Chapter 5: Elasticity. measures how strongly people respond to changes in prices and changes in income.

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1 Chpter 5: Elsticity Elsticity responsiveness mesures how strongly people respond to chnges in prices nd chnges in income. Exmples of questions tht elsticity helps nswer Wht hppens to ttendnce t your museum if you increse the dmissions price y 10%? if peoples incomes increse y 10%? to demnd for your product if you increse the price? to demnd for Big Mcs when the price of Whoppers flls? 1

2 Elsticity is lso importnt to pulic policy. Wht hppens to lor supply when we increse the tx on wges? to gsoline demnd when we lower the gs tx? to demnd for ychts if we impose tx on luxury goods? Does the slope of demnd curve mesure responsiveness of demnd to price chnges? No. Why? 2

3 rice untity demnded oint 2 3 oint 1 4 rice Ä Slope 1 Ä 2 rice untity demnded oint oint Ä Slope 100 Ä untity D Slope depends on units! will not e good mesure of responsiveness for this reson 3

4 Elsticity percent chnge in quntity demnded due to percent chnge in price Elsticity %Ä d %Ä å Exmples % 10% % d 3% ε 3% /10%.3 % 10% % d 25% ε 25% /10% 2.5 Definitions ε < 1 D is inelstic (respond wekly) ε 1 D is unit elstic ε > 1 D is elstic (respond strongly) Different products hve different elsticities. 4

5 oint 4 2 oint 3 3 Step 1: Clculte d / Ä d 3??? ( 2 - ) Clculting Elsticities rice Use 2 in denomintor? Use 3? Use the midpoint (the verge) of the two points. Averge (2+3)/2 2.5 d ( 2-3) 1 Ä untity D 5

6

7 Step 2: Clculte / Ä ( 4-3)??? Use midpoint verge 3.5 Use 4 in denomintor? Use 3? Ä ( - 3) Step 1: Clculte d / d ( 2-3) 1 Ä Step 2: Clculte / Ä ( - 3) Step 3: Ä d 1 Elsticity å Ä percent chngein quntity demnd percent chnge in price 7

8 8 Why use midpoint? Direction of chnge does not mtter ( to versus to ) If you used initil points you would get different elsticities for movement from to nd movement from to This does not mke sense economiclly! Midpoint formul å

9 Extreme Cses erfectly inelstic A specil cse of n inelstic demnd curve Verticl line Elsticity 0 No mtter wht hppens to, stys the sme Exmple: Demnd for insulin erfectly elstic A specil cse of n elstic demnd curve Horizontl line Elsticity Exmple: Demnd for corn from n individul corn frmer. 9

10 Reltion etween totl revenues nd elsticity Exmple. Consider pricing dmissions to museum. Should you consider chnging the price of dmission to increse totl revenue? Do you rise the price of dmission, or do you lower it? depends on the elsticity of demnd. If demnd for museum visits is inelstic in dmission price would totl revenue. ( increses, does not chnge very much) If demnd is elstic in dmission price would totl revenue (it would cuse the numer of visitors to y so much tht totl revenue would ) in dmission price would totl revenue The numer of visitors would rise y so much tht totl revenue would increse! 10

11 Totl revenue * mount pid y uyers nd received y sellers of the good Note: nd work in opposite directions. TR my increse, decrese or sty the sme. When would TR decrese? If increse in price cused ig decrese in demnd. When would TR increse? If increse in price cused little decrese in demnd. The chnge in totl revenue depends on the elsticity of demnd: ε > 1 then strongly TR ε 1 then TR stys the sme ε < 1 then wekly TR ε > 1 then strongly TR ε 1 then TR stys the sme ε < 1 then wekly TR 11

12 Fctors tht influence the elsticity of demnd 1. Avilility of close sustitutes More sustitutes Fewer sustitutes more elstic is D more inelstic is D 2. Definition of mrket Brod (very inclusive) definition: Food few sustitutes more inelstic Nrrow definition: Honey nut cheerios mny good sustitutes more elstic 3. Necessity versus luxury Luxury: lots of good sus. Necessity: fewer sus. more elstic less elstic 4. Amount of time tht hs elpsed since the price of the product chnged (time horizon) Short-period: few sustitutes less elstic Long-period: more sustitutes more elstic 12

13 Some other elsticities 1. rice elsticity of demnd % d / % percent chnge in quntity demnded divided y percent chnge in price 2. Income elsticity of demnd % d / % Income percent chnge in quntity demnded divided y percent chnge in income Norml good (+) Inferior good (-) 3. Cross price elsticity of demnd % d i/ % j percent chnge in quntity demnded of good i divided y percent chnge in price of good j Sustitute (+) Complement (-) 4. rice elsticity of supply % s / % percent chnge in quntity supplied divided y percent chnge in price 13

14 Cn good news for frming e d news for frmers? Wht hppens to whet frmers nd the mrket for whet when university gronomists discover new whet hyrid tht is more productive thn existing vrieties? Answer in 3 steps: 1. Does S or D curve shift? 2. Which direction is the shift? 3. How does mrket equilirium chnge? 14

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