Chapter 5 Elasticity You are responsible for reading Chapter 4!!!

What have we done? Chapter 3 gave us downward sloping demand curves –Law of demand Now want to see how Q d changes when price changes

Elasticity Response of one variable to a change in another variable Price elasticity of demand –Measure of the responsiveness of Q d of a product to a change in the price of that product

So… What if E d = 3? –If price was increased from the prevailing point the % change in Q d would be 3 times the change in price Shouldn’t it be negative? –So price increases and Q d decreases? Yes!! –For ease we look at the absolute value, but know that the law of demand holds

Point elasticity Measures the change between two observed points.

example P 1 = 10 P 2 = 12 Q 1 = 100 Q 2 = 50 Elasticity?? Which is Point A??? Big Problem!!!

Problem Answers vary depending on where you start Becomes more important the larger the change

Arc Elasticity To avoid the endpoint problem take elasticity at the midpoint (average) of the two points

Differences With arc elasticity it is clear which points are used P 1 is the first price P 2 is the second price Q d 1 and Q d 2 are the first and second quantity demanded respectively

Price elasticity of demand can yield 5 basic results Numerator > Denominator Numerator < Denominator Numerator = Denominator Numerator = 0 Denominator = 0 Each has a specific name and result

Elastic Demand Ed > 1 % change in quantity demanded > % change in price FLATTER CURVE What are some examples of an elastic good???

Inelastic Demand E d <1 % change in the price > percent change in quantity demanded STEEPER CURVE What are some examples of an inelastic good?

Price Elasticity of Demand

Unit Elastic Demand E d =1 % change in price = % change in quantity demanded Change in price brings a proportionate change in quantity demanded CURVE

Price Elasticity of Demand

Perfectly Elastic Demand Ed = (denominator = 0) % change in quantity demanded is A LOT in response to a change in price Price increases and quantity demanded goes to 0 Totally flat --- horizontal Extreme Examples???

Perfectly inelastic demand E d = 0 % change in quantity demanded DOESN’T CHANGE in response to a change in price Totally steep --- vertical Extreme Examples???

Price Elasticity of Demand

Aren’t demand curve downward sloping? Because the extremes (perfectly inelastic and perfectly elastic) are not. Use as points of reference only

How does a change in price affect Total Revenue of a Firm? Revenue depends on elasticity Michael Jordan and Nike shoes –No substitutes -- inelastic demand What happens to Qd if price increases? –Substitutes – elastic demand What happens to Qd if price increases?

What is total revenue?? Total revenue = price*quantity Firm uses to decide if to produce more or less

examples Elastic demand –Price increase –Price decrease Inelastic demand –Price increase –Price decrease Unit elastic demand –Price increase –Price decrease

Elasticities, Price Changes, and Total Revenue

Important to look at because… Elasticity of the demand determines if with a price increase… –Total revenue increases –Total revenue decreases –Total revenue remains the same

Price elasticity of demand and a straight line Demand is downward sloping Along the line elasticity varies from highly elastic to highly inelastic But…remember SLOPE is constant

PointPQdQd A83 B74 C65 D56 E47 F38 G29

Price Elasticity of Demand along a Demand Curve

Summary Upper end of Demand Curve –Q d is low and price is high –Freak out more when price is high Lower end of Demand Curve –Q d is high and price is low –Freak out less when price is low

So… As move down the demand curve from higher prices to lower the price elasticity of demand goes from elastic to inelastic

Determinates of price elasticity of demand Number of substitutes available –Increase substitutes increases elasticity –More narrowly defined goods have more substitutes (compared to broadly defined) Example: Fords vs all cars

More determinates Percentage of one’s budget that is spent on the good –More expensive??? More elastic –More affected by price (even small changes)

Final determinate Amount of time that passed since price change –Increase time passed gives more opportunity to change behavior or react to price change –Overtime can look for substitutes –Increase time increases elasticity –More elastic in long term than short

Cross Elasticity of Demand Measures the responsiveness of quantity demanded to a change in price of ANOTHER good

When would you use Cross Price Elasticity? To determine if goods are substitutes or compliments Ec>0 – substitutes –% change in quantity demanded and price move in same direction Ec<0 – compliments –% change in quantity demanded and price move in opposite directions Ec=0 – goods unrelated

Income elasticity of demand Measures the responsiveness of quantity demanded to the change in income

Why use income elasticity of demand? Use to determine if a good is normal or inferior E y >0 – normal good –As income increases Q d increases E y <0 – inferior good –As income increases Q d decreases

Can also say… If |E y | > 1 –% change in Q d > % change in Y –Income elastic If |E y | < 1 –% change in Q d < % change in Y –Income inelastic If |E y | = 1 –% change in Q d = % change in Y –Income unit elastic

Can we use income elasticity in the real world?? If invest in the stock market do you want to invest in a normal or inferior good? Normal Why Increase income would increase quantity bought and increase stock prices

Price Elasticity of Supply Measures the responsiveness of quantity supplied of a good to the change in the price of that good

Classification is like demand Es > 1 –Elastic Es < 1 –Inelastic Es = 1 –Unit elastic Each of these will result in a “normal” upward sloped supply curve

Any extreme elasticities??? Yes!! Es = –Perfectly elastic or horizontal Es = 0 –Perfectly inelastic or vertical

Price Elasticity of Supply

Does time play a role in elasticity of supply? Yes!! Overtime producers are able to adjust their behavior and production patterns Supply becomes more elastic as time passes

Elasticity and taxes If government levies a tax on a product who pays the tax?? Producers?? Consumers?? Share?? Depends on the elasticity of demand and supply

How find?? Find equilibrium price Supply shifts left in the amount of the tax Find new equilibrium Find point of second equilibrium on ORGINAL supply curve –Shows the actual price realized by firm or equilibrium price – tax = point in question Difference between points determines how much of tax you pay

Who Pays the Tax?

Who pays more of the tax?? Perfectly inelastic demand Perfectly elastic demand Demand more elastic than supply Supply more elastic than demand

Different Elasticities and Who Pays the Tax

Summary E d > E s producer bears most of the tax burden E d < E s consumer bears most of the tax burden E d = E s equally share the tax burden

Homework Numbers 5, 6, and 8 Working with Graphs and Numbers 1, 2, and 4

Do we understand Chapter 5??