Chapter 4: Elasticity and its Applications

1. Chapter 4: Elasticity and its Applications

2. Elasticity of Demand The law of demand indicates an inverse relationship between price and quantity demanded. But how much does quantity demanded change when price changes? The Elasticity of Demand measures how sensitive the quantity demanded is to a change in price. A demand curve is said to be elastic when an increase (decrease) in price reduces (increases) the quantity demanded a lot. When the same increase (decrease) in price reduces (increases) quantity demanded just a little, then the demand curve is said to be inelastic.

3. Elasticity of Demand Elasticity of Demand Captures the Sensitivity of Quantity Demanded to Changes in Price Price The Same Price Increase $50 $40 Elastic Demand Inelastic Demand Quantity 75 20 80 … Causes a Small Decrease in Quantity Demanded if Demand is Inelastic … Causes a Big Decrease in Quantity Demanded if Demand is Elastic

4. Determinants of Elasticity of Demand Why is it that one good may have elastic demand while another good may have inelastic demand? Availability of Substitutes Time Horizon Necessities vs. Luxuries Purchase Size

5. Determinants of Elasticity of Demand The availability of substitutes strongly influences the sensitivity of quantity demanded to changes in price. For goods with fewer substitutes, consumers are unable to adjust quantity demanded significantly in response to a price increase making demand inelastic. For goods with many substitutes, consumers can easily reduce quantity demanded as price rises by switching to those other products making demand elastic.

6. Determinants of Elasticity of Demand The time horizon influences the elasticity of demand for a good. Immediately following a price increase, consumers may not be able to alter their consumption patterns, making demand inelastic. Over time, however, consumers can adjust their behavior by finding substitutes making demand elastic.

7. Determinants of Elasticity of Demand The nature of the good to the consumer can also affect the elasticity of demand. For goods considered as necessities, consumers are more reluctant to reduce quantity demanded when the price rises making demand inelastic. When goods are considered luxuries, consumers will cut back on their purchases when the price rises, making demand elastic.

8. Determinants of Elasticity of Demand The size of the purchase relative to the consumer’s budget will influence the elasticity of demand. Consumers are less concerned about price changes when purchases of a good represent a small portion of their incomes making demand inelastic. Consumers become much more concerned (even worried) about price changes when purchases of a good account for a large portion of their incomes making demand elastic.

9. Determinants of Elasticity of Demand Summary of Determinants of Elasticity of Demand

10. Mathematics of Demand Elasticity Elasticity of demand is the percentage change in the quantity demanded divided by the percentage change in price. Elasticity of demand is calculated from the following equation:

11. Mathematics of Demand Elasticity Example: If the price of oil increases by 10% and over a period of several years, the quantity demanded falls by 5%, then the long run elasticity of demand for oil is:

12. Mathematics of Demand Elasticity - Extra! From Lexington Herald-Leader “Putting a Price on Smoking” by Sarah Vos December 27, 2008: Democratic Gov. Steve Beshear has proposed a 70 cent per pack increase in Kentucky's excise tax as a way to improve the state's finances. If the Kentucky cigarette tax were to rise by 70 cents per pack: Average cost of a pack would go from $3.67 to $4.55. Youth smoking would be cut by an estimated 16.6 percent. Adult smoking would decrease by an estimated 4 percent. Sources: Altria, Campaign for Tobacco-Free Kids, University of Illinois at Chicago

13. Mathematics of Demand Elasticity - Extra! The numbers above are based on estimates of elasticity of demand. What are these estimates? Percentage change in quantity demanded: Youth: -16.6% Adult: -4.0% Percentage change in price: (4.55-3.67)/3.67 = 0.88/3.67 = 0.24*100 = 24.0% Elasticity of demand: Youth: -16.6%/24.0% = -0.69 or 0.69 in absolute terms Adult: -4.0%/24.0% = -0.17 or 0.17 in absolute terms

14. Mathematics of Demand Elasticity Elasticities of demand are always negative, so economists typically drop the negative sign and work with the absolute value instead. If the absolute value of the elasticity of demand is less than one, the demand curve is inelastic. If the absolute value of the elasticity of demand is greater than one, the demand curve is elastic. If the absolute value of the elasticity of demand is exactly equal to one, the demand curve is unit elastic.

