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ELASTICITIES OF DEMAND SUPPLY ECO 2023 Principles of Microeconomics Dr. Mc. Caleb Elasticities of Demand Supply 1

TOPIC OUTLINE I. Price Elasticity of Demand II. Application: Elasticity and the Demand for Smoking III. Price Elasticity of Supply IV. Cross Price Elasticity and Income Elasticity Elasticities of Demand Supply 2

Price Elasticity of Demand Elasticities of Demand Supply 3

PRICE ELASTICITY OF DEMAND § What Is the Price Elasticity of Demand? The price elasticity of demand is the ratio of the percentage change in the quantity demanded to the percentage change in price. § What Is the Price Elasticity of Demand Used For? It measures the size of the change in quantity demanded when the price of a good changes. Elasticities of Demand Supply 4

PRICE ELASTICITY OF DEMAND § How Is the Price Elasticity of Demand Calculated? Mid-point method Calculate the change in quantity demanded as a percent of the average of the two quantities and multiply by 100 to convert to percent Elasticities of Demand Supply 5

PRICE ELASTICITY OF DEMAND § How Is the Price Elasticity of Demand Calculated? Calculate the change in price as a percent of the average of the two prices and multiply by 100 to convert to percent Elasticities of Demand Supply 6

PRICE ELASTICITY OF DEMAND § Why Do Economists Use Elasticity to Measure the Size of the Change? Because elasticity is a ratio of two percentages, the percentages “cancel out” so that elasticity is a pure number, a number with no units of measurement attached to it. That allows us to compare the demands for different goods even though they are measured in different units or to compare goods at different points in time or even to compare goods in different countries that use different currencies. Elasticities of Demand Supply 7

The quantity demanded of lattes at a Starbucks decreases from 15 cups per hour to 5 cups per hour when the price increases from $3. 00 to $5. 00. Using the mid-point method, what is the percent change in quantity demanded? (Hint: Make sure the answer is in percent. Include the negative sign if it is negative, but do not include the percent sign. ) Elasticities of Demand Supply 8

The quantity demanded of lattes at a Starbucks decreases from 15 cups per hour to 5 cups per hour when the price increases from $3. 00 to $5. 00. Using the mid-point method, what is the percent change in price? (Hint: Make sure the answer is in percent. Include the negative sign if it is negative, but do not include the percent sign. ) Elasticities of Demand Supply 9

The quantity demanded of lattes at a Starbucks decreases from 15 cups per hour to 5 cups per hour when the price increases from $3. 00 to $5. 00. What is the elasticity of demand? (Hint: No decimal numbers. If the answer is negative, include the negative sign. ) Elasticities of Demand Supply 10

PRICE ELASTICITY OF DEMAND § What Does the Elasticity Number or Coefficient Mean? The absolute value of the elasticity coefficient shows whether the quantity change is bigger than the price change, the same size as the price change, or smaller than the price change. The bigger the absolute value, the more sensitive or responsive consumers are to a price change. The smaller the absolute value, the less sensitive or responsive they are to a price change. Elasticities of Demand Supply 11

PRICE ELASTICITY OF DEMAND § What Does an Elasticity Coefficient Greater than 1 in Absolute Value Mean? Demand is elastic. The percent change in quantity demanded is greater than the percent change in price Consumers are relatively sensitive or responsive to price changes. Elasticities of Demand Supply 12

PRICE ELASTICITY OF DEMAND § What Does an Elasticity Coefficient Smaller than 1 in Absolute Value Mean? Demand is inelastic. The percent change in quantity demanded is smaller than the percent change in price Consumers are relatively insensitive or not very responsive to price changes. Elasticities of Demand Supply 13

PRICE ELASTICITY OF DEMAND § What Does an Elasticity Coefficient Equal to 1 in Absolute Value Mean? Demand is unit elastic. The percent change in quantity demanded equals the percent change in price Consumers are neither very sensitive or responsive to price changes nor are they very insensitive or unresponsive. Elasticities of Demand Supply 14

PRICE ELASTICITY OF DEMAND § What Does It Mean When the Elasticity Coefficient Is Equal to 0? Demand is perfectly inelastic. The percentage change in quantity demanded is zero when the price changes. Consumers are completely insensitive or unresponsive to the price change. They want the same quantity no matter what the price is. A perfectly inelastic demand curve is vertical. Elasticities of Demand Supply 15

