1. Copyright © 2002 by Thomson Learning, Inc. A Lecture Presentation in PowerPoint to accompany Exploring Economics Second Edition by Robert L. Sexton Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting EXPLORING ECONOMICS, Second Edition by Robert L. Sexton as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0030342333

2. Copyright © 2002 by Thomson Learning, Inc. Chapter 5 Elasticities

3. Copyright © 2002 by Thomson Learning, Inc. 5.1 Price Elasticity of Demand The law of demand establishes that quantity demanded changes inversely with changes in price, ceteris paribus. But how much does quantity demanded change? This is very important to understand for many economic issues. This is what the price elasticity of demand is designed to answer.

4. Copyright © 2002 by Thomson Learning, Inc. 5.1 Price Elasticity of Demand The price elasticity of demand measures how responsive consumer behavior (quantity demanded) is due to an incentive (price) change. The price elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in price.

5. Copyright © 2002 by Thomson Learning, Inc. 5.1 Price Elasticity of Demand

6. Copyright © 2002 by Thomson Learning, Inc. 5.1 Price Elasticity of Demand Following the law of demand, there is an inverse relationship between price and quantity demanded. For this reason, price elasticity of demand is, in theory, always negative. In practice, however, this quantity is always expressed in absolute value terms, as a positive number, for simplicity.

7. Copyright © 2002 by Thomson Learning, Inc. 5.1 Price Elasticity of Demand The percentage changes in the elasticity of demand formula are measured using the average price and average quantity. This is so we do not get different values for the elasticity of demand depending on whether we moved up or down the demand curve. We are actually calculating the midpoint elasticity.

8. Copyright © 2002 by Thomson Learning, Inc. 5.1 Price Elasticity of Demand The basic intuition behind elasticities is straightforward, using an analogy to a rubber band. If the quantity demanded (or length) is very responsive to even a small change in price (or pressure), we call it elastic. If even a huge change in price (or pressure) results in only a small change in quantity demanded (or length), then demand is said to be inelastic.

9. Copyright © 2002 by Thomson Learning, Inc. 5.1 Price Elasticity of Demand A demand curve or a portion of a demand curve can be relatively elastic, unit elastic, or relatively inelastic. A segment of a demand curve is elastic (E d > 1) if the percentage change in quantity demanded is greater than the percentage change in price that caused it. A perfectly elastic demand curve is the limiting case.

10. Copyright © 2002 by Thomson Learning, Inc. Price per CD Quantity of CDs (millions per month) Demand 0 E D =.5 at midpoint 78 $21 B 80 P ave Q ave $20 82 A $19  P=$2  Q D = 4 million Exhibit 1: Elastic Demand

11. Copyright © 2002 by Thomson Learning, Inc. 5.1 Price Elasticity of Demand A segment of a demand curve is inelastic (E d < 1) if the percentage change in quantity demanded is less than the percentage change in price that caused it. A perfectly elastic demand curve is the limiting case.

12. Copyright © 2002 by Thomson Learning, Inc. Price Quantity D 0 ED=ED==.20.10 =2 %QD%P%QD%P Q1Q1 P1P1 P0P0 Q0Q0 20%  Q D Price Quantity 0 Q1Q1 P1P1 QDQD PP 10%  P P0P0 Q0Q0 D a. Elastic Demand (E D < 1) b. Perfectly Inelastic Demand (E D = 0) Exhibit 2: Elastic Demand

13. Copyright © 2002 by Thomson Learning, Inc. 5.1 Price Elasticity of Demand A segment of a demand curve is unit elastic (E d = 1) if the percentage change in quantity demanded equals the percentage change in the price that caused it.

