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Elasticity4McGraw-Hill/IrwinCopyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.1Objective: 1. Price elasticity of demand and the total revenue test. 2. Determinants of Price elasticity of demand and its applications. 3. Price elasticity of supply and its determinants.4. Cross- and income elasticities of demand. Price Elasticity of Demand FormulaMeasures buyers responsiveness to price changesFormula for price elasticity of demand

Ed =LO1Percentage Change in QuantityDemanded of Product XPercentage Change in Priceof Product X2Law of demand tells us that consumers will respond to a price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more. The degree of responsiveness or sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand.

Ed = percentage change in quantity/ percentage change in price.

Price Elasticity of Demand FormulaUse the midpoint formulaEnsures consistent results

Change in quantity Change in price Sum of quantities/2 Sum of prices/2LO1Ed ==Q2 Q1/ (Q1 + Q2) / 2 P2 P1 / (P1 + P2) /2 3Price Elasticity of Demand FormulaUse percentagesNot dollar price changeCompare responsiveness across productsEliminate the minus signEasier to compare elasticitiesLO14Note: a change in the price of a $10,000 car by $1 is very different than a change in the price a of $1 can of beer by $1. The autos price is rising by a fraction of a percent while the beers price is rising 100 percent. Ed measures percentage change in price and not dollar change (consistent comparison).

Percentages also make it possible to compare elasticities of demand for different products.

Because of the inverse relationship between price and quantity demanded, the actual elasticity of demand will be a negative number. However, we ignore the minus sign and use absolute value. This makes it less confusing to interpret the elasticity coefficient.Interpretation of Elasticity of Demand Ed > 1 demand is elastic Ed = 1 demand is unit elastic Ed < 1 demand is inelastic Extreme cases (next slides) Perfectly inelastic Perfectly elasticLO15When the elasticity coefficient is greater than 1, it means that the percentage change in quantity demanded is greater than the percentage change in price (based on the formula), indicating that consumers are sensitive to the change in price, so demand is elastic.

When the elasticity coefficient is less than 1, the percentage change in quantity demanded is less than the percentage change in price (based on the formula), indicating that consumers are not very sensitive to price changes.

When the elasticity coefficient equals 1, this is a special case called unit elasticity. This means that the percentage change in price and the percentage change in quantity are exactly equal.

Perfectly inelastic demand means that consumers will buy exactly the same amount no matter how high or low the price. Perfectly elastic demand means that nothing will be purchased if there is any deviation from the current price.

Extreme CasesLO1D1PPerfectly inelastic demandPerfectly inelastic demand(Ed = 0)06This extreme situation is called perfectly inelastic demand and it is very rare. The demand curve would be vertical and graphs as a line parallel to the vertical axis. The elasticity coefficient is 0. An example of a perfectly inelastic demand might be a diabetics demand for insulin, street drug.

Extreme CasesLO1Perfectly elastic demandPD2Perfectly elasticdemand(Ed = )0P07This extreme situation shows infinite demand at current price (P0) and the demand curve is horizontal. The elasticity coefficient is infinite. An example of a perfectly elastic demand is a firms demand curve in a purely competitive industry who is unable to change the price.

Total Revenue TestTotal Revenue = Price X QuantityIf Inelastic demand (next slide)P and TR move in the same directionIf Elastic demand (next slide)P and TR move in opposite directionsLO28Total-revenue test is the easiest way to judge whether demand is elastic or inelastic. This test can be used in place of the elasticity formula, unless there is a need to determine the elasticity coefficient. The total revenue test is important to understand the relationship between price elasticity and total revenue.

Demand is inelastic if a decrease in price results in a fall in total revenue, or an increase in price results in a rise in total revenue.

Demand is elastic if a decrease in price results in a rise in total revenue, or if an increase in price results in a decline in total revenue.

Demand is unit elastic if total revenue does not change when the price changes.

