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Elasticity and Straight-Line Demand Curves Quantity Price and since equal quantity decreases (horizontal arrows) are larger and larger percentage decreases...

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Presentation on theme: "Elasticity and Straight-Line Demand Curves Quantity Price and since equal quantity decreases (horizontal arrows) are larger and larger percentage decreases..."— Presentation transcript:

1 Elasticity and Straight-Line Demand Curves Quantity Price and since equal quantity decreases (horizontal arrows) are larger and larger percentage decreases... Since equal dollar increases (vertical arrows) are smaller and smaller percentage increases D demand becomes more and more elastic as we move leftward and upward along a straight-line demand curve.

2 Categorizing Goods by Elasticity Price elasticity of demand Demand Between 0 and -1Inelastic Equal to 0Perfectly Inelastic Absolute Value > 1Elastic Equals 1Unitary Elastic Approaches minus infinityPerfectly (infinitely) Elastic

3 Categorizing Goods by Elasticity Inelastic Demand |% Change in Quantity Demanded| < |% Change in Price| Elastic Demand Price elasticity of demand with absolute value > 1

4 Extreme Cases of Demand D Perfectly Inelastic Demand (a) Quantity Price per Unit $ (b) D Quantity $4 Price per Unit Perfectly Elastic Demand

5 Elasticity and Total Revenue Total revenue (TR) of all firms in the market is defined as TR = P x Q When two numbers are both changing, percentage change in their product is (approximately) the sum of their individual percentage changes –Applying this to total revenue % Change in TR = % Change in Price + % Change in Quantity Demanded Assume demand is unitary elastic and Q rises by 10% –% Change in TR = 10% + (-10%) = 0

6 Elasticity and Total Revenue If demand is inelastic, a 10% rise in price will cause quantity demanded to fall by less than 10% –% change in TR = 10% + (something less negative than –10%) > 0 If demand is elastic, so that Q falls by more than 10% –TR will fall % Change in TR = 10% + (something more negative than -10%) < 0

7 Elasticity and Total Revenue Where demand is inelastic, total revenue moves in same direction as price Where demand is elastic, total revenue moves in opposite direction from price Where demand is unitary elastic, total revenue remains the same as price changes At any point on a demand curve sellers’ total revenue (buyers’ total expenditure) is the area of a rectangle –Width equal to quantity demanded –Height equal to price

8 Figure 6: Elasticity and Total Expenditure B A D 3.Moving from A to B, expenditure increases, so demand must be inelastic over that range. 1.At point A, where price is $1,000 and 600,000 laptops are demanded, revenue is $600 million. 2.At point B, revenue is $750 million. Quantity of Laptops 100,000200,000300,000400,000500,000600,000 $3,500 3,000 2,500 2,000 1,500 1, Price per Laptop

9 What affects Elasticity? Availability of Substitutes Demand is more elastic –If close substitutes are easy to find and buyers can cut back on purchases of the good in question Demand is less elastic –If close substitutes are difficult to find and buyers can not cut back on purchases of the good in question

10 Narrowness of Market More narrowly we define a good, easier it is to find substitutes –More elastic is demand for the good More broadly we define a good –Harder it is to find substitutes and the less elastic is demand for the good Different things are assumed constant when we use a narrow definition compared with a broader definition

11 Necessities vs. Luxuries The more “necessary” we regard an item, the harder it is to find a substitute –Expect it to be less price elastic The less “necessary” (luxurious) we regard an item, the easier it is to find a substitute –Expect it to be more price elastic

12 Time Horizon Short-run elasticity –Measured a short time after a price change Long-run elasticity –Measured a year or more after a price change Usually easier to find substitutes for an item in the long run than in the short run –Therefore, demand tends to be more elastic in the long run than in the short run

13 Importance in the Buyer’s Budget The more of their total budgets that households spend on an item –The more elastic is demand for that item The less of their total budgets that households spend on an item –The less elastic is demand for that item

