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ECONOMICS Elasticity ECONOMICS Elasticity

Learning Objectives • Define and calculate the price elasticity of demand • Use a 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 Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -2

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

Learning Objectives • Define and calculate the price elasticity of demand • Use a 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 Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -4

The Price Elasticity of Demand You know that when supply increases, the equilibrium price 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? Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -5

The Price Elasticity of Demand The price elasticity of demand is a units-free measure 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. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -6

Price (dollars per pizza) How a Change in Supply Changes Price and Quantity 40. Price (dollars per pizza) How a Change in Supply Changes Price and Quantity 40. 00 S 0 30. 00 a large … fall in price. . . S 1 An increase in supply brings. . . Large price change and small quantity change 20. 00 10. 00 … and a small increase in quantity. . . 5. 00 0 5 10 13 15 Da 20 25 Quantity (pizza per hour) Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -7

Price (dollars per pizza) How a Change in Supply Changes Price and Quantity An Price (dollars per pizza) How a Change in Supply Changes Price and Quantity An increase in supply S 0 brings. . . 40. 00 S 1 30. 00 … a small fall in price. . . 20. 00 15. 00 Db 10. 00 0 Copyright © 1998 Addison Wesley Longman, Inc. Small price change and large quantity change … and a large increase in quantity. . . 5 10 25 15 17 20 Quantity (pizza per hour) TM 5 -8

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

The Price Elasticity of Demand Calculating Elasticity (cont. ) The original price is $20. 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/Pavg = ($1/$20) x 100 = 5% Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -10

The Price Elasticity of Demand Calculating Elasticity (cont. ) The original quantity demanded is 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/Qavg = (2/10) x 100 = 20% Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -11

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

Price (dollars per pizza) Calculating the Elasticity of Demand Original point 20. 50 = Price (dollars per pizza) Calculating the Elasticity of Demand Original point 20. 50 = $1 20. 00 Elasticity = 4 New point Pavg = $20 19. 50 = 2 9 Copyright © 1998 Addison Wesley Longman, Inc. Qavg = 10 10 D 11 Quantity (pizza per hour) TM 5 -13

The Price Elasticity of Demand Average Price and Quantity We use the average price 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. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -14

The Price Elasticity of Demand Percentages and Proportions Elasticity is the ratio of the 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. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -15

The Price Elasticity of Demand A Units-Free Measure Elasticity is a units-free measure because 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. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -16

The Price Elasticity of Demand Minus Sign and Elasticity The price elasticity of demand 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. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -17

The Price Elasticity of Demand Inelastic and Elastic Demand Perfectly inelastic demand Implies that 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 Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -18

The Price Elasticity of Demand Inelastic and Elastic Demand (cont. ) Unit elastic demand 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 Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -19

Inelastic and Elastic Demand (cont. ) Perfectly elastic demand Implies that if price changes 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 = Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -20

Inelastic and Elastic Demand (cont. ) Inelastic demand Implies the percentage change in quantity 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. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -21

Inelastic and Elastic Demand (cont. ) Elastic demand Implies the percentage change in quantity 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. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -22

Inelastic and Elastic Demand Price Perfectly inelastic demand D 1 Elasticity = 0 12 Inelastic and Elastic Demand Price Perfectly inelastic demand D 1 Elasticity = 0 12 6 0 Copyright © 1998 Addison Wesley Longman, Inc. Quantity TM 5 -23

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

Inelastic and Elastic Demand Price Perfectly elastic demand Elasticity = 12 D 3 6 Inelastic and Elastic Demand Price Perfectly elastic demand Elasticity = 12 D 3 6 0 Copyright © 1998 Addison Wesley Longman, Inc. Quantity TM 5 -25

Inelastic and Elastic Demand Elasticity Along a Straight-Line Demand Curve Along a straight-line demand 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. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -26

Price (dollars per pizza) Elasticity Along a Straight-Line Demand Curve 25. 00 Elasticity = Price (dollars per pizza) Elasticity Along a Straight-Line Demand Curve 25. 00 Elasticity = 4 20. 00 Elasticity = 1 15. 00 12. 50 Inelastic 10. 00 Elasticity = 1/4 5. 00 0 Copyright © 1998 Addison Wesley Longman, Inc. 10 20 25 30 40 50 Quantity (pizza per hour) TM 5 -27

Learning Objectives • Define and calculate the price elasticity of demand • Use a 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 Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -28

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

Total Revenue and Elasticity Elastic demand: a 1 percent price cut increases the quantity 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. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -30

Total Revenue and Elasticity Total Revenue Test Price elasticity of demand can be estimated 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). Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -31

Total Revenue and Elasticity Total Revenue Test If a price cut increases total revenue, 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. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -32

