1. Chapter Elasticity and Its Application 5

2. The Elasticity of Demand Elasticity – Measure of the responsiveness of quantity demanded or quantity supplied Percentage change in quantity demanded (∆Qd/Qd) Percentage change in quantity supplied (∆Qs/Qs) – To a change in one of its determinants (driver variables) Demand-side – (own) price demand elasticity (∆Qx/Qx)/ (∆Px/Px ) – Price of substitute/complement cross-price (∆Qx/Qx)/(∆Py/Py ) – Income income elasticity ((∆Qx/Qx)/ (∆I/I ) 2

3. The Elasticity of Demand (Own) Price elasticity of demand – Elastic demand (e.g. price elasticity) Quantity demanded responds substantially to changes in the price – elasticity of demand > 1 – ∆Qd/Qd > ∆P/P %change in Qd > % change in P – Inelastic demand Quantity demanded responds only slightly to changes in the price elasticity < 1 (closer to zero) ∆Qd/Qd < ∆P/P 3

4. The price elasticity of demand (d, e) 1 4 (d) Elastic demand: Elasticity > 1 1. an Price Quantity 0 $5 4 1.A 22% increase in price… 2. … leads to a 67% decrease in quantity demanded Demand 100 50 The price elasticity of demand determines whether the demand curve is steep or flat. Note that all percentage changes are calculated using the midpoint method. (e) Perfectly elastic demand: Elasticity equals infinity 1. an Price Quantity 0 Demand $4 1. At any price above $4, quantity demanded is zero 2. At exactly $4, consumers will buy any quantity 3. At any price below $4, quantity demanded is infinite

5. The Elasticity of Demand Determinants of (own) price elasticity of demand (∆Qx/Qx)/ (∆Px/Px ) – Availability of close substitutes Goods with close substitutes – More elastic demand – Necessities vs. luxuries Necessities – inelastic demand Luxuries – elastic demand – Definition of the market Narrowly defined markets – more elastic demand – Time horizon – More elastic over longer time horizons 5

6. The Elasticity of Demand (own) Computing the price elasticity of demand – Percentage change in quantity demanded Divided by percentage change in price – Use absolute value (drop the minus sign) It’s always negative (own-price) Midpoint method – Two points: (Q 1, P 1 ) and (Q 2, P 2 ) 6

7. The Elasticity of Demand Variety of demand curves – Demand is elastic Elasticity > 1 – Demand is inelastic Elasticity < 1 – Demand has unit elasticity Elasticity = 1 7

8. The Elasticity of Demand Cigarettes (US) [41] [41] – -0.3 to -0.6 (General) – -0.6 to -0.7 (Youth) – proportion of income? Soft drinks – -0.8 to -1.0 (general) [51] (broadly defined) [51] – -3.8 (Coca-Cola) [52] (narrow)Coca-Cola [52] – -4.4 (Mountain Dew) [52] (narrow)Mountain Dew [52] Car fuel [45] [45] – -0.25 (Short run) (same car – reduce trips) – -0.64 (Long run) (new car?) 8

9. The Elasticity of Demand Total revenue – Amount paid by buyers – Received by sellers of a good – Computed as: price of the good times the quantity sold (P ˣ Q) 9

10. Figure Total revenue 2 10 1. an P Q P ˣ Q=$400 (revenue) Quantity 0 Demand Price The total amount paid by buyers, and received as revenue by sellers, equals the area of the box under the demand curve, P × Q. Here, at a price of $4, the quantity demanded is 100, and total revenue is $400. 100 $4

11. The Elasticity of Demand Total revenue and price elasticity of demand Inelastic demand – Increase in price Increase in total revenue Elastic demand – Increase in price Decrease in total revenue 11

12. The Elasticity of Demand When demand is inelastic – Price and total revenue move in the same direction When demand is elastic – Price and total revenue move in opposite directions If demand is unit elastic – Total revenue remains constant when the price changes 12

13. The Elasticity of Demand Elasticity and total revenue along a linear demand curve Linear demand curve – Constant slope – Different elasticities Points with low price & high quantity – Inelastic Points with high price & low quantity – Elastic 13

14. Figure Elasticity of a linear demand curve (graph) 4 14 1. an Quantity 0 Price Demand $7 14 6 5 4 3 2 1 2 4 6 8 10 12 Elasticity is larger than 1 Elasticity is smaller than 1 The slope of a linear demand curve is constant, but its elasticity is not. The demand schedule in the table was used to calculate the price elasticity of demand by the midpoint method. At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic.

15. Figure Elasticity of a linear demand curve (schedule) 4 15 The slope of a linear demand curve is constant, but its elasticity is not. The demand schedule in the table was used to calculate the price elasticity of demand by the midpoint method. At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic. PriceQuantity Total revenue (Price ˣ Quantity) Percentage Change in Price Percentage Change in QuantityElasticityDescription $7 6 5 4 3 2 1 0 O 2 4 6 8 10 12 14 $0 12 20 24 20 12 0 15 18 22 29 40 67 200 67 40 29 22 18 15 13.0 3.7 1.8 1.0 0.6 0.3 0.1 Elastic Unit elastic Inelastic

16. Figure The Elasticity of Demand Income elasticity of demand – Measure of how much the quantity demanded of a good responds To a change in consumers’ income – Percentage change in quantity demanded Divided by the percentage change in income – Normal goods: positive income elasticity Necessities: smaller income elasticities (~0, <1) Luxuries: large income elasticities ( > 1) – Inferior goods: negative income elasticities (<0) 16