14. Copyright © 2002 by Thomson Learning, Inc. D P0P0 Q0Q0 Price Quantity 0 %QD%P%QD%P ED =ED ==.10 = 1 10%  P 10%  Q D Q1Q1 P1P1 Exhibit 4: Unit Elastic Demand

15. Copyright © 2002 by Thomson Learning, Inc. 5.1 Price Elasticity of Demand At a given point, quantity demanded is much more responsive to a given change in price on a flatter, more elastic demand curve. When a demand curve is relatively steep, ceteris paribus, its price elasticity of demand is relatively low (more inelastic). When the demand curve is relatively flat, its price elasticity of demand is relatively high (more elastic).

16. Copyright © 2002 by Thomson Learning, Inc. Price D 1 (relatively elastic) D 0 (relatively inelastic) Quantity 0 Q1Q1 P1P1 P0P0 Q0Q0 Q2Q2 Exhibit 5: Slope and Relative Elasticity

17. Copyright © 2002 by Thomson Learning, Inc. 5.1 Price Elasticity of Demand The price elasticity of demand depends on the availability of close substitutes, the proportion of income spent on the good, and the amount of time people have to adapt to a price change.

18. Copyright © 2002 by Thomson Learning, Inc. 5.1 Price Elasticity of Demand Substitutes Goods with close substitutes tend to have more elastic demands. Goods without close substitutes tend to have less elastic demand. Example: the elasticity of demand for a Ford, Toyota, or a Honda is more elastic than the demand for a car because there are more and better substitutes for a certain type of car than for a car itself.

19. Copyright © 2002 by Thomson Learning, Inc. 5.1 Price Elasticity of Demand The fewer the number of close substitutes, the less elastic the demand curve. Examples: insulin for diabetics, heroin for an addict, and emergency medical care have few, if any, close substitutes.

20. Copyright © 2002 by Thomson Learning, Inc. The smaller the proportion of income spent on a good, the lower its elasticity of demand. If the amount spent on a good relative to income is small (example: salt), then the impact of a change in its price on one's budget will also be small.

21. Copyright © 2002 by Thomson Learning, Inc. 5.1 Price Elasticity of Demand Consumers will respond less to price changes for these goods than for similar percentage changes in large-ticket items (example: textbooks), where a price change could have a potentially large impact on the consumer's budget.

22. Copyright © 2002 by Thomson Learning, Inc. 5.1 Price Elasticity of Demand The more time that people have to adapt to a new price change, the greater the elasticity of demand. The more time that passes, the more time consumers have to find or develop suitable substitutes and to plan and implement changes in their patterns of consumption.

23. Copyright © 2002 by Thomson Learning, Inc. 5.1 Price Elasticity of Demand Hence, the short-run demand curve is generally less elastic than the long-run demand curve.

24. Copyright © 2002 by Thomson Learning, Inc. 5.2 Total Revenue and Price Elasticity of Demand When demand is relatively price elastic (E d > 1), total revenues will rise as the price declines. This occurs because the percentage increase in the quantity demanded is greater than the percentage reduction in price.

25. Copyright © 2002 by Thomson Learning, Inc. 5.2 Total Revenue and Price Elasticity of Demand If the price rises and the quantity demanded falls, then total revenue falls. This occurs because the percentage decrease in the quantity demanded is greater than the percentage increase in price.

26. Copyright © 2002 by Thomson Learning, Inc. Price cb a D ELASTIC Quantity 0 20406080100 A $10 B $5 Exhibit 1: Elastic Demand and Total Revenue

27. Copyright © 2002 by Thomson Learning, Inc. 5.2 Total Revenue and Price Elasticity of Demand When demand is relatively price inelastic (E d < 1), total revenues will fall as the price declines. Total revenues fall because the percentage increase in the quantity demanded is less than the percentage reduction in price.

28. Copyright © 2002 by Thomson Learning, Inc. 5.2 Total Revenue and Price Elasticity of Demand If the price rises and the quantity demanded falls, then total revenue rises. Total revenue rises because the percentage decrease in the quantity demanded is less than the percentage increase in price.

