Section 2 topics Elasticity Costs of production Pure Competition Pure Monopoly Oligopoly Monopolistic Competition

Elasticity Please listen to the audio as you work through the slides.

Microeconomics Looking at the behavior of: Consumers, Businesses, and Resource suppliers In various market structures

Elasticity Learning objectives Students should be able to thoroughly and completely explain: 1.What Elasticity measures, who cares, and why. 2.All the measures of elasticity that we covered in class: 1.Elasticity of Demand, 2.Supply, 3.Income, and 4.Cross Elasticity of Demand 3.The determinants of Price Elasticity of Demand.

Extend the discussion of demand and supply to look at the concept of Responsiveness. 1.The buying and selling responses of consumers and producers to price changes. 2.The responses of producers of one product when the price of another product changes. 3.The buying responses of consumers when their incomes change. Elasticity

Elasticity of: Demand Supply Cross Elasticity Income Elasticity Types of Elasticity (responsiveness)

How much more or less? Does it matter? To whom? THE LAW OF DEMAND SAYS... Price Elasticity of Demand Consumers will buy more when prices go down and less when prices go up Price Elasticity Provides an Answer

The Price-Elasticity Coefficient and Formula Price Elasticity of Demand E d = Percentage change in quantity demanded of product X Percentage change in price of product X Or equivalently… E d = Percentage change in quantity demanded of X Original quantity demanded of X Change in price of X  Original price of X

Price Elasticity of Demand Example Please calculate the price elasticity of demand given the following data: Original price = $9 New price = $10 Original qty. demanded = 150 New qty. demanded = 110 (110 – 150 / 150) = -40/150 = ( / 9) =.1111 ( )/(0.1111) = Since we are interested in the absolute value we drop the minus sign and see that the price elasticity of demand is We would say that the demand for this product is Elastic.

Interpretations of E d Price Elasticity of Demand Demand is Elastic if a specific percentage change in price results in a larger percentage change in quantity demanded. Then E d will be > 1 What is an example of a product with elastic demand? Vacations, restaurants, movies, concerts, books, etc. If the price rises, you can easily give it up either because they are not necessary or have substitutes

Interpretations of E d Price Elasticity of Demand Demand is Inelastic if a specific percentage change in price results in a smaller percentage change in quantity demanded. Not very responsive. Then E d will be < 1 What would be an example of a product with inelastic demand? Gasoline, staple foods, basic clothing, phone, internet or cable service is often seen as a necessity and will not get cut based on a price increase.

Interpretations of E d Price Elasticity of Demand Demand is of Unit Elasticity if a specific percentage change in price results in an equal percentage change in quantity demanded. Then E d will be = 1 What would be an example of a product with unit elasticity?

Interpretations of E d Price Elasticity of Demand Demand is Perfectly Inelastic if a price change results in no change in quantity demanded. Then E d will be = 0 Example - A diabetic’s demand for insulin. Other examples?

Interpretations of E d Price Elasticity of Demand Demand is Perfectly Elastic if a small price reduction causes buyers to increase their purchases from 0 to all they can obtain. Then E d will be =  Example - A firm selling it’s product in a purely competitive market.

Elastic Demand - E d will be > 1 Inelastic Demand - E d will be < 1 Unit Elastic Demand - E d will be = 1 Perfectly Inelastic Demand - E d will be = 0 Perfectly Elastic Demand - E d will be =  Summary of Price Elasticity of Demand 5 interpretations

The percentage change in price The percentage change in quantity Elasticity is.5 Q P P1P1 P2P2 Q1Q1 Q2Q2 D Measures Responsiveness to Price Changes Price Elasticity of Demand

The percentage change in price The percentage change in quantity Q P P1P1 P2P2 Q1Q1 Q2Q2 D Commonly Expressed as… Price Elasticity of Demand  %P %  Q d Elasticity is.5

Extreme Cases Price Elasticity of Demand Perfectly Inelastic Demand Perfectly Elastic Demand P 0 P 0 D1D1 E d = 0 D2D2 E d =  Q Q

So, who cares about elasticity? Firms do! Why? Impact on Revenue!

