AN INTRODUCTION TO MICROECONOMICS PROF. DR. MOHAMMED MIGDAD FIRST SEMESTER 2015

ELASTICITY AND ITS APPLICATIONS CHAPTER 3

CHAPTER 3 CONTENT: Elasticity and its applications, It includes:  Price elasticity of demand,  Point and arc elasticity,  Types of elasticity,  Factors affecting elasticity,  Elasticity and total revenue,  Income elasticity of demand,  Price elasticity of supply,  In addition to elasticity and tax.

4 Elasticity Elasticity is a general concept that can be used to quantify the response in one variable when another variable changes.

5 How to measure elasticity

6 Price Elasticity of Demand A popular measure of elasticity is price elasticity of demand measures how responsive consumers are to changes in the price of a product. A popular measure of elasticity is price elasticity of demand measures how responsive consumers are to changes in the price of a product.

7 How to measure P.E.D Price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in price of the product.

3.2 Price Elasticity of Demand Elasticity = Change in quantity demanded ÷ Change in price Quantity demandedPrice

9 How to measure P.E.D

10 The absolute term The value of demand elasticity is always negative, but it is stated in absolute terms.

11 The negative sign The negative sign of the P.E.D show the negative relation between price and quantity demanded.

12 Slope and Elasticity The value of the slope of the demand curve and the value of elasticity are not the same. Unlike the value of the slope, the value of elasticity is a useful measure of responsiveness.

Example 1 Consider the market for sales of ice- cream cones at a state fair. The table below gives the market quantity demanded with consideration in giving all the sellers the same price. Calculate the price elasticity of demand for the ice-cram.

Ice-Cream Demand Schedule Continue

You can calculate the market price elasticity of demand using the information contained in the table above. For instance, suppose you decided to calculate the price elasticity of demand at the price $2.00 by examining a price decrease from $2.00 to $1.50 per cone. Continue

In this case, the demand for ice cream will increase from 7 million cones to 10 million cones. You can use these figures to calculate the price elasticity of demand as follows: Continue

This implies the following: The price elasticity of demand for ice-cream cones at a price of $2.00, according to the demand schedule provided, is Continue

The sign here illustrates the negative relation between price and quantity demanded and that we deal here with the absolute number. So the value of the elasticity in this case equals This elasticity means that the % change in quantity is higher than the % change in price, which indicates that the demand here is an elastic demand.

Example 2 You are a cement producer. You wish to plot your firm's demand curve and to find the price elasticity of demand at various points along the demand curve. You decide to calculate elasticity by examining the effects of price declines from $50 to $40, $40 to $30, etc.

To calculate the price elasticity of demand between a price of $50 and $40 on the demand curve, divide the percentage change in quantity demanded by the percentage change in price. Continue

Cement Demand Schedule Continue

Similarly, you can find the elasticity between prices of $40 and $30, $30 and $20, and $20 and $10. To illustrate, here is what you will find when you calculate elasticity between $40 and $30: Continue

This is the equation of elasticity between $30 and $20: Continue

This is the equation for elasticity between $20 and $10 Continue

Notice that demand becomes increasingly less as prices fall. Intuitively, this makes sense; consumers can be expected to react much more dramatically to a change in price when prices are high than they are low.

26 Slope and Elasticity

27 Slope and Elasticity when we calculate slope in the two graphs: The slope of the first graph equals change in price / change in quantity = -1/5 = -20% The slope of the second graph equals -1/ 80 = -1.25%

28 Slope and Elasticity But when we calculate elasticity in the two graphs: The elasticity of the first graph = % change in quantity / % change in price = q2-q1/q1 divided by p2-p1/p1= 10-5 / 5 divided 2-3/3 = 1/ = -3 The elasticity of the second graph = /80 divided 2-3/3 =1/-0.33 = -3

29 continue Changing the units of measure yields a very different value of the slope, yet the behavior of buyers in both diagrams is identical. And as a result the elasticity is the same, in both graphs and equals -3

Arc Elasticity Supposing we want to measure the elasticity between point A and point B appearing on the same curve in the figure we assume that: P1 = 4, Qd1 = 12 P2 = 5, Qd2 = 9

Arc Elasticity

If we intend to calculate the elasticity between the two points, A and B, starting from point B and using the elasticity formula as illustrated above, this is what we get:

If we intend to calculate the elasticity between the two points, A and B, starting from point A and using the elasticity formula as illustrated above, this is what we get:

We notice some differences in the results because the starting points were different. To avoid this difference in calculating the Arc Elasticity, calculating from the middle point between both points, A and B, could be the best way. This is known as the Midpoint Law which gives an average result.

