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ELASTICITIES Microeconomics

ELASTICITIES Microeconomics . S ection 2: Microeconomics Resource: Blink & Dorton , 2007, p 49-63. Introduction to Elasticities . Elasticity is a measures of responsiveness. It measures how much something changes when there is a change in one of the factors that determines it.

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ELASTICITIES Microeconomics

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  1. ELASTICITIESMicroeconomics Section 2: Microeconomics Resource: Blink & Dorton, 2007, p49-63

  2. Introduction to Elasticities • Elasticity is a measures of responsiveness. • It measures how much something changes when there is a change in one of the factors that determines it. • Elasticity will be examined in regard to demand and supply.

  3. Elasticity of Demand • Elasticity of demand is a measure of how much the demand for a product changes when there is a change in one of the factors that determines demand. There are three elasticities of demand to be examined: • Price Elasticity of Demand (PED) • Cross Elasticity of Demand (XED) • Income Elasticity of Demand (YED)

  4. Price Elasticity of Demand (PED) Formula and Definition • Price Elasticity of demand is a measure of how much the quantity demanded of product changes when there is a change in the price of the product. • It is usually calculated as follows: PED = Percentage change in quantity demanded of the product Percentage change in the price of the product

  5. Price Elasticity of Demand (PED) Example of PED Question • A publishing firm discovers that when they lower the price of one of their monthly magazine from $5 to $4.50, the number of magazines that are bought by customers each month rises from 200,000 to 230,000 Task calculate the PED for the magazine

  6. Price Elasticity of Demand (PED) Example of PED Question & Solution • Calculate the percentage change $5.00 to 4.50. Price has fallen by 50 cents. Change in Price 50 cents (.5) Original Price 5.00 (5) = .1 x 100 = 10% .

  7. Price Elasticity of Demand (PED) Example of PED Question and Solution • Calculate the percentage change in demand Demand increased by 30,000 Change in Demand 30,000 = .15 x100 = 15% Original Demand 200,000

  8. Price Elasticity of Demand (PED) Insert values in the equation for PED PED = Percentage change in quantity demanded of the product .15 Percentage change in the price of the product. .10 = .15 / .10 = 1.5 • The PED for the monthly magazine is 1.5. • But what does this mean?

  9. The Range of Values for Elasticity • The possible range of values for price elasticity of demand usually goes from zero to infinity. • The two extremes values are theoretical and the real value lies in between. • If the PED is equal to zero, then a change in the price of the product will have no effect on the quantity demanded at all. • The percentage change in quantity demanded would be zero.

  10. Perfectly Inelastic Demand A demand curve with a PED value of zero is shown in this graph. Demand is said to be perfectly inelastic – it is completely unresponsive to price changes. Whether price is P1 or P2. or any other price, the quantity demanded will be Q.

  11. Perfectly Elastic Demand A PEV value of infinity is best explained by using a diagram. A the Price P1 the demand curve goes on for ever and so the quantity demanded is infinite. However, if the price is raised above P1 even by the smallest amount, demand will fall to zero, an infinite change. The value on the top of the PED equation would be infinity. Infinity divided by anything is infinity, no mater what the percentage change in price.

  12. The Range of Values for Elasticity • It must be remembered that the extreme values of PED are simply theoretical and there are no single products that would possess at PED value of zero or infinity. • The range of values of PED is normally split into three categories: • Inelastic Demand • Elastic Demand • Unit Elastic Demand

  13. Inelastic Demand • The value of PED is less than one and greater than zero. 0 to 1 = Inelastic Demand • If a product has inelastic demand, then a change in the price of the product leads to a proportionally smaller change in the quantity demanded. • If the price is raised, the quantity demanded will not fall by much in comparison and so the total revenue gained by the firm (the number of units sold x the price of the product) will increse

  14. Inelastic Demand - Example • When a price of a carton of yoghurt is raised from $1 to 1.20, the firms finds that the quantity demanded per week falls from 12000 cartoons to 10,800 cartoons. A 20% increase in price is a causing a 10% fall in the quantity demanded. PED = % change in Quantity demanded10% = .5 % change in price 20%

  15. Inelastic Demand - Example • With PED of .5, this less than 1, so demand for yoghurt is inelastic. • Before price increase revenue was $12,000 x$1 each = $12,000. • After the price increase revenue was $10,800 x $1.20 = $12,960.

