Principles of Microeconomics 4 and 5 Elasticity* Akos Lada July 24th and July 25th, 2014 * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint

Contents Review Elasticity of Demand Elasticity and Revenue Other Elasticities Elasticity of Supply

1. Review

Equilibrium, surplus and shortage

Comparative statics No change in Supply Increase in Supply Decrease in Supply No Change in Demand P same Q same P down Q up P up Q down Increase in Demand P ambiguous Q ambiguous Decrease in Demand

Three Steps to Analyzing Changes in Equilibrium To determine the effects of any event, 1. Decide whether event shifts S curve, D curve, or both. 2. Decide in which direction curve shifts. 3. Use supply-demand diagram to see how the shift changes equilibrium P and Q. Step one requires knowing all of the things that can shift D and S – the non-price determinants of demand and of supply. 6

EXAMPLE: The Market for Hybrid Cars Q price of hybrid cars S1 D1 P1 Q1 quantity of hybrid cars 7

EXAMPLE 1: A Shift in Demand EVENT TO BE ANALYZED: Increase in price of gas. P Q S1 D2 D1 STEP 1: D curve shifts because price of gas affects demand for hybrids. S curve does not shift, because price of gas does not affect cost of producing hybrids. P2 Q2 STEP 2: D shifts right because high gas price makes hybrids more attractive relative to other cars. P1 Q1 STEP 3: The shift causes an increase in price and quantity of hybrid cars. 8

EXAMPLE 1: A Shift in Demand Notice: When P rises, producers supply a larger quantity of hybrids, even though the S curve has not shifted. P Q S1 D2 D1 P2 P1 Q1 Always be careful to distinguish be a shift in a curve and a movement along the curve. Q2 9

EXAMPLE 2: A Shift in Supply EVENT: New technology reduces cost of producing hybrid cars. P Q S1 S2 D1 STEP 1: S curve shifts because event affects cost of production. D curve does not shift, because production technology is not one of the factors that affect demand. STEP 2: S shifts right because event reduces cost, makes production more profitable at any given price. P1 Q1 P2 Q2 STEP 3: The shift causes price to fall and quantity to rise. 10

EXAMPLE 3: A Shift in Both Supply and Demand EVENTS: price of gas rises AND new technology reduces production costs P Q S1 S2 D2 D1 STEP 1: Both curves shift. P2 Q2 P1 Q1 STEP 2: Both shift to the right. STEP 3: Q rises, but effect on P is ambiguous: If demand increases more than supply, P rises. 11

EXAMPLE 3: A Shift in Both Supply and Demand EVENTS: price of gas rises AND new technology reduces production costs P Q S1 S2 D2 D1 STEP 3, cont. P1 Q1 But if supply increases more than demand, P falls. P2 Q2 12

STUDENTS’ TURN: Shifts in Supply and Demand Use the three-step method to analyze the effects of each event on the equilibrium price and quantity of music downloads. Event A: A fall in the price of CDs Event B: Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. Event C: Events A and B both occur. Important note about Event B: The royalties that sellers must pay the artists are part of sellers’ “costs of production.” Typically, this royalty is a fixed amount each time one of the artist’s songs is downloaded. Event B, therefore, describes a reduction in sellers’ “costs of production.”

The market for music downloads A. Fall in price of CDs The market for music downloads STEPS P Q 1. D curve shifts S1 2. D shifts left D2 D1 P1 Q1 3. P and Q both fall. P2 Q2 This is an extension of Active Learning exercise 1C, where we saw that a fall in the price of compact discs would cause a fall in demand for music downloads, because the two goods are substitutes.

B. Fall in cost of royalties The market for music downloads STEPS P Q 1. S curve shifts S1 S2 (Royalties are part of sellers’ costs) D1 P1 Q1 2. S shifts right Q2 P2 3. P falls, Q rises. NOTE: Don’t worry that the text on this slide looks garbled in “Normal view” (i.e., edit mode). It works fine in “Slide Show” (i.e., presentation mode). Event B: Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. This event causes a fall in “costs of production” for sellers of music downloads. Hence, the S curve shifts to the right.