Point Elasticity and Types of Demand Elasticity Types of Demand Elasticity

3.4.1 Types of Price Elasticity of Demand 1.Elastic Demand 2.Inelastic Demand 3.Unitary Elastic Demand 4.Perfectly Elastic Demand 5.Perfectly Inelastic Demand/The Zero Elasticity

Elastic Demand

Inelastic Demand

The Unitary-Elastic Demand

Perfectly Elastic Demand

Perfectly Inelastic Demand/The Zero Elasticity

Special Cases for the Negative Demand Elasticity Luxury cars, particularly at the higher end, like the Rolls-Royce Phantom pictured here, are often said to be desirable due to their price. As a result, it is argued that luxury cars are Veblen goods. In such cases, if we measure the demand elasticity, it will be positive with positive relationship between price and quantity demanded

3.5 Elasticity and Total Revenue Example Product X1 can be sold for $5. The seller decides to increase the price to $7 in order to earn more money, but finds that he earns less money. This is because he is selling fewer of the products due to the increased price. His/her total revenue is falling, as a result. The demand for this product must be elastic. The producer failed in achieving his/her aim due to the lack of knowledge about the elasticity of the good.

3.5.1The Relationship between (TR) and Elasticity, and (TE) and Elasticity If the demand on a product was as follows, the demand on this product will be elastic Table: Total Revenue when the Price Decreases in the Elastic Demand The demand on this product is elastic; therefore, the decrease in price causes an increase in total revenue (TR). The price decreases 20%, the quantity increases 30%, and total revenue increases 8.3%.

If the demand was unitary-elastic, total revenue remains constant no matter the price changes.

Total Revenue when the Price Decreases in the Unitary Elastic Demand The price decreases 20%, the quantity increases 20%, and total revenue remains constant.

The Relationship between Elasticity and Total Revenue Elasticity of demand Inelastic demandUnitary-demandElastic demand Ed <1Ed = 1Ed > 1 Change in price Price increasesRevenue increasesRevenue constantRevenue decreases Price decreasesRevenue decreasesRevenue constantRevenue increases

The Relationship between Price and Total Revenue

3.6 The Relationship between Marginal Revenue, Price, and Elasticity Marginal revenue can be defined as "the change in total revenue caused by selling an additional new unit".

3.7 Elasticity and the Slop The Slope of the Infinity Elastic Demand Curve

The Slope of the Perfectly Inelastic Demand Curve

The Slope of the Normal Demand Curve

The Slope of the Unitary-Elastic Demand Curve

3.7.1 The Determinants of Price Elasticity of Demand (Factors that Affect Elasticity) The elasticity differs from one good to another depending on different factors as following: 1)The Availability of Substitutes 2)Necessity of a Product 3)Amount of Income Spent on the Good 4)Consumer Income (The Wealth of Consumers) 5)Time

3.8 Practical Applications to Price Elasticity of Demand The Effect of Decreasing Supply on Total Revenue

Monopoly ……

3.9 Cross Price Elasticity of Demand (CPED) CPED is the extent to which the quantity of good (y) is affected by the change in the price of good (x). Continue

The more precise equation in calculating cross price elasticity of demand is the mid-point law

3.10 Income Elasticity of Demand Income elasticity of demand could be measured through the following formula:

Example Measure the income elasticity of demand from the following data, and then illustrate the level of elasticity and type of the good. (Income increases from 100 to $150, as a result quantity increases from 90 to 110 units).

The income elasticity is positive and less than one that indicates a normal good with an inelastic demand

3.11 Price Elasticity of Supply Its formula is as follows:

Formula’s also include: The sign of "price elasticity of supply" is generally positive because there is a positive relationship between prices and quantity supplied.

