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**Demand and Supply: Elasticities and Applications**

Chapter 5

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**Price Elasticity of Demand**

The responsiveness of consumers to a change in the price of a good/service In other words: How much does changing the price of a good impact how much we demand of that good.

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**Price Elasticity of Demand**

Practice: Think about your spending habits. Come up with one good that you do not care what it costs when it comes to buying it…you will buy the same amount no matter what happens. Come up with one good that you would definitely buy more of it was cheaper and less of if it was more expensive.

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**Price Elasticity of Demand**

So how do we figure out exactly what the elasticity of demand is? A lovely formula! Ed = % change in Qd of X % change in P of X

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**Price Elasticity of Demand**

Here’s another way of looking at it! Ed = (Q2 – Q1)/Q1 (P2 – P1)/P1 We always use absolute value when calculating elasticity!

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**Midpoint Formula Ed = (Q2 – Q1)/[(Q1 + Q2)/2] (P2 – P1)/[(P1 + P2)/2]**

This is the formula you should actually use to calculate the elasticity of demand (why do they give you the other one too?....I don’t know!)

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Let’s Practice Price Per Cup of Coffee Quantity Demanded $10 $9 20 $8 40 $7 60 $6 80 $5 100 $4 120 $3 140 $2 160 $1 180 Free! 200 Calculate the price elasticity of demand when price changes from $1 to $2

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Let’s Practice Price Per Cup of Coffee Quantity Demanded $10 $9 20 $8 40 $7 60 $6 80 $5 100 $4 120 $3 140 $2 160 $1 180 Free! 200 Calculate the price elasticity of demand when price changes from $1 to $2 Midpoint Formula = (Q2-Q1)/[(Q1+Q2)/2] (P2-P1)/[(P1+P2)/2]

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Let’s Practice Price Per Cup of Coffee Quantity Demanded $10 $9 20 $8 40 $7 60 $6 80 $5 100 $4 120 $3 140 $2 160 $1 180 Free! 200 Calculate the price elasticity of demand when price changes from $1 to $2 Midpoint Formula = ( )/[ )/2] ($2.00-$1.00)/[($2.00+$1.00)/2]

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Let’s Practice Price Per Cup of Coffee Quantity Demanded $10 $9 20 $8 40 $7 60 $6 80 $5 100 $4 120 $3 140 $2 160 $1 180 Free! 200 Calculate the price elasticity of demand when price changes from $1 to $2 Midpoint Formula = -20/170 $1.00/$1.50

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Let’s Practice Price Per Cup of Coffee Quantity Demanded $10 $9 20 $8 40 $7 60 $6 80 $5 100 $4 120 $3 140 $2 160 $1 180 Free! 200 Calculate the price elasticity of demand when price changes from $1 to $2 Midpoint Formula = .667

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Let’s Practice Price Per Cup of Coffee Quantity Demanded $10 $9 20 $8 40 $7 60 $6 80 $5 100 $4 120 $3 140 $2 160 $1 180 Free! 200 Calculate the price elasticity of demand when price changes from $1 to $2 Midpoint Formula = Use absolute value and change to percent = 0.18

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Let’s Practice Price Per Cup of Coffee Quantity Demanded $10 $9 20 $8 40 $7 60 $6 80 $5 100 $4 120 $3 140 $2 160 $1 180 Free! 200 Calculate the price elasticity of demand when price changes from $1 to $2 Use absolute value and change to percent = 0.18 So what is our demand?! Inelastic? Elastic? Unit Elastic?

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Elastic Demand %change in Qd > %change in P Elasticity Ratio > 1

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**Inelastic Demand %change in Qd < %change in P**

Elasticity Ratio < 1

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Unitary Elasticity %change in Qd = %change in P Elasticity Ratio = 1

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Let’s Practice Price Per Cup of Coffee Quantity Demanded $10 $9 20 $8 40 $7 60 $6 80 $5 100 $4 120 $3 140 $2 160 $1 180 Free! 200 Calculate the price elasticity of demand when price changes from $1 to $2 Use absolute value and change to percent = 0.18 So what is our demand?! Inelastic? Elastic? Unit Elastic?

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Let’s Practice Price Per Cup of Coffee Quantity Demanded $10 $9 20 $8 40 $7 60 $6 80 $5 100 $4 120 $3 140 $2 160 $1 180 Free! 200 Calculate the price elasticity of demand when price changes from $1 to $2 Use absolute value and change to percent = 0.18 Inelastic at this price point!

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Your turn! Price Per Cup of Coffee Quantity Demanded $10 $9 20 $8 40 $7 60 $6 80 $5 100 $4 120 $3 140 $2 160 $1 180 Free! 200 Calculate the price elasticity of demand when price changes from $5 to $6

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Your turn! Price Per Cup of Coffee Quantity Demanded $10 $9 20 $8 40 $7 60 $6 80 $5 100 $4 120 $3 140 $2 160 $1 180 Free! 200 Calculate the price elasticity of demand when price changes from $5 to $6 (80-100)/[(100+80)/2] ($6-$5)/[$5+$6)/2] (-20/90)/($1/$5.50) -.222/.182 = -1.22 Absolute value = 1.22 Elastic Demand!

