Elasticity Intr Measures hw sensitive quantity (demanded r supplied) is t changes in price If Q D r Q S changes a lt in respnse t a price change, then the relatinship is elastic If changes a little, then inelastic Examples Insulin (inelastic) Mvie theatre tickets (elastic) Measuring Elasticity Definitin: Price Elasticity f Demand / Supply Fr X = Demand r Supply: Q2 Q1 % ΔQ ( 1 2 ) / 2 X Q + Q ε X = = % ΔP P2 P1 ( P + P ) / 2 1 2 Why midpint frmula? aviding calculus! Example, ging frm $1.00 t $1.20 is 20% increase ($1 as base) Ging frm $1.20 t $1.00 is 16.7% decrease ($1.20 as base) In ecn 101 we cmprmise by using $1.10, hence average This means that when we calculate elasticity using tw pints, we are calculating the elasticity BETWEEN the tw pints. EXAMPLE: Fall 03 Midterm 1 #20 Prperties Unit free (gallns, tns, bushels cancels ut) s can cmpare acrss gds Prperty f mving alng a curve (nt a shift) Negative fr elasticity f demand Psitive fr elasticity f supply Interpreting Elasticity Elastic, inelastic, unit elastic Elastic: e > 1: %ΔQ bigger than %ΔP - sensitive Inelastic: e < 1: %ΔQ smaller than %ΔP - insensitive Unit Elastic: e = 1: %ΔQ equals than %ΔP - even Perfectly Elastic and Perfectly Inelastic Pictures Intuitin Mnemnic (E and I n graphs) D bth supply and demand, and shw a few shifts What determines price elasticity f demand Necessicies (elastic) versus luxuries (inelastic) Clse substitutes (mre = mre elastic) Big ticket versus small ticket (bigger = mre elastic) Elasticity alng a curve Picture with triangles P Relative Elasticity f tw different curves Elasticity is NOT the same a slpe, but they are related 1 P ε = slpe Q S yu can use relative slpe t determine relative elasticity
Imprtance f elasticities f supply and demand Revenue maximizatin with arrw equatins TR = P x Q Demand Elastic: %ΔQ > %ΔP s lwer P Demand Inelastic: %ΔQ < %ΔP s raise P Demand Unit Elastic: %ΔQ = %ΔP s P is perfect S revenue is maximized when elasticity f demand = -1 (gd trick fr tests) EXAMPLE: Fall 03 Midterm 1, #21 Taxes and Subsidies Intrduce tax incidence P The mre elastic the demand curve, the greater the cnsumer tax incidence P The mre elastic the supply curve, the greater the prducer tax incidence P Whichever agent has the mre elastic curve has the greater tax incidence P Other elasticities Elasticity f incme %ΔQ D / %Δincme Psitive nrmal; negative inferir Crss-price elasticity f demand Percentage change in quantity demanded f gd A fr a percentage change in the price f gd B Psitive substitutes; negative cmplements Cnsumer Behavir S far, we have been drawing supply and demand curves withut any real theretical justificatin nw we are ging back t the beginning and justifying the curves that we have been using. Marginal analysis in general (cmes up again and again) Cmpares the cst f ne mre unit t the benefit f ne mre unit MB > MC d mre MB < MC d less MB = MC just right maximized well-being / payff Cnsumers measure marginal cst as the price (this is hw much it csts t get ne mre unit f smething) What abut the marginal benefit need a measure f hw much yu like cnsuming smething
Utility and Preferences Individuals make decisins based n hw much satisfactin they get frm smething (but they must be able t affrd it). Utility is a numeric measure f satisfactin frm cnsuming Everyne has a different utility functin, which takes ptential cnsumptin bundles and cnverts it t a number if yu like a cnsumptin bundle mre than anther ne, it will have a higher utility number. Allws us t cmpare different cnsumptin ptins and different types f gds. Define cnsumptin bundles If can affrd tw different bundles, buy the ne with higher utility Ttal utility versus marginal utility Ttal utility ges up as we cnsume mre gds (that s why they are gds nt bads ) Marginal utility is change in utility fr change in cnsumptin MU = ΔU / ΔQ Law f Decreasing Marginal Utility Getting tired f stuff Can cntinue t be diminishing and still psitive Remember mre f gd less Marginal Utility # f grapes 1 2 3 4 5 6 7 Utility 20 38 54 68 80 90 98 Marginal Utility 10 18 16 14 12 10 6 Budget cnstraint and Prices Budget cnstraint: yu must spend an amunt less than r equal t hw much yu have Prices: the cst f a unit f a gd Optimal Chice and Utility Maximize utility (satisfactin frm cnsuming), while satisfying budget cnstraint Cnditins fr maximized utility: Set MU A / MU B B = PA / P BB (if > mre A, less B; if < less A, mre B) Spend less than r equal t budget Prblem slving EXAMPLE: Hmewrk 4, Part I, #1 1) Create table f MU/$ (bang fr yur buck) 2) Lk fr places where ratis are same and budget is satisfied 3) If budget nt satisfied at any places where ratis are same, then pick ne by ne Budget Changes Incme Changes May increase r decrease quantity demanded f each gd depending n whether it is nrmal r inferir Price Changes If price f A ges up, demand less f gd A because can substitute t ther gds that meet the same need substitutin effect If price f A ges up, feel prer verall since yur mney is wrth less in terms f actual gds that yu buy incme effect Nrmal gds when yur incme (real r perceived) ges up, yu demand mre Inferir gds when yur incme (real r perceived ges up, yu demand less Nte that all f these definitins g the ther way (say ut lud) Nw the crazy ne Giffen gd
What if we have a gd that is really inferir ptates in Ireland (rare effect, s nt t many examples in real life) If the price ges up, then by the substitutin effect, we shuld demand less f it, but by the incme effect fr an inferir gd we demand mre f it since we feel prer If the incme effect is s strng that is swamps the substitutin effect, we might demand mre even thugh the price went up Mentin test prblem where the prblem described a giffen gd, but nly gave inferir as an answer Demand Curves and Willingness t Pay Hw much am I willing t pay fr smething? WTP up t the marginal benefit I get frm that smething Demand curve is hw much d I want fr a given price, s turning this arund, it says what am I willing t pay fr this amunt. S Marginal Utility Marginal Benefit Willingness t Pay Demand Curve Distinguish between straight line market curves and step individual curves EXAMPLE: Hmewrk 4, Text p.132 # 7 a) b) c) Shw hw t draw demand curve Start with high prices, s that quantity demanded is zer Quantity demanded jumps right suddenly at the price where P=MWTP (s have dts with sticks ging dwn) Hrizntal aggregatin f individual curves t market curve Efficiency and Surplus Cnsumer and Prducer Surplus Main idea Cnsumer Surplus Step functin picture, shwing bars fr difference between a given price and the willingness t pay (use crrect clrs) D same thing n smth demand curve Prducer Surplus Willingness t accept defines a supply curve as WTP defines supply curve Shw hw t draw a step functin supply curve (dts with bars pinting up) Shw bars fr difference between given price and willingness t accept D same thing n smth supply curve Put them tgether n an equilibrium diagram with smth curves Deadweight Lss (maybe leave this fr next quiz) Efficient prductin The ttal amunt f surplus (cnsumer and prducer) is maximized Inefficient prductin and Deadweight Lss Shw diagram with quantity belw efficient equilibrium level Nte lss in surplus Deadweight Lss: The lss in prducer and cnsumer surplus due t an inefficient level f prductin D same fr quantity abve efficient equilibrium level P
Changes in surplus due t plicies Tax Subsidy P Quta P