Elasticityslide 1 ELASTICITY Elasticity is the concept economists use to describe the steepness or flatness of curves or functions. In general, elasticity measures the responsiveness of one variable to changes in another variable.

Elasticityslide 2 PRICE ELASTICITY OF DEMAND Measures the responsiveness of quantity demanded to changes in a good’s own price. The price elasticity of demand is the percent change in quantity demanded divided by the percent change in price that caused the change in quantity demanded.

Elasticityslide 3 FACTS ABOUT ELASTICITY It’s always a ratio of percentage changes. That means it is a pure number -- there are no units of measurement on elasticity. Price elasticity of demand is computed along a demand curve. Elasticity is not the same as slope.

Elasticityslide 4 LOTS OF ELASTICITIES! THERE ARE LOTS OF WAYS TO COMPUTE ELASTICITIES. SO BEWARE! THE DEVIL IS IN THE DETAILS. MOST OF THE AMBIGUITY IS DUE TO THE MANY WAYS YOU CAN COMPUTE A PERCENTAGE CHANGE. BE ALERT HERE. IT’S NOT DIFFICULT, BUT CARE IS NEEDED.

Elasticityslide 5 What’s the percent increase in price here because of the shift in supply? p E = $2 QEQE S D Q price S' p E = $2.50 CIGARETTE MARKET

Elasticityslide 6 IS IT: A) [.5/2.00] times 100? B) [.5/2.50] times 100? C) [.5/2.25] times 100?

Elasticityslide 7 From time to time economists have used ALL of these measures of percentage change -- including the “Something else”! Notice that the numerical values of the percentage change in price is different for each case: Go to hidden slide

Elasticityslide 8 A) [.5/2.00] times 100 = 25 percent B) [.5/2.50] times 100 = 20 percent C) [.5/2.25] times 100 = percent

Elasticityslide 9 Economists usually use the “midpoint” formula (option C), above) to compute elasticity in cases like this in order to eliminate the ambiguity that arises if we don’t know whether price increased or decreased.

Elasticityslide 10 Using the Midpoint Formula Elasticity = % change in p = times 100. % change in p = For the prices $2 and $2.50, the % change in p is approx percent.

Elasticityslide 11 What’s the percent change in Q due to the shift in supply? p E = $2.00 Q E = 10 S D Q (millions) price S' p E ’ = $2.50 CIGARETTE MARKET Q E ’ = 7

Elasticityslide 12 Use the midpoint formula again. Elasticity = % change in Q = For the quantities of 10 and 7, the % change in Q is approx percent. (3/8.5 times 100)

Elasticityslide 13 NOW COMPUTE ELASTICITY % change in p = percent % change in Q = percent E = / = -1.6 (approx.)

Elasticityslide 14 But you can do the other options as well: A) If you use the low price, and its corresponding quantity, as the base values, then elasticity = 1.2 B) If you use the high price, and its corresponding quantity, as the base values, then elasticity = 2.1 (approx.) C) And the midpoint formula gave 1.6 (approx.) SAME PROBLEM...DIFFERENT ANSWERS!!!

Elasticityslide 15 MORE ELASTICITY COMPUTATIONS Q P QUANTITYPRICE Compute elasticity between prices of $9 and $8. Compute elasticity between prices of $9 and $8.

Elasticityslide 16 The % change in Q = The % change in P = Therefore elasticity = USE THE MIDPOINT FORMULA. Go to hidden slide

Elasticityslide 17 The % change in Q = = 1 / 1.5 times 100 The % change in P = = 1 / 8.5 times 100 Therefore elasticity = / = (approx.)

Elasticityslide 18 Q P QUANTITYPRICE So elasticity between these prices is So elasticity between these prices is

Elasticityslide 19 Now we try different prices Q P QUANTITY PRICE Compute elasticity between prices of $3 and $2. Compute elasticity between prices of $3 and $2.

Elasticityslide 20 The % change in Q = The % change in P = Therefore elasticity = Go to hidden slide

Elasticityslide 21 The % change in Q = = 1 / 7.5 times 100 The % change in P = 40 = 1 / 2.5 times 100 Therefore elasticity = / 40 = -.33 (approx.)

Elasticityslide 22 Q P QUANTITYPRICE So elasticity between these prices is So elasticity between these prices is -.33.

