Elasticity of Demand

1. Elasticity of Demand Chapter 5

2. D1 D1 D1 Price 10% => Qty Demanded ?(how much?) Slope of Demand Curves • Demand curves do not all have the same slope • Slope indicates response of buyers to a change in price Which demand curve is most sensitive to price changes?

3. ELASTICITY OF DEMAND • Price elasticity of demand: how much quantity demanded of a good responds to a change in price • Responsiveness is measured in percentage terms:

4. Determinants of Elasticity of Demand • Availability of Close Substitutes • Necessities versus Luxuries • Proportion of Income • Time Horizon

5. Demand is moreelastic: • the larger the number of close substitutes • if the good is a luxury • Good is a larger percent of budget • the longer the time period

6. Gasoline Soda Heart Surgery Table Salt Price Elastic orPrice Inelastic? Price Inelastic No real substitutes Price Elastic Many substitutes Price Inelastic Necessity & No real substitutes, Short time period Price Inelastic Small proportion of income, no good substitute

7. Computing Price Elasticity of Demand • Example: • If the price of an ice cream cone increases from $2.00 to $2.20 • The quantity bought falls from 10 to 8 cones:

8. Variety of Demand Curves • Inelastic Demand • Quantity demanded does not respond strongly to price changes. • Price elasticity of demand is less than 1 • Elastic Demand • Quantity demanded responds strongly to changes in price. • Price elasticity of demand is greater than 1

9. Computing Price Elasticity of Demand Price $5 4 Demand Quantity 0 50 100 Demand is Price Elastic or Greater than 1---(use absolute values)

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

11. The Variety of Demand Curves • Price elasticity of demand is closely related to the slope of the demand curve. • But it is not the same thing as the slope!

12. Demand $5 4 1. An increase in price . . . 100 2. . . . leaves the quantity demanded unchanged. Perfectly Inelastic (a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Quantity 0

13. 1. At any price above $4, quantity demanded is zero. $4 Demand 2. At exactly $4, consumers will buy any quantity. 3. At a price below $4, quantity demanded is infinite. Perfectly Elastic (e) Perfectly Elastic Demand: Elasticity Equals Infinity Price Quantity 0

14. $5 4 1. A 22% Demand increase in price . . . 90 100 2. . . . leads to an 11% decrease in quantity demanded. Inelastic Demand (b) Inelastic Demand: Elasticity Is Less Than 1 Price Quantity 0

15. $5 4 Demand 1. A 22% increase in price . . . 80 100 2. . . . leads to a 22% decrease in quantity demanded. Unit Elastic Demand (c) Unit Elastic Demand: Elasticity Equals 1 Price Quantity 0

16. $5 4 Demand 1. A 22% increase in price . . . 50 100 2. . . . leads to a 67% decrease in quantity demanded. Elastic Demand (d) Elastic Demand: Elasticity Is Greater Than 1 Price Quantity 0

17. Elasticity & Total Revenue Chapter 5

18. Total Revenue • Total revenue is not profit • It is the total amount of money received by a business • Total Revenue = Price & Quantity Sold Coffee Shop: Price coffee: $2/cup Qty Sold: 500 per day Total Revenue = $2 * 500 = $1,000 Profit = TR – all expenses

19. $4 P × Q = $400 P ( total revenue) Demand 100 Q Total Revenue Price When the price is $4, consumers demand 100 units, and spend $400 on this good. Quantity 0

20. in price => a smaller % in Qty demanded = > TR in price => a greater % in Qty demanded = > TR Elasticity and Total Revenue • Inelastic demand curve: • Elastic demand curve

21. $3 Total Revenue = $240 $1 Demand Demand Total Revenue = $100 100 80 Total Revenue & Inelastic Demand An Increase in price from $1 to $3 … Price Price … leads to an Increase in total revenue from $100 to $240 Quantity Quantity 0 0

22. $5 $4 Demand Demand Total Revenue = $200 Total Revenue = $100 50 20 Total Revenue & Elastic Demand Price Price An Increase in price from $4 to $5 … … leads to an decrease in total revenue from $200 to $100 Quantity Quantity 0 0 Note that with each price increase, the Law of Demand still holds – an increase in price leads to a decrease in the quantity demanded. It is the change in TR that varies!

23. Which demand curve is inelastic? D1 D1 Elastic demand curves tend to flat (horizontal) Inelastic demand curves tend to be steep (vertical) Linear demand curves: 1) Have a constant slope 2) Do not have constant elasticity 3) Have both elastic & inelastic ranges 4) SLOPE is constant------ELASTICITY changes

24. Elasticity of Linear Demand Curves Demand curves have both elastic & inelastic ranges Points with high price & low quantity demand is elastic Points with low price & high quantity demand is inelastic

25. Price from $4 to $5 => TR from $24 to $20. Price from $2 to $3 => TR from $20 to $24 Linear Demand Curve Elasticity Price $7 Elastic Range: Elasticity > 1 6 5 4 3 Inelastic Range:Elasticity < 1 2 1 14 12 0 6 8 10 2 4 Quantity

26. Price increases leads to: Total Revenue rising in inelastic ranges Total Revenue falling in elastic ranges Total Revenue staying constant in unit elastic

27. Income Elasticity of Demand • Income elasticity of demand- how much quantity demanded responds to a change in consumers’ income • EI = % change in Qty Demanded % change in income • Normal Goods have positive Income elasticity • Income elastic: EI >1 (considered a luxury) • Income inelastic: 1 > EI > 0 (considered a necessity) • Inferior Goods: EI < 0 (negative income elasticity)

