Elasticity and Its Applications Chapter 5 Elasticity and Its Applications 1

QUESTION You have just been hired by Crayola Crayon. The company would like to increase its revenue. The CEO comes to you for advice. She wants to know if the company should lower product prices or raise product prices to increase total revenue. What do you advise?

Elasticity . . . … is a measure of how much buyers and sellers respond to changes in market conditions. . . … means responsiveness. 2

Price Elasticity of Demand The percentage (%) change in Quantity Demanded . . . . . . given a percentage change in Price. 3

Three Types of Elasticities. . . Price Price Elasticity of Demand Income Elasticity Price Elasticity of Supply Quantity 4

Price Elasticity of Demand The percentage change in the quantity demanded given. . . . . . a percentage change in the price. A B Q 5

Ranges of Elasticity . . . (Figure 5-1) Perfectly Inelastic Consumers are “totally unresponsive” to price changes. Perfectly Elastic Consumers are “totally responsive” to price changes. Unit Elastic Response is “equal to” change in price. 6

Determinants of Price Elasticity of Demand Demand tends to be more elastic: if the good is a luxury; the longer the time period; the greater the number of close substitutes; and the more narrowly defined the market. 8

Determinants of Price Elasticity of Demand Demand tends to be more inelastic: if the good is a necessity; the shorter the adjustment time; if there are few good substitutes; and the more broadly defined the market. 9

Computing Elasticity Coefficient Percentage Change in Quantity Demanded Price Elasticity of Demand = Percentage Change in Price Computed as the percentage change in the quantity demanded divided by the percentage change in price. 10

Computing Elasticity Coefficient Midpoint Formula Demand for Ice Cream ED = Change in QD / avg Q 2.20 Change in P / avg P 2.00 8 10 11

Computing Elasticity Coefficient Demand for Ice Cream ED = (8-10) / (8+10) / 2 2.20 (2.20-2.00) / (2.20+2.00)/2 2.00 8 10 11

Computing Elasticity Coefficient Demand for Ice Cream Demand is Elastic ED 2.33 2.20 = 2.00 8 10 14

Elasticity and Linear Demand Curves Elasticity varies over Price ranges on the same linear demand curve.

Elasticity and Total Revenue Over the Elastic Range of prices and quantity the relationship between price and total revenue is INDIRECT or OPPOSITE 15

Elasticity and Total Revenue ED > 1 then P Q TR and 16

Elasticity and Total Revenue Over the Inelastic Range of prices and quantity the relationship between price and total revenue is DIRECT or THE SAME 17

Elasticity and Total Revenue ED < 1 then P Q TR and 18

Income Elasticity of Demand The percentage change in the quantity demanded given a percentage change in income. 19

Computing Income Elasticity Percentage Change in Quantity Demanded Income Elasticity of Demand = Percentage Change in Income Computed as the percentage change in the quantity demanded divided by the percentage change in Income. 20

Income Elasticity... Types YD > 0 Normal Goods YD < 0 Inferior Goods YD = 0 Income-neutral Goods 21

Income Elasticity... Types Goods consumers regard as “necessities” tend to be income inelastic... Examples include: food, fuel, clothing, utilities, & medical services. 22

Income Elasticity... Types Goods consumers regard as “luxuries” tend to be income elastic... Examples include: Sports cars, furs, and expensive foods. 23

Price Elasticity of Supply The percentage change in quantity supplied resulting from a percentage change in price. B A Quantity 25

Ranges of Elasticity Perfectly Elastic infinite Relatively Elastic >1 Unitary or Unit =1 Relatively Inelastic <1 Perfectly Inelastic = 0 26

Determinants of Elasticity of Supply Flexibility or ability of sellers to change the amount of the good they produce. Beachfront land verses books, cars, manufactured goods, etc. More elastic in the long run. 28

Computing Elasticity Coefficient Percentage Change in Quantity Supplied Elasticity of Supply = Percentage Change in Price Computed as the percentage change in the quantity supplied divided by the percentage change in price. 29

Applications of Elasticity “Can Good News for Farming Be Bad News For Farmers?” What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties? 31

Apply Comparative Statics (Chapter 4) Examine whether the supply or demand curve shifts. Consider the direction the curve shifts. Use supply-and-demand diagram to see how the market equilibrium changes. 32

Examine whether the supply or demand curve shifts. SA Price $4.00 DA 2000 Quantity 33

Consider which direction the curve shifts. SA Price SB Technology causes an increase in supply. $4.00 DA 2000 Quantity 34

Use Supply-and-Demand diagram to see how the market changes. SA Price SB $4.00 $2.60 DA 2000 2400 Quantity 35

ED = ED = Compute Elasticity (2400 - 2000) / (2000) ($2.60 - $4.00) / ($4.00) ED = 0.57 (Inelastic) 36

Observe the Change in Total Revenue SA Price SB TRSA = $8,000 $4.00 $2.60 TRSB = $5,760! DA 2000 2400 Quantity 37