Elastic demand When demand is elastic, price cut increases total revenue Total Revenue (billions Elastic demand When demand is elastic, price cut increases total revenue Total Revenue (billions of dollars) Price (dollars per pizza) 25. 00 20. 00 15. 00 Unit elastic 12. 50 10. 00 Inelastic demand 5. 00 0 350. 00 312. 50 300. 00 25 50 Maximum total revenue 250. 00 When demand is inelastic, price cut decreases total revenue 200. 00 150. 00 100. 00 50. 00 0 Copyright © 1998 Addison Wesley Longman, Inc. 25 50 Quantity (pizza per hour) TM 5 -33

Total Revenue and Elasticity Your Expenditure and Your Elasticity If your demand is elastic, 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. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -34

Total Revenue and Elasticity Your Expenditure and Your Elasticity (cont. ) If your demand 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. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -35

Total Revenue and Elasticity Your Expenditure and your Elasticity (cont. ) If your demand 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. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -36

Some Real-World Price Elasticities of Demand Good or Service Elastic Demand Metals Electrical engineering Some Real-World Price Elasticities of Demand Good or Service Elastic Demand Metals Electrical engineering products Mechanical engineering products Furniture Motor vehicles Instrument engineering products Professional services Transportation services Inelastic Demand Gas, electricity, and water Oil Chemicals Beverages (all types) Clothing Tobacco Banking and insurance services Housing services Agricultural and fish products Books, magazines, and newspapers Food Copyright © 1998 Addison Wesley Longman, Inc. Elasticity 1. 52 1. 30 1. 26 1. 14 1. 10 1. 09 1. 03 0. 92 0. 91 0. 89 0. 78 0. 64 0. 61 0. 56 0. 55 0. 42 0. 34 0. 12 TM 5 -37

Learning Objectives • Define and calculate the price elasticity of demand • Use a 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 Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -38

Factors That Influence Elasticity the Elasticity of Demand Closeness of Substitutes. The closer the Factors That Influence Elasticity the Elasticity of Demand Closeness of Substitutes. The closer the substitutes, the more elastic the demand. • necessities • luxuries Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -39

Factors That Influence Elasticity the Elasticity of Demand Proportion of Income Spent on the 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 Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -40

Price Elasticities in 20 Countries Copyright © 1998 Addison Wesley Longman, Inc. TM 5 Price Elasticities in 20 Countries Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -41

Learning Objectives • Define and calculate the cross elasticity of demand • Define and 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 Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -42

More Elasticities of Demand Cross elasticity of demand Measures the responsiveness of the demand 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 Copyright © 1998 Addison Wesley Longman, Inc. = Percentage change in quantity demanded Percentage change in price of a substitute or complement TM 5 -43

Price of pizzas Cross Elasticity of Demand Price of a burger, a substitute, falls. Price of pizzas Cross Elasticity of Demand Price of a burger, a substitute, falls. Positive cross elasticity. 0 Copyright © 1998 Addison Wesley Longman, Inc. Price of soda, a complement, falls. Negative cross elasticity. D 1 D 0 D 2 Quantity of pizzas TM 5 -44

Learning Objectives • Define and calculate the cross elasticity of demand • Define and 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 Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -45

Income Elasticity of Demand Income elasticity Measures the responsiveness of the demand to a Income Elasticity of Demand Income elasticity Measures the responsiveness of the demand to a change in income. Income elasticity of demand Copyright © 1998 Addison Wesley Longman, Inc. = Percentage change in quantity demanded Percentage change in income TM 5 -46

Income Elasticity of Demand Income elasticity can be: 1 ) Greater than 1 (normal 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) Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -47

Income Elasticity of Demand Income elastic Elasticity less than 1 and becomes negative Quantity Income Elasticity of Demand Income elastic Elasticity less than 1 and becomes negative Quantity demanded Elasticity between zero and 1 Quantity demanded Elasticity greater than 1 Income inelastic Positive income elasticity Income Copyright © 1998 Addison Wesley Longman, Income Negative income elasticity m Income TM 5 -48

Some Real-World Income Elasticities of Demand Elastic Demand Airline Travel Movies Foreign Travel Electricity Some Real-World Income Elasticities of Demand Elastic Demand Airline Travel Movies Foreign Travel Electricity Restaurant meals Local buses and trains Haircutting Cars Inelastic Demand Tobacco Alcoholic beverages Furniture Clothing Newspapers and magazines Telephone Food Copyright © 1998 Addison Wesley Longman, Inc. 5. 82 3. 41 3. 08 1. 94 1. 61 1. 38 1. 36 1. 07 0. 86 0. 62 0. 53 0. 51 0. 38 0. 32 0. 14 TM 5 -49

Income Elasticities in 15 Countries Copyright © 1998 Addison Wesley Longman, Inc. TM 5 Income Elasticities in 15 Countries Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -50

Learning Objectives • Define and calculate the cross elasticity of demand • Define and 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 Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -51