3.12 Supply Elasticity in the Short Run and the Long Run Economists usually differentiate between three time periods due to some conditions: 1)Market Period (Very Short Run) 2)The Short Run 3)The Long Run

The Supply Curve in the Very Short Run

Supply Curve in the Short Run

Supply Curve in the Long Run

3.12 Elasticity and Tax Incidence (Practical Cases) There are five different cases concerning both supply and demand elasticity First: Cases of Price Elasticity of Demand Second: Cases of Price Elasticity of Supply

First: Cases of Price Elasticity of Demand 1. If the demand for product (x) is perfectly inelastic and the government imposes ($1) tax on this product, the consumer bears the full burden of the imposed tax

First: Cases of Price Elasticity of Demand 2. If the demand for product (x) is infinity elastic and the government imposes ($1) tax on this product, the supplier bears the full burden of the imposed tax

First: Cases of Price Elasticity of Demand 3. If the demand on product (x) is unitary elastic and the government imposes ($1) tax on this product, the supplier bears half the burden of the imposed tax and the consumer bears the other half.

First: Cases of Price Elasticity of Demand 4. If the demand on product (x) is inelastic, and the government imposes ($1) tax on this product, the customer bears most of the burden of the imposed tax and the supplier bears the remaining few burden of tax.

First: Cases of Price Elasticity of Demand 5. If the demand on product (x) is elastic and the government imposes ($1) tax on this product, the supplier bears most of the burden of imposed tax and the customer bears the remaining few burden of tax.

Second: Cases of Price Elasticity of Supply 1.If the supply of product (x) is perfectly inelastic and the government imposes ($1) tax on this product, the supplier bears the full burden of imposed tax.

Second: Cases of Price Elasticity of Supply 2. If the supply of product (x) is infinity elastic, and the government imposes ($1) tax on this product, the consumer bears the full burden of imposed tax. In this case, the supplier is able to increase the prices to cover the burden of tax.

Second: Cases of Price Elasticity of Supply 3. If the supply of product (x) is unitary elastic and the government imposes ($1) tax on this product, the consumer bears half the burden of imposed tax and the supplier bares the remaining burden of tax. In this case, the suppliers are not able to increase the prices to cover the full burden of tax.

Second: Cases of Price Elasticity of Supply 4. If the supply of product (x) is inelastic and the government imposes ($1) tax on this product, the consumer bears less and the supplier bears more of the burden of imposed tax.

Second: Cases of Price Elasticity of Supply 5. If the supply of product (x) is elastic and the government imposes ($1) tax on this product, the consumer bears more and the supplier bears less of the burden of imposed tax.

THE END OF CHAPTER 3

82 Types of Elasticity 1. Unitary elasticity = Elastic demand > Inelastic demand < Perfectly elastic demand = ∞ 5. Perfectly inelastic demand = 0

83 Types of Elasticity Hypothetical Demand Elasticity for Four products

84 Hypothetical Demand Elasticities for Four Products PRODUCT % CHANGE IN PRICE (%  P) % CHANGE IN QUANTITY DEMANDED (%  Q D ) ELASTICITY (%  Q D d %  P) Insulin+10%0%0.0Perfectly inelastic Basic telephone service +10%-1%-0.1Inelastic Beef+10%-10%Unitarily elastic Bananas+10%-30%-3.0Elastic

85 Elastic and Inelastic Demand Curves Different graphs that show different types of elasticity

86 Perfectly Elastic and Perfectly Inelastic Demand Curves

87 Perfect inelasticity When demand does not respond at all to a change in price, demand is perfectly inelastic, this is the horizontal demand curve.

88 Perfect elasticity Demand is perfectly elastic when quantity demanded drops to zero at the slightest increase in price, this is the vertical demand curve.