C. Fall in price of CDs and fall in cost of royalties STEPS 1. Both curves shift (see parts A & B). 2. D shifts left, S shifts right. 3. P unambiguously falls. Effect on Q is ambiguous: The fall in demand reduces Q, the increase in supply increases Q. It’s not necessary to draw a graph here. The answers to steps 1 and 2 should be clear from parts A and B. The answer to step 3 is a combination of the results from A and B.

2. Elasticity of Demand

You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per month. Your costs are rising (including the opportunity cost of your time), so you consider raising the price to $250. The law of demand says that you won’t sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase? A scenario… We will follow this scenario throughout the first section of this chapter (the section on price elasticity of demand) to illustrate and motivate several important concepts, such as the impact of price changes on sales and revenue. 18

Elasticity Basic idea: Elasticity measures how much one variable responds to changes in another variable. One type of elasticity measures how much demand for your websites will fall if you raise your price. Definition: Elasticity is a numerical measure of the responsiveness of Qd or Qs to one of its determinants. Here, Qd and Qs are short for quantity demanded and quantity supplied, as in the PowerPoint for Chapter 4. 19

Price Elasticity of Demand Price elasticity of demand measures how much Qd responds to a change in P. Price elasticity of demand = Percentage change in Qd Percentage change in P Loosely speaking, it measures the price-sensitivity of buyers’ demand. 20

Price Elasticity of Demand Price elasticity of demand = Percentage change in Qd Percentage change in P P Q Example: D P rises by 10% Price elasticity of demand equals P2 Q2 P1 Q1 15% 10% = 1.5 Q falls by 15% 21

Price Elasticity of Demand Price elasticity of demand = Percentage change in Qd Percentage change in P Along a D curve, P and Q move in opposite directions, which would make price elasticity negative. We will drop the minus sign and report all price elasticities as positive numbers. P Q D P2 It might be worth explaining to your students that “P and Q move in opposite directions” means that the percentage change in Q and the percentage change in P will have opposite signs, thus implying a negative price elasticity. To be consistent with the text, the last statement in the green box says that we will report all price elasticities as positive numbers. It might be slightly more accurate to say that we will report all elasticities as non-negative numbers: we want to allow for the (admittedly rare) case of zero elasticity. Q2 P1 Q1 22

Calculating Percentage Changes Standard method of computing the percentage (%) change: Demand for your websites end value – start value start value x 100% P Q $250 8 B D Going from A to B, the % change in P equals $200 12 A ($250–$200)/$200 = 25% 23

Calculating Percentage Changes Problem: The standard method gives different answers depending on where you start. Demand for your websites P Q From A to B, P rises 25%, Q falls 33%, elasticity = 33/25 = 1.33 From B to A, P falls 20%, Q rises 50%, elasticity = 50/20 = 2.50 $250 8 B D $200 12 A 24

Calculating Percentage Changes So, we instead use the midpoint method: end value – start value midpoint x 100% The midpoint is the number halfway between the start & end values, the average of those values. It doesn’t matter which value you use as the “start” and which as the “end” – you get the same answer either way! 25

Calculating Percentage Changes Using the midpoint method, the % change in P equals $250 – $200 $225 x 100% = 22.2% The % change in Q equals 12 – 8 10 x 100% = 40.0% These calculations are based on the example shown a few slides back: points A and B on the website demand curve. The price elasticity of demand equals 40/22.2 = 1.8 26

STUDENTS’ TURN: Calculate an Elasticity Use the following information to calculate the price elasticity of demand for hotel rooms: if P = $70, Qd = 5000 if P = $90, Qd = 3000

Answers Use midpoint method to calculate % change in Qd (5000 – 3000)/4000 = 50% % change in P ($90 – $70)/$80 = 25% The price elasticity of demand equals 50% 25% = 2.0

The Variety of Demand Curves The price elasticity of demand is closely related to the slope of the demand curve. Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity. Five different classifications of D curves.… Economists classify demand curves according to their elasticity. The next 5 slides present the five different classifications, from least to most elastic. 29

