1. Economics 101 Principles of microeconomics Elasticities 2016 FALL TERM LECTURE 8 CHAPTER 4

2. Content  Define, calculate, and explain the factors that influence the price elasticity of demand  Elasticity– inelastic, elastic, along the curve, point, arc, slop  Define, calculate, and explain the factors that influence the income elasticity of demand and the cross elasticity of demand  Complement & Substitutes  Define, calculate, and explain the factors that influence the elasticity of supply 2

3. Elasticity... … allows us to analyze supply and demand with greater precision. … is a measure of how much buyers and sellers respond to changes in market conditions

4. Elasticity... Price Elasticity of Supply = (% change in quantity supplied) (% change in price) The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good, with all other factors remaining the same.factors How much it increases depends on the elasticity of supply.

5. 5 Healthy red wine ◦increase red wine demand ◦Increase price ◦Switch from white to red grape production ◦Increased supply Higher price results in response of more quantity supplied

6. 6 Also here? Fixed supply

7. Elasticity... Price Elasticity of Demand = (% change in quantity demanded) (% change in price) The elasticity of demand measures the responsiveness of the quantity demanded to a change in the price of a good, with all other factors remaining the same.factors How much it increases depends on the elasticity of demand

8. 8

9. 9

10. Price Elasticity of Demand 10

11. Price Elasticity of Demand Law of Demand ◦Change occurs then equilibrium price rises and the equilibrium quantity decreases. ◦But does the price rise by a large amount and the quantity decrease by a little? The answer depends on the responsiveness of the quantity demanded of a good to a change in its price.

12. Price Elasticity of Demand Role of Slope of the Demand Curve in assessing responsiveness of price changes ◦If the demand curve is steep, the price rises and Qd barely changes ◦if the demand curve is almost flat, the price rises and Qd changes a great deal ◦To measure responsiveness we need a measure that is independent of units of measurement. – ◦Elasticity is such a measure.

13. What is the Price Elasticity of Demand? The price elasticity of demand reviews the percentage change in the quantity demanded resulting from a percentage change in price. ◦Epsilon (ε) to represent price elasticity of demand. Firms want to understand the relationship between Qd and Price ◦They know if they increase the price - Qd will decrease but they want to know how much it will decrease ◦And vice versa 13

14. How to calc Price Elasticity of Demand? Option 1 Point Elasticity ε = Price elasticity of demand is computed along a demand curve. (ΔQ/Q) (ΔP/P) = 14

15. How to calculate Price Elasticity of Demand? Option 1 Point Elasticity (using slope values) ε = (ΔQ/Q)/(ΔP/P) where rise/run = ΔP/ΔQ So can simply use ε = (P/Q)(1/slope) 15

16. How to calculate Price Elasticity of Demand? Option 2 Arc Elasticity ε = Where % change in P = x 100 % change in Q = x 100 16

17. Price Elasticity of Demand ( ε ) Option 1 and 2 are known as point elasticity Option 3 is arc elasticity 17

18. Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as:

19. Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:

20. Price Elasticity of Demand and the Demand Curve ◦Figure 4.1 calculates the price elasticity of demand for pizza. ◦Initially, the price of a pizza is $20.50 and the quantity demanded is 9 pizzas an hour.

21. Price Elasticity of Demand and the Demand Curve ◦The price of a pizza falls to $19.50 and the quantity demanded increases to 11 pizzas an hour. ◦The price falls by $1 and the quantity demanded increases by 2 pizzas an hour.

22. Price Elasticity of Demand and the Demand Curve ◦The percentage change in quantity demanded, %DQ, is calculated as DQ/Qave x 100, which is ◦(2/10) x 100 = 20%. ◦The percentage change in price, %DP, is calculated as DP/Pave x 100, which is ◦ ($1/$20) x 100 = 5%. ◦The price elasticity of demand equals ◦%  Q / %  P = 20% / 5% ◦ = 4.

