ECONOMICS Elasticity

Learning Objectives Define and calculate the price elasticity of demand Use a total revenue test and an expenditure test to estimate the price elasticity of demand Explain the factors that influence the price elasticity of demand

Learning Objectives (cont.) Define and calculate the cross elasticity of demand Define and calculate the income elasticity of demand Define and calculate the elasticity of supply

Learning Objectives Define and calculate the price elasticity of demand Use a total revenue test and an expenditure test to estimate the price elasticity of demand Explain the factors that influence the price elasticity of demand

The Price Elasticity of Demand You know that when supply increases, the equilibrium price falls and the equilibrium quantity increases. But does the price fall by a large amount and the quantity increase by a little? Or does the price barely fall and the quantity increase by a large amount?

The Price Elasticity of Demand The price elasticity of demand is a units- free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buyers’ plans remain the same.

How a Change in Supply Changes Price and Quantity 40.00 S0 S1 An increase in supply brings ... 30.00 … a large fall in price... Large price change and small quantity change Price (dollars per pizza) 20.00 10.00 … and a small increase in quantity... 5.00 Da 5 10 13 15 20 25 Quantity (pizza per hour)

How a Change in Supply Changes Price and Quantity An increase in supply brings ... 40.00 S0 S1 30.00 … a small fall in price... Price (dollars per pizza) Small price change and large quantity change 20.00 15.00 Db 10.00 … and a large increase in quantity... 5 10 15 17 20 25 Quantity (pizza per hour)

The Price Elasticity of Demand Calculating Elasticity Percent change in quantity demanded Price elasticity of demand = Percent change in price Express the changes in price and quantity demanded as percentages of the average price and the average quantity.

The Price Elasticity of Demand Calculating Elasticity (cont.) The original price is $20.50 and the new price is $19.50, so the average price is $20. The $1.00 price decrease is 5 percent of the average price. P/Pavg = ($1/$20) x 100 = 5%

The Price Elasticity of Demand Calculating Elasticity (cont.) The original quantity demanded is 9 pizzas and the new quantity demanded is 11 pizzas. The 2 pizza increase in the quantity demanded is 20 percent of the average quantity. Q/Qavg = (2/10) x 100 = 20%

The Price Elasticity of Demand Calculating Elasticity (cont.) Price elasticity of demand 20% = = 4 5%

Calculating the Elasticity of Demand Original point 20.50 = $1 Elasticity = 4 Price (dollars per pizza) 20.00 Pavg = $20 New point 19.50 = 2 D Qavg = 10 9 10 11 Quantity (pizza per hour)

The Price Elasticity of Demand Average Price and Quantity We use the average price and average quantity to avoid having two values for the elasticity of demand at a single point on the demand curve, depending whether the price falls or rises.

The Price Elasticity of Demand Percentages and Proportions Elasticity is the ratio of the percentage change in the quantity demanded to the percentage change in the price. Equivalently, the proportionate change in the quantity demanded divided by the proportionate change in price.

The Price Elasticity of Demand A Units-Free Measure Elasticity is a units-free measure because the percentage change in each variable is independent of the units in which the variable is measured. And the ratio of the two percentages is a number without units.

The Price Elasticity of Demand Minus Sign and Elasticity The price elasticity of demand is a negative number. But, it is the magnitude, or absolute value, of the price elasticity of demand that tells us how elastic demand is. We use the magnitude and ignore the minus sign.

The Price Elasticity of Demand Inelastic and Elastic Demand Perfectly inelastic demand Implies that quantity demanded remains constant when price changes occur. Price elasticity of demand = 0

The Price Elasticity of Demand Inelastic and Elastic Demand (cont.) Unit elastic demand Implies that the percentage change in quantity demanded equals the percentage change in price. Price elasticity of demand = 1

Inelastic and Elastic Demand Inelastic and Elastic Demand (cont.) Perfectly elastic demand Implies that if price changes by any percentage, quantity demanded will fall to 0. Price elasticity of demand =

Inelastic and Elastic Demand Inelastic and Elastic Demand (cont.) Inelastic demand Implies the percentage change in quantity demanded is less than the percentage change in price. Price elasticity of demand > 0 and < 1.

Inelastic and Elastic Demand Inelastic and Elastic Demand (cont.) Elastic demand Implies the percentage change in quantity demanded is greater than the percentage change in price. Price elasticity of demand > 1.

Inelastic and Elastic Demand Perfectly inelastic demand D1 Price Elasticity = 0 12 6 Quantity

Inelastic and Elastic Demand Unit elastic demand Price Elasticity = 1 12 6 D2 1 2 3 Quantity

Inelastic and Elastic Demand Perfectly elastic demand Price Elasticity = 12 D3 6 Quantity

Inelastic and Elastic Demand Elasticity Along a Straight-Line Demand Curve Along a straight-line demand curve, the elasticity varies. At high prices and small quantities, the elasticity is large and at low prices and large quantities, the elasticity is small.

