Principles of Economics

1. Principles of Economics Session 2

2. Topics To Be Covered • Price Elasticity of Demand • Income Elasticity of Demand • Cross-Price Elasticity of Demand • Elasticity of Supply • Application of Elasticity • Networks and Positive Feedback

3. Elasticity • Elasticity is a measure of how much buyers and sellers respond to changes in market conditions • It allows us to analyze supply and demand with greater precision.

4. Price Elasticity of Demand • Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price. • It is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

5. Computing the Price Elasticity of Demand The price elasticity of demand (Ed) is computed as the percentage change in the quantity demanded divided by the percentage change in price.

6. Computing the Price Elasticity of Demand Example: If the price of an ice cream cone increases from $0.50 to $1.00 and the amount customers buy falls from 10 to 8 cones then the elasticity of demand would be calculated as:

7. Computing the Arc Elasticity of Demand P $3.00 2.50 2.00 1.50 Ed=0.2 1.00 0.50 Qd 0 1 2 3 4 5 6 7 8 9 10 11 12

8. Computing the Arc Elasticity of Demand Example: If the price of an ice cream cone decreases from $1.00 to $0.50 and the amount customers buy increases from 8 to 10 cones then the elasticity of demand would be calculated as:

9. Computing the Arc Elasticity of Demand P $3.00 2.50 2.00 1.50 Ed=0.5 1.00 0.50 Qd 0 1 2 3 4 5 6 7 8 9 10 11 12

10. Computing the Arc Elasticity of Demand Using the Midpoint Formula The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.

11. Computing the Arc Elasticity of Demand Example: If the price of an ice cream cone increases from 0.50 to $1.00 and the amount customers buy falls from 10 to 8 cones the your elasticity of demand, using the midpoint formula, would be calculated as:

12. Computing the Arc Elasticity of Demand P $3.00 2.50 2.00 1.50 Ed=0.33 1.00 0.50 Qd 0 1 2 3 4 5 6 7 8 9 10 11 12

13. Ranges of Elasticity • Inelastic (E＜ 1) Quantity demanded does not respond strongly to price changes. • Elastic (E ＞ 1)Quantity demanded responds strongly to changes in price.

14. Ranges of Elasticity • Unit Elastic (E= 1)Quantity demanded changes by the same percentage as the price. • Perfectly Inelastic (E = 0)Quantity demanded does not respond to price changes. • Perfectly Elastic (E =∞)Quantity demanded changes infinitely with any change in price.

15. $5 1. A 22% increase in price... 4 Demand 90 100 2. ...leads to a 11% decrease in quantity. Inelastic Demand Price E＜ 1 Quantity

16. $5 1. A 22% increase in price... 4 Demand 50 100 2. ...leads to a 67% decrease in quantity. Elastic Demand Price E ＞ 1 Quantity

17. $5 1. A 22% increase in price... 4 Demand 80 100 2. ...leads to a 22% decrease in quantity. Unit Elastic Demand Price E= 1 Quantity

18. Demand $5 1. An increase in price... 4 100 Perfectly Inelastic Demand Price E = 0 Quantity 2. ...leaves the quantity demanded unchanged.

19. 1. At any price above $4, quantity demanded is zero. Demand $4 2. At exactly $4, consumers will buy any quantity. Perfectly Elastic Demand Price E =∞ Quantity

20. Computing the Arc Elasticity of Demand Ed = ∞ P $3.00 Linear Demand CurveQd = a + bPQd =12 – 4P Ed＞1 2.50 Ed = 1 2.00 1.50 Ed＜1 1.00 0.50 Ed = 0 Qd 0 1 2 3 4 5 6 7 8 9 10 11 12

21. Arc Elasticity vs. Point Elasticity • Arc ElasticityIt is calculated over a portion of demand curve. • Point ElasticityIt is computed at a point on demand curve.

