1. Elasticity ECONOMICS

2. TM 5-2 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Define and calculate the price elasticity of demand Use a total revenue test and an expenditure test to estimate the price elasticity of demand Explain the factors that influence the price elasticity of demand

3. TM 5-3 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives (cont.) Define and calculate the cross elasticity of demand Define and calculate the income elasticity of demand Define and calculate the elasticity of supply

4. TM 5-4 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Define and calculate the price elasticity of demand Use a total revenue test and an expenditure test to estimate the price elasticity of demand Explain the factors that influence the price elasticity of demand

5. TM 5-5 Copyright © 1998 Addison Wesley Longman, Inc. The Price Elasticity of Demand You know that when supply increases, the equilibrium price falls and the equilibrium quantity increases. But does the price fall by a large amount and the quantity increase by a little? Or does the price barely fall and the quantity increase by a large amount?

6. TM 5-6 Copyright © 1998 Addison Wesley Longman, Inc. The Price Elasticity of Demand The price elasticity of demand is a units- free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buyers’ plans remain the same.

7. TM 5-7 Copyright © 1998 Addison Wesley Longman, Inc. S1S1 How a Change in Supply Changes Price and Quantity Quantity (pizza per hour) Price (dollars per pizza) 10.00 20.00 30.00 40.00 DaDa 0 255 1015 20 13 5.00 S0S0 An increase in supply brings... … and a small increase in quantity... Large price change and small quantity change … a large fall in price...

8. TM 5-8 Copyright © 1998 Addison Wesley Longman, Inc. S1S1 How a Change in Supply Changes Price and Quantity Quantity (pizza per hour) Price (dollars per pizza) 10.00 20.00 30.00 40.00 DbDb 0 255 1015 2017 15.00 S0S0 Small price change and large quantity change An increase in supply brings... … a small fall in price... … and a large increase in quantity...

9. TM 5-9 Copyright © 1998 Addison Wesley Longman, Inc. The Price Elasticity of Demand Percent change in quantity demanded Calculating Elasticity Price elasticity of demand = Percent change in price Express the changes in price and quantity demanded as percentages of the average price and the average quantity.

10. TM 5-10 Copyright © 1998 Addison Wesley Longman, Inc. The Price Elasticity of Demand Calculating Elasticity (cont.) The original price is $20.50 and the new price is $19.50, so the average price is $20. The $1.00 price decrease is 5 percent of the average price. ∆P/P avg = ($1/$20) x 100 = 5%

11. TM 5-11 Copyright © 1998 Addison Wesley Longman, Inc. The Price Elasticity of Demand Calculating Elasticity (cont.) The original quantity demanded is 9 pizzas and the new quantity demanded is 11 pizzas. The 2 pizza increase in the quantity demanded is 20 percent of the average quantity. ∆Q/Q avg = (2/10) x 100 = 20%

12. TM 5-12 Copyright © 1998 Addison Wesley Longman, Inc. The Price Elasticity of Demand Calculating Elasticity (cont.) Price elasticity of demand = 20% 5% =4

13. TM 5-13 Copyright © 1998 Addison Wesley Longman, Inc. Calculating the Elasticity of Demand 9 10 11 19.50 20.50 D New point P avg = $20 = $1 = 2 Quantity (pizza per hour) Price (dollars per pizza) 20.00 Elasticity = 4 Q avg = 10 Original point

14. TM 5-14 Copyright © 1998 Addison Wesley Longman, Inc. The Price Elasticity of Demand Average Price and Quantity We use the average price and average quantity to avoid having two values for the elasticity of demand at a single point on the demand curve, depending whether the price falls or rises.

15. TM 5-15 Copyright © 1998 Addison Wesley Longman, Inc. The Price Elasticity of Demand Percentages and Proportions Elasticity is the ratio of the percentage change in the quantity demanded to the percentage change in the price. Equivalently, the proportionate change in the quantity demanded divided by the proportionate change in price.

16. TM 5-16 Copyright © 1998 Addison Wesley Longman, Inc. The Price Elasticity of Demand A Units-Free Measure Elasticity is a units-free measure because the percentage change in each variable is independent of the units in which the variable is measured. And the ratio of the two percentages is a number without units.

17. TM 5-17 Copyright © 1998 Addison Wesley Longman, Inc. The Price Elasticity of Demand Minus Sign and Elasticity The price elasticity of demand is a negative number. But, it is the magnitude, or absolute value, of the price elasticity of demand that tells us how elastic demand is. We use the magnitude and ignore the minus sign.