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Practice Price Per Cup of Coffee Quantity Demanded $10 $9 20 $8 40 $7 60 $6 80 $5 100 $4 120 $3 140 $2 160 $1 180 Free! 200 If the price changes from $3 per cup to $4 per cup, is demand elastic, inelastic or unit elastic?

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Practice Price Per Cup of Coffee Quantity Demanded $10 $9 20 $8 40 $7 60 $6 80 $5 100 $4 120 $3 140 $2 160 $1 180 Free! 200 If the price changes from $3 per cup to $4 per cup, is demand elastic, inelastic or unit elastic? Inelastic!

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Why Use Percentages? 1.Using absolute changes would be affected by the units used Example: If $ units used: $3$2 causes 60100 Qd change Seems very responsive If cents used: 300200 causes 60100 Qd change Does not seem as responsive

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**Why Use Percentages? Easier to compare different products**

$ changes depend on the original cost of the good/service $1 increase in a good/service which costs $1 has a different impact than a $1 increase in a good/service which costs $20,000

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Why Use Percentages? In other words…. - Adding $1 to the price of a pack of starbursts is going to have a different impact that adding $1 to the price of a new car!

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**Elasticity Varies with Price Range**

Demand is more elastic in the upper left region of the demand curve than in the lower right region

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**Elasticity Varies with Price Range**

In upper left: %change in quantity is large because original quantity is small %change in price is small because the original price is large

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**Elasticity Varies with Price Range**

In lower right: %change in quantity is small because original quantity is large %change in price is large because the original price is small

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**Perfectly Inelastic Demand**

%change in price does not change the quantity demanded Demand Curve is Parallel to the Y Axis Q P D 15 700 100

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**Perfectly Elastic Demand**

%change increase in price causes quantity demanded to fall to zero %change decrease in price causes quantity demanded to increase to infinity Demand Curve is Parallel to the X Axis P Q D 16 10 20

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**Midpoint Formula If original formula used, two different answers**

P1=5; P2=4; Q1=4; Q2=5 Ed = (Q2 – Q1)/Q1 (P2 – P1)/P1 = (5-4)/4 (4-5)/5 = (1/4)/1/5 = 5/4=1.25

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**Midpoint Formula If original formula used, two different answers**

P1=4; P2=5; Q1=5; Q2=4 Ed = (Q2 – Q1)/Q1 (P2 – P1)/P1 = (4-5)/5 (5-4)/4 = (1/5)/(1/4)=.8

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**Determinants of Supply**

Explain how each of these impacts supply: Technology Subsidies/Taxes Costs/Resource Prices Other good prices Number of Sellers Expectations/Fears

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**Slope Does NOT Measure Elasticity**

Slope is calculated from absolute changes in price and quantity, not percentage changes

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Total Revenue Test TR = PQ Total revenue = Price X Quantity

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**Total Revenue Test Elastic Demand P increase leads to decrease in TR**

P decrease leads to increase in TR Firms tend to have sales on elastic goods

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**Total Revenue Test Inelastic Demand:**

P increase leads to increase in TR P decrease leads to decrease in TR Government taxes inelastic goods e.g., (sin taxes)

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**Total Revenue Test Unitary Demand: P increasesNo change in TR**

P decreasesNo change in TR

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**Determinants of Price Elasticity of Demand**

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1. Substitutability The larger the number of substitutes, the greater the elasticity of demand There are how many different pizza places out there? Vs. There are how many utility companies out there?

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1. Substitutability Individual products versus industry: Tide, All, Cheer versus laundry detergent Our demand for the industry might be inelastic (we need clean clothes!) But Our demand for a specific brand might be elastic (I don’t care what makes them clean…just do it)

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**2. Proportion of Income Step One: Look at your income**

Step Two: Look at the price of the good/service Step Three: What portion of your income does it take to buy the good/service?

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2. Proportion of Income If it takes a large portion of your income to buy the good/service – greater the elasticity. If it take a small portion of your income to buy the good/service – usually more inelastic. Low-priced items are usually more inelastic than high-priced items: salt versus cars

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**3. Luxuries versus Necessities**

Necessities = inelastic Luxuries = elastic

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**3. Luxuries versus Necessities**

Necessities = inelastic Life saving heart surgery (probably doesn’t matter if the price increases…I’m gonna go ahead and have that) Luxuries = elastic Starbursts (while desirable…not worth it if the price goes up!)

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4. Time Goods tend to have more elastic demand over longer time periods Consider the market for gasoline: When the price rises, the quantity of gasoline in the first few months/years changes very little Over longer periods of time quantity will change as people switch to public transportation, buy fuel efficient cars or move closer to work.

