© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Fernando & Yvonn Quijano Prepared by: Chapter 6 Elasticity: The Responsiveness of Demand and Supply

2 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Do People Care about the Prices of Books? 6.1Define the price elasticity of demand and understand how to measure it. 6.2Understand the determinants of the price elasticity of demand. 6.3Understand the relationship between the price elasticity of demand and total revenue. 6..4Define the cross-price elasticity of demand and the income elasticity of demand, and understand their determinants and how they are measured. 6.5Use price elasticity and income elasticity to analyze economic issues. 6.6Define the price elasticity of supply and understand its main determinants and how it is measured. Learning Objectives In 2006, U.S. consumers spent almost $54 billion to buy 3.2 billion copies of new printed books.

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 3 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Elasticity: The Responsiveness of Demand and Supply Elasticity A measure of how much one economic variable responds to changes in another economic variable.

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 4 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Price elasticity of demand The responsiveness of the quantity demanded to a change in price, measured by dividing the percentage change in the quantity demanded of a product by the percentage change in the product’s price. 4.1 The Price Elasticity of Demand and Its Measurement Learning Objective 6.1 Measuring the Price Elasticity of Demand

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 5 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Elastic demand Demand is elastic when the percentage change in quantity demanded is greater than the percentage change in price, so the price elasticity is greater than 1 in absolute value. The Price Elasticity of Demand and Its Measurement Learning Objective 6.1 Inelastic demand Demand is inelastic when the percentage change in quantity demanded is less than the percentage change in price, so the price elasticity is less than 1 in absolute value. Elastic Demand and Inelastic Demand Unit-elastic demand Demand is unit-elastic when the percentage change in quantity demanded is equal to the percentage change in price, so the price elasticity is equal to 1 in absolute value.

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 6 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Price Elasticity of Demand and Its Measurement Learning Objective 6.1 An Example of Computing Price Elasticities FIGURE 6-1 Elastic and Inelastic Demand Curves

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 7 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Price Elasticity of Demand and Its Measurement Learning Objective 6.1 The Midpoint Formula Price elasticity of demand = Ed Between A & B on D1 = -(12/10)x((50/44) = >1 Ed Between A & C on D2 = -(4/10)x(50/36) = <1 = [(Q2-Q1)/(P2-P1)]x[(P1+P2)/(Q1+Q2)]

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 8 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Solved Problem 6-1 Calculating the Price Elasticity of Demand Learning Objective 6.1

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 9 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Solved Problem: 6-1 Data For Demand Curves: Points A & B On D1Points A & C On D2 PQPQ 3540 (A)3540 (A) 2580 (B)2550 (C) Ed = [(Q2-Q1)/(P2-P1)]x[(P1+P2)/(Q1+Q2)] Ed Between A & B on D1 = -(40/10)x((60/120) = >1 Ed Between A & C on D2 = -(10/10)x(60/90) = <1

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 10 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Price Elasticity of Demand and Its Measurement Learning Objective 6.1 When Demand Curves Intersect, the Flatter Curve Is More Elastic Polar Cases of Perfectly Elastic and Perfectly Inelastic Demand Perfectly inelastic demand The case where the quantity demanded is completely unresponsive to price, and the price elasticity of demand equals zero. Perfectly elastic demand The case where the quantity demanded is infinitely responsive to price, and the price elasticity of demand equals infinity.

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 11 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Summary of the Price Elasticities of Demand Learning Objective 6.1 Ed in Panel A = -(0.55/0.40) >1; Ed in Panel B = -(0.22/0.40) <1; Ed in Panel C = -(0.40/0.40) = 1

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 12 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Extreme Cases of Price Elasticities of Demand Learning Objective 6.1 Table 6-1 Summary of the Price Elasticities of Demand Ed in Panel A = Infinity; Ed in Panel B = 0

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 13 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Price Elasticity of Demand and Its Measurement Learning Objective 6.1 Don’t Let This Happen to YOU! Don’t Confuse Inelastic with Perfectly Inelastic

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 14 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Determinants of the Price Elasticity of Demand Learning Objective 6.2 Availability of Close Substitutes Passage of Time Luxuries versus Necessities Addictions or Habits Definition of the Market Share of a Good in a Consumer’s Budget The key determinants of the price elasticity of demand are as follows: Is the Demand for Books Perfectly Inelastic?

