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Elasticity Elasticity What do you think? Could reducing the supply of illegal drugs cause an increase in drug-related burglaries? Total Expenditure = P x Q S $2500 = $50 x 50 S’ $3200 = $80 x 40 S’ 80 S 50 D 40 50

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Elasticity l.jpg
Elasticity

  • What do you think?

    • Could reducing the supply of illegal drugs cause an increase in drug-related burglaries?

Chapter 4: Elasticity


E g 4 1 the effect of extra border patrols on the market for drugs l.jpg

Total Expenditure = P x Q

S $2500 = $50 x 50

S’ $3200 = $80 x 40

S’

80

S

50

D

40

50

e.g. 4.1 The Effect of Extra Border Patrols on the Market for Drugs

How will drug addicts behave?

P($/ounce)

Q(1,000s of ounces/day)

Chapter 4: Elasticity


Elasticity4 l.jpg
Elasticity

  • Generally, elasticity is a measure of the responsiveness

Chapter 4: Elasticity


Price elasticity of demand l.jpg
Price Elasticity of Demand

  • is a measure of the responsiveness of the quantity demanded of a good to a change in the price of that good.

  • i.e. the percentage change in the quantity demanded that results from a 1 percent change in its price.

Chapter 4: Elasticity


Example 4 2 l.jpg
Example 4.2

  • The price of beef increases by 2% and the quantity demanded decreases by 6%

    • Then the price elasticity of demand for beef is

- 6%

-3

=

2%

Chapter 4: Elasticity


Price elasticity of demand7 l.jpg
Price Elasticity of Demand

  • Measuring Price Elasticity of Demand

  • Observations

    • Price elasticity of demand will always be negative (i.e., an inverse relationship between price and quantity).

    • For convenience sometimes we drop the negative sign/ take absolute sign.

Chapter 4: Elasticity


Price elasticity of demand8 l.jpg
Price Elasticity of Demand

Unit elastic

inelastic

Elastic

Price elasticity

of demand

-3

-2

-1

0

Chapter 4: Elasticity


E g 4 3 elasticity of demand for dim sum l.jpg
e.g 4.3elasticity of demand for dim sum?

  • Originally

    • Price = $10/piece

    • Quantity demanded = 600 pieces/day

  • New

    • Price = $9.5/piece

    • Quantity demanded = 606 pieces/day, then

-1

(606 - 600)/600

1%

=

=

(9.5 - 10)/10

-5%

5

Inelastic!

Chapter 4: Elasticity


Example 4 4 what is the elasticity of ocean park annual passes l.jpg
Example 4.4 What is the elasticity of Ocean Park Annual Passes?

  • Originally

    • Price = $1200

    • Quantity demanded = 20,000 passes/year

  • New

    • Price = $1140

    • Quantity demanded = 26,000 passes/year, then

(26000 - 20000)/20000

30%

=

=

-6

(1140 - 1200)/1200

-5%

Elastic!

Chapter 4: Elasticity


Determinants of price elasticity of demand l.jpg
Determinants of Price Elasticity of Demand

  • Availability of substitutes

    More substitute to choose from

     when P of good X changes people can substitute X by other goods easily

     higher elasticity

Chapter 4: Elasticity


Determinants of price elasticity of demand12 l.jpg
Determinants of Price Elasticity of Demand

  • Proportion of income used to buy the good

     the higher the fraction of income spent on a good x

     higher elasticity as a slight increase in Px will affect your purchasing power adversely

     e.g. Housing

Chapter 4: Elasticity


Determinants of price elasticity of demand13 l.jpg
Determinants of Price Elasticity of Demand

  • Temporary versus permanent change in price

     if price change is temporary

     people react more to it

     higher elasticity

     e.g. Airline promotions

Chapter 4: Elasticity


Determinants of price elasticity of demand14 l.jpg
Determinants of Price Elasticity of Demand

  • Time

     facing a sudden price increases

     if we have more time to search for substitutes

     responsiveness higher

     higher elasticity

     e.g. marketing tactics

Chapter 4: Elasticity


E g 4 5 price elasticity estimates for selected products l.jpg
e.g 4.5 Price Elasticity Estimates for Selected Products

Good or service Price elasticity

Green peas -2.80

Restaurant meals -1.63

Automobiles -1.35

Electricity -1.20

Beer -1.19

Movies -0.87

Air travel (foreign) -0.77

Shoes -0.70

Coffee -0.25

Theater, opera -0.18

Why is the price elasticity of demand more than 14 times larger for green peas than for theater and opera performances?

