1. Elasticity 04 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Elasticity Elasticity extends our understanding of markets by letting us know the degree to which changes in price affect the quantity supplied and the quantity demanded. Elasticity = Responsiveness

3. Price Elasticity of Demand The law of demand tells us that consumers will buy more of a good when its price falls and less when its price rises. But how much more or less? The amount varies from product to product and over different price ranges for the same product. It may also vary over time. Price elasticity of demand shows how responsive consumers are to a price change. LO1 4-3

4. 3 Ranges of Elasticity 1.Elastic Demand- When a given change in price causes a relatively larger change in the quantity demanded. See figure 4.2, panel a. 2.Inelastic Demand- When a given change in price causes a relatively smaller change in the quantity demanded, see panel b. 3.Unit Elastic- When a given change in price causes a proportional change in the quantity demanded, see panel c.

5. Price Elasticity of Demand Formula Use the midpoint formula Ensures consistent results Change in quantity Change in price Sum of quantities/2 Sum of prices/2 LO1 E d = ÷ 4-5

6. Interpretation of Elasticity of Demand E d > 1 demand is elastic E d = 1 demand is unit elastic E d < 1 demand is inelastic LO1 4-6

7. Total Revenue Test The importance of elasticity for firms relates to the effect of price changes on total revenue, and thus on profits. Total revenue is the amount the seller receives from the sale of his product and is calculated by multiplying the product price (P) by the quantity sold (Q) so TR=P×Q. LO2 4-7

8. Graphically, total revenue is represented by the P×Q rectangle lying below a point on the demand curve. See figure 4.2.

9. Total Revenue Test Key Point: What happens to total revenue when price changes? If total revenue changes in the opposite direction from price, demand is elastic. If total revenue changes in the same direction as price, demand is inelastic. If total revenue does not change when price changes, demand is unit elastic.

10. Total Revenue Test LO2 $3 2 1 0 10 20 30 40 Q P a b D1D1 Lower price and elastic demand Blue gain exceeds orange loss 4-10

11. Total Revenue Test LO2 $4 3 2 1 0 10 20 Q P c d D2D2 Lower price and inelastic demand Orange loss exceeds blue gain 4-11

12. Total Revenue Test LO2 $3 2 1 0 10 20 30 Q P e f D3D3 Lower price and unit elastic demand Blue gain equals orange loss 4-12

13. Total Revenue Test LO2 Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity Coefficient and the Total-Revenue Test (1) Total Quantity of Tickets Demanded per Week, Thousands (2) Price per Ticket (3) Elasticity Coefficient (E d ) (4) Total Revenue (1) X (2) (5) Total Revenue Test 1$8$8,000 275.0014,000Elastic 362.6018,000Elastic 451.5720,000Elastic 541.0020,000Unit Elastic 630.6418,000Inelastic 720.3814,000Inelastic 810.20 8,000Inelastic 4-13

14. Elasticity and Total Revenue LO2 012345678 012345678 Quantity Demanded Price Total Revenue (Thousands of Dollars) $20 18 16 14 12 10 8 6 4 2 $8 7 6 5 4 3 2 1 a b c d e f g h Elastic E d > 1 Unit Elastic E d = 1 Inelastic E d < 1 D TR 4-14

15. Summary of Price Elasticity of Demand LO2 Price Elasticity of Demand: A Summary Absolute Value of Elasticity CoefficientDemand Is:Description Impact on Total Revenue of a: Price IncreasePrice Decrease Greater than 1 (E d > 1) Elastic or relatively elastic Q d changes by a larger percentage than does price Total Revenue decreases Total Revenue increases Equal to 1 (E d = 1) Unit or unitary elastic Q d changes by the same percentage as does price Total revenue is unchanged Total revenue is unchanged Less than 1 (E d < 1) Inelastic or relatively inelastic Q d changes by a smaller percentage than does price Total revenue increases Total revenue decreases 4-15

16. Determinants of Elasticity of Demand The following generalizations can be helpful in determining the elasticity for a product. 1.Substitutability-The larger the number of substitute goods that are available, the greater the elasticity of demand. Candy bars are elastic Gasoline is inelastic LO1 4-16

17. 2.Proportion of Income- The higher the price of a good relative to consumers income, the greater the elasticity of demand. New cars are elastic Chewing gum is inelastic

18. 3.Luxuries vs. Necessities-The more the good is considered a “luxury”, the greater the elasticity of demand. Vacation travel is elastic Electricity is inelastic

19. 4.Time-Generally, product demand is more elastic the longer the time period under consideration. This is true for 2 reasons. Consumers are creatures of habit and often need time to adjust to changes in price. Product durability is another factor.

20. Price Elasticity of Demand LO1 Selected Price Elasticities of Demand Product or Service Price Elasticity of Demand (E d )Product or Service Price Elasticity of Demand (E d ) Newspapers.10Milk.63 Electricity (household).13Household appliances.63 Bread.15Liquor.70 MLB Tickets.23Movies.87 Telephone Service.26Beer.90 Cigarettes.25Shoes.91 Sugar.30Motor vehicles1.14 Medical Care.31Beef1.27 Eggs.32China, glassware1.54 Legal Services.37Residential land1.60 Automobile repair.40Restaurant meals2.27 Clothing.49Lamb and mutton2.65 Gasoline.60Fresh peas2.83 4-20

21. Applications of E d Large Crop Yields Inelastic demand, lower total revenue Excise Taxes Inelastic demand, more total revenue Decriminalization of Illegal Drugs Inelastic demand, more total revenue LO1 4-21

22. Price Elasticity of Supply Measures sellers’ responsiveness to price changes Elastic supply, producers are responsive to price changes Inelastic supply, producers are not responsive to price changes LO3 4-22

23. Price Elasticity of Supply Formula to compute elasticity E s > 1 supply is elastic E s < 1 supply is inelastic LO3 4-23

24. Price Elasticity of Supply Time is primary determinant of elasticity of supply Time periods considered Market period Short Run Long Run LO3 4-24

25. The Market Period LO3 P Q Perfectly inelastic supply D1D1 D2D2 SmSm Q0Q0 PmPm P0P0 4-25

26. The Short Run LO3 Supply is more elastic than in market period P Q D1D1 D2D2 SsSs Q0Q0 PsPs P0P0 QsQs 4-26

27. The Long Run LO3 Supply is even more elastic than in the short run P Q D1D1 D2D2 SlSl Q0Q0 PlPl P0P0 QlQl 4-27

28. Applications of Elasticity of Supply Antiques Inelastic supply Reproductions More elastic supply Volatile gold prices Inelastic supply LO3 4-28