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 15 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 6.2 CEREAL PRICE ELASTICITY OF DEMAND Post Raisin Bran-2.5 All family breakfast cereals-1.8 All types of breakfast cereals-0.9 The Price Elasticity of Demand for Breakfast Cereal Making the Connection What happens when the price of raisin bran increases?

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 16 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Relationship between Price Elasticity of Demand and Total Revenue Learning Objective 6.3 Total revenue The total amount of funds received by a seller of a good or service, calculated by multiplying price per unit by the number of units sold.

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 17 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Relationship between Price Elasticity of Demand and Total Revenue Learning Objective 6.3 Figure 6-2 The Relationship between Price Elasticity and Total Revenue

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 18 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 6.3 Table 6-2 The Relationship between Price Elasticity and Revenue IF DEMAND IS...THEN... BECAUSE... elastic an increase in price reduces revenue the decrease in quantity demanded is proportionally greater than the increase in price. elastic a decrease in price increases revenue the increase in quantity demanded is proportionally greater than the decrease in price. inelastic an increase in price increases revenue the decrease in quantity demanded is proportionally smaller than the increase in price. inelastic a decrease in price reduces revenue the increase in quantity demanded is proportionally smaller than the decrease in price. unit-elastic an increase in price does not affect revenue the decrease in quantity demanded is proportionally the same as the increase in price. unit-elastic a decrease in price does not affect revenue the increase in quantity demanded is proportionally the same as the decrease in price. The Relationship between Price Elasticity of Demand and Total Revenue

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 19 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 6.3 Elasticity and Revenue with a Linear Demand Curve The Relationship between Price Elasticity of Demand and Total Revenue Figure 6-3 Elasticity Is Not Constant Along a Linear Demand Curve

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 20 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Solved Problem 6-3 Price and Revenue Don’t Always Move in the Same Direction Learning Objective 6.3 Briefly explain whether you agree or disagree with the following statement: “The only way to increase the revenue from selling a product is to increase the product’s price.”

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 21 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 6.3 Estimating Price Elasticity of Demand The Relationship between Price Elasticity of Demand and Total Revenue To estimate the price elasticity of demand, economists need to know the demand curve for a product. To calculate the price elasticity of demand for new products, firms often rely on market experiments. With market experiments, firms try different prices and observe the change in quantity demanded that results.

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 22 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 6.3 Determining the Price Elasticity of Demand for DVDs by Market Experiment Making the Connection FILMDVD PRICEVHS PRICE Rugrats in Paris$22.46$22.99 The Mummy Returns Miss Congeniality The Perfect Storm When DVDs were first introduced, the movie studios were uncertain about their price elasticity of demand.

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 23 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Cross-price elasticity of demand The percentage change in quantity demanded of one good divided by the percentage change in the price of another good. Other Demand Elasticities Learning Objective 6.4 Cross-Price Elasticity of Demand

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 24 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Other Demand Elasticities Cross-Price Elasticity of Demand Learning Objective 6.4 IF THE PRODUCTS ARE... THEN THE CROSS-PRICE ELASTICITY OF DEMAND WILL BE. … EXAMPLE substitutespositive Two brands of digital music players complementsnegativeDigital music players and song downloads from online music stores unrelatedzero Digital music players and peanut butter Table 6-3 Summary of Cross-Price Elasticity of Demand

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 25 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Other Demand Elasticities Income Elasticity of Demand Learning Objective 6.4 Income elasticity of demand A measure of the responsiveness of quantity demanded to changes in income, measured by the percentage change in quantity demanded divided by the percentage change in income.