23. ◦Average Price and Quantity ◦By using the average price and average quantity, we get the same elasticity value regardless of whether the price rises or falls. ◦Percentages and Proportions ◦The ratio of two proportionate changes is the same as the ratio of two percentage changes. ◦%  Q / %  P =  Q /  P Note this about Price Elasticity of Demand

24. ◦A Units-Free Measure ◦Elasticity is a ratio of percentages, so a change in the units of measurement of price or quantity leaves the elasticity value the same. ◦Minus Sign and Elasticity ◦The formula yields a negative value, because price and quantity move in opposite directions. ◦But it is the magnitude, or absolute value, that reveals how responsive the quantity change has been to a price change. Note this about Price Elasticity of Demand

25. The Variety of Demand Curves Inelastic Demand ◦Quantity demanded does not respond strongly to price changes. ◦Price elasticity of demand is less than one. Elastic Demand ◦Quantity demanded responds strongly to changes in price. ◦Price elasticity of demand is greater than one.

26. The Variety of Demand Curves Perfectly Inelastic ◦Quantity demanded does not respond to price changes. Perfectly Elastic ◦Quantity demanded changes infinitely with any change in price. Unit Elastic ◦Quantity demanded changes by the same percentage as the price.

27. The Variety of Demand Curves Perfectly Inelastic Demand: Elasticity Equals 0 $5 4 Quantity Demand 100 0 1. An increase in price... 2.... leaves the quantity demanded unchanged. Price

28. The Variety of Demand Curves Perfectly Elastic Demand: Elasticity Equals Infinity Quantity 0 Price $4 Demand 2. At exactly $4, consumers will buy any quantity. 1. At any price above $4, quantity demanded is zero. 3. At a price below $4, quantity demanded is infinite.

29. The Variety of Demand Curves If ϵ p > 1, elastic then ◦1 % Change in P results in a > 1% Change is Q If ϵ p < 1, inelastic then ◦1 % Change in P results in a < 1% Change is Q If ϵ p = 1, unitary then ◦1 % Change in P results = 1% Change is Q 29

30. The Factors That Influence the Elasticity of Demand ◦The elasticity of demand for a good depends on:  The closeness of substitutes  The proportion of income spent on the good  The time elapsed since a price change Factors that Influence Price Elasticity of Demand

31. ◦Closeness of Substitutes ◦The closer the substitutes for a good or service, the more elastic is the demand for the good or service. ◦Necessities, such as food or housing, generally have inelastic demand. ◦Luxuries, such as exotic vacations, generally have elastic demand. Factors that Influence Price Elasticity of Demand

32. ◦Proportion of Income Spent on the Good ◦The greater the proportion of income consumers spend on a good, the larger is the elasticity of demand for that good. ◦Time Elapsed Since Price Change ◦The more time consumers have to adjust to a price change, or the longer that a good can be stored without losing its value, the more elastic is the demand for that good. Factors that Influence Price Elasticity of Demand

33. Elasticity Along a Linear Demand Curve ◦Figure 4.3 shows how the elasticity of demand changes along a linear demand curve. ◦At the mid-point of the demand curve, demand is unit elastic.

34. Elasticity Along a Linear Demand Curve ◦At prices above the mid- point of the demand curve, demand is elastic. ◦At prices below the mid- point of the demand curve, demand is inelastic.

35. Elasticity Along a Linear Demand Curve ◦For example, if the price falls from $25 to $15, the quantity demanded increases from 0 to 20 pizzas an hour. ◦The average price is $20 and the average quantity is 10 pizzas. ◦The price elasticity of demand is (20/10) divided by (10/20), which equals 4.

36. Elasticity Along a Linear Demand Curve ◦If the price falls from $10 to $0, the quantity demanded increases from 30 to 50 pizzas an hour. ◦The average price is $5 and the average quantity is 40 pizzas. ◦The price elasticity is (20/40) divided by (10/5), which equals 1/4.

37. Elasticity Along a Linear Demand Curve ◦If the price falls from $15 to $10, the quantity demanded increases from 20 to 30 pizzas an hour. ◦The average price is $12.50 and the average quantity is 25 pizzas. ◦The price elasticity is (10/25) divided by (5/12.5), which equals 1.