Inelastic DD & Total Revenue TestLO2$4

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0 10 20 QPcdD2 A lower price, inelastic demand, TR drop Orange loss exceeds blue gain9A lower price and inelastic demand means that total revenue will fall. Blue gain (extra total revenue from extra sales) is less than the orange loss (the loss in total revenue from the higher price).

Elastic DD & Total Revenue TestLO2$3

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0 10 20 30 40QPabD1 A lower price, elastic demand, TR rise Blue gain exceeds orange loss10A lower price and elastic demand means that total revenue will rise. Blue gain (extra total revenue from extra sales) exceeds orange loss (the loss in total revenue from the higher price).

Total Revenue TestLO2$3

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0 10 20 30 QPefD3 Lower price and unit elastic demand Blue gain equals orange loss11A lower price and unit-elastic demand, means that total revenue is unchanged. Blue gain (extra total revenue from extra sales) is exactly equal to the orange loss (the loss in total revenue from the higher price).DD Curve, Ed, Total Revenue TestLO2Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity Coefficient and the Total-Revenue Test(1)Total Quantity of Tickets Demanded per Week, Thousands(2)Price per Ticket(3)Elasticity Coefficient (Ed)(4)Total Revenue(1) X (2)(5)Total Revenue Test1$8$8,000275.0014,000Elastic362.6018,000Elastic451.5720,000Elastic541.0020,000Unit Elastic630.6418,000Inelastic720.3814,000Inelastic810.20 8,000Inelasticlow priceHigh price12Notice that in the high price region, demand for movie tickets is elastic and revenues increase as price falls. Midway demand for movie tickets is unit elastic and revenues stay the same as price falls. In the low price region, elasticities of demand are inelastic and revenues fall as the price falls.DD curve, Elasticity and Total RevenueLO2012345678012345678Quantity DemandedQuantity DemandedPriceTotal Revenue(Thousands of Dollars)$2018161412108642$87654321abcdefghElasticEd > 1Unit ElasticEd = 1InelasticEd < 1DTR13You can see from the graph that elasticity changes along a demand curve. Demand tends to be more elastic in the upper-left portion of demand and more inelastic in the lower-right portion of demand.

This graph shows the relationship between price elasticity of demand for movie tickets and total revenue. It shows that the hypothetical weekly demand for movie tickets is elastic at higher price ranges and inelastic at lower price ranges. The total-revenue curve, TR, in (b) is derived from demand curve D. When price falls and TR increases, demand is elastic; when price falls and TR is unchanged, demand is unit elastic; and when price falls and TR declines, demand is inelastic.

Summary for Ed Ed > 1, %P , %Qd , TR

Ed = 1, %P , % Qd , TR

Ed < 1, %P , % Qd , TR Determinants of Elasticity of DemandSubstitutabilityMore substitutes, demand is more elasticProportion of IncomeHigher proportion of income, demand is more elasticLuxuries vs. NecessitiesLuxury goods, demand is more elasticTimeMore time available, demand is more elasticLO115With more substitutes available, consumers have more alternative options, so when there is a change in price, there is a greater percentage change in quantity demanded, making the demand more elastic. The broader the definition of the market, the more inelastic the demand. With a more narrow definition of the market, demand is more elastic. E.g. Meat Vs beef

The greater the proportion of income needed to buy the good the more elastic the demand. Consumers will be more sensitive to changes in prices because the price change can result in thousands of dollars difference. E.g. car vs chewing gum

Since luxuries are goods that consumers can go without, they will change the amount they purchase by a greater amount even if the price changes by a small amount. Necessity like rice or sugar is more inelastic.