Elasticity Along a Straight-Line Demand Curve 25.00 Elasticity = 4 Elastic 20.00 Elasticity = 1 Price (dollars per pizza) 15.00 12.50 Inelastic 10.00 Elasticity = 1/4 5.00 0 10 20 25 30 40 50 Quantity (pizza per hour)

Learning Objectives Define and calculate the price elasticity of demand Use a total revenue test and an expenditure test to estimate the price elasticity of demand Explain the factors that influence the price elasticity of demand

Total Revenue and Elasticity When a price changes, the change in producers’ total revenue depends on the elasticity of demand.

Total Revenue and Elasticity Elastic demand: a 1 percent price cut increases the quantity sold by more than 1 percent and total revenue increases. Unit elastic demand: a 1 percent price cut increases the quantity sold by 1 percent and so total revenue does not change. Inelastic demand: a 1 percent price cut increases the quantity sold by less than 1 percent and total revenue decreases.

Total Revenue and Elasticity Total Revenue Test Price elasticity of demand can be estimated by observing the change in total revenue that results from a price change (ceteris paribus).

Total Revenue and Elasticity Total Revenue Test If a price cut increases total revenue, demand is elastic. If a price cut decreases total revenue, demand is inelastic. If a price cut leaves total revenue unchanged, demand is unit elastic.

0 25 50 25.00 Elastic demand 20.00 15.00 Unit elastic Price (dollars per pizza) 12.50 10.00 Inelastic demand 5.00 25 50 350.00 312.50 Maximum total revenue 300.00 250.00 When demand is inelastic, price cut decreases total revenue When demand is elastic, price cut increases total revenue Total Revenue (billions of dollars) 200.00 150.00 100.00 50.00 Quantity (pizza per hour) 0 25 50

Total Revenue and Elasticity Your Expenditure and Your Elasticity If your demand is elastic, a 1 percent price cut increases the quantity you buy by more than 1 percent and your expenditure on the item increases.

Total Revenue and Elasticity Your Expenditure and Your Elasticity (cont.) If your demand is unit elastic, a 1 percent price cut increases your quantity bought by 1 percent and so your expenditure on the item does not change.

Total Revenue and Elasticity Your Expenditure and your Elasticity (cont.) If your demand is inelastic, a 1 percent price cut increases your quantity bought by less than 1 percent and so your expenditure on the item decreases.

Some Real-World Price Elasticities of Demand Good or Service Elasticity Elastic Demand Metals 1.52 Electrical engineering products 1.30 Mechanical engineering products 1.30 Furniture 1.26 Motor vehicles 1.14 Instrument engineering products 1.10 Professional services 1.09 Transportation services 1.03 Inelastic Demand Gas, electricity, and water 0.92 Oil 0.91 Chemicals 0.89 Beverages (all types) 0.78 Clothing 0.64 Tobacco 0.61 Banking and insurance services 0.56 Housing services 0.55 Agricultural and fish products 0.42 Books, magazines, and newspapers 0.34 Food 0.12

Learning Objectives Define and calculate the price elasticity of demand Use a total revenue test and an expenditure test to estimate the price elasticity of demand Explain the factors that influence the price elasticity of demand

Factors That Influence Elasticity the Elasticity of Demand Closeness of Substitutes. The closer the substitutes, the more elastic the demand. necessities luxuries Instructor Notes: The next slide will illustrate the relationship between income and price elasticity of demand.

Factors That Influence Elasticity the Elasticity of Demand Proportion of Income Spent on the Good The greater the proportion of income spent on food, the more elastic the demand. Time Elapsed Since Price Change The longer the time, the more elastic the demand. Short-run demand Long-run demand Instructor Notes: The next slide will illustrate the relationship between income and price elasticity of demand.

Price Elasticities in 20 Countries

Learning Objectives Define and calculate the cross elasticity of demand Define and calculate the income elasticity of demand Define and calculate the elasticity of supply

More Elasticities of Demand Cross elasticity of demand Measures the responsiveness of the demand for a good to a change in the price of a substitute or complement good. Cross elasticity of demand = Percentage change in quantity demanded Percentage change in price of a substitute or complement

Cross Elasticity of Demand Price of soda, a complement, falls. Negative cross elasticity. Price of pizzas D1 Price of a burger, a substitute, falls. Positive cross elasticity. D0 Quantity of pizzas

Learning Objectives Define and calculate the cross elasticity of demand Define and calculate the income elasticity of demand Define and calculate the elasticity of supply

Income Elasticity of Demand Measures the responsiveness of the demand to a change in income. Income elasticity of demand = Percentage change in quantity demanded Percentage change in income

