Our Friend Elasticity Or, how I learned to love percentages

Our Friend Elasticity

Our Friend Elasticity

Or, how I learned to love percentages

Or, how I learned to love percentages

Measuring Responsiveness or Sensitivity

Measuring Responsiveness or Sensitivity

• Slope– Unit dependent

• Currency • Quantities

– No Starting Point

• Percentages– Unit free– Relational

• Slope– Unit dependent

• Currency • Quantities

– No Starting Point

• Percentages– Unit free– Relational

Computing ElasticityComputing Elasticity

• Price elasticity of demand = %change in quantity demanded/% change in price

• Income elasticity of demand = %change in demand/% change in income

• Cross-price elasticity of demand = %change in demand/% change in the price of a related good

• Price elasticity of demand = %change in quantity demanded/% change in price

• Income elasticity of demand = %change in demand/% change in income

• Cross-price elasticity of demand = %change in demand/% change in the price of a related good

An Intuitive Approach to Elasticity

An Intuitive Approach to Elasticity

• Since price elasticity is always zero (law of demand) we ignore the negative sign and take the absolute value of price elasticity.

• Ep > 1 Responsive or elastic – %ΔQd > %ΔP a small %ΔP creates a large %ΔQd

• Ep < 1 Not responsive or inelastic– %ΔQd < %ΔP a large %ΔP creates a small %ΔQd

• Ep = 1 unit elastic– %ΔQd = %ΔP a given %ΔP creates an equal %ΔQd

• Since price elasticity is always zero (law of demand) we ignore the negative sign and take the absolute value of price elasticity.

• Ep > 1 Responsive or elastic – %ΔQd > %ΔP a small %ΔP creates a large %ΔQd

• Ep < 1 Not responsive or inelastic– %ΔQd < %ΔP a large %ΔP creates a small %ΔQd

• Ep = 1 unit elastic– %ΔQd = %ΔP a given %ΔP creates an equal %ΔQd

So????Price and Total Revenue

TR= P X Q

So????Price and Total Revenue

TR= P X Q• Ep > 1 Responsive or elastic

– %ΔQd > %ΔP if P goes down (up) total revenue goes up (down)

• Ep < 1 Not responsive or inelastic– %ΔQd < %ΔP if P goes down (up) total revenue goes

down (up)

• Ep = 1 unit elastic– %ΔQd = %ΔP if P goes down (up) total revenue stays

the same

• Ep > 1 Responsive or elastic – %ΔQd > %ΔP if P goes down (up) total revenue goes

up (down)

• Ep < 1 Not responsive or inelastic– %ΔQd < %ΔP if P goes down (up) total revenue goes

down (up)

• Ep = 1 unit elastic– %ΔQd = %ΔP if P goes down (up) total revenue stays

the same

Figure 2 Total RevenueFigure 2 Total Revenue

Copyright©2003 Southwestern/Thomson Learning

Demand

Quantity

Q

P

0

Price

P × Q = $400(revenue)

$4

100

Determinants of Price Elasticity

Determinants of Price Elasticity

• Availability of close substitutes

• Necessity versus luxury

• Definition of the market

• Time horizon

• Percentage of consumer budget

• Availability of close substitutes

• Necessity versus luxury

• Definition of the market

• Time horizon

• Percentage of consumer budget

Price Elasticity – Using Numbers

Price Elasticity – Using Numbers

Ep = %ΔQd/ %ΔP

= (Q2- Q1)/[(Q2+ Q1)/2]

(P2- P1)/[(P2+ P1)/2]

Ep = %ΔQd/ %ΔP

= (Q2- Q1)/[(Q2+ Q1)/2]

(P2- P1)/[(P2+ P1)/2]

Calculating Price Elasticitymputing the Price Elasticity of Demand

Demand is price elastic

$5

4Demand

Quantity1000 50

-3percent 22-percent 67

5.00)/2(4.005.00)-(4.00

50)/2(10050)-(100

ED

Price

Linear Demand Curve:ElasticityLinear Demand Curve:Elasticity

Linear Demand

0

1

2

3

4

5

6

7

8

0 2 4 6 8 10 12 14

Quantity

Pri

ce

Elasticity of Other Demand CurvesElasticity of Other Demand Curves

• Perfectly Elastic

• Perfectly Inelastic

• Unit Elastic

• Perfectly Elastic

• Perfectly Inelastic

• Unit Elastic

Figure 1 The Price Elasticity of DemandFigure 1 The Price Elasticity of Demand

(e) Perfectly Elastic Demand: Elasticity Equals Infinity

Quantity0

Price

$4 Demand

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

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

3. At a price below $4,quantity demanded is infinite.

Figure 1 The Price Elasticity of DemandFigure 1 The Price Elasticity of Demand


(a) Perfectly Inelastic Demand: Elasticity Equals 0

$5

4

Quantity

Demand

1000

1. Anincreasein price . . .

2. . . . leaves the quantity demanded unchanged.