18. TM 5-18 Copyright © 1998 Addison Wesley Longman, Inc. The Price Elasticity of Demand Inelastic and Elastic Demand Perfectly inelastic demand Implies that quantity demanded remains constant when price changes occur. Price elasticity of demand = 0

19. TM 5-19 Copyright © 1998 Addison Wesley Longman, Inc. The Price Elasticity of Demand Inelastic and Elastic Demand (cont.) Unit elastic demand Implies that the percentage change in quantity demanded equals the percentage change in price. Price elasticity of demand = 1

20. TM 5-20 Copyright © 1998 Addison Wesley Longman, Inc. Inelastic and Elastic Demand Inelastic and Elastic Demand (cont.) Perfectly elastic demand Implies that if price changes by any percentage, quantity demanded will fall to 0. Price elasticity of demand =

21. TM 5-21 Copyright © 1998 Addison Wesley Longman, Inc. Inelastic and Elastic Demand Inelastic and Elastic Demand (cont.) Inelastic demand Implies the percentage change in quantity demanded is less than the percentage change in price. Price elasticity of demand > 0 and < 1.

22. TM 5-22 Copyright © 1998 Addison Wesley Longman, Inc. Inelastic and Elastic Demand Inelastic and Elastic Demand (cont.) Elastic demand Implies the percentage change in quantity demanded is greater than the percentage change in price. Price elasticity of demand > 1.

23. TM 5-23 Copyright © 1998 Addison Wesley Longman, Inc. Inelastic and Elastic Demand 6 12 Price Quantity D1D1 Elasticity = 0 Perfectly inelastic demand 0

24. TM 5-24 Copyright © 1998 Addison Wesley Longman, Inc. Inelastic and Elastic Demand 6 12 Price Quantity D2D2 1 2 3 Elasticity = 1 Unit elastic demand 0

25. TM 5-25 Copyright © 1998 Addison Wesley Longman, Inc. Inelastic and Elastic Demand 6 12 Price Quantity D3D3 Elasticity = Perfectly elastic demand 0

26. TM 5-26 Copyright © 1998 Addison Wesley Longman, Inc. Inelastic and Elastic Demand Elasticity Along a Straight-Line Demand Curve Along a straight-line demand curve, the elasticity varies. At high prices and small quantities, the elasticity is large and at low prices and large quantities, the elasticity is small.

27. TM 5-27 Copyright © 1998 Addison Wesley Longman, Inc. Elasticity Along a Straight-Line Demand Curve 0 10 20 25 30 40 50 12.50 5.00 10.00 15.00 20.00 25.00 Quantity (pizza per hour) Price (dollars per pizza) Elasticity = 1/4ElasticInelasticElasticity = 1Elasticity = 4

28. TM 5-28 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Define and calculate the price elasticity of demand Use a total revenue test and an expenditure test to estimate the price elasticity of demand Explain the factors that influence the price elasticity of demand

29. TM 5-29 Copyright © 1998 Addison Wesley Longman, Inc. Total Revenue and Elasticity When a price changes, the change in producers’ total revenue depends on the elasticity of demand.

30. TM 5-30 Copyright © 1998 Addison Wesley Longman, Inc. Total Revenue and Elasticity Elastic demand: a 1 percent price cut increases the quantity sold by more than 1 percent and total revenue increases. Unit elastic demand: a 1 percent price cut increases the quantity sold by 1 percent and so total revenue does not change. Inelastic demand: a 1 percent price cut increases the quantity sold by less than 1 percent and total revenue decreases.

31. TM 5-31 Copyright © 1998 Addison Wesley Longman, Inc. Total Revenue and Elasticity Total Revenue Test Price elasticity of demand can be estimated by observing the change in total revenue that results from a price change (ceteris paribus).

32. TM 5-32 Copyright © 1998 Addison Wesley Longman, Inc. Total Revenue and Elasticity Total Revenue Test If a price cut increases total revenue, demand is elastic. If a price cut decreases total revenue, demand is inelastic. If a price cut leaves total revenue unchanged, demand is unit elastic.

33. TM 5-33 Copyright © 1998 Addison Wesley Longman, Inc. Elasticity and Total Revenue

34. TM 5-34 Copyright © 1998 Addison Wesley Longman, Inc. 350.00 25 50 12.50 5.00 10.00 20.00 25.00 0 25 50 150.00 200.00 250.00 312.50 Total Revenue (billions of dollars) Maximum total revenue When demand is inelastic, price cut decreases total revenue Unit elastic Elastic demand Quantity (pizza per hour) Price (dollars per pizza) 15.00 Inelastic demand 300.00 100.00 50.00 0 When demand is elastic, price cut increases total revenue

35. TM 5-35 Copyright © 1998 Addison Wesley Longman, Inc. Total Revenue and Elasticity Your Expenditure and Your Elasticity If your demand is elastic, a 1 percent price cut increases the quantity you buy by more than 1 percent and your expenditure on the item increases.