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 26 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Other Demand Elasticities Income Elasticity of Demand Learning Objective 6.4 IF THE INCOME ELASTICITY OF DEMAND IS...THEN THE GOOD IS... EXAMPLE positive, but less than 1normal and a necessity Milk positive and greater than 1normal and a luxuryCaviar negativeinferior High-fat Meat Table 6-4 Summary of Income Elasticity of Demand

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 27 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 6.4 Price Elasticity, Cross-Price Elasticity, and Income Elasticity in the Market for Alcoholic Beverages Making the Connection Price elasticity of demand for beer-0.23 Cross-price elasticity of demand between beer and wine0.31 Cross-price elasticity of demand between beer and spirits0.15 Income elasticity of demand for beer-0.09 Income elasticity of demand for wine5.03 Income elasticity of demand for spirits1.21

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 28 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Using Elasticity to Analyze the Disappearing Family Farm Learning Objective 6.5 Figure 6-4 Elasticity and the Disappearing Farm

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 29 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Solved Problem 6-5 Using Price Elasticity to Analyze Policy toward Illegal Drugs Learning Objective 6.5 Verify that the percentage change in quantity demanded is 1.9%.

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 30 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Price Elasticity of Supply and Its Measurement Measuring the Price Elasticity of Supply Learning Objective 6.6 Price elasticity of supply The responsiveness of the quantity supplied to a change in price, measured by dividing the percentage change in the quantity supplied of a product by the percentage change in the product’s price.

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 31 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Price Elasticity of Supply and Its Measurement Determinants of the Price Elasticity of Supply Learning Objective 6.6 Whether supply is elastic or inelastic depends on the ability and willingness of firms to alter the quantity they produce as price increases. Often, firms have difficulty increasing the quantity of the product they supply during any short period of time.

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 32 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 6.6 Why Are Oil Prices So Unstable? Making the Connection

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 33 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Price Elasticity of Supply and Its Measurement Polar Cases of Perfectly Elastic and Perfectly Inelastic Supply Learning Objective 6.6 Table 6-5 Summary of the Price Elasticities of Supply

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 34 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Price Elasticity of Supply and Its Measurement Polar Cases of Perfectly Elastic and Perfectly Inelastic Supply Learning Objective 6.6 Table 6-5 Summary of the Price Elasticities of Supply (continued)

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 35 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Price Elasticity of Supply and Its Measurement Using Price Elasticity of Supply to Predict Changes in Price Learning Objective 6.6 Figure 6-5 Changes in Price Depend on the Price Elasticity of Supply

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 36 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Price Elasticity of Supply and Its Measurement Using Price Elasticity of Supply to Predict Changes in Price Learning Objective 6.6 Table 6-6 Summary of Elasticities

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 37 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Price Elasticity of Supply and Its Measurement Using Price Elasticity of Supply to Predict Changes in Price Learning Objective 6.6 Table 6-6 Summary of Elasticities (continued)

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 38 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Price Elasticity of Supply and Its Measurement Using Price Elasticity of Supply to Predict Changes in Price Learning Objective 6.6 Table 6-6 Summary of Elasticities (continued)

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 39 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Price Elasticity of Supply and Its Measurement Using Price Elasticity of Supply to Predict Changes in Price Learning Objective 6.6 Table 6-6 Summary of Elasticities (continued)

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 40 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. An Inside LOOK Borders Changes Its Rewards Program Borders Slashes Buyer Rewards, Cuts Discounts

Chapter 6: Elasticity: The Responsiveness of Demand and Supply 41 of 40 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Cross-price elasticity of demand Elastic demand Elasticity Income elasticity of demand Inelastic demand Perfectly elastic demand Perfectly inelastic demand Price elasticity of demand Price elasticity of supply Total revenue Unit-elastic demand K e y T e r m s