15. Mathematics of Demand Elasticity An alternative approach in calculating the elasticity of demand is to use the Midpoint Formulagiven by:

16. Mathematics of Demand Elasticity Example At the initial price of $10, the quantity demanded is 100. When the price rises to $20, the quantity demanded is 90.

17. Elasticity of Demand and Total Revenue A firm’s revenues are equal to price per unit times quantity sold. Revenue = Price*Quantity R = P*Q The elasticity of demand directly influences revenues when the price of the good changes.

18. Elasticity of Demand and Total Revenue If the demand curve is inelastic, then revenues go up (down) when the price goes up (down). When price goes up (down), quantity demanded goes down (up) by a relatively smaller amount, so revenues must be higher (lower). If the demand curve is elastic, then revenues go down (up) when the price goes up (down). When price goes up (down), quantity demanded goes down (up) by a relatively greater amount, so revenues must be lower (higher).

19. Elasticity of Demand and Total Revenue Revenues Rise as Price Rises with Inelastic Demand Curves P $20 $10 R=$20*90 =$1,800 R=$10*100 =$1,000 D R=$10*100 =$1,000 100 Q 90

20. Elasticity of Demand and Total Revenue Revenues Fall as Price Rises with Elastic Demand Curves P $20 $10 R=$20*50 =$1,000 D R=$10*250 =$2,500 R=$10*250 =$2,500 250 Q 50

21. Elasticity of Demand and Total Revenue Summary of Relationship between Elasticity of Demand and Revenues

22. Applications of Elasticity of Demand Elasticity of demand can play an important role in analyzing changes in market fundamentals and evaluating policy. How the American Farmer has Worked Himself Out of a Job: Increased agricultural productivity has led to fewer farmers because the demand for most agricultural products is inelastic. Why the War on Drugs is Hard to Win: Because elasticity of demand for illegal drugs is inelastic; drug dealers earn greater revenue and gain more power as the drug war becomes more effective.

23. Which is more elastic, the demand for computers or the demand for Dell computers? • The elasticity of demand for eggs has been estimated to be 0.1. If egg producers raised their prices by 10 percent, what will happen to their total revenue? • If a fashionable clothing store raised its prices by 25 percent, what does that tell you about the store’s estimate of the elasticity of demand for its products?

24. Elasticity of Supply The law of supply indicates a direct relationship between price and quantity supplied. But how much does quantity supplied change when price changes? The Elasticity of Supply measures how sensitive the quantity supplied is to a change in price.

25. Elasticity of Supply A supply curve is said to be elastic when an increase (decrease) in price increases (decreases) the quantity supplied a lot. When the same increase (decrease) in price increases (decreases) quantity supplied just a little, then the supply curve is said to be inelastic.

26. Elasticity of Supply Elasticity of Supply Captures the Sensitivity of Quantity Supplied to Changes in Price Price per Unit Inelastic Supply Elastic Supply $50 The Same Price Increase $40 Quantity 85 170 80 …Causes a Small Increase in Quantity Supplied if Supply is Inelastic …Causes a Big Increase in Quantity Supplied if Supply is Elastic

27. Determinants of Elasticity of Supply Why is it that one good may have elastic supply while another good may have inelastic supply? Change in Per-Unit Costs with Increased Production Time Horizon Share of Market for Inputs Geographic Scope

28. Determinants of Elasticity of Supply The main determinant of the elasticity of supply is how quickly per-unit costs increase with an increase in production. If increased production requires much higher costs, then the supply curve will be inelastic. If production can increase with constant costs then the supply curve will be elastic.

29. Determinants of Elasticity of Supply The time horizon influences the elasticity of supply for a good. Immediately following a price increase, producers can expand output only using their current capacity making supply inelastic. Over time, however, producers can expand their capacity making supply elastic.