36. TM 5-36 Copyright © 1998 Addison Wesley Longman, Inc. Total Revenue and Elasticity Your Expenditure and Your Elasticity (cont.) If your demand is unit elastic, a 1 percent price cut increases your quantity bought by 1 percent and so your expenditure on the item does not change.

37. TM 5-37 Copyright © 1998 Addison Wesley Longman, Inc. Total Revenue and Elasticity Your Expenditure and your Elasticity (cont.) If your demand is inelastic, a 1 percent price cut increases your quantity bought by less than 1 percent and so your expenditure on the item decreases.

38. TM 5-38 Copyright © 1998 Addison Wesley Longman, Inc. Some Real-World Price Elasticities of Demand Good or ServiceElasticity Elastic Demand Metals1.52 Electrical engineering products1.30 Mechanical engineering products1.30 Furniture1.26 Motor vehicles1.14 Instrument engineering products1.10 Professional services1.09 Transportation services1.03 Inelastic Demand Gas, electricity, and water0.92 Oil0.91 Chemicals0.89 Beverages (all types)0.78 Clothing0.64 Tobacco0.61 Banking and insurance services0.56 Housing services0.55 Agricultural and fish products0.42 Books, magazines, and newspapers0.34 Food0.12

39. TM 5-39 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Define and calculate the price elasticity of demand Use a total revenue test and an expenditure test to estimate the price elasticity of demand Explain the factors that influence the price elasticity of demand

40. TM 5-40 Copyright © 1998 Addison Wesley Longman, Inc. Factors That Influence Elasticity the Elasticity of Demand Closeness of Substitutes. The closer the substitutes, the more elastic the demand. necessities luxuries

41. TM 5-41 Copyright © 1998 Addison Wesley Longman, Inc. Factors That Influence Elasticity the Elasticity of Demand Proportion of Income Spent on the Good The greater the proportion of income spent on food, the more elastic the demand. Time Elapsed Since Price Change The longer the time, the more elastic the demand. Short-run demand Long-run demand

42. TM 5-42 Copyright © 1998 Addison Wesley Longman, Inc. Price Elasticities in 20 Countries

43. TM 5-43 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Define and calculate the cross elasticity of demand Define and calculate the income elasticity of demand Define and calculate the elasticity of supply

44. TM 5-44 Copyright © 1998 Addison Wesley Longman, Inc. More Elasticities of Demand Cross elasticity of demand Measures the responsiveness of the demand for a good to a change in the price of a substitute or complement good. Cross elasticity of demand = Percentage change in quantity demanded Percentage change in price of a substitute or complement

45. TM 5-45 Copyright © 1998 Addison Wesley Longman, Inc. Cross Elasticity of Demand Price of pizzas Quantity of pizzas Price of soda, a complement, falls. Negative cross elasticity. D2D2 Price of a burger, a substitute, falls. Positive cross elasticity. D0D0 D1D1 0

46. TM 5-46 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Define and calculate the cross elasticity of demand Define and calculate the income elasticity of demand Define and calculate the elasticity of supply

47. TM 5-47 Copyright © 1998 Addison Wesley Longman, Inc. Income Elasticity of Demand Income elasticity Measures the responsiveness of the demand to a change in income. Income elasticity of demand = Percentage change in quantity demanded Percentage change in income

48. TM 5-48 Copyright © 1998 Addison Wesley Longman, Inc. Income Elasticity of Demand Income elasticity can be: 1 ) Greater than 1 (normal good, income elastic) 2 ) Between zero and 1 (normal good, income inelastic) 3 ) Less than zero (inferior good)

49. TM 5-49 Copyright © 1998 Addison Wesley Longman, Inc. Income Elasticity of Demand Income Quantity demanded Income Quantity demanded m Income inelastic Income elastic Positive income elasticity Negative income elasticity Elasticity greater than 1 Elasticity between zero and 1 Elasticity less than 1 and becomes negative

50. TM 5-50 Copyright © 1998 Addison Wesley Longman, Inc. Some Real-World Income Elasticities of Demand Elastic Demand Airline Travel5.82 Movies3.41 Foreign Travel3.08 Electricity1.94 Restaurant meals1.61 Local buses and trains1.38 Haircutting1.36 Cars1.07 Inelastic Demand Tobacco0.86 Alcoholic beverages0.62 Furniture0.53 Clothing0.51 Newspapers and magazines0.38 Telephone0.32 Food0.14

51. TM 5-51 Copyright © 1998 Addison Wesley Longman, Inc. Income Elasticities in 15 Countries

52. TM 5-52 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Define and calculate the cross elasticity of demand Define and calculate the income elasticity of demand Define and calculate the elasticity of supply

53. TM 5-53 Copyright © 1998 Addison Wesley Longman, Inc. Elasticity of Supply Elasticity of supply measures the responsiveness of quantity supplied to a change in price. Elasticity of supply = Percentage change in quantity supplied Percentage change in price

54. TM 5-54 Copyright © 1998 Addison Wesley Longman, Inc. How a Change in Demand Changes Price and Quantity Quantity (pizza per hour) Price (dollars per pizza) 10.00 30.00 40.00 D0D0 0 255 1015 20 13 SaSa … a large price rise... Large price change and small quantity change 20.00 D1D1 An increase in demand brings... … and a small quantity increase...