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**Price Elasticity of Supply**

The responsiveness of producers to price changes Es = %change in quantity supplied of X %change in price of X Es >1elastic Es < 1inelastic Es = 1unitary You can still use the midpoint method to calculate this!

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**Determinants of Price Elasticity of Supply**

How flexible are sellers when it comes to changing the amount of the good they produce? For example: Land in Manhattan for development – inelastic supply because you can’t really create more of it Soccer balls produced by a factory – elastic supply because you could operate your factory for longer, hire more workers, etc. to produce more if you wanted.

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**Determinants of Price Elasticity of Supply**

Time Period Long Time = All factors of production are adjustable = more elastic the supply Firms have a longer amount of time to shift resources to adjust to a price change Short Run = plant capacity is fixed = more inelastic supply Harder to make changes in production quickly

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**Determinants of Price Elasticity of Supply**

There is no revenue test for Price Elasticity of Supply

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Homework Read “Why Did OPEC Fail to Keep the Price of Oil High?” in your book starting on page 105 Answer question 10 on page 110 Be prepared to share your answer tomorrow.

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**Group Work We are going to assemble into groups of four**

Once you are in your group, the youngest two people in the group are partners and the oldest two are partners Each pair will be given a topic to take notes on as you read about it in your book. Using these notes, the pair must devise a short lesson designed to share this information with the rest of the class

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Group Work You may utilize technology, posters, the board or any other supplies you feel are necessary in order to teach your lesson. You must design a lesson plan that contains all the components listed on your half sheet. When you are finished, you will turn your lesson plan into Mrs. Krieger Young ones – your topic is Cross Elasticity of Demand Oldies – your topics is Income Elasticity of Demand

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**Cross Elasticity of Demand**

Responsiveness of quantity demanded of good/service X when the price of good/service Y changes Exy = %change in quantity demanded of X %change in price of Y

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**If Cross Elasticity of Demand is:**

PositiveX and Y are Substitutes NegativeX and Y are Complements (Near) ZeroX and Y are Independent (i.e., no relation to each other)

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**Income Elasticity of Demand**

Responsiveness of quantity demanded to a change in income Ei = %change in quantity demanded of X %change in income Ei > 0Normal Goods Ei < 0Inferior Goods

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**Government Intervention**

Price Ceilings and Price Floors Basically the same thing as a surplus or shortage caused by the government!

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**Price Ceilings and Floors**

Everyone point to the ceiling now Now point to the floor Now forget everything you ever thought you knew about ceilings and floors

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Price Ceiling A Price Ceiling is actually located BELOW equilibrium price It is a set price that suppliers may not charge more than – that’s why it’s called a ceiling

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Price Ceiling

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**Examples of Price Ceilings**

Live Nation Ticketmaster

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**Price Floors A Price Floor is actually located ABOVE equilibrium price**

This is a set price that suppliers may not charge less than – that’s why it’s called a floor

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Price Floors

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**Famous Price Floor = MILK**

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**Attempts to Correct Ticket Scalpers Got Milk? Campaign**

Sell tickets to those in need – but at a higher price! Changing the quantity demanded Got Milk? Campaign Increase demand for milk and bring equilibrium price up to floor

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Discussion Question How would elasticity impact the shortage/surplus caused by a ceiling/floor?

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Homework Read pages 124 through 127 in your textbook talking about taxes. Create a graphic organizer (chart is probably the easiest way to go) including information on the three steps to analyzing taxes on buyers and sellers and the implications of these taxes.

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**Homework For example: Taxes on Buyers Taxes on Sellers Step One**

Step Two Step Three Implications

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**Taxes on Buyers Which curve would this impact? Demand or Supply?**

This is a tax on consumers. Which curve deals with consumers? The Demand Curve This is the curve that is going to be shifting.

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**Taxes on Buyers Which curve would this impact? Demand or Supply?**

This is a tax on consumers. Which curve deals with consumers? The Demand Curve This is the curve that is going to be shifting.

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**Taxes on Buyers Which way is our curve going to move?**

Does this added tax make the product more or less desirable? Less desirable – shifting to the left The amount of the shift is determined by looking at the amount of the tax.

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**Taxes on Buyers Now we examine what actually happened with the tax:**

Compare the new equilibrium to the old equilibrium Money going to sellers goes down Quantity will go down The tax has reduced the size of the market!

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**Taxes on Buyers What does this mean?**

Consumers pay higher prices due to the tax Even though equilibrium price might be lower, there is still a 50 cent tax on top! Sellers receive less for each product Due to the decrease in equilibrium

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**Taxes on Buyers What does this mean? Taxes make markets shrink**

Quantity at equilibrium goes down Buyers and sellers both get hurt Buyers pay more for the good Sellers make less for the good

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Copyright © 2004 South-Western 5 Elasticity and Its Applications.

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