Elasticity of Supply Elasticity of supply measures the responsiveness of quantity supplied to a Elasticity of Supply Elasticity of supply measures the responsiveness of quantity supplied to a change in price. Elasticity of supply Copyright © 1998 Addison Wesley Longman, Inc. Percentage change in quantity supplied = Percentage change in price TM 5 -52

Price (dollars per pizza) How a Change in Demand Changes Price and Quantity 40. Price (dollars per pizza) How a Change in Demand Changes Price and Quantity 40. 00 An increase in demand brings. . . Sa Large price change and small quantity change 30. 00 20. 00 10. 00 … a large price rise. . . D 1 … and a small quantity increase. . . 0 Copyright © 1998 Addison Wesley Longman, Inc. 5 10 13 15 20 25 D 0 Quantity (pizza per hour) TM 5 -53

Price (dollars per pizza) How a Change in Demand Changes Price and Quantity 40. Price (dollars per pizza) How a Change in Demand Changes Price and Quantity 40. 00 30. 00 21. 00 20. 00 10. 00 An increase in demand brings. . . Small price change and large quantity change Sb … a small price rise. . . D 1 … and a large quantity increase. . . 0 5 D 0 10 15 20 25 Quantity (pizza per hour) Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -54

Elasticity of Supply elasticity depends on: • Resource substitution possibilities • Time frame for Elasticity of Supply elasticity depends on: • Resource substitution possibilities • Time frame for the supply decision Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -55

Inelastic and Elastic Demand Price Perfectly inelastic supply 0 Copyright © 1998 Addison Wesley Inelastic and Elastic Demand Price Perfectly inelastic supply 0 Copyright © 1998 Addison Wesley Longman, Inc. S 1 Elasticity of supply = 0 Quantity TM 5 -56

Inelastic and Elastic Demand Price Unit elastic supply S 1 Elasticity of supply = Inelastic and Elastic Demand Price Unit elastic supply S 1 Elasticity of supply = 1 0 Copyright © 1998 Addison Wesley Longman, Inc. Quantity TM 5 -57

Inelastic and Elastic Demand Price Perfectly elastic supply Elasticity of supply = S 3 Inelastic and Elastic Demand Price Perfectly elastic supply Elasticity of supply = S 3 0 Copyright © 1998 Addison Wesley Longman, Inc. Quantity TM 5 -58

Elasticity of Supply Resource Substitution Possibilities The more unique the resource, the more inelastic Elasticity of Supply Resource Substitution Possibilities The more unique the resource, the more inelastic the supply. • Van Gogh painting - Van Gogh • Wheat/corn — farmland Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -59

Elasticity of Supply Time Frame for Supply Decisions • Momentary supply • Long-run supply 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. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -60

A Compact Glossary of Elasticities PRICE ELASTICITIES OF DEMAND A relationship is described as 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 Infinity The smallest possible increase in price causes an infinitely large decrease in quantity demanded Elastic Less than infinity but greater than 1 The percent decrease in the quantity demanded exceeds the percent increase in price Unit elastic 1 The percent decrease in the quantity demanded equals the percent increase in price In elastic Greater than zero but less than 1 The percentage decrease in the quantity demanded is less than the percent increase in price. Perfectly inelastic Zero or completely inelastic Copyright © 1998 Addison Wesley Longman, Inc. The quantity demanded is the same at all prices TM 5 -61

A Compact Glossary of Elasticities CROSS ELASTICITIES OF DEMAND A relationship is described as A Compact Glossary of Elasticities CROSS ELASTICITIES OF DEMAND A relationship is described as When its magnitude is Which means that Perfect substitutes Infinity The smallest possible increase in price of one good causes an infinitely large in the demand of the other good. Substitutes Positive, less than infinity If the price of one good increases, the quantity demanded of the other good also increases. Independent Zero The demand for one good remains constant, regardless of the price of the other good. Complements Less than zero The demand for one good decreases when the price of the other good increases. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -62

A Compact Glossary of Elasticities INCOME ELASTICITIES OF DEMAND A relationship is described as 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 1 The percent increase in the quantity demanded is greater than the percentage increase in income. Income inelastic (normal good) Less than 1 but greater than zero The percent increase in the quantity demanded is less than the percentage increase in income. Negative income elastic (inferior good) Less than zero When income increases, quantity demanded decreases. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -63

A Compact Glossary of Elasticities ELASTICITIES OF SUPPLY A relationship is described as When A Compact Glossary of Elasticities ELASTICITIES OF SUPPLY A relationship is described as When its magnitude is Which means that Perfectly elastic Infinity The smallest possible increase in price causes an infinitely large increase in the quantity supplied. Elastic Less than infinity but greater than 1 The percent increase in the quantity supplied exceeds the percentage increase in the price. Inelastic Greater than zero but less than 1 The percentage increase in the quantity supplied is less than the percentage increase in price. Perfectly inelastic Zero The quantity supplied is the same at all prices. Copyright © 1998 Addison Wesley Longman, Inc. TM 5 -64