Elasticity and Demand

1. Elasticity and Demand

2. Elasticity and Demand • The law of demand tells us that there is an inverse relationship between price and quantity demanded. • But it does not tell us how responsive consumers are to price changes.

3. Elasticity and Demand • To find out exactly how responsive consumers are to a price change, we need the price elasticity of demand for that good or service. • Price elasticity of demand: • A measure of how responsive people are to price changes.

4. Elastic vs. Inelastic • Elastic demand – occurs when slight changes in price produce very large changes in quantity demanded. • Inelastic demand- occurs when large price change produce only small changes in quantity demanded.

5. Computing Price Elasticity • Price elasticity of demand = EP. • Ep = percentage change in quantity demanded of a product divided by the percentage change in the price of that product. EP = % ^ QD. % ^ P . • If EP > 1.00 then we have elastic demand. • If EP < 1.00 then we have inelastic demand.

6. Elasticity and Total Revenue Elastic demand • If demand is elastic, a decrease in price will result in an increase in revenue. • The price cut will lead to a very large increase in quantity demanded. (Sales) • This increase in sales swamps the lower price per unit.

7. Elastic demand • If demand is elastic what will happen to revenue when prices are increased? • The price hike will lead to a very large decrease in quantity demanded. (Sales) • This decrease in sales swamps the higher price per unit.

8. Inelastic Demand • If demand is in inelastic, a decrease in price will result in a decrease in revenue. • The price cut will lead to a very small • Increase in quantity demanded. (Sales) • But the lower price per unit swamps the slight increase in sales.

9. Inelastic Demand • If demand is inelastic what will happen to revenue when prices are increased? • The price hike will lead to a very small decrease in quantity demanded. (Sales) • But the higher price per unit swamps the slight decrease in sales.

10. Determinants of Elasticity of Demand • Substitutes • The greater the number of substitutes available, the easier it is to switch between products. • Therefore, the greater the number of substitutes available, the higher the elasticity of demand for a good.

11. Determinants of Elasticity of Demand • Closeness of the Substitutes • The closer the substitutes are to the original product, the easier it is to switch between products. • Therefore, the closer the substitutes are to the original, the higher the elasticity of demand for a product.

12. Determinants of Elasticity of Demand • Luxuries vs. Necessities • Necessities have low elasticity's of demand. • Luxuries have a high elasticity of demand.

13. Determinants of Elasticity of Demand • Time • The longer the time period, the more time people have to search for substitutes. • The longer the time, the more elastic the demand will be.

14. Elasticity Problems • Discuss and explain why the demand for the good is elastic or inelastic. 1oranges 2cigarettes  3Winston cigarettes 4gasoline 5butter 6diamond engagement rings 7automobiles  8tickets to a live, professional football game 9your econ textbook, from 1 week before the semester starts to 1 week after the end of the semester

15. Accounting vs. Economic Profits • Accountants and economists count costs and profits differently!

16. Accounting vs. Economic Profits • Accountants • Total profits = total revenues – total costs

17. Accounting Profits • A dentist has a practice that generates revenues of $500,000. • All expenses total $400,000. • Accounting profits equal $100,000.

18. Economists’ Profits • Economists • Economic profits = total revenues – total costs – total implicit costs

19. Economists’ Profits • The total revenues of the same dentist are $500,000. • Total explicit, direct costs are $400,000.

20. Opportunity or Implicit Costs • What are implicit costs? • The opportunity costs. • Opportunity cost is the value of the best alternative given up.

21. Opportunity Cost of Capital • Suppose the dentist had used $400,000 of his or her own money to start this business. What if they had taken this money and invested it for an annual rate of return of 10%? What did they give up when they invested this money in their business? • Opportunity cost of capital = $40,000.

22. Opportunity Cost of Labor • Suppose the dentist could have earned $50,000 working for a company. What did they give up in order to set up their own business? • Opportunity cost of labor = $50,000 • Total opportunity costs = • $40,000 + $50,000

23. Total Opportunity Costs • The total opportunity costs are: • $40,000 + $50,000 = $90,000

24. Total Economic Profits Economic Profits = Total Revenues – Total Costs – Total Opportunity Costs • $500,000 - $400,000 - $90,000 = $10,000.

25. Total Economic Profits Economic Profits = $500,00 • $400,000 • -$90,000 • = $10,000

26. Short Run vs. the Long Run Short Run • Short Run = the time period in which all inputs of production are fixed. • Often defined as: = All inputs of production except labor, are fixed.

27. Short Run vs. Long Run Long Run • Long Run = the time period in which all inputs of production can be varied. • In other words, firms can make all the necessary adjustments to changing market conditions.