ECON 211 Lecture Chapter Four, Spring 2015

1 of 32 PART I Introduction to Economics © 2012 Pearson Education 5 Elasticity C H A P T E R O U T L I N EPrice Elasticity of Demand Slope and Elasticity Types of Elasticity Calculating Elasticities Calculating Percentage Changes Elasticity Is a Ratio of Percentages The Midpoint Formula Elasticity Changes Along a Straight-Line Demand Curve Elasticity and Total Revenue The Determinants of Demand Elasticity Availability of Substitutes The Importance of Being Unimportant The Time Dimension Other Important Elasticities Income Elasticity of Demand Cross-Price Elasticity of Demand Elasticity of Supply Looking Ahead 2 of 32 PART I Introduction to Economics © 2012 Pearson Education Elasticity A general concept used to quantify the response in one variable when another variable changes. Elasticity is a scale free measure which does not depend on the measurement metrics (prices, weights). % elasticity of with respect to % A A B B    3 of 32 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 5.1 Slope Is Not a Useful Measure of Responsiveness Changing the unit of measure from pounds to ounces changes the numerical value of the demand slope dramatically, but the behavior of buyers in the two diagrams is identical. Price Elasticity of Demand Slope and Elasticity 1 pound = 16 ounces steeper 4 of 32 PART I Introduction to Economics © 2012 Pearson Education price elasticity of demand The ratio of the percentage of change in quantity demanded to the percentage of change in price; measures the responsiveness of quantity demanded to changes in price. change in price % price elasticity of demand % change in quantity demanded  Price Elasticity of Demand Slope and Elasticity 5 of 32 PART I Introduction to Economics © 2012 Pearson Education You must be very careful about signs. Because it is generally understood that demand elasticities are negative (demand curves have a negative slope), they are often reported and discussed without the negative sign. Price Elasticity of Demand Types of Elasticity A warning: 6 of 32 PART I Introduction to Economics © 2012 Pearson Education perfectly inelastic demand Demand in which quantity demanded does not respond at all to a change in price. Price Elasticity of Demand Types of Elasticity perfectly elastic demand Demand in which quantity drops to zero at the slightest increase in price. A good way to remember the difference between the two perfect elasticities is 7 of 32 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 5.2 Perfectly Inelastic and Perfectly Elastic Demand Curves Figure 5.2(a) shows a perfectly inelastic demand curve for insulin. Price elasticity of demand is zero. Quantity demanded is fixed; it does not change at all when price changes. Figure 5.2(b) shows a perfectly elastic demand curve facing a wheat farmer. A tiny price increase drives the quantity demanded to zero. In essence, perfectly elastic demand implies that individual producers can sell all they want at the going market price but cannot charge a higher price. Price Elasticity of Demand Types of Elasticity Slope ∞ Slope 0 8 of 32 PART I Introduction to Economics © 2012 Pearson Education inelastic demand Demand that responds somewhat, but not a great deal, to changes in price. Inelastic demand always has a numerical value between zero and -1. Price Elasticity of Demand Types of Elasticity unitary elasticity A demand relationship in which the percentage change in quantity of a product demanded is the same as the percentage change in price in absolute value (a demand elasticity of -1). elastic demand A demand relationship in which the percentage change in quantity demanded is larger than the percentage change in price in absolute value (a demand elasticity with an absolute value greater than 1). 9 of 32 PART I Introduction to Economics © 2012 Pearson Education % 1 change in quantity demanded change in quantity demanded x 100% Q  1 2 - 1 x 100% Q Q Q  To calculate percentage change in quantity demanded using the initial value as the base, the following formula is used with Q1 initial value: Calculating Elasticities Calculating Percentage Changes 10 of 32 PART I Introduction to Economics © 2012 Pearson Education We can calculate the percentage change in price in a similar way. Once again, let us use the initial value of P—that is, P1—as the base for calculating the percentage. By using P1 as the base, the formula for calculating the percentage of change in P is 1 change in price % change in price x 100% P  2 1 1 - x 100% P P P  Calculating Elasticities Calculating Percentage Changes 11 of 32 PART I Introduction to Economics © 2012 Pearson Education Once the changes in quantity demanded and price have been converted to percentages, calculating elasticity is a matter of simple division. Recall the formal definition of elasticity: % change in quantity demanded price elasticity of demand % change in price  Calculating Elasticities Elasticity Is a Ratio of Percentages 12 of 32 PART I Introduction to Economics © 2012 Pearson Education Price Elasticity of Demand Problems with the earlier formula Elasticity starting from P1 to P2 Elasticity = -3 Elasticity starting from P2 to P1 Elasticity = -1 But should they not be equal? Price change from P1 to P2: Elasticity = [(10-5)/5]/[(2-3)/3]= - 3 14 of 32 PART I Introduction to Economics © 2012 Pearson Education midpoint formula The value of elasticity changes depending on the base value! So computing elasticity for a price increase or decrease will give different values over the same range. A more accurate way of calculating percentages uses the value halfway between P1 and P2 for the base in calculating the percentage change in price and the value halfway between Q1 and Q2 as the base for calculating the percentage change in quantity demanded. 1 ( 2 change in quantity demanded % change in quantity demanded x 100% ) / 2 Q Q   2 1 1 2 - x 100% ( ) / 2 Q Q Q Q   Calculating Elasticities The Midpoint Formula 15 of 32 PART I Introduction to Economics © 2012 Pearson Education Using the point halfway between P1 and P2 as the base for calculating the percentage change in price, we get 1 2 change in price % change in price x 100% ( ) / 2 P P   2 1 1 2 - x 100% ( ) / 2 P P P P   Calculating Elasticities The Midpoint Formula 16 of 32 PART I Introduction to Economics © 2012 Pearson Education Calculating Elasticities The Midpoint Formula Note that this formula gives an elasticity between the two values calculated earlier which were -1 and -3. 