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Principles of Microeconomics 4 and 5 Elasticity*

Principles of Microeconomics 4 and 5 Elasticity*. Akos Lada July 24 th and July 25 th , 2014. * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint. Contents. Review Elasticity of Demand Elasticity and Revenue Other Elasticities

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Principles of Microeconomics 4 and 5 Elasticity*

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  1. Principles of Microeconomics4 and 5 Elasticity* AkosLada July 24thand July 25th, 2014 * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint

  2. Contents • Review • Elasticity of Demand • Elasticity and Revenue • Other Elasticities • Elasticity of Supply

  3. 1. Review

  4. P S D Q Equilibrium, surplus and shortage Surplus P* Shortage Q*

  5. Comparative statics

  6. To determine the effects of any event, 1.Decide whether event shifts S curve, D curve, or both. 2.Decide in which direction curve shifts. 3.Use supply-demand diagram to see how the shift changes equilibrium P and Q. Three Steps to Analyzing Changes in Equilibrium

  7. EXAMPLE: The Market for Hybrid Cars P price of hybrid cars S1 P1 D1 Q Q1 quantity of hybrid cars

  8. EXAMPLE 1: A Shift in Demand EVENT TO BE ANALYZED: Increase in price of gas. P S1 P2 P1 D2 D1 Q Q1 Q2 STEP 1: D curve shifts because price of gas affects demand for hybrids. S curve does not shift, because price of gas does not affect cost of producing hybrids. STEP 2: D shifts rightbecause high gas price makes hybrids more attractive relative to other cars. STEP 3: The shift causes an increase in price and quantity of hybrid cars.

  9. EXAMPLE 1: A Shift in Demand P S1 P1 D2 D1 Q Q1 Notice: When P rises, producers supply a larger quantity of hybrids, even though the S curve has not shifted. P2 Always be careful to distinguish be a shift in a curve and a movement along the curve. Q2

  10. EXAMPLE 2: A Shift in Supply EVENT: New technology reduces cost of producing hybrid cars. P S1 S2 P1 P2 D1 Q Q1 Q2 STEP 1: S curve shifts because event affects cost of production. D curve does not shift, because production technology is not one of the factors that affect demand. STEP 2: S shifts rightbecause event reduces cost, makes production more profitable at any given price. STEP 3: The shift causes price to fall and quantity to rise.

  11. EXAMPLE 3: A Shift in Both Supply and Demand EVENTS:price of gas rises AND new technology reduces production costs P S1 S2 P2 P1 D2 D1 Q Q1 Q2 STEP 1: Both curves shift. STEP 2: Both shift to the right. STEP 3: Q rises, but effect on P is ambiguous: If demand increases more than supply, P rises.

  12. EXAMPLE 3: A Shift in Both Supply and Demand STEP 3, cont. P S1 S2 P1 P2 D2 D1 Q Q1 Q2 EVENTS:price of gas rises AND new technology reduces production costs But if supply increases more than demand, P falls.

  13. STUDENTS’ TURN:Shifts in Supply and Demand Use the three-step method to analyze the effects of each event on the equilibrium price and quantity of music downloads. Event A: A fall in the price of CDs Event B: Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. Event C: Events A and B both occur.

  14. P S1 P1 P2 D2 D1 Q Q1 Q2 A. Fall in price of CDs The market for music downloads STEPS 1. D curve shifts 2. D shifts left 3. P and Q both fall.

  15. P S1 S2 P1 P2 D1 Q Q1 Q2 B. Fall in cost of royalties The market for music downloads STEPS 1. S curve shifts (Royalties are part of sellers’ costs) 2. S shifts right 3. P falls, Q rises.

  16. C. Fall in price of CDs and fall in cost of royalties STEPS 1. Both curves shift (see parts A & B). 2. D shifts left, S shifts right. 3. P unambiguously falls. Effect on Q is ambiguous: The fall in demand reduces Q, the increase in supply increases Q.

