Chapter 5 Part 2 notes

0 2 64 10

8 12

14

2

1

4

3

5

6

$7

Demand is elastic; demand is responsive to changes in price.

Demand is inelastic; demand is not very responsive to changes in price.

When price increases from $4 to $5, TR declines from $24 to $20.

When price increases from $2 to $3, TR increases from $20 to $24.

Elasticity is > 1 in this range.

Elasticity is < 1 in this range.

Price

Quantity

Figure 4 Elasticity of a Linear Demand Curve

Income Elasticity of Demand•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.

Other Demand Elasticities

•Computing 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

Remember, all elasticities are measured by dividing one percentage change by another

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.

▫Goods consumers regard as necessities tend to be income inelastic Examples 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.

Rule about income elasticity

•If you calculate the income elasticity and the answer is positive, it is a normal good.

•If you calculate the income elasticity and the answer is negative, it is an inferior good.

Cross-Price Elasticity

▫A measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good

2 good of pricein %change

1 good of demandedquantity in %changedemand of elasticity price-Cross

Rule about CPE

•> 0 = subs•< 0 = comps

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 percentage change in price.

The Price Elasticity of Supply and Its Determinants•Ability of sellers to change the amount of

the 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.

P 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 5 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

Figure 5 The Price Elasticity of Supply(b) Inelastic Supply: Elasticity Is Less Than 1

110

$5

100

4

Quantity0

1. A 22%increasein price . . .

Price

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

Supply

Figure 5 The Price Elasticity of Supply(c) Unit Elastic Supply: Elasticity Equals 1

125

$5

100

4

Quantity0

Price

2. . . . leads to a 22% increase in quantity supplied.

1. A 22%increasein price . . .

Supply

(If SUPPLY is unit elastic and linear, it will begin at the origin.)

Figure 5 The Price Elasticity of Supply

(d) Elastic Supply: Elasticity Is Greater Than 1

Quantity0

Price

1. A 22%increasein price . . .

2. . . . leads to a 67% increase in quantity supplied.

4

100

$5

200

Supply

Figure 5 The Price Elasticity of 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.

Applications

•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?

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 Demand When There Is a Change in 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

( ) /. .

( . . ) /

.

..

Demand is inelastic.

Does Drug Interdiction Increase or Decrease Drug-Related Crime?•Drug interdiction impacts sellers rather

than buyers.▫Demand is unchanged.▫Equilibrium price rises although quantity

falls.•Drug education impacts the buyers rather

than sellers.▫Demand is shifted.▫Equilibrium price and quantity are lowered.

Price of Drugs

Quantity of Drugs

Price of Drugs

Quantity of Drugs

Drug Interdiction

Drug Education

D2

D1

D1

S2

S1S1

The demand for illegal drugs is inelastic.

Interdiction shifts the supply,

while education shifts the demand.

In each case, the change in price is the same.

But in one market the price goes up.

And in the other it goes down.

The changes in quantities (and TR) are remarkable.

It is amazing how useful knowledge of elasticities can be!

Policies to Reduce the Use of Illegal Drugs

Homework for tonight

•P. 109/110Probs/Apps: 4, 8, 10, 11