Chapter 5 Elasticity

1. Chapter 5Elasticity You are responsible for reading Chapter 4!!!

2. What have we done? • Chapter 3 gave us downward sloping demand curves • Law of demand • Now want to see how Qd changes when price changes

3. Elasticity • Response of one variable to a change in another variable • Price elasticity of demand • Measure of the responsiveness of Qd of a product to a change in the price of that product

4. or rewrite as

5. So… • What if Ed = 3? • If price was increased from the prevailing point the % change in Qd would be 3 times the change in price • Shouldn’t it be negative? • So price increases and Qd decreases? • Yes!! • For ease we look at the absolute value, but know that the law of demand holds

6. Point elasticity • Measures the change between two observed points.

7. example • P1 = 10 • P2 = 12 • Q1 = 100 • Q2 = 50 • Elasticity?? • Which is Point A??? • Big Problem!!!

8. Problem • Answers vary depending on where you start • Becomes more important the larger the change

9. Arc Elasticity • To avoid the endpoint problem take elasticity at the midpoint (average) of the two points

10. Differences • With arc elasticity it is clear which points are used • P1 is the first price • P2 is the second price • Qd1 and Qd2 are the first and second quantity demanded respectively

11. Price elasticity of demand can yield 5 basic results • Numerator > Denominator • Numerator < Denominator • Numerator = Denominator • Numerator = 0 • Denominator = 0 • Each has a specific name and result

12. Elastic Demand • Ed > 1 • % change in quantity demanded > % change in price • FLATTER CURVE • What are some examples of an elastic good???

13. Inelastic Demand • Ed<1 • % change in the price > percent change in quantity demanded • STEEPER CURVE • What are some examples of an inelastic good?

14. Price Elasticity of Demand

15. Unit Elastic Demand • Ed=1 • % change in price = % change in quantity demanded • Change in price brings a proportionate change in quantity demanded • CURVE

16. Price Elasticity of Demand

17. Perfectly Elastic Demand • Ed = (denominator = 0) • % change in quantity demanded is A LOT in response to a change in price • Price increases and quantity demanded goes to 0 • Totally flat --- horizontal • Extreme • Examples???

18. Perfectly inelastic demand • Ed = 0 • % change in quantity demanded DOESN’T CHANGE in response to a change in price • Totally steep --- vertical • Extreme • Examples???

19. Price Elasticity of Demand

20. Aren’t demand curve downward sloping? • Because the extremes (perfectly inelastic and perfectly elastic) are not. • Use as points of reference only

21. How does a change in price affect Total Revenue of a Firm? • Revenue depends on elasticity • Michael Jordan and Nike shoes • No substitutes -- inelastic demand • What happens to Qd if price increases? • Substitutes – elastic demand • What happens to Qd if price increases?

22. What is total revenue?? • Total revenue = price*quantity • Firm uses to decide if to produce more or less

23. examples • Elastic demand • Price increase • Price decrease • Inelastic demand • Price increase • Price decrease • Unit elastic demand • Price increase • Price decrease

24. Elasticities, Price Changes, and Total Revenue

25. Important to look at because… • Elasticity of the demand determines if with a price increase… • Total revenue increases • Total revenue decreases • Total revenue remains the same

26. Price elasticity of demand and a straight line • Demand is downward sloping • Along the line elasticity varies from highly elastic to highly inelastic • But…remember SLOPE is constant

27. P A B C D E F G Q Find Total Revenue and Elasticity of Demand

28. Price Elasticity of Demand along a Demand Curve

29. Summary • Upper end of Demand Curve • Qd is low and price is high • Freak out more when price is high • Lower end of Demand Curve • Qd is high and price is low • Freak out less when price is low

30. So… • As move down the demand curve from higher prices to lower the price elasticity of demand goes from elastic to inelastic

31. Determinates of price elasticity of demand • Number of substitutes available • Increase substitutes increases elasticity • More narrowly defined goods have more substitutes (compared to broadly defined) • Example: Fords vs all cars

32. More determinates • Percentage of one’s budget that is spent on the good • More expensive??? More elastic • More affected by price (even small changes)

33. Final determinate • Amount of time that passed since price change • Increase time passed gives more opportunity to change behavior or react to price change • Overtime can look for substitutes • Increase time increases elasticity • More elastic in long term than short

34. Cross Elasticity of Demand • Measures the responsiveness of quantity demanded to a change in price of ANOTHER good

35. When would you use Cross Price Elasticity? • To determine if goods are substitutes or compliments • Ec>0 – substitutes • % change in quantity demanded and price move in same direction • Ec<0 – compliments • % change in quantity demanded and price move in opposite directions • Ec=0 – goods unrelated

36. Income elasticity of demand • Measures the responsiveness of quantity demanded to the change in income

37. Why use income elasticity of demand? • Use to determine if a good is normal or inferior • Ey>0 – normal good • As income increases Qd increases • Ey<0 – inferior good • As income increases Qd decreases

38. Can also say… • If |Ey| > 1 • % change in Qd > % change in Y • Income elastic • If |Ey| < 1 • % change in Qd < % change in Y • Income inelastic • If |Ey| = 1 • % change in Qd = % change in Y • Income unit elastic

39. Can we use income elasticity in the real world?? • If invest in the stock market do you want to invest in a normal or inferior good? • Normal • Why • Increase income would increase quantity bought and increase stock prices

40. Price Elasticity of Supply • Measures the responsiveness of quantity supplied of a good to the change in the price of that good

41. Classification is like demand • Es > 1 • Elastic • Es < 1 • Inelastic • Es = 1 • Unit elastic • Each of these will result in a “normal” upward sloped supply curve

42. Any extreme elasticities??? • Yes!! • Es = • Perfectly elastic or horizontal • Es = 0 • Perfectly inelastic or vertical

43. Price Elasticity of Supply

44. Price Elasticity of Supply

45. Price Elasticity of Supply

46. Does time play a role in elasticity of supply? • Yes!! • Overtime producers are able to adjust their behavior and production patterns • Supply becomes more elastic as time passes

47. Elasticity and taxes • If government levies a tax on a product who pays the tax?? • Producers?? Consumers?? Share?? • Depends on the elasticity of demand and supply

48. How find?? • Find equilibrium price • Supply shifts left in the amount of the tax • Find new equilibrium • Find point of second equilibrium on ORGINAL supply curve • Shows the actual price realized by firm or equilibrium price – tax = point in question • Difference between points determines how much of tax you pay

49. Who Pays the Tax?

50. Who pays more of the tax?? • Perfectly inelastic demand • Perfectly elastic demand • Demand more elastic than supply • Supply more elastic than demand