“Perfectly inelastic demand” (one extreme case) Price elasticity of demand = % change in Q % change in P 0% = 0 10% D curve: P Q D vertical Q1 P1 Consumers’ price sensitivity: P2 If Q doesn’t change, then the percentage change in Q equals zero, and thus elasticity equals zero. It is hard to think of a good for which the price elasticity of demand is literally zero. Take insulin, for example. A sufficiently large price increase would probably reduce demand for insulin a little, particularly among people with very low incomes and no health insurance. However, if elasticity is very close to zero, then the demand curve is almost vertical. In such cases, the convenience of modeling demand as perfectly inelastic probably outweighs the cost of being slightly inaccurate. none P falls by 10% Elasticity: Q changes by 0% 30

Price elasticity of demand “Inelastic demand” Price elasticity of demand = % change in Q % change in P < 10% < 1 10% D D curve: P Q relatively steep Q1 P1 Consumers’ price sensitivity: P2 Q2 relatively low An example: Student demand for textbooks that their professors have required for their courses. Here, it’s a little more clear that elasticity would be small, but not zero. At a high enough price, some students will not buy their books, but instead will share with a friend, or try to find them in the library, or just take copious notes in class. Another example: Gasoline in the short run. P falls by 10% Elasticity: < 1 Q rises less than 10% 31

Price elasticity of demand “Unit elastic demand” Price elasticity of demand = % change in Q % change in P 10% = 1 10% D D curve: P Q intermediate slope Q1 P1 Consumers’ price sensitivity: P2 Q2 intermediate This is the intermediate case: the demand curve is neither relatively steep nor relatively flat. Buyers are neither relatively price-sensitive nor relatively insensitive to price. (This is also the case where price changes have no effect on revenue.) P falls by 10% Elasticity: 1 Q rises by 10% 32

Price elasticity of demand “Elastic demand” Price elasticity of demand = % change in Q % change in P > 10% > 1 10% D D curve: P Q relatively flat Q1 P1 Consumers’ price sensitivity: P2 Q2 relatively high A good example here would be breakfast cereal, or nearly anything with readily available substitutes. An elastic demand curve is flatter than a unit elastic demand curve (which itself is flatter than an inelastic demand curve). P falls by 10% Elasticity: > 1 Q rises more than 10% 33

“Perfectly elastic demand” (the other extreme) Price elasticity of demand = % change in Q % change in P any % = infinity 0% D curve: P Q horizontal P2 = P1 D Consumers’ price sensitivity: Q1 Q2 “Extreme price sensitivity” means the tiniest price increase causes demand to fall to zero. “Q changes by any %” – when the D curve is horizontal, quantity cannot be determined from price. Consumers might demand Q1 units one month, Q2 units another month, and some other quantity later. Q can change by any amount, but P always “changes by 0%” (i.e., doesn’t change). If perfectly inelastic is one extreme, this case (perfectly elastic) is the other. Here’s a good real-world example of a perfectly elastic demand curve, which foreshadows an upcoming chapter on firms in competitive markets. Suppose you run a small family farm in Iowa. Your main crop is wheat. The demand curve in this market is downward-sloping, and the market demand and supply curves determine the price of wheat. Suppose that price is $5/bushel. Now consider the demand curve facing you, the individual wheat farmer. If you charge a price of $5, you can sell as much or as little as you want. If you charge a price even just a little higher than $5, demand for YOUR wheat will fall to zero: Buyers would not be willing to pay you more than $5 when they could get the same wheat elsewhere for $5. Similarly, if you drop your price below $5, then demand for YOUR wheat will become enormous (not literally infinite, but “almost infinite”): if other wheat farmers are charging $5 and you charge less, then EVERY buyer will want to buy wheat from you. Why is the demand curve facing an individual producer perfectly elastic? Recall that elasticity is greater when lots of close substitutes are available. In this case, you are selling a product that has many perfect substitutes: the wheat sold by every other farmer is a perfect substitute for the wheat you sell. extreme P changes by 0% Elasticity: infinity Q changes by any % 34

3. Elasticity and Revenue

Effect of price increase on revenue Revenue = P x Q A price increase has two effects on revenue: Higher P means more revenue on each unit you sell. But you sell fewer units (lower Q), due to Law of Demand. Which of these two effects is bigger? It depends on the price elasticity of demand. We return to our scenario. It’s not hard for students to imagine being in this position – running their own business and trying to decide whether to raise the price. To most of your students, it should be clear that making the best possible decision would require information about the likely effects of the price increase on revenue. That is why elasticity is so helpful, as we will now see…. 36