89 Calculating Elasticities The elasticity of the first graph = % change in quantity / % change in price = q2-q1/q1 divided by p2-p1/p1

90 % change in Quantity

91 Calculating Elasticities

92 Calculating Elasticities

93 Elasticity Elasticity is a ratio of percentages. Using the values on the graph to compute elasticity, using percentage changes yields the following result:

94 Price Elasticity

95 Calculating Elasticities

96 The midpoint formula A more accurate way of computing elasticity than percentage changes is the midpoint formula:

97 The midpoint formula

98 The midpoint formula

99 Interpret Elasticities Here is how to interpret two different values of elasticity: When  = 0.2, a 10% increase in price leads to a 2% decrease in quantity demanded. When  = 2.0, a 10% increase in price leads to a 20% decrease in quantity demanded.

100 Elasticity Changes along a Straight-Line Demand Curve

101 Elasticity along a Straight-Line Price elasticity of demand decreases as we move downward along a straight line demand curve. This is because quantity is large.

102 Elasticity along a Straight-Line Demand is elastic in the upper range and inelastic in the lower range of the line, this is because quantity is small.

103

104 Elasticity Along the elastic range, elasticity values are greater than one. Along the inelastic range, elasticity values are less than one. And in the middle elasticity equals one

105 Elasticity and Total Revenue

106 Type of demand Value of E d Change in quantity versus change in price Effect of an increase in price on total revenue P ↑ Effect of a decrease in price on total revenue P ↓ ElasticGreater than 1.0 Larger percentage change in quantity Total revenue decreases Total revenue increases InelasticLess than 1.0 Smaller percentage change in quantity Total revenue increases Total revenue decreases Unitary elastic Equal to 1.0 Same percentage change in quantity and price Total revenue does not change

107 Elasticity and Total Revenue When demand is inelastic, price and total revenues are directly & positively related. Price increases generate higher revenues.

108 continue When demand is elastic, price and total revenues are indirectly & negatively related. Price increases generate lower revenues.

109 The Determinants of Demand Elasticity 1. Availability of substitutes - demand is more elastic when there are more substitutes for the product. 2. Time dimension -- demand becomes more elastic over time.

110 continue 3. Importance of the item in the budget -- demand is more elastic when the item is a more significant portion of the consumer’s budget.

111 Home Exam 1. Define economics and it main branches. 2. What is elasticity, and what is its application? 3. Give example to calculate price elasticity of demand & explain its importance.

112 Exam 4. Explain the relation between elasticity & revenue? How to use the relation in decision making? Give numerical examples. 5. What are factors determines the elasticity? Use Graphs and numerical examples as much as you can in answers.

113 Other Important Elasticities Income elasticity of demand – measures the responsiveness of demand to changes in income.

114 The form

115 Other Important Elasticities Cross-price elasticity of demand: A measure of the response of the quantity of one good demanded to a change in the price of another good.

116 The form

117 Other Important Elasticities Elasticity of supply: A measure of the response of quantity of a good supplied to a change in price of that good. Likely to be positive in output markets.

118 The form

119 Other Important Elasticities Elasticity of labor supply: A measure of the response of labor supplied to a change in the price of labor.

120 The form

121 Constraints on the Market A price ceiling is a maximum price that sellers may charge for a good, usually set by government.

122 price ceiling In 1974, the government set a price ceiling to distribute the available supply of gasoline. At an imposed price of 57 cents per gallon, the result was excess demand.

123

124 Prices and the Allocation of Resources Price changes resulting from shifts of demand cause profits to rise or fall. Profits attract capital; losses lead to disinvestment.

125 price ceiling Higher wages attract labor and encourage workers to acquire skills. At the core of the system, supply, demand, and prices in input and output markets determine the allocation of resources and the ultimate combinations of things produced.

126 Price Floors A price floor is a minimum price below which exchange is not permitted. – The most common example of a price floor is the minimum wage, which is a floor set under the price of labor.

127 Price Floors The result of setting a price floor will be excess supply, or higher quantity supplied than quantity demanded.

128 Impact of tax and subsidies on price and quantity Taxes shift supply curve up to the left And we reach a new equilibrium point Pe will increase and Qe will decrease

129 How tax or tariffs on imports affect foreign trade This depend on the elasticity of demand and supply.

130 Energy price control An example for government intervention comes when the Gov. legislates a maximum price ceiling.