30. Determinants of Elasticity of Supply The elasticity of supply for a good relates to its share of the market for the inputs used in production. Supply is elasticwhen the industry can be expanded without causing a big increase in the demand for the industry’s inputs. Supply is inelastic when industry expansion causes a significant increase in the demand for the industry’s inputs.

31. Determinants of Elasticity of Supply The geographic scope of the market determines the elasticity of supply for a good. The wider the scope of the market of a good, the less elastic its supply. The narrowerthe scope of the market of a good, the more elastic its supply.

32. Determinants of Elasticity of Supply Summary of Determinants of Elasticity of Supply

33. Mathematics of Supply Elasticity Elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in price. Elasticity of supply is calculated from the following equation:

34. Mathematics of Supply Elasticity Example: If the price of cocoa rises by 10% and the quantity supplied increases by 3%, then the elasticity of supply for cocoa is:

35. Mathematics of Supply Elasticity If the absolute value of the elasticity of supply is less than one, the supply curve is inelastic. If the absolute value of the elasticity of supply is greater than one, the supply curve is elastic. If the absolute value of the elasticity of supply is exactly equal to one, the supply curve is unit elastic.

36. Mathematics of Supply Elasticity An alternative approach in calculating the elasticity of supply is to use the midpoint formula given by:

37. Mathematics of Supply Elasticity Example: At the initial price of $10, the quantity supplied is 100. When the price rises to $20, the quantity supplied is 110.

38. Applications of Elasticity of Demand Elasticity of supply can play an important role in analyzing changes in market fundamentals and evaluating policy. The Economics of Slave Redemption Depending on the elasticity of supply, slave redemption programs may actually lead to morepeople in bondage. Elasticity of Supply and Gun Buyback Programs Depending on the elasticity of supply of guns, it is possible for gun buyback programs to increase the number of guns in circulation.

39. A computer manufacturer makes an experimental computer chip that critics praise, leading to a huge increase in the demand for the chip. How elastic is supply in the short run? What about the long run? • Will the same increase in the demand for housing increase prices more in Manhattan or in Des Moines, Iowa?

40. Elasticity and Quick Predictions Two simple formulas allow for quick predictions of price changes using elasticities:

41. Cross-Price Elasticity of Demand The Cross-Price Elasticity of Demand measures how sensitive the quantity demanded of good A is to the price of good B. Cross-Price Elasticity of Demand =

42. Cross-Price Elasticity of Demand The cross-price elasticity of demand is closely related to the idea of substitutes and complements. If the cross-price elasticity of demand is positive, then the two goods are substitutes. If the cross-price elasticity of demand is negative, then the two goods are complements.

43. Income Elasticity of Demand The Income Elasticity of Demand measures how sensitive the quantity demanded of a good is to changes in income. Income Elasticity of Demand =

44. Income Elasticity of Demand The income elasticity of demand can be used to distinguish normal from inferior goods. If the income elasticity of demand is positive then, the good is a normal good. If the income elasticity of demand is negative then, the good is an inferior good. If the income elasticity of demand is greater than one, then the good is a luxury good.

45. The elasticity of demand measures how sensitive the quantity demanded is to a change in price. • The more responsive, the more elastic the demand. • Elasticity of demand=percentage change in the quantity demanded divided by the percentage change in price. • The elasticity of supply measures how sensitive the quantity supplied is to a change in price. • The more responsive, the more elastic the supply. • Elasticity of supply=percentage change in the quantity supplied divided by the percentage change in price.

46. The elasticity of demand directly influences revenues when the price of the good changes. • If the demand curve is inelastic, then revenues go up (down) when the price goes up (down). • If the demand curve is elastic, then revenues go down (up) when the price goes up (down).

47. The cross-price elasticity of demand measures how sensitive the quantity demanded of good A is to the price of good B. • If the cross-price elasticity of demand is positive, then the two goods are substitutes. • If the cross-price elasticity of demand is negative, then the two goods are complements.

48. The income elasticity of demand measures how sensitive the quantity demanded of a good is to changes in income. • If the income elasticity of demand is positive,then the good is a normal good. • If the income elasticity of demand is negative, then the good is an inferior good. • If the income elasticity of demand is greater than one, then the good is a luxury good.