Chapter 5 Elasticity

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# Chapter 5 Elasticity - PowerPoint PPT Presentation

Chapter 5 Elasticity. You are responsible for reading Chapter 4!!!. What have we done?. Chapter 3 gave us downward sloping demand curves Law of demand Now want to see how Q d changes when price changes. Elasticity. Response of one variable to a change in another variable

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Chapter 5Elasticity

You are responsible for reading Chapter 4!!!

What have we done?
• Chapter 3 gave us downward sloping demand curves
• Law of demand
• Now want to see how Qd changes when price changes
Elasticity
• Response of one variable to a change in another variable
• Price elasticity of demand
• Measure of the responsiveness of Qd of a product to a change in the price of that product
So…
• What if Ed = 3?
• If price was increased from the prevailing point the % change in Qd would be 3 times the change in price
• Shouldn’t it be negative?
• So price increases and Qd decreases?
• Yes!!
• For ease we look at the absolute value, but know that the law of demand holds
Point elasticity
• Measures the change between two observed points.
example
• P1 = 10
• P2 = 12
• Q1 = 100
• Q2 = 50
• Elasticity??
• Which is Point A???
• Big Problem!!!
Problem
• Answers vary depending on where you start
• Becomes more important the larger the change
Arc Elasticity
• To avoid the endpoint problem take elasticity at the midpoint (average) of the two points
Differences
• With arc elasticity it is clear which points are used
• P1 is the first price
• P2 is the second price
• Qd1 and Qd2 are the first and second quantity demanded respectively
Price elasticity of demand can yield 5 basic results
• Numerator > Denominator
• Numerator < Denominator
• Numerator = Denominator
• Numerator = 0
• Denominator = 0
• Each has a specific name and result
Elastic Demand
• Ed > 1
• % change in quantity demanded > % change in price
• FLATTER CURVE
• What are some examples of an elastic good???
Inelastic Demand
• Ed<1
• % change in the price > percent change in quantity demanded
• STEEPER CURVE
• What are some examples of an inelastic good?
Unit Elastic Demand
• Ed=1
• % change in price = % change in quantity demanded
• Change in price brings a proportionate change in quantity demanded
• CURVE
Perfectly Elastic Demand
• Ed = (denominator = 0)
• % change in quantity demanded is A LOT in response to a change in price
• Price increases and quantity demanded goes to 0
• Totally flat --- horizontal
• Extreme
• Examples???
Perfectly inelastic demand
• Ed = 0
• % change in quantity demanded DOESN’T CHANGE in response to a change in price
• Totally steep --- vertical
• Extreme
• Examples???
Aren’t demand curve downward sloping?
• Because the extremes (perfectly inelastic and perfectly elastic) are not.
• Use as points of reference only
How does a change in price affect Total Revenue of a Firm?
• Revenue depends on elasticity
• Michael Jordan and Nike shoes
• No substitutes -- inelastic demand
• What happens to Qd if price increases?
• Substitutes – elastic demand
• What happens to Qd if price increases?
What is total revenue??
• Total revenue = price*quantity
• Firm uses to decide if to produce more or less
examples
• Elastic demand
• Price increase
• Price decrease
• Inelastic demand
• Price increase
• Price decrease
• Unit elastic demand
• Price increase
• Price decrease
Important to look at because…
• Elasticity of the demand determines if with a price increase…
• Total revenue increases
• Total revenue decreases
• Total revenue remains the same
Price elasticity of demand and a straight line
• Demand is downward sloping
• Along the line elasticity varies from highly elastic to highly inelastic
• But…remember SLOPE is constant
P

A

B

C

D

E

F

G

Q

Find Total Revenue and Elasticity of Demand

Summary
• Upper end of Demand Curve
• Qd is low and price is high
• Freak out more when price is high
• Lower end of Demand Curve
• Qd is high and price is low
• Freak out less when price is low
So…
• As move down the demand curve from higher prices to lower the price elasticity of demand goes from elastic to inelastic
Determinates of price elasticity of demand
• Number of substitutes available
• Increase substitutes increases elasticity
• More narrowly defined goods have more substitutes (compared to broadly defined)
• Example: Fords vs all cars
More determinates
• Percentage of one’s budget that is spent on the good
• More expensive??? More elastic
• More affected by price (even small changes)
Final determinate
• Amount of time that passed since price change
• Increase time passed gives more opportunity to change behavior or react to price change
• Overtime can look for substitutes
• Increase time increases elasticity
• More elastic in long term than short
Cross Elasticity of Demand
• Measures the responsiveness of quantity demanded to a change in price of ANOTHER good
When would you use Cross Price Elasticity?
• To determine if goods are substitutes or compliments
• Ec>0 – substitutes
• % change in quantity demanded and price move in same direction
• Ec<0 – compliments
• % change in quantity demanded and price move in opposite directions
• Ec=0 – goods unrelated
Income elasticity of demand
• Measures the responsiveness of quantity demanded to the change in income
Why use income elasticity of demand?
• Use to determine if a good is normal or inferior
• Ey>0 – normal good
• As income increases Qd increases
• Ey<0 – inferior good
• As income increases Qd decreases
Can also say…
• If |Ey| > 1
• % change in Qd > % change in Y
• Income elastic
• If |Ey| < 1
• % change in Qd < % change in Y
• Income inelastic
• If |Ey| = 1
• % change in Qd = % change in Y
• Income unit elastic
Can we use income elasticity in the real world??
• If invest in the stock market do you want to invest in a normal or inferior good?
• Normal
• Why
• Increase income would increase quantity bought and increase stock prices
Price Elasticity of Supply
• Measures the responsiveness of quantity supplied of a good to the change in the price of that good
Classification is like demand
• Es > 1
• Elastic
• Es < 1
• Inelastic
• Es = 1
• Unit elastic
• Each of these will result in a “normal” upward sloped supply curve
Any extreme elasticities???
• Yes!!
• Es =
• Perfectly elastic or horizontal
• Es = 0
• Perfectly inelastic or vertical
Does time play a role in elasticity of supply?
• Yes!!
• Overtime producers are able to adjust their behavior and production patterns
• Supply becomes more elastic as time passes
Elasticity and taxes
• If government levies a tax on a product who pays the tax??
• Producers?? Consumers?? Share??
• Depends on the elasticity of demand and supply
How find??
• Find equilibrium price
• Supply shifts left in the amount of the tax
• Find new equilibrium
• Find point of second equilibrium on ORGINAL supply curve
• Shows the actual price realized by firm or equilibrium price – tax = point in question
• Difference between points determines how much of tax you pay
Who pays more of the tax??
• Perfectly inelastic demand
• Perfectly elastic demand
• Demand more elastic than supply
• Supply more elastic than demand
Summary
• Ed > Es producer bears most of the tax burden
• Ed < Es consumer bears most of the tax burden
• Ed = Es equally share the tax burden
Homework

Numbers 5, 6, and 8Working with Graphs and Numbers1, 2, and 4