PRICE ELASTICITY OF DEMAND Special Case: Perfectly Inelastic Demand When the price rises, . . . the quantity demanded does not change. There is no change in the quantity demanded when price changes. Therefore, demand is perfectly inelastic. Elasticities of Demand Supply 16

PRICE ELASTICITY OF DEMAND § What Does It Mean If the Elasticity Coefficient Is Infinite? Demand is perfectly elastic. Even an infinitesimally small percentage price change will cause a very (“infinitely”) large percentage change in quantity demanded. The numerator (the percent change in quantity demanded) is so large and the denominator (the percent change in price) is so small that the coefficient of elasticity approaches infinity in the limit. The demand curve is horizontal are almost so. Elasticities of Demand Supply 17

PRICE ELASTICITY OF DEMAND Special Case: Perfectly Elastic Demand For even a very small change in the price of spring water, . . . the quantity demanded of spring water changes by a very large amount. The change in the quantity demanded is much (infinitely) larger than the change in price. Therefore, the demand for spring water is perfectly elastic. Elasticities of Demand Supply 18

If the price elasticity of demand for furniture is 1. 26, the demand for furniture is 1. Perfectly elastic 2. Elastic but not perfectly elastic 3. Unit elastic 4. Inelastic but not perfectly inelastic 5. Perfectly inelastic Elasticities of Demand Supply 19

If the price elasticity of demand for furniture is 1. 26, the percent change in quantity demanded is _____ the percent change in price and buyers are _____ sensitive to price changes. 1. Greater than; very 2. Greater than; not very 3. Less than; very 4. Less than; not very Elasticities of Demand Supply 20

If the price elasticity of demand for tobacco is 0. 61, the demand for tobacco is 1. Perfectly elastic 2. Elastic but not perfectly elastic 3. Unit elastic 4. Inelastic but not perfectly inelastic 5. Perfectly inelastic Elasticities of Demand Supply 21

If the price elasticity of demand for tobacco is 0. 61, the percent change in quantity demanded is _____ the percent change in price and buyers are _____ sensitive to price changes. 1. Greater than; very 2. Greater than; not very 3. Less than; very 4. Less than; not very Elasticities of Demand Supply 22

PRICE ELASTICITY OF DEMAND § What Causes the Demand for Some Goods To Be More Elastic or More Inelastic than Others? • Substitution effects • Income effects • Time Elasticities of Demand Supply 23

PRICE ELASTICITY OF DEMAND Substitution effects If it is easy to find a substitute for a good, then, ceteris paribus, the demand for the good tends to be more elastic or less inelastic. More or better substitutes Higher elasticity If it is harder to find a substitute for a good, then, ceteris paribus, the demand for the good tends to be more inelastic or less elastic. Few or poorer substitutes Lower elasticity Elasticities of Demand Supply 24

PRICE ELASTICITY OF DEMAND Substitution effects: Examples • Ceteris paribus, the demand for Toyota Camrys is likely to be more elastic (or less inelastic) than the demand for automobiles which in turn is more elastic (or less inelastic) than the demand for motor vehicles. • The demand for a college textbook is likely to be more inelastic (or less elastic), ceteris paribus, than the demand for a popular novel. Elasticities of Demand Supply 25

PRICE ELASTICITY OF DEMAND Income Effects If consumers spend a relatively larger percent of their income on a good, then, ceteris paribus, the demand for the good tends to be more elastic or less inelastic. Larger share of income Higher elasticity If consumers spend a relatively smaller percent of their income on a good, then, ceteris paribus, the demand for the good tends to be less elastic or more inelastic. Smaller share of income Lower elasticity Elasticities of Demand Supply 26

PRICE ELASTICITY OF DEMAND Income Effects: Examples • Purchases of automobiles require a larger proportion of income than purchases of gasoline so, ceteris paribus, the demand for automobiles is likely to be more elastic (or less inelastic) than the demand for gasoline. • Households spend more of their income on steak than on the salt to put on the steak. Ceteris paribus, the demand salt is likely to be more inelastic (or less elastic) than the demand for steak. Elasticities of Demand Supply 27

