1. C H A P T E R 5 Prepared by: Fernando and Yvonn Quijano © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin Elasticity: A Measure of Responsiveness

2. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 2 of 24 The Price Elasticity of Demand The price elasticity of demand (E d ) measures the responsiveness of consumers to changes in price.

3. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 3 of 24 The Price Elasticity of Demand For example, if the price of milk increases by 10% (from $2 to $2.20) and the quantity demanded decreases by 15% (from 100 to 85), the price elasticity of demand is: We compute the price elasticity of demand as follows:

4. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 4 of 24 Price Elasticity and the Demand Curve

5. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 5 of 24 Price Elasticity and the Demand Curve

6. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 6 of 24 Price Elasticity and the Demand Curve When demand is perfectly inelastic, the quantity demanded is the same at every price, so the price elasticity of demand is zero. When demand is perfectly elastic, the quantity demanded is infinitely responsive to changes in price, so the price elasticity of demand is infinite.

7. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 7 of 24 What Determines the Price Elasticity of Demand? The price elasticity of demand for a particular product depends on the availability of substitutes. Products with relatively inelastic demand have few good substitutes. The demand for a specific brand of a product is typically elastic.

8. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 8 of 24 What Determines the Price Elasticity of Demand? The short-run price elasticity of demand is typically smaller than the long-run elasticity. Elasticity is larger for goods that take a relatively large part of a consumer’s budget. The price elasticity of demand for some products varies with the age of the consumer.

9. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 9 of 24 Computing Price Elasticity: Initial Value versus Midpoint Table 5.1: Computing Percentage Changes and Elasticity OldNewInitial Value Method Midpoint value method Price $2.00$2.20 Percent change: 10% = $0.20 / $2.00Percent change: 9.52% = 0.20 / 2.10 Quantity 10085 Percent change: 15% = 15 / 100Percent change: 16.22% = 15 / 92.5 Elasticity: 1.5 = 15% / 10%Elasticity: 1.70 = 16.22% / 9.52% The midpoint method measures the percentage changes more precisely, so we get a more precise measure of price elasticity.

10. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 10 of 24 Elasticity Along a Linear Demand Curve The price elasticity of demand decreases as we move downward along a linear demand curve. Demand is elastic on the upper half of the demand curve and inelastic on the lower half. Percentage decrease in price Percentage increase in quantityElasticity Point r to point s 4 / 80 = 5%2 / 10 = 20%20% / 5% = 4.0 Point t to point u 4 / 50 = 8%2 / 25 = 8%8% / 8% = 1.0 Point v to point w 4 / 20 = 20%2 / 40 = 5%5% / 20% = 0.25

11. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 11 of 24 Using the Price Elasticity of Demand to Make Predictions Predicting changes in quantity demanded: We can rearrange the elasticity formula to predict changes in quantity demanded as a result of price changes. For example:

12. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 12 of 24 Predicting Changes in Total Revenue Table 5.2 Price and Total Revenue with Elastic Demand PriceQuantity of Tickets SoldTotal Revenue 4.00100$400 4.4080$352 An increase in the ticket price brings good news and bad news: Good news. You get more money for each ticket sold. Bad news. You sell fewer tickets.

13. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 13 of 24 Predicting Changes in Total Revenue Table 5.3 Elasticity and Total Revenue Type of Demand Value of Price Elasticity of Demand Change in Quantity Versus Change in Price Effect of Higher Price on Total Revenue Effect of Lower Price on Total Revenue ElasticGreater than 1.0Larger percentage change in quantity DecreasesIncreases InelasticLess than 1.0Smaller percentage change in quantity IncreasesDecreases Unitary elastic 1.0Same percentage changes in quantity and price Does not change

14. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 14 of 24 Predicting Changes in Total Revenue Total revenue reaches its maximum at the midpoint of the demand curve, where demand is unitary elastic. Demand is elastic along the upper half of a linear demand curve, so an increase in quantity increases total revenue. Demand is inelastic along the lower half of a linear demand curve, so a decrease in price decreases total revenue.

15. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 15 of 24 Other Elasticities of Demand The income elasticity of demand measures of the responsiveness of demand to changes in income, indicating how much more or less of a particular product is purchased as income changes.

16. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 16 of 24 Other Elasticities of Demand The cross elasticity of demand measures the responsiveness of demand to changes in the price of other goods.

17. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 17 of 24 The Price Elasticity of Supply The price elasticity of supply measures the responsiveness of producers to changes in price.

18. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 18 of 24 The Price Elasticity of Supply A 10% increase in the price of milk (from $2 to $2.20) increases the quantity supplied by 20% (from 100 million gallons to 120 million), so the price elasticity of supply is 2.0 = 20%/10%.

19. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 19 of 24 Predicting Changes in Quantity Supplied Predicting changes in quantity supplied: We can rearrange the elasticity formula to predict changes in quantity supplied as a result of price changes. For example:

20. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 20 of 24 Extreme Cases: Perfectly Inelastic Supply and Perfectly Elastic Supply When supply is perfectly elastic, the quantity supplied is infinitely responsive to changes in price, so the price elasticity of supply is infinite. When supply is perfectly inelastic, the quantity supplied is the same at every price, so the price elasticity of supply is zero.

21. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 21 of 24 Predicting Changes in Price Using Supply and Demand Elasticities The price-change formula shows the percentage change in equilibrium price resulting from a change in demand or supply, given values for the price elasticity of supply and price elasticity of demand.

22. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 22 of 24 Predicting Changes in Price Using Supply and Demand Elasticities In this example, an increase in demand shifts the demand curve to the right, increasing the equilibrium price. In this case, a 35% increase in demand increases the price by 10%.

23. C H A P T E R 5: Elasticity: A Measure of responsiveness C H A P T E R 5: Elasticity: A Measure of responsiveness © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 23 of 24 The Price Effects of a Change in Supply A slight variation of the price-change formula is used to predict the change in price resulting from a change in supply. For example, when the price elasticities of demand and supply are 0.6 and 1.4 respectively, an increase in the supply of milk by 10% will decrease equilibrium price by 5%.