38. Total Revenue and the Price Elasticity of Demand Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold. TR = P x Q

39. Figure 2 Total Revenue Demand Quantity Q P 0 Price P × Q = $400 (revenue) $4 100 Total Revenue and the Price Elasticity of Demand

40. How Total Revenue Changes When Price Changes: Inelastic Demand Demand Quantity 0 Price Revenue = $100 Quantity 0 Price Revenue = $240 Demand $1 100 $3 80 An Increase in price from $1 to $3 … … leads to an Increase in total revenue from $100 to $240

41. Elasticity and Total Revenue along a Linear Demand Curve With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.

42. How Total Revenue Changes When Price Changes: Elastic Demand Copyright©2003 Southwestern/Thomson Learning Demand Quantity 0 Price Revenue = $200 $4 50 Demand Quantity 0 Price Revenue = $100 $5 20 An Increase in price from $4 to $5 … … leads to an decrease in total revenue from $200 to $100

43. Elasticity of a Linear Demand Curve

44. Price Elasticity of Demand The change in total revenue due to a change in price depends on the elasticity of demand: ◦If demand is elastic, a 1 percent price cut increases the quantity sold by more than 1 percent, and total revenue increases. ◦If demand is inelastic, a 1 percent price cut increases the quantity sold by less than 1 percent, and total revenues decreases. ◦If demand is unit elastic, a 1 percent price cut increases the quantity sold by 1 percent, and total revenue remains unchanged.

45. Firms use of price elasticity of demand 45

46. Why is Price Elasticity of Demand useful to firms? Why is elasticity useful? ◦ We know if we raise a price, ◦ the Qd will decline (law of demand) but firms want to know how much of a Q change will occur In Business, we want to know the relationship between Qd and Price.. Put it on sale or not.. 46

47. 47 Suppose a retail gourmet coffee outlet is selling its premium “Cappuccino ” for $3/cup. The store generally is selling 15 cups of “Cappuccino ” per hour, and the store manager is thinking seriously of raising the price to $5/cup. She knows they will lose some sales but thinks that most of the customers are willing to pay more. Link the price to total expenditure ◦also called total revenue for firms Cappuccino Decisions

48. Firms use price elasticity of Demand to determine price changes ElasticityChanges in Price Changes in Total Revenue ε D < 1 Increases Decreases ε D = 1 IncreasesUnchanged DecreasesUnchanged ε D > 1 IncreasesDecreases Increases Can you logic these out.. This is important! 48

49. 49 ProductPrice Elasticity ◦Green Beans 2.80 ◦Beer 1.19 ◦Theatre.18 How do you interpret these? And why?

50. 50 How do Policy makers use ED? o Tobacco or Alcohol How do Business people use price elasticity of demand? ◦Branded products ◦Commodity products ◦Differentiated products

51. Other Types of Elasticity CONSIDER THE OTHER TYPES OF ELASTICITY 51

52. Income Elasticity of Demand ◦The percentage amount by which the quantity demanded changes in response to a one-percent change in income Income Elasticity of Demand If income elasticity is positive: the good is normal. Why? If income elasticity is negative: the good is inferior. Why? 52

53. Cross Price Elasticity of Demand ◦The percentage amount by which the quantity demanded of one good changes in response to a one-percent change in the price of another good Cross Price Elasticity of Demand  If cross price elasticity is positive: goods are substitutes. Why?  If cross price elasticity is negative: goods are not substitutes but complements. Why? 53

54. Cross Price Elasticity of Demand In Cross Price Elasticity of Demand & Income Elasticity of Demand we do not take the absolute value.. Instead we use them to determine relationships Why can we then take the absolute value in price elasticity of demand (looking at P & Q of same good) but not in these? 54

55. Cross Price Elasticity of Demand ◦Figure 4.5 shows the increase in the quantity of pizza demanded when the price of a burger (a substitute for pizza) rises. ◦The figure also shows the decrease in the quantity of pizza demanded when the price of a soft drink (a complement of pizza) rises.

