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Elasticity Today: Thinking like an economist requires us to know how quantities change in response to price.

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Presentation on theme: "Elasticity Today: Thinking like an economist requires us to know how quantities change in response to price."— Presentation transcript:

1 Elasticity Today: Thinking like an economist requires us to know how quantities change in response to price

2 Today Elasticity Calculated by the percentage change in quantity divided by the percentage change in price Denominator could be something else, but for now think price

3 Elasticity Elasticity is most commonly associated with demand Percentage changes are typically small when calculating elasticity Note elasticity is negative, since price and quantity move in opposite directions We will typically ignore negative sign

4 Elasticity Demand elasticity falls into three broad categories Elastic, if elasticity is greater than 1 Unit elastic, if elasticity is equal to 1 Inelastic, if elasticity is less than 1

5 Economist questions of the day How can you maximize the total ticket expenditures on the Santa Barbara Foresters? What happens to total expenditures spent on strawberries (or total revenue received by firms) when growing conditions are good?

6 Inelastic demand When demand is inelastic, quantity demanded changes less than price does (in percentage terms) What goods are unresponsive to price? Salt Illegal Drugs? Coffee

7 Salt, illegal drugs, and coffee Why are these goods price inelastic? Some determinants of price elasticity of demand Availability of good substitutes Fraction of budget necessary to buy the item Age of currently-owned item when considering replacement, if a durable good

8 Salt, illegal drugs, and coffee These items do not have good substitutes Salt Potassium chloride Illegal drugs Legal drugs? Coffee Tea, energy drinks

9 Caution Some economists use the reference point in calculating percentage changes to be the initial price Other economists use the average of the two prices involved (see Appendix, Chapter 4) In this class, you can use either method I will use the initial price

10 Example Suppose the price of apples falls from $1.00/lb. to $0.90/lb. This causes the number of apples consumed in Santa Barbara to increase from 2 tons/day to 2.1 tons/day What is the price elasticity of apples at this point?

11 Example %ΔQ %ΔP We will ignore the negative on %ΔP

12 Example The demand elasticity of apples in Santa Barbara is thus 0.05/0.1 = 0.5 The demand of apples is inelastic

13 Algebra lesson for straight-line demand curves Slope on straight line is ΔP/ΔQ Along a straight line, elasticity is also equal to P/Q times inverse of the slope (see above)

14 Why is studying elasticity important? Suppose that you work for the Santa Barbara Foresters, the local amateur baseball team Suppose that in a previous season, a UCSB student studied demand and elasticity of demand for tickets You are asked to use this information to maximize ticket expenditures

15 Some information lost The student from the previous season only provided the following information Demand for tickets is nearly linear A table of estimated elasticity at various prices You are asked to price tickets to maximize expenditure

16 How do we solve this? We need two additional pieces of information When demand is linear, total expenditure is maximized at the midpoint of the demand curve We can prove that price elasticity is 1 at the midpoint of the demand curve Solution: Find the point with price elasticity is 1

17 Solution: Find price elasticity of 1 Answer: Price each ticket at $5 Is this table consistent with a linear demand curve? Yes Try P = 10 - Q Price ($/ticket) Price elasticity

18 Some other important elasticity facts On a linear demand curve Elasticity is greater than 1 on the upper half of the curve Elasticity is less than 1 on the lower half of the curve Exceptions Horizontal demand: Elasticity is always Vertical demand: Elasticity is always 0

19 Back to increasing expenditure This is an example of being able to control price (more on this while studying monopoly) When you can control price and you want to increase expenditure, go in the direction of the highest change When demand is elastic, %ΔQ is higher than %ΔP Decrease P to increase expenditures Inelastic demand, the opposite occurs Increase P to increase expenditures

20 Back to our bumper crop of strawberries Under normal growing conditions, suppose that S 1 is the supply curve In the bumper crop season, supply shifts out to S 2 What happens to total expenditure?

21 Back to our bumper crop of strawberries Normal growing conditions: Total expenditure is $56 million However, look at elasticity (note slope is 1): ε = P/(Q slope) ε = 0.29 inelastic Expenditure goes DOWN moving from S 1 to S 2 The bumper crop of strawberries actually hurts farmers collectively

22 What is happening here? The price drops by 50%, while the % increase in strawberries is small Price change dominates Assuming costs are the same in both years, farmers will make less profit in the bumper crop year

23 Elasticity of supply Supply has elasticity, too Most of the math is the same or similar to what we have talked about with demand

24 Summary Elasticity tells us what happens to total expenditure along the demand curve On a straight line demand curve, total expenditure is maximized halfway between the vertical intercept and horizontal intercept Supply shift to the right does not necessarily increase total expenditure

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