1 Chapter 4 Elasticity 5/15/2015 © ©1999 South-Western College Publishing

2 What is Elasticity? A term economists use to describe sensitivity © ©1999 South-Western College Publishing

3 The percentage change in quantity demanded divided by the percentage change in price How do we measure the Price Elasticity of Demand? © ©1999 South-Western College Publishing

4 Price Elasticity of Demand E d = % change in Q % change 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 elasticity E d > 1 Elastic demand E d < 1 Inelastic demand

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

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

9 Very horizontal When consumers are very sensitive to a price change what does the demand curve look like? © ©1999 South-Western College Publishing

10 Very vertical When consumers are less sensitive to a price change what does the demand curve look like? © ©1999 South-Western College Publishing

11 Problem - When we move along a demand curve between two points, we get different answers to elasticity depending if we are moving up or down the demand curve © ©1999 South-Western College Publishing

12 If there is an increase from 3 units to 5, what is the percentage increase? If there is an increase from 3 units to 5, what is the percentage increase? 2/3 = 66% © ©1999 South-Western College Publishing

13 If there is a decrease from 5 units to 3, what is the percentage decrease? 2/5 = 40% © ©1999 South-Western College Publishing

14 If we go from 3 to 5, the percentage change is 2/3, but if we go from 5 to 3, the percentage change is 2/5, so the elasticities are different © ©1999 South-Western College Publishing

15 The answer to this problem is to work with averages... © ©1999 South-Western College Publishing

16 Price elasticity equals the change in quantity demanded sum of quantities/2 divided by change in price sum of prices/2 © ©1999 South-Western College Publishing 16

17 Quantity Price Bananas Oranges $20 $18 $40 $70 © ©1999 South-Western College Publishing 17

18 What is the Price Elasticity of Demand for bananas? X 19 2 = = = 1.727

19 What is the Price Elasticity of Demand for oranges? X = = 6,600 10,200 =.647

20 Practice: calculating E d You usually buy 4 cd’s per month at a price of $14, but when the price rises to $18, you purchase only 3 per month. What is your elasticity of demand for cd’s over this range of prices?

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

22 more money per unit fewer units are sold When price increases, what two things happen? © ©1999 South-Western College Publishing

23 If total revenue does not change when price increases, the demand curve is unitary elastic, value equals 1 © ©1999 South-Western College Publishing

24 If price increases and the revenue gained is less than the revenue lost, the demand curve is price elastic, > 1 © ©1999 South-Western College Publishing

25 If price increases and the revenue gained is greater than the revenue lost, the demand curve is price inelastic, < 1 © ©1999 South-Western College Publishing

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

27 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 © ©1999 South-Western College Publishing

28 The more substitutes a good has, the more sensitive consumers are to a price change What do substitutes have to do with sensitivity? © ©1999 South-Western College Publishing

29 A B D D Which demand curve is for spark plugs and which for Coca-Cola? © ©1999 South-Western College Publishing

30 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 with sensitivity? © ©1999 South-Western College Publishing

31 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? © ©1999 South-Western College Publishing

32 The more time to adjust, the more sensitive consumers are to a price change What does time have to do with sensitivity? © ©1999 South-Western College Publishing

33 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? © ©1999 South-Western College Publishing

34 What strategies do Coca- Cola and Pepsi use to make the demand for their products less elastic? © ©1999 South-Western College Publishing

35 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? © ©1999 South-Western College Publishing

36 E c = %  Quantity of X %  Price of Y

37 If negative - complements (steak & steak sauce) If positive - substitutes (butter & margarine) Unrelated goods should have a cross elasticity close to zero

38 The ratio of the percentage change in quantity demanded to the percentage change in income What is Income Elasticity of Demand? © ©1999 South-Western College Publishing

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

40 When does a good face an income elastic demand curve? A 1% change in income generates a greater than 1% change quantity demanded © ©1999 South-Western College Publishing

41 When does a good face an income inelastic demand curve? A 1% change in income generates a less than 1% change quantity demanded © ©1999 South-Western College Publishing

42 Something that people will buy less of as their incomes increase What is an Inferior Good? © ©1999 South-Western College Publishing

43 Something that people will buy more of as their incomes increase What is a Normal Good? © ©1999 South-Western College Publishing

44 What is Price Elasticity of Supply? The ratio of the percentage change in quantity supplied to the percentage change in price © ©1999 South-Western College Publishing

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

46 Extreme cases of E s E s = 0, perfectly inelastic (vertical supply curve E s = , perfectly elastic (horizontal supply curve)

47 Does time effect Supply Elasticities? Yes! The more time, the more elastic the supply curve © ©1999 South-Western College Publishing

48 Applications of Elasticity The farm problem Illegal drugs The volunteer army Tax incidence

49 The Farm Problem Inelastic demand for many farm goods Low income elasticity of demand also

50 D P Q S S1S1 P1P1 P2P2 Q1Q1 Q2Q2 Since farmers face volatile supply, with inelastic demand, % change in Price is greater than % change in quantity, making for more fluctuating of incomes

51 Recall with inelastic demand, lower prices do not increase quantity by the same %, leading to lower revenue, yet costs are higher due to increased quantity, resulting in lower farm profits. Low income elasticity means that farming is not a “growth” industry, as our incomes rise we tend to allocate that income to other goods, not as much to food products.

52 D P Q S S1S1 P1P1 P2P2 Q1Q1 Q2Q2 (legal) (illegal) inelastic

53 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 © ©1999 South-Western College Publishing

54 What factors influence Demand Sensitivity?What factors influence Demand Sensitivity? What is Elasticity? How do we measure the Price Elasticity of Demand?How do we measure the Price Elasticity of Demand? What is Cross Elasticity of Demand?What is Cross Elasticity of Demand? What is Income Elasticity of Demand?What is Income Elasticity of Demand?

55 ENDEND © ©1999 South-Western College Publishing