  17. 2. Elasticity of Demand

  18. You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per month. Your costs are rising (including the opportunity cost of your time), so you consider raising the price to $250. The law of demand says that you won’t sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase? A scenario… 0

  19. Elasticity 0 • Basic idea: Elasticity measures how much one variable responds to changes in another variable. • One type of elasticity measures how much demand for your websites will fall if you raise your price. • Definition: Elasticity is a numerical measure of the responsiveness of Qd or Qs to one of its determinants.

  20. Price elasticity of demand measures how much Qd responds to a change in P. Percentage change in Qd Price elasticity of demand = Percentage change in P Price Elasticity of Demand 0 • Loosely speaking, it measures the price-sensitivity of buyers’ demand.

  21. Price elasticity of demand equals P Percentage change in Qd Price elasticity of demand P1 = P2 Percentage change in P D Q Q1 Q2 15% = 1.5 10% Price Elasticity of Demand 0 Example: P rises by 10% Q falls by 15%

  22. Along a D curve, P and Q move in opposite directions, which would make price elasticity negative. We will drop the minus sign and report all price elasticities as positive numbers. P Percentage change in Qd Price elasticity of demand P1 = P2 Percentage change in P D Q Q1 Q2 Price Elasticity of Demand 0

  23. P end value – start value x 100% B start value D $250 A Q $200 8 12 Calculating Percentage Changes 0 Standard method of computing the percentage (%) change: Demand for your websites Going from A to B, the % change in P equals ($250–$200)/$200 = 25%

  24. P B D $250 A Q $200 8 12 Calculating Percentage Changes 0 Problem: The standard method gives different answers depending on where you start. Demand for your websites From A to B, P rises 25%, Q falls 33%,elasticity = 33/25 = 1.33 From B to A, P falls 20%, Q rises 50%, elasticity = 50/20 = 2.50

  25. So, we instead use the midpoint method: end value – start value x 100% midpoint Calculating Percentage Changes 0 • The midpoint is the number halfway between the start & end values, the average of those values. • It doesn’t matter which value you use as the “start” and which as the “end” – you get the same answer either way!

  26. Using the midpoint method, the % change in P equals = 40.0% x 100% 12 – 8 $250 – $200 10 = 22.2% x 100% $225 40/22.2 = 1.8 Calculating Percentage Changes 0 • The % change in Q equals • The price elasticity of demand equals

  27. STUDENTS’ TURN:Calculate an Elasticity Use the following information to calculate the price elasticity of demand for hotel rooms: if P = $70, Qd = 5000 if P = $90, Qd = 3000

  28. 50% = 2.0 25% Answers Use midpoint method to calculate % change in Qd (5000 – 3000)/4000 = 50% % change in P ($90 – $70)/$80 = 25% The price elasticity of demand equals

  29. The Variety of Demand Curves 0 • The price elasticity of demand is closely related to the slope of the demand curve. • Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity. • Five different classifications of D curves.…

  30. “Perfectly inelastic demand” (one extreme case) % change in Q Price elasticity of demand = = % change in P P D P1 P2 Q Q1 0 0% = 0 10% D curve: vertical Consumers’ price sensitivity: none P falls by 10% Elasticity: 0 Q changes by 0%

  31. “Inelastic demand” % change in Q Price elasticity of demand = = % change in P P P1 P2 Q D Q1 Q2 0 < 10% < 1 10% D curve: relatively steep Consumers’ price sensitivity: relatively low P falls by 10% Elasticity: < 1 Q rises less than 10%

  32. “Unit elastic demand” % change in Q Price elasticity of demand = = % change in P P P1 D P2 Q Q1 Q2 0 10% = 1 10% D curve: intermediate slope Consumers’ price sensitivity: intermediate P falls by 10% Elasticity: 1 Q rises by 10%

  33. “Elastic demand” % change in Q Price elasticity of demand = = % change in P P P1 D P2 Q Q1 Q2 0 > 10% > 1 10% D curve: relatively flat Consumers’ price sensitivity: relatively high P falls by 10% Elasticity: > 1 Q rises more than 10%

  34. “Perfectly elastic demand” (the other extreme) % change in Q Price elasticity of demand = = % change in P P D Q Q2 Q1 0 any % = infinity 0% D curve: horizontal P1 P2 = Consumers’ price sensitivity: extreme P changes by 0% Elasticity: infinity Q changes by any %

  35. 3. Elasticity and Revenue

  36. Effect of price increase on revenue 0 Revenue = P x Q • A price increase has two effects on revenue: • Higher P means more revenue on each unit you sell. • But you sell fewer units (lower Q), due to Law of Demand. • Which of these two effects is bigger? It depends on the price elasticity of demand.