55. TM 5-55 Copyright © 1998 Addison Wesley Longman, Inc. How a Change in Demand Changes Price and Quantity Quantity (pizza per hour) Price (dollars per pizza) 10.00 30.00 40.00 D0D0 0 255 1015 20 SbSb … a small price rise... Small price change and large quantity change 20.00 D1D1 An increase in demand brings... 21.00 … and a large quantity increase...

56. TM 5-56 Copyright © 1998 Addison Wesley Longman, Inc. Elasticity of Supply Supply elasticity depends on: Resource substitution possibilities Time frame for the supply decision

57. TM 5-57 Copyright © 1998 Addison Wesley Longman, Inc. Inelastic and Elastic Demand Price Quantity S1S1 Elasticity of supply = 0 Perfectly inelastic supply 0

58. TM 5-58 Copyright © 1998 Addison Wesley Longman, Inc. Inelastic and Elastic Demand Price Quantity S1S1 Elasticity of supply = 1 Unit elastic supply 0

59. TM 5-59 Copyright © 1998 Addison Wesley Longman, Inc. Inelastic and Elastic Demand Price Quantity S3S3 Elasticity of supply = Perfectly elastic supply 0

60. TM 5-60 Copyright © 1998 Addison Wesley Longman, Inc. Elasticity of Supply Resource Substitution Possibilities The more unique the resource, the more inelastic the supply. Van Gogh painting - Van Gogh Wheat/corn — farmland

61. TM 5-61 Copyright © 1998 Addison Wesley Longman, Inc. Elasticity of Supply Time Frame for Supply Decisions Momentary supply Long-run supply Short-run supply The longer producers have to adjust to a price change, the more elastic is supply.

62. TM 5-62 Copyright © 1998 Addison Wesley Longman, Inc. A Compact Glossary of Elasticities PRICE ELASTICITIES OF DEMAND A relationship is described as When its magnitude is Which means that Perfectly elastic or infinitely elastic Unit elastic In elastic Perfectly inelastic or completely inelastic InfinityThe smallest possible increase in price causes an infinitely large decrease in quantity demanded Less than infinity but greater than 1 Greater than zero but less than 1 Elastic 1 Zero The percent decrease in the quantity demanded exceeds the percent increase in price The percent decrease in the quantity demanded equals the percent increase in price The percentage decrease in the quantity demanded is less than the percent increase in price. The quantity demanded is the same at all prices

63. TM 5-63 Copyright © 1998 Addison Wesley Longman, Inc. A Compact Glossary of Elasticities CROSS ELASTICITIES OF DEMAND A relationship is described as When its magnitude is Which means that Perfect substitutesInfinityThe smallest possible increase in price of one good causes an infinitely large in the demand of the other good. Positive, less than infinity SubstitutesIf the price of one good increases, the quantity demanded of the other good also increases. IndependentZeroThe demand for one good remains constant, regardless of the price of the other good. ComplementsLess than zeroThe demand for one good decreases when the price of the other good increases.

64. TM 5-64 Copyright © 1998 Addison Wesley Longman, Inc. A Compact Glossary of Elasticities INCOME ELASTICITIES OF DEMAND A relationship is described as When its magnitude is Which means that Income elastic (normal good) Greater than 1The percent increase in the quantity demanded is greater than the percentage increase in income. Less than 1 but greater than zero Income inelastic (normal good) The percent increase in the quantity demanded is less than the percentage increase in income. Negative income elastic (inferior good) Less than zeroWhen income increases, quantity demanded decreases.

65. TM 5-65 Copyright © 1998 Addison Wesley Longman, Inc. A Compact Glossary of Elasticities ELASTICITIES OF SUPPLY A relationship is described as When its magnitude is Which means that Perfectly elasticInfinityThe smallest possible increase in price causes an infinitely large increase in the quantity supplied. Less than infinity but greater than 1 ElasticThe percent increase in the quantity supplied exceeds the percentage increase in the price. InelasticGreater than zero but less than 1 The percentage increase in the quantity supplied is less than the percentage increase in price. Perfectly inelasticZeroThe quantity supplied is the same at all prices.