PRICE ELASTICITY OF DEMAND Time The longer the time period over which elasticity is measured, the larger, ceteris paribus, it is likely to be because consumers have more time to find good substitutes and adjust their consumption. Longer time Higher elasticity Shorter time Lower elasticity Example: The elasticity of demand for gasoline is very low one day or one week after a change in the price, but the elasticity is higher (although still inelastic) one year after the price change. In fact, the demand for gasoline becomes elastic after several years have passed. Elasticities of Demand Supply 28

Universal to cut price of CD's to raise sales Amy Harmon New York Times Friday, September 5, 2003 Universal Music Group's plan to cut prices on compact discs by as much as 30 percent represents a big gamble in its aggressive bid to lure consumers back into record stores. The deep price cut, announced on Wednesday, is the only one to apply to new CD's since the format was introduced in the early 1980's. Universal, owned by Vivendi Universal, is betting that consumers will buy more CD's once the price dips below $13. Elasticities of Demand Supply 29

PRICE ELASTICITY OF DEMAND § Total Revenue and Price Elasticity of Demand Relationship between price elasticity of demand total revenue There is a unique relationship between the price elasticity of demand, a change in the price of the good, and sellers’ total revenue from (or buyers’ total expenditure on) the good. This relationship is valid for the price elasticity of demand only. It is not valid for any other elasticity (that is, income elasticity of demand, price elasticity of supply, or cross-elasticities). Elasticities of Demand Supply 30

PRICE ELASTICITY OF DEMAND § Total Revenue and Price Elasticity of Demand Elastic demand • If demand is elastic, a price change results in a change in total revenue (or total expenditure) in the opposite direction. P increase TR decrease P decrease TR increase • According to the law of demand, a price change causes a change in quantity demanded in the opposite direction. Because demand is elastic, the quantity change is bigger than the price change. So the quantity change determines what happens to total revenue. Elasticities of Demand Supply 31

PRICE ELASTICITY OF DEMAND § Total Revenue and Price Elasticity of Demand Inelastic demand • If demand is inelastic, a price change results in a change in total revenue (or total expenditure) in the same direction. P increase TR increase P decrease TR decrease • According to the law of demand, a price change causes a change in quantity demanded in the opposite direction. Because demand is inelastic, the price change is bigger than the quantity change. So the price change determines what happens to total revenue. Elasticities of Demand Supply 32

PRICE ELASTICITY OF DEMAND § Total Revenue and Price Elasticity of Demand Unit elastic demand • If demand is unit elastic, a price change results in no change in total revenue (or total expenditure). P increase TR unchanged P decrease TR unchanged • According to the law of demand, a price change causes a change in quantity demanded in the opposite direction. Because demand is unit elastic, the quantity change equals the price change. So the quantity change and the price change offset each other and total revenue doesn’t change. Elasticities of Demand Supply 33

The price elasticity of demand for automobiles is 1. 35. If Toyota wants to increase its revenues, it should 1. Raise price 2. Leave price unchanged 3. Lower price Elasticities of Demand Supply 34

President Weatherell wants to raise tuition (price) by a significant amount to increase the University's budget (total revenue). Therefore, he must be assuming that your demand for an FSU education is 1. elastic 2. unit elastic 3. inelastic Elasticities of Demand Supply 35

The demand for most agricultural commodities is inelastic. Therefore, when a freeze reduces the size of the orange crop, total revenue of all orange growers increases even though the incomes of growers who lose a large part of their crop falls. Elasticities of Demand Supply 36

Application: Elasticity and the Demand for Smoking Elasticities of Demand Supply 37

ELASTICITY AND THE DEMAND FOR SMOKING Example: Oregon’s Anti. Smoking Campaign In November 1996, residents of Oregon approved a ballot measure increasing the excise tax on sellers of cigarettes by $0. 30 per pack. The average price per pack increased from $1. 75 to $2. 05. Annual per capita consumption decreased from 92 packs to 86 packs. Elasticities of Demand Supply 38

ELASTICITY AND THE DEMAND FOR SMOKING Example: Oregon’s Anti. Smoking Campaign 10% of the additional tax revenue was allocated to the Oregon Health Division (OHD) to develop and implement a tobacco-use prevention program. Because of the fall in demand, annual per capita consumption decreased by an additional 4 packs, from 86 to 82. Elasticities of Demand Supply 39

ELASTICITY AND THE DEMAND FOR SMOKING § Addiction and Elasticity Nonusers’ demand for addictive substances is elastic. For example, the estimated elasticity of demand for cigarettes among teenage nonusers is 1. 2. Therefore, a moderately higher price leads to a substantially smaller number of people trying a drug. Elasticities of Demand Supply 40

