Lecture 5. Elasticity and its applications

Transcription

1 Lecture 5 Elasticity and its applications

2 By the end of this lecture, you should understand: the meaning of the elasticity of demand what determines the elasticity of demand the meaning of the elasticity of supply what determines the elasticity of supply the concept of elasticity in three very different markets (the market for wheat, the market for oil, and the market for illegal drugs). Introduction

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

4 The price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. When we talk about elasticity, that responsiveness is always measured in percentage terms. Specifically, the price elasticity of demand is the percentage change in quantity demanded due to a percentage change in the price. THE ELASTICITY OF DEMAND

5 Availability of Close Substitutes Necessities versus Luxuries Definition of the Market Time Horizon The Price Elasticity of Demand and Its Determinants

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

7 The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. Price elasticity of demand = Percentage change in quantity demanded Percentage change in price Computing the Price Elasticity of Demand

8 Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as: ( 10 8) ( ) % 10% 2 Computing the Price Elasticity of Demand

9 The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the price change. ( Q Q ) /[( Q Q ) / 2] Price elasticity of demand = ( P2 P ) /[( ) / 2] 1 P2 P1 The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities

10 Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as: (10 8) (10 8) / 2 22% ( ) 9.5% ( ) / The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities

11 Inelastic Demand Quantity demanded does not respond strongly to price changes. Price elasticity of demand is less than one. Elastic Demand Quantity demanded responds strongly to changes in price. Price elasticity of demand is greater than one. The Variety of Demand Curves

12 Price $ Demand Quantity E D (100 50) (100 50)/2 ( ) ( )/2 67 percent 22 percent 3 Demand is price elastic. Computing the Price Elasticity of Demand

13 Perfectly Inelastic Quantity demanded does not respond to price changes. Perfectly Elastic Quantity demanded changes infinitely with any change in price. Unit Elastic Quantity demanded changes by the same percentage as the price. The Variety of Demand Curves

14 Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve. But it is not the same thing as the slope! The Variety of Demand Curves

15 Figure 1 The Price Elasticity of Demand (a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand $5 $ Quantity An increase in price (from 4$ to 5$) leaves the quantity demanded unchanged.

16 Figure 1 The Price Elasticity of Demand Price (b) Inelastic Demand: Elasticity Is Less Than 1 $5 1. A 22% increase in price... 4 Demand Quantity leads to an 11% decrease in quantity demanded.

17 Figure 1 The Price Elasticity of Demand Price (c) Unit Elastic Demand: Elasticity Equals 1 $5 1. A 22% increase in price... 4 Demand Quantity leads to a 22% decrease in quantity demanded.

18 Figure 1 The Price Elasticity of Demand Price (d) Elastic Demand: Elasticity Is Greater Than 1 $5 1. A 22% increase in price... 4 Demand Quantity leads to a 67% decrease in quantity demanded.

19 Figure 1 The Price Elasticity of Demand Price (e) Perfectly Elastic Demand: Elasticity Equals Infinity 1. At any price above $4, quantity demanded is zero. $4 Demand 2. At exactly $4, consumers will buy any quantity At a price below $4, quantity demanded is infinite. Quantity

20 Total Revenue and the Price Elasticity of Demand 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.

21 Price Figure 2 Total Expenditure When the price is $4, consumers will demand 100 units, and spend $400 on this good. $4 P P Q = $400 (revenue) Demand 0 Figure 2 Total Revenue Q 100 Quantity

22 With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases. Elasticity and Total Revenue along a Linear Demand Curve

23 Figure 3 How Total Revenue Changes When Price Changes: Inelastic Demand Price $3 With an inelastic demand, an increase in price leads to a decrease in quantity demanded that is proportionately smaller. In this case, an increase in price from 1$ to 3$ leads to an increase in total revenues (or expenditure) from 100$ (100 x 1$) to 240$ (80 x 3$) $1 Demand Quantity

24 With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases. Elasticity and Total Revenue along a Linear Demand Curve

25 Figure 4 How Total Revenue Changes When Price Changes: Elastic Demand Price $3 With an elastic demand, an increase in price leads to a decrease in quantity demanded that is proportionately larger. In this case, an increase in price from 1$ to 3$ leads to an decrease in total revenues (or expenditure) from 70$ (70 x 1$) to 60$ (20 x 3$) $1 Demand Quantity

26 Elasticity of a Linear Demand Curve THE SLOPE OF A LINEAR DEMAND CURVE IS CONSTANT BUT ITS ELASTICITY IS NOT. THE DEMAND SCHEDULE ABOVE IS USED TO CALCULATE THE PRICE ELASTICITY OF DEMAND USING THE MIDPOINT METHOD. AT POINTS WITH LOW PRICE (AND HIGH QUANTITY), THE DEMAND CURVE IS INELASTIC. AT POINTS WITH HIGH PRICE (AND LOW QUANTITY), THE DEMAND CURVE IS ELASTIC 25

27 Figure 5 Elasticity of a Linear Demand Curve Price $7 6 Elasticity is > 1 in this range Elasticity is < 1 in this range ELASTICITY >1: When P increases from $4 to $5, TR declines from $24 (4$ x 6) to $20 (5$ x 4). Quantity ELASTICITY < 1: When price increases from $2 to $3, TR increases from $20 to $24. 26