  16. Inelastic Demand Example The “revenue boxes” in the diagram clearly show why a price increase causes an increase in total revenue. Before the price rise the firm was getting revenue equal to revenue box b + revenue box c. After the price increase the firm loses revenue box c, because quantity demanded falls from 10,800 but gains revenue box a because the remaining cartoons are now sold at $1.20 each. Since revenue box a is larger than revenue box c, the firms total revenue rises by $960.

  17. Elastic Demand • When the value of the PED is greater than one and less than infinity. > 1 = elastic demand. • If a product has elastic demand, then a change in the price of a product leads to a greater than proportionate change in the quantity demanded of it. • If the price is raised, the quantity demanded will fall by more in comparison, and so the total revenue gained by the firm will fall.

  18. Elastic Demand Example • When the price of a hot dog is raised from $2 to $2.10 a hot dog seller finds that quantity demanded per weeks falls from a 200 hot dogs to 180 hot dogs. • A 5% increase in price is causing a 10% fall in the quantity demanded. PED = % change in Quantity demanded10% = 2 % change in price 5%

  19. Elastic Demand Example • In this example the PED is 2, greater than 1, so the demand for hot dog is elastic. • Before the price rise, the total revenue gained by the hot dog seller was 200 x $2 = $400. • After the increase, the total revenue becomes 180 x $2.10 = $378. • The seller has caused a fall in revenue by increasing price.

  20. Elastic Demand Example The revenue boxes in the diagram clearly show why a price increase causes a decrease in total revenue, when the demand for a product is elastic. Before the price rise the hot dog seller was earning revenue equal to revenue box b + revenue box c. After the price increase the hot dog seller lost revenue box c but gains revenue box a. Since revenue box a (180 x 10 cents = $18) is clearly smaller than revenue box c (20 x $2 = $40) , the hot dog seller’s total revenue falls by $22. If a firm has elastic demand for its product is should not raise the price of the product.

  21. Unit Elastic Demand • The value of PED is equal to one • If a product has unit elastic demand, then a change in the price of the product leads to a proportionate, opposite, change in the quantity demanded of it. • This means that if the price is raised by a certain percentage, then the quantity demanded will fall by the same percentage. • PED is equal to 1 and the total revenue gained by the firm will not change.

  22. UNIT ELATSIC DEMAND A curve that has unit elasticity at every point is shown in this graph. It is know as Rectangular Hyperbola. The rectangular hyperbola is drawn in such a way that the price times quantity at any point is constant. This means that the revenue boxes always have the same area and if the revenue does not change, when price changes, then PED must be unity. The two rectangles a & b have the same area. a + b is equal to b + c.

  23. Mathematical Note about Elasticity • It is a common mistake for students to assumed that elasticity is a measure of the slope of the demand curve and the value is always the same any point on the curve. • For a straight line, downward sloping demand curve, the value of PED falls as price falls.

  24. A MATHEMATICAL NOTE ABOUT ELASTICITY For a straight-line, downward sloping demand curve, the value of PED falls as price falls. When the price falls from $20 to $18, the quantity demanded increases from 60 to 80 units. The PED equals 3.3, which is elastic. This is evident as we move from a to b. But.. When the price falls from $10 to $8, the quantity demanded increases from 160 to 180 units. The PED equals 0.625, which is inelastic. This is evident as we move from point c to point d.

  25. Why does elasticity vary on a demand curve? • The value of PED falls as we move down a demand curve. • Low priced products have a more inelastic demand than high priced products, because consumers are less concerned when the price of inexpensive product rises, than they are when the price of an expensive product falls.

  26. Determinants of Price Elasticity of Demand • Different products will have different values for PED. For example: • The demand for restaurant meal may have a PED value of 3 (clearly elastic) • The demand for petrol may have a PED value of 0.4 which is inelastic.

  27. What actually determines the value of PED for a product? 1. The number and closeness of substitutes • The number and closeness of substitutes that are available is certainly the most important determinant of PED. • It is fair to say that the more substitutes there are for a product, the more elastic will be the demand for it. • Also the closer the substitutes available the more elastic will be the demand.

  28. What actually determines the value of PED for a product? • The number and closeness of substitutes Example • There are many brands of butter available, so an increase in price of one brand will lead a large number of customers changing their demands to another brand. • Demand for products with lots of substitutes such as brand of household products, types of meat, and types of fruit, will tend to have elastic demand.

  29. What actually determines the value of PED for a product? 1. The number and closeness of substitutes • Products with few substitutes such as oil, will tend to have relatively inelastic demand, with the demand falling relatively little as the price goes up.