Total Revenue Test Demand for a product is elastic if a price change causes total revenue to change in the opposite direction. – Price falls and Total Revenue rises – Price rises and Total Revenue falls Demand for a product is Inelastic if a price change causes total revenue to change in the same direction. – Price falls and Total Revenue falls – Price rises and Total Revenue rises

] ] ] ] ] ] ] Elasticity on a Linear Demand Curve It has 3 phases $ $8,000 14,000 18,000 20,000 18,000 14,000 8,000 Elastic Unit Elastic Inelastic (1) Total Quantity of Tickets Demanded Per Week, Thousands (2) Price Per Ticket (3) Elasticity Coefficient (E d ) (4) Total Revenue (1) X (2) (5) Total-Revenue Test ] ] ] ] ] ] ]

Elasticity and the TR Curve Quantity Demanded Price Total Revenue (Thousands of Dollars) $ $ a b c d e f g h Elastic E d > 1 Unit Elastic E d = 1 Inelastic E d < 1 D TR

Inelastic from 0 to 1 Typical of necessities one must have Typical of luxuries one wants Elastic from 1 to  Unit elastic when exactly = 1 Price change does not reduce total revenue Price Elasticity is... Price Elasticity and Total Revenue

Determinants of Price Elasticity of Demand (Generalizations) 1.Substitutability 2.Proportion of Income 3.Luxuries versus necessities 4.Time

Determinants of Price Elasticity of Demand Substitutability The larger the number of substitute goods that are available, the greater the Price Elasticity of Demand. In the purely competitive market, the single seller faces a perfectly elastic demand curve. Why? Lowering world trade barriers increases elasticity of demand for most products. Why?

Determinants of Price Elasticity of Demand Substitutability The elasticity of demand for a product depends on how narrowly the product is defined. Reeboks – lots of substitutes Shoes – few substitutes for shoes

Determinants of Price Elasticity of Demand Proportion of Income Other things equal, the higher the price of a good relative to consumers’ incomes, the greater the Price Elasticity of Demand. A 10% increase in price of cheap pencils yields a small decline in quantity demanded. Small proportion of income. A 10% increase in price of cars or housing yields a large decline in quantity demanded. Large proportion of income.

Determinants of Price Elasticity of Demand Luxuries versus Necessities In general, the more that a good is considered a “luxury” rather than a “necessity”, the greater is the Price Elasticity of Demand. Food and water - necessities (inelastic) Travel vacations and jewelry – luxuries (elastic)

Determinants of Price Elasticity of Demand Time Generally, product demand is more elastic the longer the time period under consideration. Consumers often need time to adjust to price changes. Elasticity of demand for gasoline in the “short run” E d =.2 more inelastic than… Elasticity of demand for gasoline in the “long run” E d =.7

Determinants of Price Elasticity of Demand Some Applications Excise Taxes When selecting which goods and services on which to levy excise taxes, the Government needs to pay attention to elasticity of demand. Higher taxes on products with elastic demand will bring in less tax revenue. Why tax the following? Liquor, Gasoline, Cigarettes

State the law of supply

Price Elasticity of Supply a measure used in economics to show the responsiveness, or elasticity, of the quantity supplied of a good or service to a change in its price or cost. 5 interpretations If producers are relatively responsive to price or cost changes, supply is elastic If producers are relatively insensitive to price or cost changes, supply is inelastic. The degree of Price Elasticity of Supply depends on how easily – and therefore how quickly – producers can shift resources between alternate uses.

*Now, compare the immediate market period, the short-run, and long run impact on elasticity of supply. Supply curve becomes more elastic with time. Price Elasticity of Supply Coefficient of Price Elasticity of Supply Es=Es= Percentage change in quantity supplied of good X Percentage change in the price of good X

How does Time impact the Price Elasticity of Supply? Immediate Market period – All resources are fixed – Perfectly inelastic supply Short run – Fixed plant size – Inelastic supply Long run – Adjustable plant size – Supply more elastic 6-34

Time periods The immediate market period The period that occurs when the time immediately after a change in market prices is too short for producers to respond with a change in quantity supplied. The tomato farmer case Supply is perfectly inelastic. Vertical supply curve.

