1. University of Papua New Guinea Principles of Microeconomics Lecture 4: Elasticity

2. The University of Papua New Guinea Slide 1 Lecture 4: Elasticity Michael Cornish Overview Price elasticity of demand Cross-price elasticity of demand Income elasticity of demand Price elasticity of supply

3. The University of Papua New Guinea Slide 2 Lecture 4: Elasticity Michael Cornish Price elasticity of demand Elasticity is a concept that measure the responsiveness of one variable to another Price elasticity of demand measures the responsiveness of the quantity demanded to changes in price P ε D = % ΔQ D % ΔP

4. The University of Papua New Guinea Slide 3 Lecture 4: Elasticity Michael Cornish Price elasticity of demand Example: The price of bread is $2, and the quantity demanded is 5 million units. The price increases to $2.50, and we see that the quantity demanded drops to 4 million units. Therefore, P ε D = % ΔQ D = (5 – 4) /5 = 1/5 % ΔP (2 – 2.5)/2 -0.5/2 = 0.2 = -0.8 -0.25 Note: P ε D is always negative! However, usual convention is to use the absolute value (to drop the minus sign)

5. The University of Papua New Guinea Slide 4 Lecture 4: Elasticity Michael Cornish Price elasticity of demand Also note: because we use percentages to measure elasticity, P ε D changes along a straight line demand curve Why do we use percentages instead of units to measure elasticity?

6. The University of Papua New Guinea Slide 5 Lecture 4: Elasticity Michael Cornish Price elasticity of demand So what does the P ε D number mean? »Remember: the convention is to use the absolute value... P ε D > 1 Elastic [Q D is highly responsive to Δs in P] P ε D = 1 Unit elastic [Q D is equally proportionally responsive to Δs in P] P ε D < 1 Inelastic [Q D is not very responsive to Δs in P]

7. The University of Papua New Guinea Slide 6 Lecture 4: Elasticity Michael Cornish Price elasticity of demand P Q D P ε D = 0 Perfectly inelastic demand

8. The University of Papua New Guinea Slide 7 Lecture 4: Elasticity Michael Cornish Price elasticity of demand P Q D P ε D = Perfectly Elastic

9. The University of Papua New Guinea Slide 8 Lecture 4: Elasticity Michael Cornish Price elasticity of demand P Q D P ε D = 1 Unit Elastic For your interest only: A unit elastic demand curve is a rectangular hyperbola, such that P * Q is a constant [i.e., P * Q = c]

10. The University of Papua New Guinea Slide 9 Lecture 4: Elasticity Michael Cornish Price elasticity of demand Elastic Inelastic Pε D = 1 0 5 10 12.5 15 20 25 2.50 1 2 3 4 5 Price ($ per smoothie) Quantity (smoothies per hour) Pε D = 1/4 Pε D = 4 Note: This applies only to a linear demand curve!

11. The University of Papua New Guinea Slide 10 Lecture 4: Elasticity Michael Cornish Note: TR = P * Q

12. The University of Papua New Guinea Slide 11 Lecture 4: Elasticity Michael Cornish Price elasticity of demand The midpoint formula: –An alternative way of calculating elasticity, but at a point on a line (note, our previous formula calculated elasticity between two points) –Is an approximate measure (but a good approximate!) –Uses average of initial and final quantities and prices (Q 2 – Q 1 ) ÷ (P 2 – P 1 ) P ε D = Q 1 + Q 2 P 1 + P 2 2 2

13. The University of Papua New Guinea Slide 12 Lecture 4: Elasticity Michael Cornish Price elasticity of demand But why is P ε D different in different markets? More elastic More inelastic Many close substitutesFew close substitutes LuxuriesNecessities Big budget itemsSmall budget items Long runShort run Market is narrowly definedMarket is broadly defined Not addictiveAddictive

14. The University of Papua New Guinea Slide 13 Lecture 4: Elasticity Michael Cornish Cross-price elasticity of demand Just as the price of a product helps determine the quantity demanded, so too can the price of another, related product help determine the quantity demanded… The responsiveness of the quantity demanded to changes in the price of another product is called cross-price elasticity of demand Cross-P ε D = % ΔQ D % ΔP of another product

15. The University of Papua New Guinea Slide 14 Lecture 4: Elasticity Michael Cornish Cross-price elasticity of demand If the products are… Cross-P ε D will be… Example: SubstitutesPositiveLamb and chicken ComplementsNegativeFish and chips UnrelatedZero Economics textbooks and movie tickets

16. The University of Papua New Guinea Slide 15 Lecture 4: Elasticity Michael Cornish Income elasticity of demand Income elasticity of demand measures the responsiveness of the quantity demanded to changes in income Income ε D = % ΔQ D % ΔY Note: ‘Y’ is income

17. The University of Papua New Guinea Slide 16 Lecture 4: Elasticity Michael Cornish Income elasticity of demand If income ε D is...Then the good is…Example: O > 1NormalMilk > 1 Superior (normal and a luxury) Caviar < 0Inferior Meat flaps (i.e. those horrible meat offcuts...)

18. The University of Papua New Guinea Slide 17 Lecture 4: Elasticity Michael Cornish Price elasticity of supply Price elasticity of supply measures the responsiveness of the quantity supplied to changes in price P ε S = % ΔQ S % ΔP

19. The University of Papua New Guinea Slide 18 Lecture 4: Elasticity Michael Cornish Price elasticity of supply P Q S P ε S = 0 0 Perfectly Inelastic

20. The University of Papua New Guinea Slide 19 Lecture 4: Elasticity Michael Cornish Price elasticity of supply Perfectly Elastic P ε S = P Q S 0

21. The University of Papua New Guinea Slide 20 Lecture 4: Elasticity Michael Cornish Price elasticity of supply The price elasticity of supply increases as time passes: –‘Momentary supply’ reflects the immediate responsiveness of quantity supplied to a change in price: i.e. No change in quantity! –In the very long-run, quantity supplied is perfectly responsive to changes in price

22. The University of Papua New Guinea Slide 21 Lecture 4: Elasticity Michael Cornish Price elasticity of supply P0P0 P Q D0D0 SmSm PmPm D1D1 Q0Q0 ‘Momentary supply’ => There is no immediate response of quantity supply to a change in price (just a price response!)

23. The University of Papua New Guinea Slide 22 Lecture 4: Elasticity Michael Cornish Price elasticity of supply Short run => An expansion in demand only leads to a small increase in quantity supplied D1D1 P0P0 PSPSP Q D0D0 Q0Q0 SsSs QSQS

24. The University of Papua New Guinea Slide 23 Lecture 4: Elasticity Michael Cornish Price elasticity of supply Long run => An expansion in demand leads to a large increase in quantity supplied P0P0 PLPL PQ D0D0 SLSL D1D1 Q0Q0 QLQL

25. The University of Papua New Guinea Slide 24 Lecture 4: Elasticity Michael Cornish Price elasticity of supply The ‘very’ long run => The quantity supplied is completely responsive to price P 0 ; P L′ PQ D0D0 SL′SL′ D1D1 Q0Q0 QL′QL′ This same concept applies to demand over the long-run for most products