1. 6-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Chapter 6 Elasticity and its applications

2. 6-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Learning objectives Introduce the concept of price elasticity of demand and discuss its determinants Relate price elasticity of demand to the changes in total revenue that result from a change in market price Introduce the concept of the elasticity of supply and its relationship to time Define the cross-price and income elasticities of demand Survey some applications of supply and demand analysis

3. 6-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Price elasticity of demand The price elasticity of demand is the measure of how responsive consumers’ demand quantity is to a change in the price of a product

4. 6-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Price elasticity is... Q P P1P1 P2P2 Q1Q1 Q2Q2 D As price increases from P 1 to P 2, quantity decreases from Q 1 to Q 2

5. 6-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Price elasticity is... (cont.) Q P P2P2 P1P1 Q2Q2 Q1Q1 D As price decreases from P 1 to P 2, quantity increases from Q 1 to Q 2

6. 6-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Price elasticity is... (cont.) Q P P1P1 P2P2 Q1Q1 Q2Q2 D But what percentage did price change and what percentage did quantity change?

7. 6-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia The price elasticity formula Original quantity demanded of X E d = Change in Quantity of X Change in Price of X Original Price of X Percentage change in price of X Percentage change in quantity demanded of X EdEd = ÷

8. 6-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Price elasticity of demand Percentages are used rather than absolute amounts to measure responsiveness –Absolute changes will be affected by choice of units –Percentages enable product comparison Ignore the minus sign –The absolute value of the coefficient is what is important

9. 6-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Price elasticity of demand (cont.) Elastic demand –A given percentage change in price results in a larger percentage change in quantity demanded E d > 1

10. 6-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Price elasticity of demand (cont.) Inelastic demand –A given percentage change in price results in a relatively smaller percentage change in quantity demanded E d < 1

11. 6-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Price elasticity of demand (cont.) Unit elasticity –A given percentage change in price results in an equal percentage change in quantity demanded E d = 1

12. 6-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Perfectly elastic demand Q P D1D1D1D1 Perfectly inelastic demand D2D2D2D2 Perfectly elastic demand

13. 6-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Midpoints formula EdEd= Change in quantity Sum of quantities/2 Change in price Sum of prices/2 

14. 6-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia

15. 6-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Total revenue (TR) test Elastic demand –A change in price will cause total revenue to change in the opposite direction. A decline in price will result in an increase in TR Inelastic demand –A change in price will cause total revenue to change in the same direction. A fall in price will result in lower TR Unit elasticity –A change in price leaves total revenue unchanged. An increase or decrease in price will leave TR unchanged

16. 6-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Determinants of price elasticity of demand Substitutability –The larger the number of good substitute the greater is elasticity Proportion of income –The higher the proportion of income spent on a good the greater the elasticity Luxuries versus necessities –Luxury items are generally elastic while necessities tend to be inelastic Time –The longer the period the more elastic is demand

17. 6-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Elasticity of demand: some applications Bumper crops Automation Excise taxes Heroin and crime

18. 6-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Price elasticity of supply Es=Es= Percentage change in quantity supplied of product X Percentage change in the price of product X

19. 6-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia The market period A period of time in which producers of a product are unable to change the quantity produced in response to a change in its price The short run –A period of time in which at least one factor of production is fixed. Output can altered by changing the intensity of use of the variable factors, and supply is more elastic The long run –A period of time in which all factors of production are variable. The elasticity of supply increases and in extreme cases even becoming perfectly elastic

20. 6-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Price elasticity of supply (cont.) Immediate market period PoPoPoPo P Q D1D1D1D1 SmSmSmSm PmPmPmPm D1D1D1D1 QoQo D2D2D2D2 D2D2D2D2

21. 6-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Price elasticity of supply (cont.) PoPoPoPo PsPsPsPs P Q D1D1D1D1 QoQo SsSsSsSs Short run QsQs D2D2D2D2

22. 6-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Price elasticity of supply (cont.) PoPoPoPo PLPLPLPL P Q D1D1D1D1 QoQo SLSLSLSL Long run QoQo QLQL Q′LQ′L D2D2D2D2 S′LS′LS′LS′L S′LS′LS′LS′L

23. 6-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia E xy = Percentage change in quantity demanded of good X Percentage change in the price of good Y Substitute goods — positive sign Complementary goods — negative sign Independent goods — zero or near-zero value Cross-price elasticity of demand

24. 6-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Income elasticity of demand E i = Percentage change in quantity demanded Percentage change in in income Normal goods — positive sign

25. 6-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Income elasticity of demand (cont.) E i = Percentage change in quantity demanded Percentage change in income Normal goods — positive sign Inferior goods — negative sign

26. 6-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Price ceilings and shortages Price ceiling is the maximum legal price a seller may charge for a product or service. Price ceilings result in shortages. The size of the shortage depends on the elasticity of supply and demand Prevents the market-clearing adjustment process and the rationing ability of the market –Wartime price controls –Rationing problem –Black markets –Rent controls

27. 6-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Elasticity & price ceilingsSS DD Legal price ceiling PcPcPcPc P QP QeQe QdQd QsQs Shortage

28. 6-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Price support and surpluses Price support or ‘price floor’ is a minimum price fixed by government, above equilibrium prices –Minimum wage legislation –Agricultural support prices Price support results in surpluses

29. 6-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Price support lead to surpluses D D S S PePePePe Legal price support PsPsPsPsQ P Q Surplus QsQs QdQd

30. 6-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Elasticity and tax incidence Elasticity of demand and supply determines who bears the burden of sales or excise tax, called the incidence of a tax

31. 6-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Tax $1 S1S1S1S1 Incidence of a sales tax P Q 0 5432154321 5 10 15 20 25 30 35 40 Price ($ per bottle) Quantity demanded (thousands of bottles/month) S D

32. 6-32 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Tax $1 S1S1S1S1 Elastic demand and incidence P Q 0 Pt P1 Qt Q1 Price ($ per bottle) Quantity demanded (thousands of bottles/month) S D Consumer’s tax incidence Producer’s tax incidence

33. 6-33 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Inelastic demand & incidence P Q 0 5432154321 Price ($ per bottle) Quantity demanded (thousands of bottles/month) Tax $1 S1S1S1S1 S D Consumer’s tax incidence Producer’s tax incidence Qt Q1

34. 6-34 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIver By Muni Perumal, University of Canberra, Australia Next chapter: Consumer behaviour