29. Copyright © 2002 by Thomson Learning, Inc. Price bc a D INELASTIC Quantity 0 10203040 $10 A $5 B Exhibit 2: Inelastic Demand and Total Revenue

30. Copyright © 2002 by Thomson Learning, Inc. Price b D a (gain) c (loss) S0S0 Q0Q0 Quantity 0 Q1Q1 S1S1 P0P0 P1P1 Exhibit 3: Total Revenue & Inelastic Demand:A Reduction in Supply

31. Copyright © 2002 by Thomson Learning, Inc. Price of Wheat b D a (loss) c (gain) Quantity of Wheat 0 S0S0 Q0Q0 Q1Q1 S1S1 P1P1 P0P0 Exhibit 3: Total Revenue & Inelastic Demand: An Increase in Supply

32. Copyright © 2002 by Thomson Learning, Inc. 5.2 Total Revenue and Price Elasticity of Demand A straight-line demand curve (having a constant slope) will change price elasticity continuously as you move up or down it. When the price falls on the upper half of the demand curve, there is a negative relationship between price and total revenue. Demand is relatively price elastic.

33. Copyright © 2002 by Thomson Learning, Inc. 5.2 Total Revenue and Price Elasticity of Demand When the price falls on the lower half of the demand curve, there is a positive relationship between price and total revenue. Demand is relatively price inelastic.

34. Copyright © 2002 by Thomson Learning, Inc. Price c b a Quantity 0 E D > 1 = Elastic D Price fe d Quantity 0 E D < 1 = Inelastic D Midpoint E D = 1 P0P0 Q0Q0 P1P1 Q1Q1 P2P2 Q2Q2 P3P3 Q3Q3 a. Elastic Range Midpoint E D = 1 b. Inelastic Range Exhibit 4: Price Elasticity Along a Linear Demand Curve

35. Copyright © 2002 by Thomson Learning, Inc. 5.3 Price Elasticity of Supply According to the law of supply, there is a positive relationship between price and quantity supplied, ceteris paribus. But by how much does quantity supplied change as price changes? The price elasticity of supply measures how responsive the quantity sellers are willing to sell is to changes in the price.

36. Copyright © 2002 by Thomson Learning, Inc. 5.3 Price Elasticity of Supply In other words, price elasticity of supply measures the relative change in the quantity supplied that results from a change in price. The price elasticity of supply (E s ) is defined at the percentage change in the quantity supplied divided by the percentage change in price.

37. Copyright © 2002 by Thomson Learning, Inc. 5.3 Price Elasticity of Supply

38. Copyright © 2002 by Thomson Learning, Inc. 5.3 Price Elasticity of Supply Goods with a supply elasticity that is greater than 1 (E s > 1 ) are relatively elastic in supply. With that, a 1 percent change in price will result in a greater than 1 percent change in quantity supplied. The extreme case is perfectly elastic supply, where E s = infinity.

39. Copyright © 2002 by Thomson Learning, Inc. 5.3 Price Elasticity of Supply Goods with a supply elasticity that is less than 1 (E s < 1) are relatively inelastic in supply. This means that a 1 percent change in the price of these goods will induce a proportionately smaller change in the quantity supplied. The extreme case is perfectly inelastic supply, where E s = 0.

40. Copyright © 2002 by Thomson Learning, Inc. Price Quantity 0 = = 4 %QS%P%QS%P E S =.20.05 S 20%  Q S 5%  P P0P0 Q0Q0 P1P1 Q1Q1 a. Elastic Supply (E S > 1) Exhibit 1: The Price Elasticity of Supply

41. Copyright © 2002 by Thomson Learning, Inc. Price Quantity 0 = =.25.05.20 E S = %QS%P%QS%P S P1P1 Q1Q1 P0P0 Q0Q0 20%  P 5%  Q S b. Inelastic Supply (E S < 1) Exhibit 1: The Price Elasticity of Supply

42. Copyright © 2002 by Thomson Learning, Inc. Price Quantity 0 Q 0 = Q 1 S P0P0 P1P1 20%  P c. Perfectly Inelastic Supply (E S = 0) Exhibit 1: The Price Elasticity of Supply

43. Copyright © 2002 by Thomson Learning, Inc. Price Quantity 0 P0P0 Q0Q0 P1P1 S PP d. Perfectly Elastic supply (E S =  ) Exhibit 1: The Price Elasticity of Supply

44. Copyright © 2002 by Thomson Learning, Inc. 5.3 Price Elasticity of Supply Time is usually critical in supply elasticities because it is more costly for producers to bring forth and release resources in shorter periods of time. Hence, supply tends to be more elastic in the long run than the short run.