Chapter 4: Elasticity


A graphical interpretation of price elasticity l.jpg
A Graphical Interpretationof Price Elasticity

  • For small changes in price

Where Q is the original quantity and P is the original price.

Chapter 4: Elasticity


A graphical interpretation of price elasticity17 l.jpg

A

P

P

P - P

Q

D

Q

Q + Q

A Graphical Interpretationof Price Elasticity

  • For small changes in price

Price

Chapter 4: Elasticity


Example 4 6 calculating price elasticity of demand l.jpg

D

A

Example 4.6 Calculating Price Elasticity of Demand

20

16

12

Price

8

Question:

What is the price elasticity

of demand when P = $8?

4

1

2

3

4

5

Quantity

Chapter 4: Elasticity


Example 4 7 price elasticity and steepness of the demand curve l.jpg

12

D1

6

4

D2

4

6

12

Example 4.7 Price Elasticity and Steepness of the Demand Curve

What is the price elasticity of Demand for D1 & D2 when P = $4?

P

Observation

If two demand curves have a point in common, the steeper curve must be less elastic with respect to price at that point.

Q

Chapter 4: Elasticity


Price elasticity regions along a straight line demand curve l.jpg

a

a/2

b/2

b

Price Elasticity Regions along a Straight-Line Demand Curve

Observation

Price elasticity varies at every point along a straight-line demand curve

Price

Quantity

Chapter 4: Elasticity


Example 4 8 price elasticity regions along a straight line demand curve l.jpg
Example 4.8 Price Elasticity Regions along a Straight-Line Demand Curve

When P = $4

When P = $1

12

6

Price

Observation

Price elasticity varies at every point along a straight-line demand curve

4

D

1

4

6

10

12

Quantity

Chapter 4: Elasticity


Perfectly elastic demand curve l.jpg

Price

Quantity

Perfectly Elastic Demand Curve

If the price increases a little, the quantity demanded will drop to zero. If the price drops a little, the quantity demanded will increase a lot.

i.e. Consumers are extremely responsive to price changes

Chapter 4: Elasticity


Perfectly inelastic demand curve l.jpg

Price

Quantity

Perfectly Inelastic Demand Curve

The quantity demanded is not responsive to any change in price.

i.e. consumers are extremely inert to changes in price

Chapter 4: Elasticity


Elasticity total expenditure l.jpg
Elasticity & Total Expenditure

  • From a consumer’s point of view,

  • Total Expenditure = P x Q

    • Market demand measures the quantity (Q) at each price (P)

  • Total Expenditure = Total Revenue

    (buyer’s view) (seller’s view)

Chapter 4: Elasticity


Example 4 9 the demand curve for drama tickets l.jpg

12

10

8

6

Price ($/ticket)

4

2

0

1

2

3

4

5

6

Quantity (100s of tickets/day)

Example 4.9 The Demand Curve for Drama Tickets

Price ($/ticket)

Total expenditure ($/day)

12

0

10

1000

8

1600

 HIGHEST!

6

1800

4

1600

2

1000

0

0

Chapter 4: Elasticity


Total expenditure as a function of price l.jpg

12

10

1,800

1,600

8

6

Price ($/ticket)

1,000

Total expenditure ($/day)

4

2

0

2

4

6

8

10

12

0

1

2

3

4

5

6

Price ($/ticket)

Quantity (100s of tickets/day)

Total Expenditure as a Function of Price

Total revenue is at a maximum at the midpoint on a straight-line demand curve.

Chapter 4: Elasticity


Example 4 10 l.jpg
Example 4.10

  • What happens to total expenditure on shelter when the price is reduced from $12/sq yd to $10/sq yd?

  • When P drop

  • Total Exp rise (fall)

    if gain from additional sales is larger (smaller) than loss from existing sales

Chapter 4: Elasticity


Example 4 11 elasticity and total expenditure l.jpg
Example 4.11 Elasticity and Total Expenditure

  • Should a jazz band raise or lower its price to increase total revenue?

    • Assume P=$20, Q=5,000, and e=-3.

  • Total revenue = $20 x 5,000 = $100,000/week

  • If P is increased 10%,

    • Q will decrease 30%

    • Total revenue = $22 x 3,500 = $77,000/week

  • If P is lowered 10%,

    • Q will increase 30%

    • Total revenue = $18 x 6,500 = $177,000/week

Assume: Production Cost data is negligible in this case.