56. Cross Price Elasticity of Demand

57. Elasticity of Supply 57

58. Elasticity of Supply ◦The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good, when all other influences on selling plans remain the same. ◦Calculating the Elasticity of Supply ◦The elasticity of supply is calculated by using the formula: Percentage change in quantity supplied Percentage change in price

59. Elasticity of Supply ◦Figure 4.6 on the next slide shows three cases of the elasticity of supply. ◦Supply is perfectly inelastic if the supply curve is vertical and the elasticity of supply is 0. ◦Supply is unit elastic if the supply curve is linear and passes through the origin. (Note that slope is irrelevant.) ◦Supply is perfectly elastic if the supply curve is horizontal and the elasticity of supply is infinite.

60. Elasticity of Supply

61. The Variety of Supply Curves Copyright©2003 Southwestern/Thomson Learning (a) Perfectly Inelastic Supply: Elasticity Equals 0 $5 4 Supply Quantity100 0 1. An increase in price... 2.... leaves the quantity supplied unchanged. Price

62. The Variety of Supply Curves Copyright©2003 Southwestern/Thomson Learning (e) Perfectly Elastic Supply: Elasticity Equals Infinity Quantity 0 Price $4 Supply 3. At a price below $4, quantity supplied is zero. 2. At exactly $4, producers will supply any quantity. 1. At any price above $4, quantity supplied is infinite.

63. Factors That Influence the Elasticity of Supply The Factors That Influence the Elasticity of Supply ◦The elasticity of supply depends on  Resource substitution possibilities  Time frame for supply decision ◦Resource Substitution Possibilities ◦The easier it is to substitute among the resources used to produce a good or service, the greater is its elasticity of supply.

64. Factors That Influence the Elasticity of Supply ◦Time Frame for Supply Decision ◦The more time that passes after a price change, the greater is the elasticity of supply. ◦Momentary supply is perfectly inelastic. The quantity supplied immediately following a price change is constant. ◦Short-run supply is somewhat elastic. ◦Long-run supply is the most elastic.

65. Ability of sellers to change the amount of the good they produce. ◦Beach-front land is inelastic. ◦Books, cars, or manufactured goods are elastic. Time period. ◦Supply is more elastic in the long run.

66. 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?

67. Examine whether the supply or demand curve shifts. Determine the direction of the shift of the curve. Use the supply-and-demand diagram to see how the market equilibrium changes.

68. Figure 8 An Increase in Supply in the Market for Wheat Quantity of Wheat 0 Price of Wheat 3.... and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220. Demand S1S1 S2S2 2.... leads to a large fall in price... 1. When demand is inelastic, an increase in supply... 2 110 $3 100

69. Compute the Price Elasticity of Supply Supply is inelastic

70. Table 4.1 provides a glossary of all the elasticity measures.

74. Questions Define, interpret and compute all three types of elasticity of demand. Identify shapes of perfectly elastic, perfectly inelastic and unit elastic demand curves and what their shapes imply Define and interpret values for income elasticity of demand. Define and interpret cross-price elasticity. Understand how firms use price elasticity of demand Understand relationship between price changes and total expenditure and total revenue for firms in elastic, inelastic and unitary 74

75. Questions Define and compute arc elasticity of demand. Calculate price elasticity of demand along a linear demand curve. Identify shapes of perfectly elastic, perfectly inelastic and unit elastic demand curves. Define and interpret values for income elasticity of demand. Define and interpret cross-price elasticity. 75

76. End of slides 76

77. Extra examples 77

78. Income Milk ◦Milk has a low positive Income Elasticity of Demand value of + 0.3 ◦Income Elasticity of Demand a product like milk is inelastic because if income increases the quantity consumed of milk remains much the same. Fillet + 5 ◦Fillet of steak is elastic because if income increases the quantity consumed will rise substantially and it will have a high positive Income Elasticity of Demand value e.g. + 5 78

79. EXTRA INFO: Can you interpret these? 79

80. Income Elasticity of Demand for Chocolate Total consumption USA 0.79 Germany 0.39 United Kingdom 0.44 France 0.60 Japan 0.08 Switzerland 1.06 Reference: Henri Jason Trends in cocoa and chocolate consumption with particular reference to developments in the major markets. Malaysian International Cocoa Conference, Kuala Lumpur, 20-21 October 1994 (ICCO, ED(MEM) 686) Which country has the sweeter tooth when it comes to income elasticity for chocolate?? 80