Price Elasticity and Total Revenue Price elasticity of demand = Percentage change in Q Percentage change in P Revenue = P x Q If demand is elastic, then price elast. of demand > 1 % change in Q > % change in P The fall in revenue from lower Q is greater than the increase in revenue from higher P, so revenue falls. If demand is inelastic, then price elast. of demand < 1 % change in Q < % change in P The fall in revenue from lower Q is smaller than the increase in revenue from higher P, so revenue rises. 37

4. Other elasticities of demand

Income elasticity of demand Measures the response of Qd to a change in consumer income Income elasticity of demand = Percent change in Qd Percent change in income Recall : An increase in income causes an increase in demand for a normal good. Hence, for normal goods, income elasticity > 0. For inferior goods, income elasticity < 0. This topic and the next one (cross-price elasticity) do not appear anywhere else in the book. Instructors who are pressed for time may consider cutting these topics. (This is merely my suggestion, not the official position of Greg Mankiw or Cengage/South-Western.) 39

Cross-price elasticity of demand Measures the response of demand for one good to changes in the price of another good Cross-price elast. of demand = % change in Qd for good 1 % change in price of good 2 For substitutes, cross-price elasticity > 0 (e.g., an increase in price of beef causes an increase in demand for chicken) For complements, cross-price elasticity < 0 (e.g., an increase in price of computers causes decrease in demand for software) 40

STUDENTS’ TURN: Calculate other elasticities of demand Refer to Questions 2 and 3 of the market demand experiments Remember that you can calculate percentage changes using Or… end value – start value midpoint x 100% The formulas for income elasticity of demand and cross-price elasticity of demand are on your handout! end value – start value end value + start value x 100% 2

5. Elasticity of Supply

Price Elasticity of Supply Price elasticity of supply = Percentage change in Qs Percentage change in P P Q Example: S P rises by 8% Price elasticity of supply equals P2 Q2 Q1 P1 16% 8% = 2.0 Q rises by 16% 43

Different types of Supply Curves The slope of the supply curve is closely related to price elasticity of supply. Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity. Five different classifications.… Economists classify supply curves according to their elasticity. The next 5 slides present the different classifications, from least to most elastic. 44

“Perfectly inelastic” (one extreme) Price elasticity of supply = % change in Q % change in P 0% = 0 10% S curve: P Q S vertical P2 Sellers’ price sensitivity: P1 none P rises by 10% Elasticity: Q1 Q changes by 0% 45

Price elasticity of supply “Inelastic” Price elasticity of supply = % change in Q % change in P < 10% S < 1 10% S curve: P Q relatively steep P2 Sellers’ price sensitivity: Q2 P1 relatively low P rises by 10% Elasticity: Q1 < 1 Q rises less than 10% 46

Price elasticity of supply “Unit elastic” Price elasticity of supply = % change in Q % change in P 10% = 1 10% S curve: P Q S intermediate slope P2 Sellers’ price sensitivity: Q2 P1 intermediate P rises by 10% Elasticity: Q1 = 1 Q rises by 10% 47

Price elasticity of supply Price elasticity of supply = % change in Q % change in P > 10% > 1 10% S S curve: P Q relatively flat P2 Sellers’ price sensitivity: Q2 P1 relatively high P rises by 10% Elasticity: Q1 > 1 Q rises more than 10% 48

“Perfectly elastic” (the other extreme) Price elasticity of supply = % change in Q % change in P any % = infinity 0% S curve: P Q horizontal P2 = P1 S Sellers’ price sensitivity: Q1 Q2 extreme P changes by 0% Elasticity: infinity Q changes by any % 49

The Determinants of Supply Elasticity The more easily sellers can change the quantity they produce, the greater the price elasticity of supply. Example: Supply of beachfront property is harder to vary and thus less elastic than supply of new cars. For many goods, price elasticity of supply is greater in the long run than in the short run, because firms can build new factories, or new firms may be able to enter the market. This section is not perfectly analogous to the section on the determinants of the price elasticity of demand, but it’s similar enough that you can probably cover it more quickly and with much less hand-holding. 50