Chapter 4: Elasticity


Elasticity and the effect of a price change on total expenditure l.jpg
Elasticity and the Effect of a Price Change on Total Expenditure

Chapter 4: Elasticity


Unitarily elastic demand curve l.jpg
Unitarily elastic demand curve Expenditure

P

Unitary elastic: PxQ=constant

 all P, Q combinations yield

the same TR for seller

elasticity on all points= 1

Q

Chapter 4: Elasticity


E g 4 12 should bus fare increases l.jpg
e.g. 4.12: should bus fare increases? Expenditure

  • A director of a big bus company said, "For each 1 percent fare hike, we lose 0.2 percent of our riders." We can conclude that:

    a. a fare increase will increase total revenue.

    b. demand for bus service will go up as fares increase.

    c. demand is price elastic.

    d. a 10 percent fare hike will produce a 20 percent reduction in riders.

    e. the price elasticity is -5.

Chapter 4: Elasticity


E g 4 12 should bus fare increases32 l.jpg
e.g. 4.12: should bus fare increases? Expenditure

  • A director of a big bus company said, "For each 1 percent fare hike, we lose 0.2 percent of our riders." We can conclude that:

  • We are told that when DP/P = 1%, DQ/Q = -0.2%.

  • Elasticity = (DQ/Q)/(DP/P) = -0.2. (inelastic)

    So a fare increase will increase total revenue.

Chapter 4: Elasticity


E g 4 12 should bus fare increases33 l.jpg
e.g. 4.12: should bus fare increases? Expenditure

  • A director of a big bus company said, "For each 1 percent fare hike, we lose 0.2 percent of our riders." We can conclude that:

    a. a fare increase will increase total revenue.

    b. demand for bus service will go up as fares increase.

    c. demand is price elastic.

    d. a 10 percent fare hike will produce a 20 percent reduction in riders.

    e. the price elasticity is -5.

answer a is correct.

Chapter 4: Elasticity


Cross price elasticity of demand l.jpg
Cross-Price Elasticity of Demand Expenditure

  • The percentage by which quantity demanded of the good X changes in response to a 1 percent change in the price of the good Y

    • Substitute Goods

    • Complement Goods

Chapter 4: Elasticity


Cross price elasticity of demand35 l.jpg
Cross-Price Elasticity of Demand Expenditure

Substitute Goods

  • the cross-price elasticity of demand is positive

  • ‘positive’ = move in same direction

  • When Px ↑(↓) Qy ↑(↓)

  • E.g. Coffee & Tea

    Complement Goods

  • the cross-price elasticity of demand is negative

  • ‘negative’ = move in opposite direction

  • When Px ↓ (↑) Qy ↑(↓)

  • E.g. Coffee & Cream

Chapter 4: Elasticity


Income elasticity of demand l.jpg
Income Elasticity of Demand Expenditure

  • The percentage by which quantity demanded changes in response to a 1 percent change in income

    • Normal Goods

    • Inferior Goods

Chapter 4: Elasticity


Income elasticity of demand37 l.jpg
Income Elasticity of Demand Expenditure

  • Normal Goods

    • Income elasticity is positive

    • Income ↑(↓) Qx ↑(↓)

    • E.g. income and movie

  • Inferior Goods

    • Income elasticity is negative

    • Income ↓ (↑) Qx ↑(↓)

    • E.g. income and McDonalds

      (let’s assume you’re not a big fan…)

Chapter 4: Elasticity


Now the supply side l.jpg
Now, the Supply Side Expenditure

So much for Demand side, let us change to the supply side discussion for elasticities

Chapter 4: Elasticity


The price elasticity of supply l.jpg
The Price Elasticity of Supply Expenditure

  • Price Elasticity of Supply

    • The percentage change in the quantity supplied that occurs in response to a 1 percent change in price

Chapter 4: Elasticity


E g 4 13 a supply curve for which price elasticity declines as quantity rises l.jpg

S Expenditure

A

8

4

2

e.g. 4.13 A Supply Curve for Which Price Elasticity Declines as Quantity Rises

B

10

8

  • Observations:

  • Elasticity >0

  • Elasticity >1 for linear supply curve that has a positive Y-intercept.

  • Elasticity decreases as quantity increases.

Price

0

2

3

Quantity

Chapter 4: Elasticity


E g 4 14 a supply curve for which price elasticity is unity l.jpg

S Expenditure

B

5

A

4

P

Q

Price

0

12

15

Quantity

e.g. 4.14 A Supply Curve for Which Price Elasticity is unity

The price elasticity of supply will always equal 1 at any point along a straight-line supply curve that passes through the origin.

Chapter 4: Elasticity


Perfectly inelastic supply curve l.jpg

S Expenditure

Elasticity = 0 at every

point along a vertical

supply curve

Perfectly Inelastic Supply Curve

What is the price elasticity of supply of land within Central?