Price

Figure 6 The Price Elasticity of SupplyFigure 6 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.

Elasticity of SupplyElasticity of Supply• Price elasticity of supply = %change in quantity

supplied/% change in price

Es= %ΔQs/ %ΔP

= (Q2- Q1)/[(Q2+ Q1)/2]

(P2- P1)/[(P2+ P1)/2]• Perfectly elastic and inelastic supply• Relatively elastic, relatively inelastic and unit elastic

(crossing the Q or P axis or the origin)• Supply curves where elasticity varies

• Price elasticity of supply = %change in quantity supplied/% change in price

Es= %ΔQs/ %ΔP

= (Q2- Q1)/[(Q2+ Q1)/2]

(P2- P1)/[(P2+ P1)/2]• Perfectly elastic and inelastic supply• Relatively elastic, relatively inelastic and unit elastic

(crossing the Q or P axis or the origin)• Supply curves where elasticity varies



(a) Perfectly Inelastic Supply: Elasticity Equals 0

$5

4

Supply

Quantity1000

1. Anincreasein price . . .

2. . . . leaves the quantity supplied unchanged.

Price



(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



(d) Elastic Supply: Elasticity Is Greater Than 1

Quantity0

Price



4

100

$5

200

Supply



(c) Unit Elastic Supply: Elasticity Equals 1

125

$5

100

4

Quantity0

Price



Supply

• Determinants of elasticity of supply– Ability to increase or decrease production

(e.g Ellensburg agates, farm crops, automobiles)

– Time period

• Determinants of elasticity of supply– Ability to increase or decrease production

(e.g Ellensburg agates, farm crops, automobiles)

– Time period

Applications of ElasticityApplications of Elasticity

• Farmers : fallacy of composition and good crop/bad revenue years

• The economics of addictive drugs

• Pricing decisions and your future business

• Farmers : fallacy of composition and good crop/bad revenue years

• The economics of addictive drugs

• Pricing decisions and your future business

Figure 8 An Increase in Supply in the Market for WheatFigure 8 An Increase in Supply in the Market for Wheat


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

Government and MarketsGovernment and Markets

• Price Controls– Price Ceilings (e.g. rent control)– Price Floors (e.g. water)

• Taxes– Who appears to pay the tax?

• Buyers “pay” tax• Sellers “pay” tax

– Who really pays the tax? Tax incidence and burden

• Price Controls– Price Ceilings (e.g. rent control)– Price Floors (e.g. water)

• Taxes– Who appears to pay the tax?

• Buyers “pay” tax• Sellers “pay” tax

– Who really pays the tax? Tax incidence and burden

• Case study – The payroll tax: Federal Insurance Contribution Act (FICA) for Social Security and Medicare

• Case study – The payroll tax: Federal Insurance Contribution Act (FICA) for Social Security and Medicare

Elasticity and Tax IncidenceElasticity and Tax Incidence

• Intuitive approach:– If the buyers can respond relatively more to

price changes more than suppliers, suppliers pay more of the tax.

– If the suppliers can respond relatively more than the buyers, then the buyers pay more of the tax.

• Intuitive approach:– If the buyers can respond relatively more to

price changes more than suppliers, suppliers pay more of the tax.

– If the suppliers can respond relatively more than the buyers, then the buyers pay more of the tax.

• Extreme examples:– Perfectly elastic demand– Perfectly elastic supply– Perfectly inelastic demand– Perfectly inelastic supply

• Less extreme examples (e.g. the luxury tax)

• Extreme examples:– Perfectly elastic demand– Perfectly elastic supply– Perfectly inelastic demand– Perfectly inelastic supply

• Less extreme examples (e.g. the luxury tax)

Documents

Our Friend Elasticity Or, how I learned to love percentages