Elasticityslide 23 ELASTICITY IS NOT SLOPE! Q P Note that elasticity is different at the two points even though the slope is the same. (Slope = -1) Note that elasticity is different at the two points even though the slope is the same. (Slope = -1) QUANTITYPRICE E = E = -.33

Elasticityslide 24 TERMS TO LEARN Demand is ELASTIC when the numerical value of elasticity is greater than 1. Demand is INELASTIC when the numerical value of elasticity is less than 1. Demand is UNIT ELASTIC when the numerical value of elasticity equals 1. NOTE: Numerical value here means “absolute value.”

Elasticityslide 25 LIKE THIS! Q P QUANTITYPRICE Demand is elastic here. Demand is inelastic here.

Elasticityslide 26 There is an important relationship between what happens to consumers’ spending on a good and elasticity when there is a change in price. Spending on a good = P Q. Because demand curves are negatively sloped, a reduction in P causes Q to rise and the net effect on PQ is uncertain, and depends on the elasticity of demand.

Elasticityslide 27 Q P At P = $9, spending is $9 (= 1 times $9). At P = $8, spending is $16 ( = 2 times $8). When price fell from $9 to $8, spending rose. Q must haveincreased by a larger percent than P decreased. So... QUANTITY PRICE Demand is elastic here.

Elasticityslide 28 Q P At P = $3, spending is $21 (= 7 times $3). At P = $2, spending is $16 ( = 8 times $2). When price fell from $3 to $2, spending fell. Q must have increased by a smaller percent than P decreased. So... QUANTITYPRICE Demand is inelastic here.

Elasticityslide 29 There is an easy way to tell whether demand is elastic or inelastic between any two prices. If, when price falls, total spending increases, demand is elastic. If, when price falls, total spending decreases, demand is inelastic.

Elasticityslide 30 But total spending is easy to see using a demand curve graph: Q P The shaded area is P times Q, or total spending when P = $9. The shaded area is P times Q, or total spending when P = $9. QUANTITYPRICE

Elasticityslide 31 Q P The shaded area is P times Q or total spending when P = $8. The shaded area is P times Q or total spending when P = $8. QUANTITY PRICE

Elasticityslide 32 Q P Total spending is higher at the price of $8 than it was at the price of $9. Total spending is higher at the price of $8 than it was at the price of $9. = loss in TR due to fall in P = gain in TR due to rise in Q QUANTITYPRICE

Elasticityslide 33 Q P The shaded area is total spending (total revenue of sellers) when P = $3. The shaded area is total spending (total revenue of sellers) when P = $3. QUANTITYPRICE

Elasticityslide 34 Q P Total revenue of sellers (total spending by buyers) falls when price falls from $3 to $2. Total revenue of sellers (total spending by buyers) falls when price falls from $3 to $2. QUANTITYPRICE

Elasticityslide 35 Here’s a convenient way to think of the relative elasticity of demand curves. p Q p* Q* relatively more inelastic at p* relatively more inelastic at p* relatively more elastic at p* relatively more elastic at p*

Elasticityslide 36 Examples of elasticity Doctors through the AMA restrict the supply of physicians. How does this affect the incomes of doctors as a group? A labor union negotiates a higher wage. How does this affect the incomes of affected workers as a group? MSU decides to raise the price of football tickets. How is income from the sale of tickets affected? Airlines propose to raise fares by 10%. Will the boost increase revenues?

Elasticityslide 37 MORE... MSU is considering raising tuition by 7%. Will the increase in tuition raise revenues of MSU? CATA recently raised bus fares in the Lansing area. Will this increase CATA’s total receipts?

Elasticityslide 38 The answers to all of these questions depend on the elasticity of demand for the good in question. Be sure you understand how and why!

Elasticityslide 39 DETERMINANTS OF DEMAND ELASTICITY The more substitutes there are available for a good, the more elastic the demand for it will tend to be. [Related to the idea of necessities and luxuries. Necessities tend to have few substitutes.] The longer the time period involved, the more elastic the demand will tend to be. The higher the fraction of income spent on the good, the more elastic the demand will tend to be.

Elasticityslide 40 OTHER ELASTICITY MEASURES In principle, you can compute the elasticity between any two variables. Income elasticity of demand Cross price elasticity of demand Elasticity of supply

Elasticityslide 41 Each of these concepts has the expected definition. For example, income elasticity of demand is the percent change in quantity demand divided by a percent change income: E INCOME = Income elasticity of demand will be positive for normal goods, negative for inferior ones.