Time periods The short run A period of time too short to change plant capacity but long enough to use fixed plant more or less intensively. What could the tomato farmer do? We expect a somewhat greater output in response to a presumed increase in demand. This greater output is reflected in a more elastic supply curve.

Time periods The long run A period of time long enough for firms to adjust their plant sizes and for new firms to enter (or existing firms to leave) the industry. We expect the Price Elasticity of Supply to be even more elastic.

PoPo P Q D1D1 QoQo An increase in demand without enough time to change supply causes… SmSm Immediate Market period Price Elasticity of Supply

PoPo PmPm P Q D1D1 QoQo D2D2 An increase in demand without enough time to change supply causes… an increase in price with no qty. supply increase. SmSm Immediate Market period Price Elasticity of Supply

PoPo P Q D1D1 QoQo Short Run Price Elasticity of Supply An increase in demand with more intense Use of fixed plant causes... SsSs

PoPo P Q D1D1 QoQo D2D2 Short Run Price Elasticity of Supply PsPs An increase in demand with more intense Use of fixed plant causes...a smaller increase in price, and a small increase in output SsSs QsQs

PoPo P Q D1D1 QoQo Long Run Price Elasticity of Supply An increase in demand in the long run allows greater change causing... SLSL

PoPo P Q D1D1 QoQo D2D2 Long Run Price Elasticity of Supply PLPL An increase in demand in the long run allows greater change causing... Supply to become even more elastic -smaller price increase --larger Change in output SLSL QLQL

Applications of Price Elasticity of Supply Antiques - Limited, Inelastic supply, high prices Reproductions – Unlimited, Elastic supply, lower prices Gold – highly inelastic supply, shifting demand Price Elasticity of Supply

Cross Elasticity of Demand Producers care about this 3 interpretations Consumption of a good also is affected by a change in the price of a related good. E XY measures how sensitive consumer purchases of one product (X) are to a change in the price of some other Product (Y). Helps quantify and better understand substitute and complementary goods.

Cross Elasticity of Demand E xy = Percentage change in quantity demanded of good X Percentage change in the price of good y E XY > 0, sales of good X move in the same direction as a change in price of good Y means the X and Y are substitutes. The larger is E XY, the greater is the substitutability of X and Y. E XY < 0, An increase in the price of one good decreases the demand for the other good. X and Y are complements. The larger is the negative E XY, the greater are X and Y as complements. E XY = 0, the two products are unrelated or independent

Cross Elasticity of Demand - Applications Business application: Coca-Cola considering raising the price of Sprite: check out the Coca-Cola product list with Google and note the number of products. What is the E d of Sprite and what is the E XY of Coke and Sprite? A low E XY between Coke and Sprite means they are weak substitutes.

Cross Elasticity of Demand - Applications Government application: Merger analysis by the Justice Dept. Should Coca-Cola and Pepsi be allowed to merge? The E XY between Coca-Cola and Pepsi is high which means? They are strong substitutes! What should the Justice Dept. do? Block the merger because competition will be hurt.

Income Elasticity of Demand 2 interpretations Measures the degree to which consumers respond to a change in their incomes by buying more or less of a particular good. We can now take a closer look at Normal goods and Inferior goods.

Normal Goods E i > 0, demand increases as income increases Inferior Goods E i < 0, demand decreases as income increases

Income Elasticity of Demand - Insights Helps explain expansion and contraction of industries in the U.S. As income in the USA increase, industries producing products for which demand is quite income-elastic have expanded their level of output. Automobiles – E i = +3 Housing – E i = +1.5 During recessions incomes fall. HEB typically does better than Best Buy. Why?

Price Elasticity of Demand elastic demand inelastic demand unit elasticity perfectly inelastic demand perfectly elastic demand total revenue (TR) total-revenue test Price Elasticity of Supply market period short run long run cross elasticity of demand income elasticity of demand