17 of 32 PART I Introduction to Economics © 2012 Pearson Education This formula will help us understand how the value of elasticity changes. {Below ∆ means a very small (infinitesimal change or derivative).} We can write an expression for elasticity at point C as follows:  FIGURE 5A.1 Elasticity at a Point along a Demand Curve CHAPTER 5 APPENDIX Point Elasticity 1 1 1 1 100 100 % % elasticity Q P P Q P P Q Q P P Q Q P Q               18 of 32 PART I Introduction to Economics © 2012 Pearson Education TABLE 5.2 Demand Schedule for Office Dining Room Lunches Price (per Lunch) Quantity Demanded (Lunches per Month) $11 10 9 8 7 6 5 4 3 2 1 0 0 2 4 6 8 10 12 14 16 18 20 22  FIGURE 5.3 Demand Curve for Lunch at the Office Dining Room Using the mid-point formula, between points A and B, demand is quite elastic at -6.3. Between points C and D, demand is quite inelastic at -0.294. Calculating Elasticities Elasticity Changes Along a Straight-Line Demand Curve 19 of 32 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 5A.2 Point Elasticity Changes Along a Demand Curve CHAPTER 5 APPENDIX Point Elasticity 20 of 32 PART I Introduction to Economics © 2012 Pearson Education TR = P x Q total revenue = price x quantity In any market, P x Q is total revenue (TR) received by producers: When price (P) declines, quantity demanded (QD) increases. The two factors, P and QD, move in opposite directions: effects of price changes on quantity demanded:     and D D Q P Q P Calculating Elasticities Elasticity and Total Revenue 21 of 32 PART I Introduction to Economics © 2012 Pearson Education Because total revenue is the product of P and Q, whether TR rises or falls in response to a price increase depends on which is bigger: the percentage increase in price or the percentage decrease in quantity demanded? Total revenue increases if the price increase in percent is larger than the percentage decline in quantity demanded : Total revenue will fall if % price increase is smaller than the percentage decline in quantity demanded effect of price increase on a product with inelastic demand:     x D TR Q P effect of price increase on a product with elastic demand:     x D TR Q P Calculating Elasticities Elasticity and Total Revenue 22 of 32 PART I Introduction to Economics © 2012 Pearson Education The opposite is true for a price cut. When demand is elastic, a cut in price increases total revenues: When demand is inelastic, a cut in price reduces total revenues: effect of price cut on a product with elastic demand:     x D TR Q P effect of price cut on a product with inelastic demand:     x D TR Q P Calculating Elasticities Elasticity and Total Revenue When is total revenue maximized? 23 of 32 PART I Introduction to Economics © 2012 Pearson Education Perhaps the most obvious factor affecting demand elasticity is the availability of substitutes. When an item represents a relatively small part of our total budget, we tend to pay little attention to its price. The elasticity of demand in the short run may be very different from the elasticity of demand in the long run. In the longer run, demand is likely to become more elastic, or responsive, simply because households make adjustments over time and producers develop substitute goods. The Determinants of Demand Elasticity Availability of Substitutes The Importance of Being Unimportant The Time Dimension 24 of 32 PART I Introduction to Economics © 2012 Pearson Education The graph shows the expected relationship between long-run and short-run demand for Frank’s sandwiches. Notice if you raise prices above the current level, the expected quantity change read off the short-run curve is less than that from the long-run curve. Elasticities at a sandwich shop in the Short Run and Long Run E C O N O M I C S I N P R A C T I C E 25 of 32 PART I Introduction to Economics © 2012 Pearson Education income elasticity of demand A measure of the responsiveness of demand to changes in income. change in income % income elasticity of demand % change in quantity demanded  Other Important Elasticities Income Elasticity of Demand Normal goods have a positive income elasticity of demand. Inferior goods have a negative income elasticity of demand. 26 of 32 PART I Introduction to Economics © 2012 Pearson Education cross-price elasticity of demand A measure of the response of the quantity of one good demanded to a change in the price of another good. X Y change in price of % cross - price elasticity of demand % change in quantity of demanded  Other Important Elasticities Cross-Price Elasticity of Demand A positive cross price elasticity implies the goods are substitutes. A negative cross price elasticity implies the goods are complements. 27 of 32 PART I Introduction to Economics © 2012 Pearson Education elasticity of supply A measure of the response of quantity of a good supplied to a change in price of that good. Likely to be positive in output markets. % change in quantity supplied elasticity of supply % change in price  Other Important Elasticities Elasticity of Supply 28 of 32 PART I Introduction to Economics © 2012 Pearson Education elasticity of labor supply A measure of the response of labor supplied to a change in the price of labor. change in the wage rate % elasticity of labor supply % change in quantity of labor supplied  Other Important Elasticities Elasticity of Supply 29 of 32 PART I Introduction to Economics © 2012 Pearson Education Looking Ahead The purpose of this chapter was to convince you that measurement is important. If all we can say is that a change in one economic factor causes another to change, we cannot say whether the change is important or whether a particular policy is likely to work. The most commonly used tool of measurement is elasticity, and the term will recur as we explore economics in more depth. We now return to the study of basic economics by looking in detail at household behavior. Recall that households demand goods and services in product markets but supply labor and savings in input or factor markets. 30 of 32 PART I Introduction to Economics © 2012 Pearson Education cross-price elasticity of demand elastic demand elasticity elasticity of labor supply elasticity of supply income elasticity of demand inelastic demand midpoint formula perfectly elastic demand perfectly inelastic demand price elasticity of demand unitary elasticity R E V I E W T E R M S A N D C O N C E P T S