14 Using Price Elasticity of Demand: The War on Drugs Every year U.S. Government spends about $20 billion on efforts to restrict the supply of drugs Figure A –Market for heroin without government intervention Figure B –Result of government efforts to restrict supply (current policy) Figure C –Results of an effective policy of reducing demand

15 Figure A: The War on Drugs P1P1 Q1Q1 D1D1 A S1S1 Quantity Price per Unit (a)

16 Figure B: The War on Drugs B (b) Q1Q1 S2S2 P2P2 Q2Q2 P1P1 D1D1 S1S1 Quantity Price per Unit A

17 Figure C: The War on Drugs P1P1 Q1Q1 D1D1 A S1S1 Quantity Price per Unit C D2D2 Q3Q3 P3P3 (c)

18 Using Price Elasticity of Demand: Mass Transit Elasticity studies show that long-run demand for mass transit is inelastic –Therefore, a rise in fare would increase revenues However, most cities do not raise transit fares due to –Desire to provide low-income households with affordable transportation –Desire to manage traffic congestion –Desire to limit air pollution in the city An increase in fares would increase revenue –Would also decrease ridership and require the city to sacrifice these other goals

19 Using Price Elasticity of Demand: An Oil Crisis For the past five decades, Middle East has been a geopolitical hot spot Both military and economic government agencies ask “What if” questions –If an event in the Middle East were to disrupt oil supplies, what would happen to the price of oil on world markets? Flipping the elasticity equation like so Tells us percentage rise in price that would bring about a 1 percent decrease in quantity demanded –Enables us to make reasonable forecasts about the impact of various events on oil prices Once we have established our forecasted oil prices we can then use that data to examine effect that higher oil prices would have on many broader issues –Effect on U.S. inflation rate –Effect on number of flights offered by U.S. airlines

20 Income Elasticity of Demand Percentage change in quantity demanded divided by the percentage change in income –With all other influences on demand—including the price of the good—remaining constant Interpret this number as percentage increase in quantity demanded for each 1% rise in income

21 Income Elasticity of Demand Income elasticities vs. price elasticities of demand –Price elasticity of demand Measures effect of change in price of good –Assumes that other influences on demand, including income, remain unchanged –Income elasticity Measures effect on demand we would observe if income changed and all other influences on demand—including price of the good—remained the same Instead of letting price vary and holding income constant, now we are letting income vary and holding price constant

22 Income Elasticity of Demand Another difference between price and income elasticity of demand –Price elasticity measures sensitivity of demand to price as we move along a demand curve from one point to another –Income elasticity tells us relative shift in demand curve—increase in quantity demanded at a given price While a price elasticity is virtually always negative –Income elasticity can be positive or negative

23 Income Elasticity of Demand Economic necessity –Good with an income elasticity of demand between 0 and 1 Economic luxury –Good with an income elasticity of demand greater than 1 An implication follows from these definitions –As income rises, proportion of income spent on economic necessities will fall While proportion of income spent on economic luxuries will rise But, it is important to remember that economic necessities and luxuries are categorized by actual consumer behavior –Not by our judgment of a good’s importance to human survival

24 Cross-Price Elasticity of Demand Cross-price elasticity of demand –Percentage change in quantity demanded of one good caused by a 1% change in price of another good While all other influences on demand remain unchanged While the sign of the cross-price elasticity helps us distinguish substitutes and complements among related goods Its size tells us how closely the two goods are related –A large absolute value for E XZ suggests that the two goods are close substitutes or complements –While a small value suggests a weaker relationship

25 Price Elasticity of Supply Percentage change in quantity of a good supplied that is caused by a 1% change in the price of the good –With all other influences on supply held constant

26 Price Elasticity of Supply When do we expect supply to be price elastic, and when do we expect it to be price inelastic? –Ease with which suppliers can find profitable activities that are alternatives to producing the good in question Supply will tend to be more elastic when suppliers can switch to producing alternate goods more easily –When can we expect suppliers to have easy alternatives? Depends on »Nature of the good itself »Narrowness of the market definition—especially geographic narrowness »Time horizon—longer we wait after a price change, greater the supply response to a price change