ELASTICITY AND THE DEMAND FOR SMOKING § Addiction and Elasticity Users Existing users’ demand for addictive substances is inelastic. For example, the estimated elasticity of demand for cigarettes among adult smokers is 0. 4. Therefore, a substantial price rise brings only a modest decrease in the quantity demanded. Even addicted users, however, may reduce their consumption at the margin so demand is not perfectly inelastic. Elasticities of Demand Supply 41

Price Elasticity of Supply Elasticities of Demand Supply 42

PRICE ELASTICITY OF SUPPLY § What Is the Price Elasticity of Supply? The price elasticity of supply is the ratio of the percent change in the quantity supplied to the percent change in price. The price elasticity of supply is interpreted in the same way as the price elasticity of demand. Elasticities of Demand Supply 43

PRICE ELASTICITY OF SUPPLY • What Causes the Supply of Some Goods To Be More Elastic or More Inelastic than Others? • Substitution effects • Time: Same effect as elasticity of demand Elasticities of Demand Supply 44

PRICE ELASTICITY OF SUPPLY Substitution effects If it is easy for sellers to switch production and sales to another good, if they have good alternative uses for their productive inputs, then, ceteris paribus, the supply of the good tends to be more elastic or less inelastic. More or better substitutes Higher elasticity If it is harder for sellers to switch to production and sales of alternative goods, if inputs tend to be more specialized, then, ceteris paribus, the supply of the good tends to be more inelastic or less elastic. Few or poorer substitutes Lower elasticity Elasticities of Demand Supply 45

PRICE ELASTICITY OF DEMAND Substitution effects: Examples • Ceteris paribus, the supply of physicians is likely to be more elastic (or less inelastic) than the supply of surgeons which in turn is more elastic (or less inelastic) than the supply of neurosurgeons. The more specialized the resources required to produce a good, the less elastic its supply is likely to be. • Storage provides sellers with a way of substituting between current sales and future sales. Ceteris paribus, the lower the cost of storing a good, frozen fish for example, the more elastic is its supply. On the other hand, the supply of a non-storable good like fresh fish is highly inelastic. Elasticities of Demand Supply 46

Cross Price Elasticity and Income Elasticity of Demand Elasticities of Demand Supply 47

CROSS PRICE ELASTICITY AND INCOME ELASTICITY OF DEMAND § What Is the Cross Price Elasticity of Demand? The ratio of the percent change in quantity demanded of a good to the percent change in the price of a substitute or a complement. Elasticities of Demand Supply 48

CROSS ELASTICITY AND INCOME ELASTICITY OF DEMAND Substitutes Suppose that when the price of a burger falls by 10 percent, the quantity of pizza demanded decreases by 5 percent. The cross price elasticity of demand between substitutes is positive. Elasticities of Demand Supply 49

CROSS ELASTICITY AND INCOME ELASTICITY OF DEMAND Complements Suppose that when the price of a burger falls by 10 percent, the quantity of pizza demanded decreases by 5 percent. Cross elasticity of demand for pizza = 2 percent – 10 percent = -0. 2 The cross price elasticity of demand between complements is negative. Elasticities of Demand Supply 50

CROSS ELASTICITY AND INCOME ELASTICITY OF DEMAND § What Is the Income Elasticity of Demand? The ratio of the percent change in quantity demanded to the percent change in buyers’ incomes. Positive income elasticity normal good Negative income elasticity inferior good Elasticities of Demand Supply 51

If the cross price elasticity of demand between two goods is positive, the two goods are 1. Normal 2. Inferior 3. Substitutes 4. Complements 5. Elastic 6. inelastic Elasticities of Demand Supply 52

If the cross price elasticity of demand between two goods is negative, the two goods are 1. Normal 2. Inferior 3. Substitutes 4. Complements 5. Elastic 6. inelastic Elasticities of Demand Supply 53

True or false: If the income elasticity of demand for a good is positive and less than 1 in absolute value, the good is a normal good and the demand for the good is inelastic. Elasticities of Demand Supply 54

True or false: If the income elasticity of demand for a good is negative and greater than 1 in absolute value, the good is an inferior good and the demand for the good is elastic. Elasticities of Demand Supply 55