Chapter 6. Elasticity: The Responsiveness of Demand and Supply

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1 Chapter 6. Elasticity: The Responsiveness of Demand and Supply Instructor: JINKOOK LEE Department of Economics / Texas A&M University ECON Principles of Microeconomics

2 Elasticity Demand curve: the relationship between the price of a good and the quantity demanded. Beyond the law of demand, we want to know how much the quantity demanded change as a result of a price increase or decrease. Economists use the concept of elasticity to measure it. Elasticity: A measure of how much one economic variable responds to changes in another economic variable.

3 Price Elasticity of Demand Price elasticity of demand: The responsiveness of the quantity demanded to a change in price Price elasticity of demand = % change in quantity demanded % change in price (1) price elasticity of demand is not the same as the slope of the demand curve. the measurement of slope is sensitive to the units chosen for quantity and price. price elasticity of demand is always negative. but we drop - sign and compare their absolute values.

4 Elastic/Inelastic Demand Elastic Price elasticity > 1 Inelastic Price elasticity < 1

5 Elastic/Inelastic Demand Unit-elastic Price elasticity = 1 Perfectly elastic Price elasticity =

6 Elastic/Inelastic Demand Perfectly inelastic Price elasticity = 0

7 Midpoint Formula It is possible to have different values for the price elasticity of demand between the same two points on the same demand curve. To ensure that we have only one value of the price elasticity of demand, we use the midpoint formula. Elasticity by Midpoint Formula (Q 2 Q 1 ) (P2 P 1 ) ( Q 1 +Q 2 2 ) ( P 1 +P 2 ) 2

8 Determinants of Price Elasticity of Demand Why do price elasticities differ among products? (1)Availability of Close Substitutes In general, if a product has more substitutes available, it will have more elastic demand. If a product has fewer substitutes available, it will have less elastic demand. (2)Luxuries versus Necessities The demand curve for a luxury is more elastic than the demand curve for a necessity.

9 Determinants of Price Elasticity of Demand Why do price elasticities differ among products? (3)Passage of Time It usually takes consumers some time to adjust their buying habits when prices change. The more time that passes, the more elastic the demand for a product becomes. (4)Definition of the Market The more narrowly we define a market, the more elastic demand will be. (5)Share of a Good in a Consumer s Budget the demand for a good will be more elastic the larger the share of the good in the average consumer s budget.

10 Elasticity and Total Revenue Total revenue: price per unit number of units sold. When demand is elastic (inelastic), a cut in price will increase (decrease) total revenue.

11 Demand, Total Revenue, Marginal Revenue Q1. Draw demand curve, total revenue curve, and marginal revenue curve. Q2. Describe the relationship between price elasticity of demand and total revenue. Q3. Describe the relationship between marginal revenue and total revenue.

12 Cross-Price Elasticity of Demand Cross-price elasticity of demand (C-PE) measures the effect of an increase in the price of one good on the quantity of another good demanded. The C-PE can is positive or negative, depending on whether the two products are substitutes or complements. Cross price elasticity of demand = % change in quantity demanded of one good % change in price of another good (2)

13 Income Elasticity of Demand Income elasticity of demand (IE) measures the responsiveness of quantity demanded to changes in income. Income elasticity of demand = % change in quantity demanded % change in income (3) Income elasticity > 0 : Normal good. 1 < IE : luxury good. 0 < IE < 1 : necessity good. Income elasticity < 0 : Inferior good.

14 Application: Elasticity and the Disappearing Family Farm We can use price elasticity and income elasticity to analyze economic issues. over the past 60 years, supply curve for wheat has moved to the right largely. income elasticity of demand for wheat was low, so demand for wheat increased relatively little. price elasticity of demand is also low, so demand curve is steep relatively. The large shift in the supply curve and the small shift in the demand curve resulted in a sharp decline in the price of wheat.

15 Price Elasticity of Supply Price Elasticity of Supply: The responsiveness of the quantity supplied to a change in price. Price elasticity of supply = % change in quantity supplied % change in price (4) the price elasticity of supply will be a positive number. elastic (>1), inelastic (<1), unit-elastic(=1). perfectly elastic (= ), perfectly inelastic (= 0)

16 Application: Changes in Price Depend on the Price Elasticity of Supply Demand Typical and Demand July4 represent the typical demand for parking spaces and demand on the Fourth of July. in figure (a), supply is inelastic, shifting from A to B results in a large increase in price and a small increase in the quantity supplied. in figure (b), supply is elastic, shifting from A B results in a smaller increase in price and a larger increase in the quantity supplied.