27 Price Elasticity of Supply Extreme cases of supply elasticity –Perfectly inelastic supply curve is a vertical line Many markets display almost completely inelastic supply curves over very short periods of time –Perfectly elastic supply curve is a horizontal line

28 Figure 8: Extreme Cases of Supply S (a) Quantity per Period Price per Unit P1P1 P2P2 S (b) Quantity per Period Price per Unit Perfectly Inelastic Supply Perfectly Elastic Supply

29 The Tax on Airline Travel: Taxes and Market Equilibrium A tax on a particular good or service is called an excise tax –Shifts market supply curve upward by amount of tax For each quantity supplied, the new, higher curve tells us firms’ gross price, and the original, lower curve tells us the net price Who really pays excise taxes? –Buyers and sellers share in the payment of an excise tax Called tax shifting –Process that causes some of tax collected from one side of market (sellers) to be paid by other side of market (buyers)

30 The Tax on Airline Travel $300 $260 7 S Before Tax A Millions of Tickets per Year Price per Ticket (a) 10 1.One way to use the supply curve is to start with the price... 2.and then find the quantity supplied at that price. 3.But another way is to start with a quantity... 4.and then find the minimum price needed for the market to supply that quantity.

31 The Tax on Airline Travel $360 S After Tax A' 10 (b) 3.But another way is to start with a quantity... 4.and then find the minimum price needed for the market to supply that quantity. Millions of Tickets per Year Price per Ticket $300 S Before Tax A

32 Effect of Excise Tax on Airlines $340 $300 Millions of Tickets per Year Price per Ticket D A B $ The $60 tax shifts the supply curve up by $ In the new equilibrium, buyers pay $ And, net of the tax, sellers receive $ Before the tax, the supply curve is S Before Tax and the price is $300. S After Tax S Before Tax

33 Tax Incidence and Demand Elasticity In most cases excise tax will be shared by both buyer and seller –For a given supply curve, the more elastic is demand, the more of an excise tax is paid by sellers –The more inelastic is demand, the more of the tax is paid by buyers

34 Figure 11: Tax Incidence and Demand Elasticity $ D A D A B B Millions of Tickets per Year Price per Ticket (a) $360 S After Tax S Before Tax S After Tax S Before Tax (b) Price per Ticket Millions of Tickets per Year

35 Tax Incidence and Supply Elasticity Although there are extreme cases of supply elasticity, in general the following is true –For a given demand curve, the more elastic is supply, the more of an excise tax is paid by buyers –The more inelastic is supply, the more of the tax is paid by sellers

36 Tax Incidence and Supply Elasticity $300 $240 $360 $ D A D A B (a) Millions of Tickets per Year Price per Ticket (b) Price per Ticket Millions of Tickets per Year S Before and After Tax S After Tax S Before Tax

37 The Market For Food Shrinking and unstable incomes are problems for farmers The market for farm goods would reach an equilibrium if it were allowed to do so But farming seems to be special –Notion of small family farm has tremendous political appeal –Farmers have banded together to form powerful and effective government lobbies Result has been continual government interference with supply and demand in agricultural markets around the world

38 The Market For Food P1P1 Q1Q1 D S Old Technology Q2Q2 P2P2 A B P1P1 Q1Q1 D A B Q2Q2 P2P2 S New Technology (a)(b) Quantity of Food Price per Unit of Food Quantity of Food S Bad Weather S Good Weather

39 Health Insurance and the Market for Health Care Health insurance has definite benefits to our society Our current health care system keeps patients from facing the full opportunity cost of their health care decisions –Can cause people to over consume health care Health insurance reduces buyers’ incentives to monitor their health care expenditures closely or to shop around for high-quality low-cost care

40 The Market For Health Care With Coinsurance Examinations per Year Price per Examination 150,000100,000 B A D After Insurance D Before Insurance S $


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