  37. If demand is elastic, then price elast. of demand > 1 % change in Q > % change in P The fall in revenue from lower Q is greater than the increase in revenue from higher P, so revenue falls. Percentage change in Q Price elasticity of demand = Percentage change in P Price Elasticity and Total Revenue 0 Revenue = P x Q • If demand is inelastic, then price elast. of demand < 1 % change in Q < % change in P • The fall in revenue from lower Q is smaller than the increase in revenue from higher P, so revenue rises.

  38. 4. Other elasticities of demand

  39. Measures the response of Qd to a change in consumer income Percent change in Qd Income elasticity of demand = Percent change in income Income elasticity of demand • Recall : An increase in income causes an increase in demand for a normal good. • Hence, for normal goods, income elasticity > 0. • For inferior goods, income elasticity < 0.

  40. Measures the response of demand for one good to changes in the price of another good % change in Qd for good 1 Cross-price elast. of demand = % change in price of good 2 Cross-price elasticity of demand • For substitutes, cross-price elasticity > 0 (e.g., an increase in price of beef causes an increase in demand for chicken) • For complements, cross-price elasticity < 0 (e.g., an increase in price of computers causes decrease in demand for software)

  41. end value – start value end value – start value x 100% x 100% midpoint end value + start value STUDENTS’ TURN:Calculate other elasticities of demand Refer to Questions 2 and 3 of the market demand experiments Remember that you can calculate percentage changes using Or… The formulas for income elasticity of demand and cross-price elasticity of demand are on your handout! 2

  42. 5. Elasticity of Supply

  43. Price Elasticity of Supply Price elasticity of supply equals P S Percentage change in Qs Price elasticity of supply = P2 Percentage change in P P1 Q Q1 Q2 16% = 2.0 8% 0 Example: P rises by 8% Q rises by 16%

  44. Different types of Supply Curves 0 • The slope of the supply curve is closely related to price elasticity of supply. • Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity. • Five different classifications.…

  45. “Perfectly inelastic” (one extreme) % change in Q Price elasticity of supply = = % change in P P S P2 Q 0 0% = 0 10% S curve: vertical Sellers’ price sensitivity: P1 none P rises by 10% Elasticity: Q1 0 Q changes by 0%

  46. “Inelastic” % change in Q Price elasticity of supply = = % change in P P S P2 Q Q2 0 < 10% < 1 10% S curve: relatively steep Sellers’ price sensitivity: P1 relatively low P rises by 10% Elasticity: Q1 < 1 Q rises less than 10%

  47. “Unit elastic” % change in Q Price elasticity of supply = = % change in P P S P2 Q Q2 0 10% = 1 10% S curve: intermediate slope Sellers’ price sensitivity: P1 intermediate P rises by 10% Elasticity: Q1 = 1 Q rises by 10%

  48. “Elastic” % change in Q Price elasticity of supply = = % change in P P S P2 Q Q2 0 > 10% > 1 10% S curve: relatively flat Sellers’ price sensitivity: P1 relatively high P rises by 10% Elasticity: Q1 > 1 Q rises more than 10%

  49. “Perfectly elastic” (the other extreme) % change in Q Price elasticity of supply = = % change in P P S Q Q2 Q1 0 any % = infinity 0% S curve: horizontal P1 P2 = Sellers’ price sensitivity: extreme P changes by 0% Elasticity: infinity Q changes by any %

  50. The Determinants of Supply Elasticity • The more easily sellers can change the quantity they produce, the greater the price elasticity of supply. • Example: Supply of beachfront property is harder to vary and thus less elastic than supply of new cars. • For many goods, price elasticity of supply is greater in the long run than in the short run, because firms can build new factories, or new firms may be able to enter the market.

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