45. Copyright © 2002 by Thomson Learning, Inc. Price Quantity 0 S SR S LR P0P0 Q0Q0 P1P1 Q SR Q LR Exhibit 2: Short-run and Long-run Supply Curves

46. Copyright © 2002 by Thomson Learning, Inc. 5.3 Price Elasticity of Supply The relative elasticity of supply and demand determines the distribution of the tax burden for a good. If demand has a lower elasticity than supply in the relevant tax region, the largest portion of the tax is paid by the consumer.

47. Copyright © 2002 by Thomson Learning, Inc. 5.3 Price Elasticity of Supply However, if demand is relatively more elastic than supply in the relevant tax region, the largest portion of the tax is paid by the producer. In general, the tax burden falls on the side of the market that is less elastic, which has nothing to do with who actually pays the tax at the time of the purchase.

48. Copyright © 2002 by Thomson Learning, Inc. Tax Paid by Consumer Tax Paid by Producer Price Quantity 0 S S + $.50 tax D Q AT $1.40.90 Q BT 1.00 $.50 a. Demand Is Relatively Less Elastic than Supply Exhibit 3: Elasticity and the Burden of Taxation

49. Copyright © 2002 by Thomson Learning, Inc. Tax Paid by Consumer Tax Paid by Producer Price Quantity 0 D S S + $.50 tax $.50 Q BT 1.00.60 Q AT $1.10 b. Demand Is Relatively More Elastic than Supply Exhibit 3: Elasticity and the Burden of Taxation

50. Copyright © 2002 by Thomson Learning, Inc. 5.4 Other Types of Elasticities The cross-price elasticity of demand measures both the direction and magnitude of the impact that a price change for one good will have on the quantity of another good demanded at a given price.

51. Copyright © 2002 by Thomson Learning, Inc. 5.4 Other Types of Elasticities The cross-price elasticity of demand is defined as the percentage change in quantity demanded of one good at a given price divided by the percentage change in price of another good.

52. Copyright © 2002 by Thomson Learning, Inc. 5.4 Other Types of Elasticities

53. Copyright © 2002 by Thomson Learning, Inc. 5.4 Other Types of Elasticities If the cross-price elasticity of demand between two goods is positive, they are substitutes because the price of one good and the demand for the other move in the same direction. If the cross-price elasticity of demand between two goods is negative, they are complements because the price of one good and the demand for the other move in opposite directions.

54. Copyright © 2002 by Thomson Learning, Inc. 5.4 Other Types of Elasticities The income elasticity of demand is a measure of the relationship between a relative change in income and the consequent relative change in quantity demanded, ceteris paribus. The income elasticity of demand coefficient expresses the degree of the connection between the two variables, and it also indicates whether the good in question is normal or inferior.

55. Copyright © 2002 by Thomson Learning, Inc. 5.4 Other Types of Elasticities The income elasticity of demand is defined as the percentage change in quantity demanded at a given price divided by the percentage change in income.

56. Copyright © 2002 by Thomson Learning, Inc. 5.4 Other Types of Elasticities

57. Copyright © 2002 by Thomson Learning, Inc. 5.4 Other Types of Elasticities If the income elasticity is positive, then the good in question is a normal good because the change in income and the change in quantity demanded move in the same direction. If the income elasticity is negative, then the good in question in an inferior good because the change in income and the change in quantity demanded move in opposite directions.