28 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. Other Demand Elasticities

29 Computing Income Elasticity Remember, all elasticities are measured by dividing one percentage change by another Other Demand Elasticities

30 Income Elasticity Types of Goods Normal Goods Inferior Goods Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. Other Demand Elasticities

31 Income Elasticity Goods consumers regard as necessities tend to be income inelastic Examples 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. Other Demand Elasticities

32 Other Demand Elasticities Cross-price elasticity of demand A measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good

33 Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good. Price elasticity of supply is the percentage change in quantity supplied resulting from a percentage change in price. THE ELASTICITY OF SUPPLY

34 Figure 6 The Price Elasticity of Supply Price (a) Perfectly Inelastic Supply: Elasticity Equals 0 Supply $5 1. An increase in price Quantity 2. leaves the quantity supplied unchanged.

35 Figure 6 The Price Elasticity of Supply Price (b) Inelastic Supply: Elasticity Is Less Than 1 $5 Supply 4 1. A 22% increase in price Quantity leads to a 10% increase in quantity supplied.

36 Figure 6 The Price Elasticity of Supply Price $ A 22% increase in price... (c) Unit Elastic Supply: Elasticity Equals 1 Supply NB: If SUPPLY is unit elastic and linear, it will begin at the origin Quantity leads to a 22% increase in quantity supplied.

37 Figure 6 The Price Elasticity of Supply Price (d) Elastic Supply: Elasticity Is Greater Than 1 Supply $ A 22% increase in price Quantity leads to a 67% increase in quantity supplied.

38 Figure 6 The Price Elasticity of Supply Price (e) Perfectly Elastic Supply: Elasticity Equals Infinity 1. At any price above $4, quantity supplied is infinite. $4 Supply 2. At exactly $4, producers will supply any quantity At a price below $4, quantity supplied is zero. Quantity

39 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. The Price Elasticity of Supply and Its Determinants

40 The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price. Price elasticity of supply = Percentage change in quantity supplied Percentage change in price Computing the Price Elasticity of Supply

41 Can good news for farming be bad news for farmers? What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties? THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITY

42 Examine whether the supply or demand curve shifts. Determine the direction of the shift of the curve. Use the supply-and-demand diagram to see how the market equilibrium changes. Can Good News for Farming Be Bad News for Farmers?

43 Figure 7 An Increase in Supply in the Market for Wheat Price of Wheat leads to a large fall in price... $3 1. When demand is inelastic, an increase in supply... S 1 S Demand Quantity of Wheat and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $

44 E D ( ) / ( ) / Demand is inelastic. Compute the Price Elasticity of Demand When There Is a Change in Supply

45 Supply and Demand can behave differently in the short run and the long run In the short run, both supply and demand for oil are relatively inelastic But in the long run, both are elastic Production outside of OPEC More conservation by consumers Why Did OPEC Fail to Keep the Price of Oil High?

46 Drug interdiction impacts sellers rather than buyers. Demand is unchanged. Equilibrium price rises although quantity falls. Drug education impacts the buyers rather than sellers. Demand is shifted. Equilibrium price and quantity are lowered. Does Drug Interdiction Increase or Decrease Drug-Related Crime?

47 Figure 8 Policies to Reduce the Use of Illegal Drugs P Drug Interdiction Drug Education P S 2 S 1 S 1 D D 1 1 D 2 Quantity of Drugs Quantity of Drugs 46

48 Drug prohibition reduces the supply of drugs from S 1 to S 2 (panel (a)), raising the price, and reducing the quantity sold. However, if the demand for drugs is inelastic, then the total amount paid by drug users rises, even as the amount of drug use falls. By contrast, drug education reduces the demand for drugs from D 1 to D 2 (panel (b)), reducing both the price and the quantity sold. Because both price and quantity fall, the amount paid by drug users falls. Policies to reduce the use of drugs (figure 8) CHAPTER 1 TEN PRINCIPLES OF ECONOMICS

49 Price elasticity of demand measures how much the quantity demanded responds to changes in the price. Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. If a demand curve is elastic, total revenue falls when the price rises. If it is inelastic, total revenue rises as the price rises. Elasticity and its applications: summary

50 The income elasticity of demand measures how much the quantity demanded responds to changes in consumers income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good. The price elasticity of supply measures how much the quantity supplied responds to changes in the price. Elasticity and its applications: summary

51 In most markets, supply is more elastic in the long run than in the short run. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. The tools of supply and demand can be applied in many different types of markets. Elasticity and its applications: summary

52 Define the price elasticity of demand and the income elasticity of demand List and explain some of the determinants of the price elasticity of demand If the elasticity is greater than 1, is demand elastic or inelastic? If the elasticity equals 0, is demand perfectly elastic or perfectly inelastic? If demand is elastic, how will an increase in price change total revenue? Quick Review Questions

53 What do we call a good whose income elasticity is less than 0? What is the price elasticity of supply of Picasso paintings? Is the price elasticity of supply usually larger in the short run or in the long run? Why? Quick Review Questions