LECTURE #4: MICROECONOMICS CHAPTER 5

1. LECTURE #4: MICROECONOMICSCHAPTER 5 Elasticity of Demand Elasticity of Supply Applications

2. Elasticity of Demand • Elasticity: How buyers respond to changes in prices • If prices drop, consumers generally buy more (and vice-versa) • If incomes rise, consumers generally will buy more (and vice-versa) • Price Elasticity of Demand (PED) • PED measures how much demand changes given a change in price. • Goods are characterized as being highly elastic if a small % change in price results in a large % change in quantity demanded. • Goods are characterized as being inelastic if a large % change in price results in relatively small % change in quantity demanded.

3. Elasticity of Demand • Factors influencing the PED • Availability of close substitutes • Necessities or Luxuries: N tends to less elastic, L tends to be more elastic • Nature of market: narrow or broadly defined • Narrowly defined markets tend to more elastic (vanilla ice cream) • Broadly defined markets tend to be relatively inelastic (food) • Time horizon: changes in consumption patterns motivated by price changes

4. Elasticity of Demand • Computing Price Elasticity of Demand (PED) Example: If PED = 2.5, the a 1% increase in price will change QD by 2.5%

5. Elasticity of Demand • Why the Mid-Point method? • The impact of Scale and Distance • Example: Point A: P1 = $4, Q1 = 120 • Point B: P2 = $6, Q2 = 80 • PED = {(120 - 80) / [(120+80)/2]}/ {(6 – 4) / [(6+4)/2]} • Midpoint method • Two points: (Q1, P1) and (Q2, P2) 5

6. Elasticity of a Linear Demand Curve 1. an Price Elasticity is larger than 1 $7 6 5 4 Elasticity is smaller than 1 3 2 1 0 2 4 6 8 10 12 14 Quantity Demand The slope of a linear demand curve is constant, but its elasticity is not. At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic.

7. CONTINUE CHAPTER 5

8. Elasticity along a Linear Demand Curve The slope of a linear demand curve is constant, but its elasticity is not. At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic. 8

9. Elasticity of Demand • Shape of Demand Curves (See Figure 1) • Perfectly Elastic = horizontal line • Perfectly Inelastic = vertical line • Elasticity equals 1 everywhere = a curve with a constant rate of change • Straight Line Demand Curve: PED varies (see Figure 4)

10. Figure 1c: Price Elasticity of Demand (c) Unit elastic demand: Elasticity = 1 Price Demand 1. an $5 • A 25% • increase • in price… 4 2. … leads to A 25% decrease in quantity demanded 75 100 0 Quantity The price elasticity of demand determines whether the demand curve is steep or flat. Note that all percentage changes are calculated using the midpoint method.

11. Figure 1d, e: Price Elasticity of Demand (d) Elastic demand: Elasticity > 1 (e) Perfectly elastic demand: Elasticity equals infinity Price Price 1. an 1. an 1. At any price above $4, quantity demanded is zero • A 25% • increase • in price… 3. At any price below $4, quantity demanded is infinite $5 Demand $4 Demand 4 2. … leads to a 50% decrease in quantity demanded 2. At exactly $4, consumers will buy any quantity 50 100 0 0 Quantity Quantity The price elasticity of demand determines whether the demand curve is steep or flat. Note that all percentage changes are calculated using the midpoint method.

12. Elasticity of Demand • Impact of PED on Total Revenue (TR) (See Figures 2 and 3) • TR = Price (P) times Quantity (Q) = P x Q • Inelastic Demand: Increase in P results in small decrease in Q – increase in TR • Elastic Demand: Increase in P results in large decrease in Q – decrease in TR • Income Demand Elasticity • Income: IED = % DQD ÷ % DI

13. Total Revenue = P * Q 1. an Price The total amount paid by buyers, and received as revenue by sellers, equals the area of the box under the demand curve, TR = P × Q. P ˣ Q=$400 (revenue) $4 P Demand 100 0 Quantity Q

14. How total revenue changes when price changes (a) (a) The Case of Inelastic Demand 1. an 1. an Price Price $1 $3 Revenue=$240 Demand Demand Revenue=$100 100 80 Quantity Quantity 0 0 Inpanel (a), the demand curve is inelastic. In this case, an increase in the price leads to a decrease in quantity demanded that is proportionately smaller, so total revenue increases.

15. How total revenue changes when price changes (b) (b) The Case of Elastic Demand 1. an 1. an Price Price Revenue =$200 Revenue=$100 $4 $5 Demand Demand 50 20 Quantity Quantity 0 0 In panel (b), the demand curve is elastic. In this case, an increase in the price leads to a decrease in quantity demanded that is proportionately larger, so total revenue decreases.. 3 15

16. Cross-price Elasticity of Demand • Measure of how much the quantity demanded of one good responds to a change in the price of another good • Percentage change in quantity demanded of the first good divided by the percentage change in price of the second good • Cross-Price: CPED = % DQD1 ÷ % DP2 • Substitutes: Positive cross-price elasticity • Complements: Negative cross-price elasticity

17. Elasticity of Supply • Elasticity: How sellers respond to changes in prices • Law of Supply: An increase in prices will lead to an increase in supply • How much supply changes in response to a change in prices = Price Elasticity of Supply (PES) • The importance of time, characteristics of the good, and the production function • Computing PES

18. Elasticity of Supply • Shape of Supply Curves (See Figure 5) • Perfectly Elastic = horizontal line • Perfectly Inelastic = vertical line • Elasticity equals 1 everywhere = a curve with a constant rate of change

19. Applications of Supply, Demand and Elasticity • Bumper crop for farmers • Increase in supply • If demand is inelastic – prices will drop more than the increase in demand

20. 3. … and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220. 2. … leads to a large fall in price. . . An increase in Supply in the Market for Wheat Price of Wheat 1. When demand is inelastic, an increase in supply . . . S2 S1 $3 2 110 100 Demand 0 Quantity of Wheat When an advance in farm technology increases the supply of wheat from S1 to S2, the price of wheat falls. 20

21. OPEC and the Price of OIL • Increase in Price of oil led to reduced consumption and long-term increases in energy efficiency – leading to decrease in real price of oil as well as a decrease in per capita consumption and BTU per unit of GDP. • Decrease in revenues led members of OPEC to cheat on quotas – further downward pressure on oil prices. • Ultimately, the path of prices is determined by both PED and PES.

22. Effects of reduction in supply in world market for oil (a) The Oil Market in the Short Run (b) The Oil Market in the Long Run 2. … leads to a large increase in price 1. In the long run, when supply and demand are elastic, a shift in supply. . . 1. In the short run, when supply and demand are inelastic, a shift in supply. . . 1. an 1. an Price Price 2. … leads to a small increase in price S1 S2 S2 S1 P1 P2 P2 P1 Demand Demand Quantity Quantity 0 0 When the supply of oil falls, the response depends on the time horizon. In the short run, supply and demand are relatively inelastic, as in panel (a). By contrast, in the long run, supply and demand are relatively elastic, as in panel (b). In this case, the same size shift in the supply curve (S1 to S2) causes a smaller increase in the price. 22

23. Homework • Questions for Review: 1, 2, 3, 4 • Problems and Applications: 2, 3, 9, 11

24. Break Time