22. Computing the Point Elasticity of a Linear Demand Curve P Ed = ∞ $3.00 Ed=5 2.50 Ed=2 2.00 Ed = 1 1.50 Ed=0.5 1.00 Ed=0.2 0.50 Ed = 0 Qd 0 1 2 3 4 5 6 7 8 9 10 11 12

23. Computing the Point Elasticity of a Linear Demand Curve P A C B Qd O D E

24. Ed=1 Ed=0.43 Elasticity vs. Slope P $3.00 2.50 2.00 1.50 1.00 0.50 Qd 0 1 2 3 4 5 6 7 8 9 10 11 12

25. Computing the Point Elasticity of a Curvilinear Demand P $3.00 2.50 Ed=2 A 2.00 ● 1.50 B Ed=1 1.00 ● 0.50 Qd 0 1 2 3 4 5 6 7 8 9 10 11 12

26. Elasticity and Total Revenue • Total revenue is the amount paid by buyers and received by sellers of a good. • Computed as the price of the good times the quantity sold. TR = P x Q

27. Q Elasticity and Total Revenue Price $4 P x Q =$400 (total revenue) P Demand 0 100 Quantity

28. B Ed＜1 A Elasticity and Total Revenue P $3.00 With inelastic demand (Ed＜1), an increase in price leads to an increase in total revenue. 2.50 2.00 1.50 TRB=1.0×8=8 TR=P ×Q 1.00 0.50 TRA=0.5×10=5 Qd 0 1 2 3 4 5 6 7 8 9 10 11 12

29. B Ed＞1 A Elasticity and Total Revenue P TRB=2.5×2=5 $3.00 TR=P ×Q 2.50 With elastic demand (Ed＞1), an increase in price leads to a decrease in total revenue. 2.00 1.50 1.00 0.50 TRA=2×4=8 Qd 0 1 2 3 4 5 6 7 8 9 10 11 12

30. Ed=1 B 1.75 A 1.25 Elasticity and Total Revenue With unit-elastic demand (Ed=1), an increase in price leads to no change in total revenue. P $3.00 TRB=1.75×5=8.75 TR=P ×Q TRA=1.25×7=8.75 Qd 0 1 2 3 4 5 6 7 8 9 10 11 12

31. Determinants of Price Elasticity of Demand • Necessities versus Luxuries • Availability of Close Substitutes • Definition of the Market • Time Horizon

32. Determinants of Price Elasticity of Demand Demand tends to be more elastic : • if the good is a luxury. • the longer the time period. • the larger the number of close substitutes. • the more narrowly defined the market.

33. Price Elasticity of Demand

34. Income Elasticity of Demand • Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. • It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

35. Percentage Change in Quantity Demanded Income Elasticity of Demand = Percentage Change in Income Computing Income Elasticity

36. Income Elasticity- Types of Goods - • Normal Goods • Inferior Goods • Higher income raises the quantity demanded for normal goodsbut lowers the quantity demanded for inferior goods.

37. Income Elasticity- Types of Goods - • Goods consumers regard as necessities tend to be income inelasticExamples include food, fuel, clothing, utilities, and medical services. • Goods consumers regard as luxuries tend to be income elastic.Examples include sports cars, furs, and expensive foods.

38. Income Elasticity of Demand

39. Cross-Price Elasticity of Demand The cross-price elasticity of a good measures the responsiveness of quantity demanded of one good to changes in the price of another good.

40. Computing Cross-Price Elasticity of Demand

41. Cross-Price Elasticity of Demand

42. Price Elasticity of Supply • Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price. • It is a measure of how much the quantity supplied of a good responds to a change in the price of that good.

43. Ranges of Elasticity • Relatively Inelastic ES < 1 • Relatively Elastic ES > 1 • Unit Elastic ES = 1

44. Ranges of Elasticity • Perfectly Elastic ES =¥ • Perfectly Inelastic ES = 0

45. Supply $5 1. A 22% increase in price... 4 100 110 2. ...leads to a 10% increase in quantity. Inelastic Supply Price E＜ 1 Quantity

46. Supply $5 1. A 22% increase in price... 4 100 200 2. ...leads to a 67% increase in quantity. Elastic Supply Price E ＞ 1 Quantity

47. Supply $5 1. A 22% increase in price... 4 100 125 2. ...leads to a 22% increase in quantity. Unit Elastic Supply Price E= 1 Quantity

48. Supply $4 1. At exactly $4, producers will supply any quantity. 2. At a price below $4, quantity supplied is zero. Perfectly Elastic Supply Price E =∞ Quantity

49. Supply $5 1. An increase in price... 4 100 Perfectly Inelastic Supply Price E = 0 Quantity 2. ...leaves the quantity supplied unchanged.

50. Determinants of Elasticity of Supply • Ability of sellers to change the amount of the good they produce. • Beach-front land is inelastic. • Books, cars, or manufactured goods are elastic. • Time period. • Supply is more elastic in the long run.