals $60/$40 100, or 66.67%.

Percentage change in the

quantity equals18 bouquets/15 bouquets 100, or 120%.



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The price elasticity ofsupply equals thePercentage change in

the quantity

Percentage change inthe price.

The price elasticity of

supply equals120% 66.67%.

The price elasticity ofsupply is 1.8.



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Cross Elasticity of Demand

Crosselasticity ofdemand

Percentage change in quantity

demanded of a goodPercentage change in the price of

one of its substitutes orcomplements

=

Cross elasticity of demand is a measure of the extent towhich the demand for a good changes when the price of asubstitute or complement changes, other things remaining thesame

5.3 CROSS ELASTICITY AND INCOME ELASTICITY


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Suppose that when the price of a burger falls by 10percent, the quantity of pizza demanded decreases by 5percent.

Crosselasticity of

demand

5 percent

10 percent= = 0.5



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The cross elasticity of demand for a substitute is positive.

A fallin the price of a substitute of the good brings a

decrease in the quantity demanded of the good.

The quantity demanded of the good and the price of itssubstitute change in the same direction.



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Figure 5.7 shows crosselasticity of demand.

2. Pizzas and soda are

complements.

When the price of sodafalls, the demand for

pizza increases.

Cross elasticity ofdemand is negative.

5.3 CROSS ELASTICITY AND INCOME ELASTICITY5.3 CROSS ELASTICITY AND INCOME ELASTICITY


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Income Elasticity of Demand

Income

elasticity ofdemand


Percentage change in income=

Income elasticity of demandis a measure of the

extent to which the demand for a good changes whenincome changes, other things remaining the same.



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What Do You Do When the Price of Gasoline Rises?

If you are like most people, you complain when the price ofgasoline rises, but you dont cut back very much on yourgas purchases.

University of London economists Phil Goodwin, JoyceDargay, and Mark Hanly studied the effects of a hike in theprice of gasoline on the quantity of gasoline demanded andon the volume of road traffic.

They estimated that a 10 percent rise in the price ofgasoline decreases the quantity of gasoline used by 2.5percent within one year and by 6 percent after five years.


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The short-run (up to one year) price elasticity of demand is2.5 percent divided by 10 percent, which equals 0.25.

The long-run (after five years) price elasticity of demand is6 percent divided by 10 percent, which equals 0.6.

Because these price elasticities are less than one, thedemand for gasoline is inelastic.

When the price of gasoline rises, the quantity of gasoline

demanded decreases but the amount spent on gasolineincreases.


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A 10-percent rise in the price of gasoline decreases thevolume of traffic by only 1 percent within one year and by3 percent after five years.

How can the volume of traffic fall by less than the quantityof gasoline used?

The answer is by switching to smaller, more fuel-efficientvehicles.

The demand for gasoline is inelasticbecause gasolinehas poor substitutes, but it does have a substituteasmaller vehicle.

Micro Ch 05 Lecture

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