next chapter 04slide 1 (a) Inelastic Demand © Pearson 2009.

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next chapter 04slide 1 (a) Inelastic Demand © Pearson 2009

next chapter 04 © Pearson 2009 slide 2 (b) Elastic Demand © Pearson 2009

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end of Chapter 4

Part 2: The Price Mechanism Chapter 4: Elasticity and its Application

next chapter 04© Pearson 2009slide 6 Price elasticity of demand The degree of responsiveness of quantity demanded to a change in price –Elastic demand: change in quantity demanded more than proportionate to change in price –Unit elasticity: response in quantity demanded is proportionate to change in price –Inelastic demand: response in quantity demanded is less than proportionate to change in price Elasticity coefficients Fig 4.1Fig 4.1 –Elastic demand; P  d > 1 –Unit elastic demand; P  d = 1 –Inelastic demand; P  d < 1 –Perfectly inelastic demand; P  d = 0 –Infinitely elastic demand; P  d = ∞

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next chapter 04© Pearson 2009slide 8 Measurement of price elasticity of demand P  d = percentage change in quantity demanded divided by percentage change in price –Called the coefficient of elasticity –Example: P  d =.58 for food (i.e. inelastic) –Example: P  d = 1.26 for furniture (i.e. elastic) Elasticity varies along a linear demand curve Fig 4.2Fig 4.2 –Elasticity measures relative change rather than slope Determinants of elasticity of demand Fig 4.3Fig 4.3 –Availability of substitutes –Necessity (inelastic) versus luxury (elastic) –Proportion of income spent on the commodity –Time

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next chapter 04© Pearson 2009slide 11 Application of Price elasticity Price changes impact on total revenue Fig 4.4Fig 4.4 –Total Revenue = Price x Quantity (TR = PQ) Price increase –An increase in price increases TR when demand is inelastic –An increase in price decreases TR when demand is elastic –An increase in price has no impact on TR when demand has unitary elasticity Price decrease –A decrease in price increases TR when demand is elastic –A decrease in price decreases TR when demand is inelastic –A decrease in price has no impact on TR when demand has unitary elasticity

next chapter 04© Pearson 2009slide 12 Primary production and demand elasticity Partial Crop failure Fig 4.5Fig 4.5 –Many vegetables have inelastic demand, example potato –Reduced quantity due to poor harvesting conditions increases price –However, the response by consumers is to reduce quantity demanded by a relatively smaller percentage than that for the price increase (i.e. inelastic) –Overall, the increase in TR due to the higher price is greater than the reduction in TR due to the lower quantity demanded. –Therefore TR increases –It may be the case that some growers benefit while others suffer since the adverse conditions may not affect all growers evenly.

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next chapter 04© Pearson 2009slide 14 Indirect taxation and elasticity Objective of indirect taxes –Revenue generation: example - goods and services tax (GST) –Discourage consumption: example - tax on tobacco; carbon tax Incidence of tax when demand is inelastic Fig 4.6aFig 4.6a –Tax imposed on goods with inelastic demand places a greater tax burden (share) on consumers than producers –Decrease in quantity demanded is relatively small making this a successful means of raising revenue Incidence of tax when demand is elastic Fig 4.6bFig 4.6b –Tax imposed on goods with elastic demand places a greater tax burden (share) on producers than consumers –Decrease in quantity demanded is relatively large making this a successful means of reducing consumption

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next chapter 04© Pearson 2009slide 17 Other types of elasticity of demand Income elasticity of demand –Measures the responsiveness of demand to a change in income: –Income elastic: percentage change in quantity demanded is greater than percentage change in income; implies the good is a luxury –Example: airline travel – income elasticity coefficient = 5.8 –Income inelastic: % change in quantity demanded is less than % change in income; implies the good is a necessity –Example: telephone – income elasticity coefficient = 0.32 see Table 4.4 –Income elasticity with a negative coefficient implies an inferior good Cross-price elasticity of demand –Measures the % change in the demand for one good (A) in response to a change in price of another good (B) –Cross-price elasticity is positive for substitutes and negative for complements –Example: margarine and butter – cross-elasticity coefficient = + 0.81 –Example: Sugar and fruits – cross-elasticity coefficient = - 0.28 see Table 4.5

next chapter 04© Pearson 2009slide 18 Price elasticity of supply Measures the degree of responsiveness of quantity supplied of a good to a change in its price Fig 4.7Fig 4.7 –Elastic supply: the response to a given change in price is a more-than- proportionate change in quantity supplied –Inelastic supply: the response to a given change in price is a less-than- proportionate change in quantity supplied Factors determining the elasticity of supply –Nature: some goods are fixed by nature, such as land and Van Gogh paintings –Time: inputs into the production process take time to vary –Example: in the market (momentary) time period all inputs are fixed – supply is completely inelastic (fixed) –Example: in the short-run time period some inputs are variable – supply is inelastic and can increase supply only slightly –Example: in the long-run time period all inputs are variable – supply is elastic and can increase output significantly