1 Elasticity © ©1999 South-Western College Publishing

2 What is Elasticity? A term economists use to describe sensitivity of quantity demanded or supplied to a change in price.

3 quantity demanded price The percentage change in quantity demanded divided by the percentage change in price How do we measure the Price Elasticity of Demand?

4 Price Elasticity of Demand E d = % change in Q d % change in P E d = % in Q d % in P

5 Notes on E d E d negative, but ignore negative use of % change-not affected by units of measurement

6 Classifying E d E d = 1 Unitary elasticityE d = 1 Unitary elasticity E d > 1 Elastic demandE d > 1 Elastic demand E d < 1 Inelastic demandE d < 1 Inelastic demand

7 Extreme elasticities E d = 0 Perfectly inelastic (vertical demand curve)E d = 0 Perfectly inelastic (vertical demand curve) E d =  Perfectly elastic (horizontal demand curve)E d =  Perfectly elastic (horizontal demand curve)

8 D P Q Perfectly inelastic demand P Q D Perfectly elastic demand

9 When consumers are very sensitive to a price change what does the demand curve look like? Very horizontal

10 When consumers are less sensitive to a price change what does the demand curve look like? Very vertical

New.2-inelastic 50%10% elastic10% 20% inelastic75% 25% elastic.6/.2 20% 5/25 60% 60/ Initial Price Elasticity of Demand % change in P % change in Q d Qu antity Price E d = % in Q d % in P

12 When price increases, what two things happen? more revenue per unit fewer units are sold

13 What factors influence Demand Sensitivity (elasticity)? Number and closeness of Substitute goods % of income a good makes up Basic goods or “needs” Time to adjust

14 What do substitutes have to do with sensitivity? The more substitutes a good has, the more sensitive consumers are to a price change

15 A B D D Which demand curve is for spark plugs and which for Coca-Cola?

16 The lower the % of ones budget a good is, the less sensitive consumers are to a price change What does % of income a good makes up have to do with sensitivity? SALT!

17 The greater the need a good has to the consumer, the less sensitive the consumer is to a price change What do basic goods have to do with sensitivity? WATER!

18 The more time to adjust, the more sensitive consumers are to a price change What does time have to do with sensitivity?

19 Elasticity and Total Revenue (TR) TR = PQ (price times quantity) E d = % change in Q d % change in P

20 elastic If demand is elastic - revenue goes down inelastic If demand is inelastic - revenue goes up If a college raises tuition, what happens to revenue?

21 If total revenue does not change when price increases, the demand curve is unitary elastic, value equals 1

22 If price increases and the revenue gained is less than the revenue lost, the demand curve is price elastic, > 1

23 If price increases and the revenue gained is greater than the revenue lost, the demand curve is price inelastic, < 1

24 Summary, elasticity, price changes, and total revenue Total revenue falls Total revenue rises E d < 1 Total revenue rises Total revenue falls E d > 1 Total revenue same E d = 1 Price increase Price Decrease

25 What is Price Elasticity of Supply? The ratio of the percentage change in quantity supplied to the percentage change in price

26 E s = %  Q supplied %  Price E s = 1 Unitary E s > 1 Elastic E s < 1 Inelastic

27 Extreme cases of E s E s = 0, perfectly inelastic (vertical supply curve E s = , perfectly elastic (horizontal supply curve) S P Q S P Q

28 Does time effect Supply Elasticities? Yes! The more time, the more elastic the supply curve

29 Which type of good would be best to tax to raise the most revenue? Goods that face a price inelastic demand curve will generate the most revenue

30 The percentage change in the quantity demanded of one commodity resulting from a 1 percent change in price of another commodity What is Cross Elasticity of Demand?

31 E c = %  Quantity of X %  Price of Y Cross Elasticity of Demand

32 E c If E c negative - complements (steak & steak sauce) E c If E c positive - substitutes (butter & margarine) E c Unrelated goods should have a E c close to zero

33 The ratio of the percentage change in quantity demanded to the percentage change in income What is Income Elasticity of Demand?

34 E i = %  Quantity %  Income E i > 0 Normal goods E i < 0 Inferior goods E i > 1 Luxury goods 0 < E i < 1 Necessities

35 When does a good face an income elastic demand curve? A 1% change in income generates a greater than 1% change quantity demanded

36 When does a good face an income inelastic demand curve? A 1% change in income generates a less than 1% change quantity demanded

37 Something that people will buy less of as their incomes increase What is an Inferior Good? I bought Mac and Cheese in college, but refuse to buy it now! What’s the difference in my income?

38 Something that people will buy more of as their incomes increase What is a Normal Good? I bought bologna in college, but now I buy steak! What’s the difference in my income?