Chapter 4: Elasticity

4.1 Price Elasticity Elasticity is a measure of the responsiveness of one variable to another. The greater the elasticity, the greater the responsiveness. Eg. Chocolate bar is $0.50 how many will you buy? 5? If price changes to $1.00, how many will you now demand? 1? –Elasticity measures how your demand will change if the price changes

Price Elasticity The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

Price Elasticity Eg. Chocolate bar Price increase from $0.50 to $0.75 % changed = $ $0.50 ($ $0.75)/2 = $0.25 / ($1.25/2) = $0.25 / $0.625 = 0.4%

Price Elasticity Eg. Chocolate bar Demand decrease from 5 to 1 % changed = 1 – 5 / (1+5)/2 = -4 / 6 = -0.67%

Price Elasticity Eg. Chocolate bar E D Choc = -0.67% / 0.4% = -1.67% So, a 0.4% increase in price leads to a 1.6% decrease in quantity demanded

Sign of Price Elasticity According to the law of demand, whenever the price rises, the quantity demanded falls. Thus the price elasticity of demand is always negative. Because it is always negative, economists usually state the value without the sign.

Graphs of Elasticities Price Quantity of software (in hundred thousands) $ D B A C (midpoint) Elasticity of demand between A and B = 1.27

Calculating Elasticities: Price elasticity of Demand D P Q What is the price elasticity of demand between A and B? $20 10 $26 14 Midpoint B A E D = %ΔQ%ΔP%ΔQ%ΔP Q 2 –Q 1 ½(Q 2 +Q 1 ) P 2 –P 1 ½(P 2 +P 1 ) = C 12 $23 = 10–14 ½(10+14) 26–20 ½(26+20) = 1.27 =

4.2 Price Elasticity Ranges Demand is elastic if the percentage change in quantity is greater than the percentage change in price. E D > 1 Change in price (0.5%) will lead to a larger change in demand (0.8%) ie. 0.5% < 0.8% so E DChoc = 1.6 where 1.6 > 1

Classifying Demand and Supply as Elastic or Inelastic Demand is inelastic if the percentage change in quantity is less than the percentage change in price. E D < 1 Change in price will lead to a smaller change in demand - unresponsive

Defining Elasticities When price elasticity is = 1, we say demand is unit elastic. Eg. Chocolate bar Say if, change in price = 0.5% And, change in demand = 0.5% What is E DChoc ? = 0.5% / 0.5% = 1

Extreme Elasticities Perfectly Elastic Demand Curve –The demand curve is horizontal, any change in price can and will cause consumers to change their consumption. Perfectly Inelastic Demand Curve –The demand curve is vertical, the quantity demanded is totally unresponsive to the price. Changes in price have no effect on consumer demand. In between the two extreme shapes of demand curves are the demand curves for most products.

Perfectly inelastic demand curve Change in price leads to NO change in quantity Eg. insulin Price 0 Quantity Perfectly Inelastic Demand Curve D

Perfectly elastic demand curve When price changes even just a little, quantity demanded changes a lot (to zero) Perfectly Elastic Demand Curve Price 0 Quantity P0P0 S0S0 P1P1

4.3 Determinants of the Price Elasticity of Demand The degree to which the price elasticity of demand is inelastic or elastic depends on: –How many substitutes there are, the more the more elastic ie quickly jump to another product, no loyalty –The importance of the product in the consumer’s total budget, the more important the more elastic eg pepper are inelastic and cars are elastic so price changes to car will affect your budget and therefore demand for other things

Determinants of the Price Elasticity of Demand The degree to which the price elasticity of demand is inelastic or elastic depends on: –The time period under consideration. If the price change is over a long period of time people have time to adjust or find substitutes so they are more elastic in demand

Price 0 Quantity Long Run Elastic Demand Curve D Eg. If you expected gas prices went up by $0.50 how do you adjust? Turn lights off, switch to solar energy ie. demand goes down, qty demanded for gas goes down!

4.4 Cross-Price Elasticity of Demand Cross-price elasticity of demand – the percentage change in demand divided by the percentage change in the price of another good. Eg. Margarine prices go up, what is effect on butter demand?

Complements and Substitutes Substitutes are goods that can be used in place of another. Eg. Butter and margarine! Substitutes have positive cross-price elasticities. As margarine price goes up, demand for butter goes up too!!!

Complements and Substitutes Complements are goods that are used in conjunction with other goods. Complements have negative cross-price elasticities. Eg. Peanut butter and jelly...when the price of up, demand for jelly goes down.

Calculating Cross-Price Elasticity D0D0 P0P0 D1D1 P0P0 104 Quantity of Beef 108 Shift due to 33% rise in price of pork, a substitute

Income Elasticity of Demand Income elasticity of demand – the percentage change in demand divided by the percentage change in income.

Income Elasticity of Demand Income elasticity of demand tells us the responsiveness of demand to changes in income. Represents a shift in demand. Eg. In market for one Honda, then win lottery, income goes up, and now buy one+

Income Elasticity of Demand An increase in income generally increases one’s consumption of almost all goods. The increase may be greater for some goods than for others.

Income Elasticity of Demand Normal goods are those whose consumption increases with an increase in income. They have income elasticities greater than zero or positive

Income Elasticity of Demand Normal goods are divided into luxuries and necessities.

Income Elasticity of Demand Luxuries are goods that have an income elasticity greater than one. Their percentage increase in demand is greater than the percentage increase in income.

Income Elasticity of Demand A necessity has an income elasticity less than 1. The consumption of a necessity rises by a smaller proportion than the rise in income.

Income Elasticity of Demand Inferior goods are those whose consumption decreases when income increases. Inferior goods have income elasticities less than zero.

Calculating Income Elasticity P0P0 D0D0 D1D1 P0P0 20Quantity26 Shift due to 20% rise in income

4.5 Price Elasticity: Supply Price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in This tells us exactly how quantity supplied responds to a change in price E S = % change in Quantity Supplied % change in Price

Price Elasticity: Supply Supply is elastic if the percentage change in quantity is greater than the percentage change in price Elastic supply is when E S > 1 Supply is inelastic if the percentage change in quantity is less than the percentage change in price Inelastic supply is when E S < 1

Calculating Elasticities: Price elasticity of Supply P Q What is the price elasticity of supply between A and B? $ $ B A E S = %ΔQ%ΔP%ΔQ%ΔP Q 2 –Q 1 ½(Q 2 +Q 1 ) P 2 –P 1 ½(P 2 +P 1 ) = = 485–476 ½( ) 5–4.50 ½(5+4.50) Midpoint C $ = 0.18 = S 7-34

Determinants of the Elasticity of Supply The shape of the supply curve depends primarily on the length of time being considered. –In the short run, suppliers don’t have time to expand or contract production in response to price changes eg. House prices go up and house builders order supplies but wait for supplies before can build more

Determinants of the Elasticity of Supply The shape of the supply curve depends primarily on the length of time being considered. –In the long run, the builder has long enough to have all supplies delivered and starts building houses for sale ie increases supply of houses

Determinants of the Elasticity of Supply The shape of the supply curve depends primarily on the availability of raw material –Easier to get raw materials, more elastic ie can respond to changes in price

Determinants of the Elasticity of Supply The shape of the supply curve depends primarily on the Complexity of Production –Easier to get make product, the more elastic ie can respond to changes in price –Eg. Paper air planes

Determinants of the Elasticity of Supply The shape of the supply curve depends primarily on the Excess Capacity and Inventories –Producers have a large number of empty houses for sale the more elastic the supply ie can respond to changes in price