1. Our Friend Elasticity Or, how I learned to love percentages

2. Measuring Responsiveness or Sensitivity Slope –Unit dependent Currency Quantities –No Starting Point Percentages –Unit free –Relational Slope –Unit dependent Currency Quantities –No Starting Point Percentages –Unit free –Relational

3. Computing Elasticity Price elasticity of demand = %change in quantity demanded/% change in price Income elasticity of demand = %change in demand/% change in income Cross-price elasticity of demand = %change in demand/% change in the price of a related good Price elasticity of demand = %change in quantity demanded/% change in price Income elasticity of demand = %change in demand/% change in income Cross-price elasticity of demand = %change in demand/% change in the price of a related good

4. An Intuitive Approach to Elasticity Since price elasticity is always zero (law of demand) we ignore the negative sign and take the absolute value of price elasticity. E p > 1 Responsive or elastic –%ΔQ d > %ΔP a small %ΔP creates a large %ΔQ d E p < 1 Not responsive or inelastic –%ΔQ d < %ΔP a large %ΔP creates a small %ΔQ d E p = 1 unit elastic –%ΔQ d = %ΔP a given %ΔP creates an equal %ΔQ d Since price elasticity is always zero (law of demand) we ignore the negative sign and take the absolute value of price elasticity. E p > 1 Responsive or elastic –%ΔQ d > %ΔP a small %ΔP creates a large %ΔQ d E p < 1 Not responsive or inelastic –%ΔQ d < %ΔP a large %ΔP creates a small %ΔQ d E p = 1 unit elastic –%ΔQ d = %ΔP a given %ΔP creates an equal %ΔQ d

5. So???? Price and Total Revenue TR= P X Q E p > 1 Responsive or elastic –%ΔQ d > %ΔP if P goes down (up) total revenue goes up (down) E p < 1 Not responsive or inelastic –%ΔQ d < %ΔP if P goes down (up) total revenue goes down (up) E p = 1 unit elastic –%ΔQ d = %ΔP if P goes down (up) total revenue stays the same E p > 1 Responsive or elastic –%ΔQ d > %ΔP if P goes down (up) total revenue goes up (down) E p < 1 Not responsive or inelastic –%ΔQ d < %ΔP if P goes down (up) total revenue goes down (up) E p = 1 unit elastic –%ΔQ d = %ΔP if P goes down (up) total revenue stays the same

6. Determinants of Price Elasticity Availability of close substitutes Necessity versus luxury Definition of the market Time horizon Percentage of consumer budget Availability of close substitutes Necessity versus luxury Definition of the market Time horizon Percentage of consumer budget

7. Price Elasticity – Using Numbers E p = %ΔQ d / %ΔP = (Q 2 - Q 1 )/[(Q 2 + Q 1 )/2] (P 2 - P 1 )/[(P 2 + P 1 )/2] E p = %ΔQ d / %ΔP = (Q 2 - Q 1 )/[(Q 2 + Q 1 )/2] (P 2 - P 1 )/[(P 2 + P 1 )/2]

8. Calculating Price Elasticitymputing the Price Elasticity of Demand Demand is price elastic $5 4 Demand Quantity 100050 Price

9. Linear Demand Curve:Elasticity

10. Elasticity of Other Demand Curves Perfectly Elastic Perfectly Inelastic Unit Elastic Perfectly Elastic Perfectly Inelastic Unit Elastic

11. Elasticity of Supply Price elasticity of supply = %change in quantity supplied/% change in price E s = %ΔQ s / %ΔP = (Q 2 - Q 1 )/[(Q 2 + Q 1 )/2] (P 2 - P 1 )/[(P 2 + P 1 )/2] Perfectly elastic and inelastic supply and unit elastic (crossing the P or Q axis) Supply curves where elasticity varies Price elasticity of supply = %change in quantity supplied/% change in price E s = %ΔQ s / %ΔP = (Q 2 - Q 1 )/[(Q 2 + Q 1 )/2] (P 2 - P 1 )/[(P 2 + P 1 )/2] Perfectly elastic and inelastic supply and unit elastic (crossing the P or Q axis) Supply curves where elasticity varies

12. Determinants of elasticity of supply –Ability to increase or decrease production (e.g Ellensburg agates, farm crops, automobiles) –Time period Determinants of elasticity of supply –Ability to increase or decrease production (e.g Ellensburg agates, farm crops, automobiles) –Time period

13. Applications of Elasticity Farmers : fallacy of composition and good crop/bad revenue years The economics of addictive drugs Pricing decisions and your future business Farmers : fallacy of composition and good crop/bad revenue years The economics of addictive drugs Pricing decisions and your future business

14. Government and Markets Price Controls –Price Ceilings (e.g. rent control) –Price Floors (e.g. water) Taxes –Who appears to pay the tax? Buyers “pay” tax Sellers “pay” tax –Who really pays the tax? Tax incidence and burden Price Controls –Price Ceilings (e.g. rent control) –Price Floors (e.g. water) Taxes –Who appears to pay the tax? Buyers “pay” tax Sellers “pay” tax –Who really pays the tax? Tax incidence and burden

15. Case study – The payroll tax: Federal Insurance Contribution Act (FICA) for Social Security and Medicare

16. Elasticity and Tax Incidence Intuitive approach: –If the buyers can respond relatively more to price changes more than suppliers, suppliers pay more of the tax. –If the suppliers can respond relatively more than the buyers, then the buyers pay more of the tax. Intuitive approach: –If the buyers can respond relatively more to price changes more than suppliers, suppliers pay more of the tax. –If the suppliers can respond relatively more than the buyers, then the buyers pay more of the tax.

17. Extreme examples: –Perfectly elastic demand –Perfectly elastic supply –Perfectly inelastic demand –Perfectly inelastic supply Less extreme examples (e.g. the luxury tax) Extreme examples: –Perfectly elastic demand –Perfectly elastic supply –Perfectly inelastic demand –Perfectly inelastic supply Less extreme examples (e.g. the luxury tax)