  30. What actually determines the value of PED for a product? • The necessity of the product and how widely the product is defined • Food is an inelastic product, thus we would expect food to be very inelastic which is true. BUT... • If we define food more narrowly and consider meat we would expect demand to be less inelastic, since there are alternatives like vegetables. • If we define meat more narrowly to chicken, beef and lamb and pork, the demand for each would be relatively elastic since the consumer can change easily. • If we talk about a particular type of chicken elasticity increases further and so.

  31. Elasticity among different consumers and cultures • Necessity will change from consumer to consumer, since different people have different tastes and necessity is often a subjective view. • For example: In Malaysia chicken is very popular and so demand is less elastic than it would be in Italy, where it is not valued as highly.

  32. Elasticity and Addictive Substances • Necessity may go to extremes when individuals consider products to be very “necessary such as habit forming goods like cigarettes, alcohol or hard drugs. • These products may have relatively inelastic demand.

  33. What actually determines the value of PED for a product? • The time period considered • As the price of a product changes, it often takes times for consumers to change their buying and consumption habits. • PED thus tends to be inelastic in the short term and then becomes more elastic, the longer the time period is measured over.

  34. Price Elasticity of Demand & Taxation • Governments needs to be aware of the possible consequences when they impose indirect taxes, such as sales tax, on products. • Higher taxes mean that the quantity demanded of the product in question is likely to fall if the product is characterized by elastic demand. • Governments normally place additional taxes on products, where demand is relatively inelastic.

  35. CROSS ELASTICITY OF DEMAND (XED) (p56) Formula & Definition • Cross elasticity of demand is a measure of how much the demand for a product changes when there is a change in the price of another product. It is usually calculated as follows: XED = Percentage of change in quantity demanded of the product X Percentage change in the price of product Y.

  36. Cross Elasticity of Demand Example (p56) • The owners of a pizza stand find that when their competitor, a hamburger stand, lowers the price of burger from $2 to $1.80, the number of pizza slices that they sell each week falls from 400 to 380, because of the lower priced burgers. • Calculate the cross elasticity for the pizza slices.

  37. Cross Elasticity of Demand Example (p56) Step 1 • The price of the competitors burgers has fallen from 20 cents from an original price, which is a change of -10%. -20 x 100 = -10% 200

  38. Cross Elasticity of Demand Example (p56) Step 2 • The quantity demanded of the pizza slices has fallen by 20 from an original demand of 400, which is a change of -5%. -20 x 100 = -5% 400

  39. Cross Elasticity of Demand Example (p56) • If we put the values into the equation for XED: -5% (-.05) -10% (-.1) which gives a value of +0.5

  40. The Range of values for Cross Elasticity of Demand • XED explains the relationship between products. • Unlike PED, where the vast majority of products have a positive value for PED, the value of XED may be positive or negative, and the sign is important, since it tells us what the relationshipbetween the two goods in question is.

  41. Positive (+) Cross Elasticity of Demand • If the value of a XED is positive, then the two goods in questions may be said to be substitutes for each other. • Products that are very close substitutes will have a higher positive value than products that are not so close.

  42. Negative (-) Cross Elasticity of Demand • If the value of XED is negative, then the two goods in question may be said to be compliments for each other. • Products that are very close substitutes will have a lower negative value than products that are not so close. • Eg: A large rise in the price of an Xbox gaming machine, may lead to fall in demand for machines, but also a fall in demand for the associated games.

  43. Zero Value: Cross Elasticity of Demand • Some products such as matchsticks and houses are not connected. • An increase in the price of one the products will have no impact on the other. • The XED value would be zero, because the goods are unrelated.

  44. The Importance of XED for business • It is essential that firms are aware of the possible impact on the demand for their products that may arise, if there is a change in the price of close rival’s product. • Firms that produce complementary products, such as power tools and accessories need to understand the relationship between price changes for one product and impact on demand for other related products.

  45. CROSS ELASTICITY OF DEMAND.

  46. Exercise – Cross Elasticity of Demand • Amtrak reduces its fares for business class on its high speed rail network between Washington and New York, from $150 to $99. As a result demand for travel on American Eagle flights falls from 5000 seats per week to 4000 seats per week. • Calculate the cross elasticity for air travel.

  47. Answer to Amtrak Exercise • 150-99 = 51 • 51 / 150 = 0.34 • 0.34 x 100 = 34% • 5000-4000 = 1000 • 1000 / 5000 = 0.20 x 100 = 20% • 34%/20% = 1.7

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