Income Elasticity of Demand Income elasticity can be: ) Greater than 1 (normal good, income elastic) ) Between zero and 1 (normal good, income inelastic) ) Less than zero (inferior good)

Income Elasticity of Demand Elasticity greater than 1 Elasticity between zero and 1 Elasticity less than 1 and becomes negative Income inelastic Income elastic Quantity demanded Quantity demanded Quantity demanded m Positive income elasticity Negative income elasticity Income Income Income Income

Some Real-World Income Elasticities of Demand Elastic Demand Airline Travel 5.82 Movies 3.41 Foreign Travel 3.08 Electricity 1.94 Restaurant meals 1.61 Local buses and trains 1.38 Haircutting 1.36 Cars 1.07 Inelastic Demand Tobacco 0.86 Alcoholic beverages 0.62 Furniture 0.53 Clothing 0.51 Newspapers and magazines 0.38 Telephone 0.32 Food 0.14

Income Elasticities in 15 Countries

Learning Objectives Define and calculate the cross elasticity of demand Define and calculate the income elasticity of demand Define and calculate the elasticity of supply

Elasticity of Supply Elasticity of supply measures the responsiveness of quantity supplied to a change in price. Percentage change in quantity supplied Elasticity of supply = Percentage change in price

How a Change in Demand Changes Price and Quantity An increase in demand brings ... 40.00 Sa D1 Large price change and small quantity change 30.00 Price (dollars per pizza) 20.00 … a large price rise... 10.00 … and a small quantity increase... D0 5 10 13 15 20 25 Quantity (pizza per hour)

How a Change in Demand Changes Price and Quantity An increase in demand brings ... D1 40.00 Small price change and large quantity change 30.00 Price (dollars per pizza) Sb 21.00 20.00 … a small price rise... 10.00 … and a large quantity increase... D0 5 10 15 20 25 Quantity (pizza per hour)

Elasticity of Supply Supply elasticity depends on: Resource substitution possibilities Time frame for the supply decision

Inelastic and Elastic Demand Perfectly inelastic supply S1 Price Elasticity of supply = 0 Quantity

Inelastic and Elastic Demand Unit elastic supply S1 Price Elasticity of supply = 1 Quantity

Inelastic and Elastic Demand Perfectly elastic supply Price Elasticity of supply = S3 Quantity

Elasticity of Supply Resource Substitution Possibilities The more unique the resource, the more inelastic the supply. Van Gogh painting - Van Gogh Wheat/corn — farmland

Elasticity of Supply Time Frame for Supply Decisions Momentary supply Long-run supply Short-run supply The longer producers have to adjust to a price change, the more elastic is supply.

A Compact Glossary of Elasticities PRICE ELASTICITIES OF DEMAND A relationship is described as Which means that When its magnitude is Perfectly elastic or infinitely elastic Infinity The smallest possible increase in price causes an infinitely large decrease in quantity demanded Elastic Less than infinity but greater than 1 The percent decrease in the quantity demanded exceeds the percent increase in price Unit elastic 1 The percent decrease in the quantity demanded equals the percent increase in price In elastic Greater than zero but less than 1 The percentage decrease in the quantity demanded is less than the percent increase in price. Perfectly inelastic or completely inelastic Zero The quantity demanded is the same at all prices

A Compact Glossary of Elasticities CROSS ELASTICITIES OF DEMAND A relationship is described as When its magnitude is Which means that Perfect substitutes Infinity The smallest possible increase in price of one good causes an infinitely large in the demand of the other good. Substitutes Positive, less than infinity If the price of one good increases, the quantity demanded of the other good also increases. Independent Zero The demand for one good remains constant, regardless of the price of the other good. Complements Less than zero The demand for one good decreases when the price of the other good increases.

A Compact Glossary of Elasticities INCOME ELASTICITIES OF DEMAND A relationship is described as When its magnitude is Which means that Income elastic (normal good) Greater than 1 The percent increase in the quantity demanded is greater than the percentage increase in income. Income inelastic (normal good) Less than 1 but greater than zero The percent increase in the quantity demanded is less than the percentage increase in income. Negative income elastic (inferior good) Less than zero When income increases, quantity demanded decreases.

A Compact Glossary of Elasticities ELASTICITIES OF SUPPLY A relationship is described as When its magnitude is Which means that Perfectly elastic Infinity The smallest possible increase in price causes an infinitely large increase in the quantity supplied. Elastic Less than infinity but greater than 1 The percent increase in the quantity supplied exceeds the percentage increase in the price. Inelastic Greater than zero but less than 1 The percentage increase in the quantity supplied is less than the percentage increase in price. Perfectly inelastic Zero The quantity supplied is the same at all prices.