17. Figure The Elasticity of Demand Cross-price elasticity of demand – Measure of how much the quantity demanded of one good responds To a change in the price of another/different good – [∆Qx/Qx] / [∆Py/Py ] – Sign matters -> tells whether substitute or complement Magnitude ( 1) -> how “good” a substitute/essential a complement – Substitutes: Positive cross-price elasticity >1 -> “close” or good substitute as big shift with small price change – Complements: Negative cross-price elasticity >1 -> “essential” to be used/consumed together (cars and gas) 17

18. The Elasticity of Supply Price elasticity of supply – Measure of how much the quantity supplied of a good responds To a change in the price of that good – Percentage change in quantity supplied Divided by the percentage change in price – Depends on the flexibility of sellers to change the amount of the good they produce 18

19. The Elasticity of Supply Price elasticity of supply – Elastic supply Quantity supplied responds substantially to changes in the price – Inelastic supply Quantity supplied responds only slightly to changes in the price Determinant of price elasticity of supply – Time period Supply is more elastic in long run 19

20. The Elasticity of Supply Computing price elasticity of supply – Percentage change in quantity supplied Divided by percentage change in price Variety of supply curves – Supply is perfectly inelastic Elasticity =0 Supply curve – vertical – Supply is perfectly elastic Elasticity = infinity Supply curve – horizontal 20

21. The Elasticity of Supply Variety of supply curves – Unit elastic supply Elasticity =1 – Elastic supply Elasticity >1 – Inelastic supply Elasticity < 1 21

22. Figure The price elasticity of supply (a, b) 5 22 (a)Perfectly inelastic supply: Elasticity = 0 1. an Price Quantity 0 Supply 100 $5 4 1.An increase in price… 2. …leaves the quantity supplied unchanged (b) Inelastic supply: Elasticity < 1 1. an Price Quantity 0 $5 4 1.A 22% increase in price… 2. … leads to a 10% increase in quantity supplied 100 110 The price elasticity of supply determines whether the supply curve is steep or flat. Note that all percentage changes are calculated using the midpoint method. Supply

23. Figure The price elasticity of supply (c) 5 23 (c) Unit elastic supply: Elasticity =1 1. an Price Quantity 0 $5 4 1.A 22% increase in price… 2. … leads to a 22% increase in quantity supplied 100 125 The price elasticity of supply determines whether the supply curve is steep or flat. Note that all percentage changes are calculated using the midpoint method. Supply

24. Figure The price elasticity of supply (d, e) 5 24 The price elasticity of supply determines whether the supply curve is steep or flat. Note that all percentage changes are calculated using the midpoint method. (d) Elastic supply: Elasticity > 1 1. an Price Quantity 0 $5 4 1.A 22% increase in price… 2. … leads to a 67% increase in quantity supplied 100 50 (e) Perfectly elastic supply: Elasticity equals infinity 1. an Price Quantity 0 Supply $4 1. At any price above $4, quantity supplied is infinite 2. At exactly $4, producers will supply any quantity 3. At any price below $4, quantity supplied is zero Supply

25. Figure How the price elasticity of supply can vary 6 25 1. an Price Quantity 0 $15 12 Supply 100 525 Because firms often have a maximum capacity for production, the elasticity of supply may be very high at low levels of quantity supplied and very low at high levels of quantity supplied. Here an increase in price from $3 to $4 increases the quantity supplied from 100 to 200. Because the 67 percent increase in quantity supplied (computed using the midpoint method) is larger than the 29 percent increase in price, the supply curve is elastic in this range. By contrast, when the price rises from $12 to $15, the quantity supplied rises only from 500 to 525. Because the 5 percent increase in quantity supplied is smaller than the 22 percent increase in price, the supply curve is inelastic in this range. 500 200 4 3 Elasticity is small (less than 1). Elasticity is large (greater than 1).

26. Applications of Supply, Demand, & Elasticity Can good news for farming be bad news for farmers? – New hybrid of wheat – increase production per acre 20% Supply curve changes Supply curve shifts to the right Higher quantity; lower price Demand – inelastic – Total revenue falls – Paradox of public policy Induce farmers not to plant crops 26

27. Figure An increase in supply in the market for wheat 7 27 S1S1 S2S2 When an advance in farm technology increases the supply of wheat from S 1 to S 2, the price of wheat falls. Because the demand for wheat is inelastic, the increase in the quantity sold from 100 to 110 is proportionately smaller than the decrease in the price from $3 to $2. As a result, farmers’ total revenue falls from $300 ($3 × 100) to $220 ($2 × 110). Price of Wheat Quantity of Wheat 0 110 $3 2 100 Demand 1. When demand is inelastic, an increase in supply... 2. … leads to a large fall in price... 3. … and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220.

28. Applications of Supply, Demand, & Elasticity Why did OPEC fail to keep the price of oil high? – 1970s: OPEC reduced supply of oil Increase in prices 1973-1974 and 1971-1981 Short-run: supply is inelastic – Decrease in supply: large increase in price – 1982-1990 – price of oil decreased Long-run: supply is elastic – Decrease in supply: small increase in price 28

29. Figure 1. an Price 1. an Price A reduction in supply in the world market for oil 8 29 Demand P2P2 (a) The Oil Market in the Short Run Demand When the supply of oil falls, the response depends on the time horizon. In the short run, supply and demand are relatively inelastic, as in panel (a). Thus, when the supply curve shifts from S 1 to S 2, the price rises substantially. By contrast, in the long run, supply and demand are relatively elastic, as in panel (b). In this case, the same size shift in the supply curve (S 1 to S 2 ) causes a smaller increase in the price. (b) The Oil Market in the Long Run S1S1 S2S2 P1P1 1. In the short run, when supply and demand are inelastic, a shift in supply... 2. … leads to a large increase in price P2P2 S1S1 S2S2 P1P1 1. In the long run, when supply and demand are elastic, a shift in supply... 2. … leads to a small increase in price Quantity 0 0