It takes time to alter the amount being purchased, so the more time available, the more elastic the demand. A person doing their Christmas shopping on Christmas Eve has a very inelastic demand because he/she doesnt have the time to look around for alternative purchases.Price Elasticity of DemandLO1Selected Price Elasticities of DemandProduct or ServicePrice Elasticity of Demand (Ed)Product or ServicePrice Elasticity of Demand (Ed)Newspapers.10Milk.63Electricity (household).13Household appliances.63Bread.15Liquor.70MLB Tickets.23Movies.87Telephone Service.26Beer.90Cigarettes.25Shoes.91Sugar.30Motor vehicles1.14Medical Care.31Beef1.27Eggs.32China, glassware1.54Legal Services.37Residential land1.60Automobile repair.40Restaurant meals2.27Clothing.49Lamb and mutton2.65Gasoline.60Fresh peas2.8316Some of the elasticities of the goods in this table are surprising. Use the determinants of demand to discuss why major league baseball tickets are not only inelastic, but they are more inelastic than gasoline. Applications of EdLarge Crop Yields (e.g. potatoes)SS rise, P drop, assume Inelastic demand, Qd increases little, total revenue decreasesExcise Taxes (e.g. beer)P rises, Inelastic demand, Qd decreases little, total revenue risesLO117Large crop yields mean that the supply of crops increases and shifts to the right. When this occurs the equilibrium price falls. Since demand is inelastic, the lower price actually leads to lower revenue for farmers. Farmers are worse off when there is a large crop yield.

When government wants to impose taxes on goods, it is important for them to understand the elasticity of demand for the good. If they place a tax on a good with an inelastic demand, the higher price wont decrease the quantity purchased by much, thereby increasing the amount of tax revenue that government collects.Lecture 5Objective: 1. Price elasticity of supply and its determinants.2. Cross- and income elasticities of demand. 3. The law of diminishing marginal utility 4. Theory of consumer choice

Price Elasticity of SupplyMeasures sellers responsiveness to price changesFormula to compute elasticityEs > 1 supply is elasticEs < 1 supply is inelastic

LO3Percentage Change in QuantitySupplied of Product XPercentage Change in Priceof Product XEs =19We know that at higher prices firms are willing and able to produce more, whereas at lower prices firms are willing and able to produce less. Price elasticity of supply measures how sensitive firms are to price changes.

Just like the price elasticity of demand, we will compute the price elasticity of supply using the midpoint formula.Price elasticity of supplyElastic supply, producers are responsive to price changesInelastic supply, producers are not responsive to price changes

Elastic supply means that even for small changes in price, firms will greatly alter the quantity being produced. On the other hand, when supply is inelastic, this means that the firm is unresponsive to price changes and therefore will not change the amount being produced by much, even when the change in price is large.

20Price Elasticity of Supply*Time is primary determinant of elasticity of supplyTime periods consideredMarket period (immediate period) (see slide 21)Short Run (fixed and variable i/ps) (slide 22)Long Run (slide 23)LO321The ease of shifting resources between alternative uses is very important in price elasticity of supply because it will determine how much flexibility a producer has to adjust his/her output to a change in the price. The degree of flexibility, and therefore the time period, will be different in different industries. The market period means that there is no time to adjust output in response to a price change (e.g. tomatoes in season). Some industries may not have a market period (e.g. rubber latex).

The short run means that there is enough time to adjust output by increasing or decreasing the variable inputs but not the fixed inputs.

The long run means that there is enough time to adjust output by increasing or decreasing all inputs.

Elasticity of Supply: The Market Period (Immediate Period)LO3PQ Perfectly inelastic supplyD1D2SmQ0PmP022There is no time to adjust to a price change, making the supply perfectly inelastic. With a perfectly inelastic supply, the increase in demand does not change the quantity at all.

If we look at the case of the tomatoes farmer, we can see that on market day he or she loads the truck and goes to the market where upon arriving discovers the price is much higher (lower) than anticipated. The farmer cannot increase (decrease) the amount supplied, this is the market period.

Elasticity of Supply: The Short RunLO3 Supply is more elastic than in market periodPQD1D2SsQ0PsP0Qs23In the short run there is enough time to adjust output by increasing or decreasing the variable inputs but not the fixed inputs. Supply is more elastic than in the market period, thereby resulting in a relatively smaller increase in price but also an increase in quantity.

