Chapter 5: Elasticity and Its Application

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1 Ch. 5: Elasticity and Its Application Why are breakfast foods cheaper than tobacco products?

2 Elasticity: is a numerical measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants. How much more ice cream will a firm sell if it decreases its price by $.5 per scoop? The Law of Demand says... a firm will sell more ice cream... but how much more? This relationship is called the price elasticity of demand.

3 Price elasticity of demand: The price elasticity of demand, loosely speaking, measures the price-sensitivity of buyers demand. Price Elasticity Percentage change in quantity demanded ( Q) of Demand = Percentage change in Price ( P) How do we calculate it, in practice?

4 Price elasticity of demand: calculating it The price elasticity of demand, loosely speaking, measures the price-sensitivity of buyers demand. Price Elasticity of Demand = Percentage change in quantity demanded ( Q) Percentage change in Price ( P)

5 Price elasticity of demand: Elasticity ranges from to infinity. A product with a low elasticity ( to 1) is said to be inelastic; consumers will continue to purchase large amounts of that product even when the price becomes extremely high. Insulin Electricity Medical treatment Oil Water Cigarettes Heroin

6 Price elasticity of demand: Elasticity ranges from to infinity. A product with a high elasticity (greater than 1) is said to be elastic; consumers will reduce their purchase of that product when the price becomes extremely high. Vacations Newspapers

7 Real world elasticities: Eggs Real world elasticities Restaurants Beef.1 Healthcare 4.4 Rice 2.3 Housing

8 What causes a product to be more or less elastic? Availability of close substitutes. Necessities versus luxuries. Definition of the market (how narrow, how broad). Does food have many substitutes? how about bananas? Time horizon. If gas prices increase, can you substitute to a prius tomorrow?

9 Terminology Elasticity terminology Elasticity number Term No matter what the price, the product will still be purchased. Perfectly inelastic Greater than, less than 1 Inelastic 1 Unit elastic Greater than 1, less than infinity Infinity Elastic Perfectly elastic? If the price increases by 1 cent, no one will purchase the product.

10 Price-inelastic demand: oil Price of a barrel of oil $16 U.S. Daily Demand for Oil A steep demand curve represents inelastic demand quantity demanded is highly less responsive to changes in price. $12 Notice if the price of oil increases 1% (from $8 to $16) demand only drops 33% (from 15 to 1) $8 $4 Perfectly price-inelastic demand would be given by a perfectly vertical demand curve Quantity demanded 25 (Millions of barrels of oil per day)

11 Price-elastic demand: mountain dew Price of a can of mountain dew $1.25 U.S. Daily Demand for Mountain Dew A flat demand curve represents elastic demand quantity demanded is highly responsive to changes in price. $1. $.825 $.75 Notice if the price of mountain dew increases by 1% (from $.75 to $.825) demand drops 5% (from 2 to 1) $.5 Perfectly price-elastic demand would be given by a perfectly horizontal demand curve Quantity demanded (cans of mountain dew per day millions)

12 Price-elastic demand: perfectly inelastic demand Price of a insulin Demand for insulin Perfectly inelastic demand: demand for insulin $3 Point A Price elasticity of demand = % change in Q = % = % change in P 66.6% $1 Point B Demand curve perfectly vertical Quantity of insulin demanded

13 Price-elastic demand: inelastic demand Price of a gallon of gasoline Demand for gasoline Inelastic demand: demand for gasoline $5 Point A Price elasticity of demand = % change in Q = 3% =. 75 % change in P 4% $3 Point B Demand curve relatively steep Consumers price sensitivity is relatively low 5 65 Gallons of gasoline demanded

14 Price-elastic demand: unit elastic demand Price of a scoop of ice cream Unit elastic demand: demand for ice cream Demand for ice cream $4 Point A Price elasticity of demand = % change in Q = 5% = 1 % change in P 5% $2 Point B Demand curve moderately steep Consumers price sensitivity is moderate Scoops of ice cream demanded

15 Price-elastic demand: elastic demand 4% 3.75

16 Price-elastic demand: perfectly elastic demand Price of a can of perfectly elastic good Perfectly elastic demand:??? Price elasticity of demand = % change in Q = 2% = infinity ( ) % change in P % $8 Demand curve for a perfectly elastic good Point A Demand curve perfectly flat Point B Consumers demand is completely sensitive to price 5 15 Quantity of perfectly elastic good demanded

17 How does price elasticity relate to total revenue generation? In any given market, the demand revenue created at a given price is the product of the price and the quantity demanded. Price of a sandwich $12 Total revenue in the Jimmy John s sandwich market $9 $6 $3 5 sandwiches X $9 per sandwich = 45 dollars of revenue Quantity of sandwiches

18 How does price elasticity relate to total revenue generation? There is a tradeoff between increasing price and decreasing quantity in total revenue generation. Increasing the price makes each unit more valuable but reduces the number of units being sold. Decreasing the price makes each unit less valuable but increases the number of units being sold. The effect on revenue will depend on the price elasticity of demand!.

19 Price increase, inelastic demand If price elasticity of demand is < 1, a rising price will increase at a faster rate than the falling quantity. Increasing the price will increase revenue.

20 Price increase, unit elastic demand If price elasticity of demand is = 1, a rising price will increase at the same rate as the falling quantity. These forces are perfectly offsetting! Increasing the price will leave the revenue unchanged. Price Unit elastic demand perfectly offsetting quantity and price effects. p Revenue p Revenue q q Quantity demanded

21 Price increase, unit elastic demand If price elasticity of demand is > 1, a rising price will increase at a slower rate than the falling quantity. Increasing the price will decrease the revenue.

22 Other forms of elasticity: Income elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in consumers income. Cross-price elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in the price of another good. Price elasticity of supply: a measure of how much the quantity supplied of a good responds to a change in consumers income.