Price ($/acre)

0

Quantity of land in Central

(1,000s of acres)

Chapter 4: Elasticity


A perfectly elastic supply curve l.jpg

If Marginal Cost of production is constant, then the Expenditure

price elasticity of supply at every point

along a horizontal supply curve is infinite

 More on Chapter 6

S

A Perfectly Elastic Supply Curve

Price (cents/cup)

14

0

Quantity of lemonade

(cups/day)

Chapter 4: Elasticity


Determinants of supply elasticity l.jpg
Determinants of Supply Elasticity Expenditure

  • Flexibility of inputs

  • Mobility of inputs

  • Ability to produce substitute inputs

  • Time

Chapter 4: Elasticity


E g 4 15 gasoline prices vs car prices l.jpg
e.g.4:15 Expendituregasoline prices vs car prices

  • Why are gasoline prices so much more volatile than car prices?

  • Differences in markets

    • Demand for gasoline is more inelastic

    • Gasoline market has larger and more frequent supply shifts

Chapter 4: Elasticity


E g 4 15 gasoline prices vs car prices46 l.jpg

S’ Expenditure

S

1.69

1.02

D

7.2

6

e.g.4:15 gasoline prices vs car prices

Gasoline

Greater Volatility in Gasoline Prices than in Car Prices

Price ($/gallon)

0

Quantity

(millions of gallons/day)

Chapter 4: Elasticity


E g 4 15 gasoline prices vs car prices47 l.jpg

S’ Expenditure

S

17

16.4

D

11

12

e.g.4:15 gasoline prices vs car prices

Greater Volatility in Gasoline Prices than in Car Prices

Cars

Price ($1,000s/car)

Quantity

(1,000s of cars/day)

Cars

Chapter 4: Elasticity


E g 4 15 gasoline prices vs car prices48 l.jpg
e.g.4:15 Expendituregasoline prices vs car prices

  • Conclusion:

  • Price will be more volatile when

     demand is more inelastic

     there are more frequent changes in the supply of that good

Chapter 4: Elasticity


E g 4 16 beckham l.jpg
e.g.4.16 Expenditure Beckham

  • Why does Beckham earn such an attractive income when compared to any soccer player?

  • Does he have a high or low price elasticity of supply of his services?

His skills as a soccer player is a unique and essential inputs, an example of ultimate supply bottleneck.

Chapter 4: Elasticity


Example 4 17 so why are the fares so different l.jpg
Example 4.17 Expenditure So why are the fares so different?

If you start in Kansas City and you fly to Honolulu round-trip, the fare is a lot lower than if you start the same trip in Honolulu and fly to Kansas City round-trip. Passengers travel on same planes, consuming the same fuel, the same in-flight amenities, and so on. So why are the fares so different?

By Karen Hittle, a student of Robert Frank.

Chapter 4: Elasticity


Example 4 17 so why are the fares so different51 l.jpg
Example 4.17 Expenditure So why are the fares so different?

  • If you are starting in Kansas City and going to Honolulu, you are probably going on vacation. You could go lots of different places. You could go to Florida, to Barbados, to Cancun. Because vacationers have many destinationsto choose from, airlines must compete fiercely for their business. Given economies of scale inherent in larger aircraft, carriers have a strong incentive to fill additional seats by targeting lower prices to the people who are more sensitive to price – vacationers.

Chapter 4: Elasticity


Example 4 17 so why are the fares so different52 l.jpg
Example 4.17 Expenditure So why are the fares so different?

  • But if you are starting in Honolulu on a trip to Kansas City, you are probably not a vacationer. More likely, you either have business or family reasons for traveling. So you are probably not shopping for a destination if you are going to Kansas City.

  • Travelers of which destination has a higher price elasticity of demand?

Chapter 4: Elasticity


E g 4 18 lifting the price ceiling l.jpg
e.g 4.18--- lifting the price ceiling Expenditure

  • when a Price Ceiling is lifted, the market equilibrium quantity and price should be restored eventually.

  • Price should increase but, how much?

P

D

S

Because supply is upward sloping,

↑P → ↑ TR

Price Ceiling

Chapter 4: Elasticity

Q


E g 4 18 lifting the price ceiling54 l.jpg
e.g 4.18--- lifting the price ceiling Expenditure

Relative inelastic

P

D

S

increase in price that occur AFTER abolishing price control is smaller when

The price elasticity of demand is elastic.

Pe

Price Ceiling

Relative elastic

Q

Chapter 4: Elasticity


Slide55 l.jpg

End of Expenditure

Chapter


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