28. %change in quantity demanded of good 1 = Cross - price elasticity of demand %change in price of good 2 Cross-price elasticity of demand • How much quantity demanded of one good responds to a change in price of another good • Substitutes have positive cross-price elasticity Ea,b > 0 • Complements have negative cross-price elasticity Ea,b < 0

29. Summary • Elastic demand curves are flat • Inelastic demand curves are steep • Slope is constant, Elasticity is not • Linear demand curves have inelastic & elastic ranges • Total Revenue=> Prices elastic goods • Firms can maximize total revenue by calculating the elasticity of demand of their product

30. Taxes & Market Equilibrium Chapter 6

31. How Taxes on Buyers (and Sellers) Affect Market Outcomes • When a good is taxed, the quantity sold is smaller • Buyers and sellers both share the tax burden • Types of Taxes: • Sales Tax: tax on most goods • Excise Tax: taxes on specific goods(ex: cigarettes, gasoline, etc…) • Why tax? • To raise Government Revenue or • To decrease consumption of a good (cigarettes)

32. Elasticity & Tax Incidence • Tax incidence is the study of who bears the burden of a tax • Taxes result in a change in market equilibrium • Buyers pay more & sellers receive less • regardless of whom the tax is levied on

33. Example: Tax on Buyers • Government places a tax on ice cream of .50 cents • Does the tax shift the supply or demand curve? • Supply Curve is not affected • Determinant of supply did not change (TINE & TP) • Demand Curve will shift left • Price of substitute good in effect fell (remember TIPSEN)

34. Price Supply, S1 buyers pay $3.30 Equilibrium without tax Tax ($0.50) 3.00 Price A tax on buyers 2.80 without shifts the demand tax curve downward by the size of Price New Equilibrium the tax ($0.50). sellers with tax receive D1 D2 90 100 Tax on Buyers Price of Ice-Cream Cone Quantity of 0 Ice-Cream Cones

35. A tax on sellers Price S2 shifts the supply Equilibrium buyers curve upward with tax pay by the amount of S1 $3.30 the tax ($0.50). Tax ($0.50) 3.00 Price 2.80 without Equilibrium without tax tax Price sellers receive TINE & TP Taxes are a Determinant of supply Demand, D1 90 100 Tax on Sellers Price of Ice-Cream Cone Quantity of 0 Ice-Cream Cones

36. Elasticity and Tax Incidence • In what proportions is the burden of the tax divided? • How do the effects of taxes on sellers compare to those levied on buyers? • It depends on the elasticity of demand & the elasticity of supply.

37. 1. When supply is more elastic than demand . . . Price buyers pay Supply Tax 2. . . . the incidence of the Price without tax tax falls more heavily on Price sellers consumers . . . receive 3. . . . than Demand on producers. Supply more elastic than demand (a) Elastic Supply, Inelastic Demand Price Quantity 0

38. 1. When demand is more elastic than supply . . . Price buyers pay Supply Price without tax 3. . . . than on consumers. Tax 2. . . . the Demand Price sellers incidence of receive the tax falls more heavily on producers . . . Demand more elastic than supply (b) Inelastic Supply, Elastic Demand Price Quantity 0

39. So, how is the burden of the tax divided? The burden of a tax falls moreheavily on the side of the market that is less elastic.

40. Incidence of Tax Summary • The incidence of a tax does not depend on whether the tax is levied on buyers or sellers • It depends on the price elasticities of supply and demand. • The burden falls on the side of the market that is less elastic

41. Welfare Economics Chapter 7:Consumer Surplus

42. Consumers, Producers & Efficiency of Markets • Market equilibrium reflects the way markets allocate scarce resources • Whether the market allocation is desirable can be addressed by welfare economics • Welfare economics is the study of how the allocation ofresources affects economic well-being

43. Welfare Economics • Equilibrium- results in maximum total welfare for consumers & producers • Consumer surplus measures economic welfare from the buyer’s side • Producer surplus measures economic welfare from the seller’sside

44. CONSUMER SURPLUS • Willingness to pay- the maximum amount that a buyer will pay for a good • It measures how much the buyer values the good or service • Consumer surplus-the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it

45. Consumers value goods differently Demand Schedule & the Demand Curve The market demand curve depicts the various quantities that buyers would be willing to purchase at different prices.

46. John ’ s willingness to pay $100 Paul ’ s willingness to pay 80 George ’ s willingness to pay 70 Ringo ’ s willingness to pay 50 Demand Demand Curve Price of Album 0 1 2 3 4 Quantity of Albums

47. John was willing to pay $100 But he only had to pay $80 John ’ s consumer surplus ($20) John is better off by $20 Demand Equilibrium Price = $80 (a) Price = $80 Price of Album $100 80 70 50 Quantity of 0 1 2 3 4 Albums

48. John ’ s consumer surplus ($30) Paul ’ s consumer surplus ($10) Notice that as price falls, consumer surplus rises Total consumer surplus ($40) Demand Equilibrium Price = $70 (b) Price = $70 Price of The area below the demand curve & above the price measures the consumer surplus in the market. Album $100 80 70 50 Quantity of 0 1 2 3 4 Albums

49. A This triangle represents the “welfare” of consumers Consumer surplus P1 B C Demand Q1 Equilibrium Price & Consumer Surplus (a) Consumer Surplus at Price P Price Quantity 0

50. A Initial consumer surplus C Consumer surplus P1 B to new consumers F P2 D E Additional consumer Demand surplus to initial consumers Q1 Q2 Price falls from P1 to P2 (b) Consumer Surplus at Price P Price As Price falls, area below Demand curve increases, so Consumer Surplus increases Quantity 0