In the short run, the tomato farmer can increase (decrease) the supply somewhat by increasing (decreasing) the variable inputs like labor, fertilizer, irrigation, etc. However, the tomato farmer cannot increase (decrease) the size of the farm in this time period because farm size is fixed.

Elasticity of Supply: The Long RunLO3 Supply is even more elastic than in the short run

PQD1D2SlQ0PlP0Ql24In the long run there is enough time to adjust output by increasing or decreasing all inputs since all inputs are variable by this time. This means that supply will be even more elastic and with the same increase in demand, there is an even greater increase in the quantity than in the short run, but a smaller increase in price.

In the long run all inputs are variable even the farm size. The tomato farmer can expand (reduce) the size of the farm in regards to long run price increases.

Applications of Elasticity of SupplyAntiquesInelastic supply ReproductionsMore elastic supplyVolatile gold pricesHighly Inelastic supplyLO325Antiques and other non-reproducible commodities have an inelastic supply, sometimes the supply is perfectly inelastic. This makes their prices highly susceptible to fluctuations in demand. The more inelastic the supply, the greater the changes in price when demand changes.

Reproductions(reproduce many times), on the other hand, have a much more elastic supply so the prices tend to remain lower even when there is an increase in demand.

Gold prices are volatile because the supply of gold is highly inelastic, and unstable demand from speculation causes prices to fluctuate significantly.Cross Elasticity of DemandMeasures responsiveness of sales to change in the price of another goodSubstitutes positive signComplements negative signIndependent goods - zeroLO4Percentage change in quantity demanded of product XEx,y = Percentage change in price of product Y26Formula: Ex,y =Qx1-Qx2/(Qx1 + Qx2)/2 Py1-Py2 /(Py1 + Py2)/2If Ex,y > 0 then they are substitutes, %Py decreases, %Qx decreases (the greater the +ve value the greater the substitutability)If Ex,y < 0, then the goods are complements, %Py decreases, %Qx rises If Ex,y = 0, then they are independent, %Py decreases has no impact on Qx. (the greater the ve value the greater the complementarity)

Cross Elasticity of DemandApplicationCompany Change the price? (Yes, if low +ve value implies weak sub.)Allow a merger? (No, if high +ve value) LO427Companies can use cross-price elasticity to determine whether raising the price of one of their products will affect sales of another of their products( a low cross elasticity shows weak substitutes, eg. Sprite & coke) .Government can use it to determine whether to allow a proposed merger of two companies or not. If there is a high cross-price elasticity between the two companies products the government will likely not allow the merger, e.g. the cross elasticity of coke and pepsi is highstrong substitutes Income Elasticity of DemandMeasures responsiveness of buyers to changes in income Normal goods positive signInferior goods negative signLO4Percentage change in quantity demandedEi = Percentage change in income28Income elasticity of demand refers to the percentage change in quantity demanded that results from some percentage change in consumer income.Formula= Qx2-Qx1 / (Qx1 + Qx2)/2 I2I1 / (I1 + I2) / 2

A positive income elasticity indicates a normal or superior good.

A negative income elasticity indicates an inferior good.

Those industries that are income elastic will expand at a higher rate as the economy grows.

Income Elasticity InsightsHigh income elasticitiesMost affected by a recessionLow or negative income elasticitiesLeast affected by a recessionNote: -ve income elasticities associated with inferior goodsLO429Income elasticity helps us understand which products and industries will be most affected when household incomes fall during economic downturns.

Ex,y and EiLO4Cross and Income Elasticities of DemandValue of CoefficientDescriptionType of Good(s)Cross elasticity: Positive (Ewz > 0)

Negative (Exy < 0)Quantity demanded of W changes in same direction as change in price of Z

Quantity demanded of X changes in opposite direction from change in price of YSubstitutes

ComplementsIncome elasticity: Positive (Ei >0)

Negative (Ei