ECON 110 Introductory Microeconomics

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ECON 110Introductory Microeconomics

• Lecture 6
• Fall, 2009
• William Chow

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Highlights

• Demand Elasticity
• Cross Price Elasticity
• Income Elasticity
• Supply Elasticity
• Examples

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Price Elasticity of Demand

• The law of demand tells us that as the price of a
  good decreases, the quantity demanded rises
• But apart from this direction of change, do we
  have additional information about the magnitude
  of this change?
• The answer lies on the price elasticity of demand

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Price Elasticity of Demand

• The price elasticity of demand is a units-free
  measure of the responsiveness of the quantity
  demanded of a good to a change in its price when
  all other influences on buyers plans remain the
  same. This can be represented by
• Percentage change in quantity demanded
• Percentage change in price

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Price Elasticity of Demand

• We express the change in price as a percentage of
  the average price the average of the initial and
  new price
• We express the change in the quantity demanded as
  a percentage of the average quantity demanded
  the average of the initial and new quantity
• The reason for doing this is to produce
  consistent measurement for cases of price
  increase and price decrease

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Important Remark

• The price elasticity of demand stated in the
  following example is a positive number
• According to the definition, it shouldnt be as
  the direction of change in P and Q is opposite
• You may consider we want just the magnitude of
  the responsiveness (or taking the absolute value
  of the said ratio)

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Price Elasticity of Demand

• In the previous example, the price elasticity of
  demand is (2/10)/(1/20) 20/5 4
• By using the average price and average quantity,
  we get the same elasticity value regardless of
  whether the price rises or fall.
• Changing the units of measurement of price or
  quantity leave the elasticity value the same.

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Price Elasticity of Demand

• Demand can be inelastic, unit elastic, or
  elastic, and can range from zero to infinity
• If the quantity demanded doesnt change when the
  price changes, the price elasticity of demand is
  0 and the good has a perfectly inelastic demand
• If the percentage change in the quantity demanded
  equals the percentage change in price, the price
  elasticity of demand equals 1 and the good has
  unit elastic demand

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Price Elasticity of Demand

• If the percentage change in the quantity demanded
  is infinitely large when the price barely
  changes, the price elasticity of demand is
  infinite and the good has perfectly elastic
  demand
• In sum, if PED
• Falls between 0 and 1 ? inelastic demand
• Falls between 1 and 8 ? elastic demand

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Price Elasticity of Demand

• Price Elasticity of Demand is inversely related
  to the slope of the demand curve over the two
  related points
• Even though the demand curve is a straight line,
  the elasticity varies across different sections
  of the demand curve

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Elasticity and Revenue

• The total revenue from the sale of a good or
  service equals the price of the good multiplied
  by the quantity sold
• When the price changes, total revenue also
  changes
• But a rise in price doesnt always increase total
  revenue

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Elasticity and Revenue

• If demand is elastic, a 1 percent price cut
  increases the quantity sold by more than 1
  percent, and total revenue increases
• If demand is inelastic, a 1 percent price cut
  decreases the quantity sold by more than 1
  percent, and total revenue decreases
• If demand is unitary elastic, a 1 percent price
  cut increases the quantity sold by 1 percent, and
  total revenue remains unchanged

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Example

• Eastern Harbour Tunnel Case.
• Toll increase in May 2005.
• Major Shareholder Citic.
• Private Cars/ Taxis/ Medium Goods Vehicles toll
  66
• After 3 days, traffic -22

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Example

• Daily throughput -8900 vehicles (per day)
• Revenue HK0.6 million (3 days)
• Western Harbour Tunnel daily throughput 1800
  vehicles (8)

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Factors affecting Elasticity of Demand

• The closeness of substitutes
• The closer the substitute for a good or service,
  the more elastic is the demand for it.
• Necessities, such as food or housing, generally
  have inelastic demand.
• Luxuries, such as exotic vacations, generally
  have elastic demand.

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Factors affecting Elasticity of Demand

• The proportion of income spent on the good
• The greater the proportion of income consumers
  spend on a good, the larger is its elasticity of
  demand.
• The time elapsed since a price change
• The more time consumers have to adjust to a price
  change, or the longer that a good can be stored
  without losing its value, the more elastic is the
  demand for that good.

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Cross Elasticity of Demand

• The cross elasticity of demand is a measure of
  the responsiveness of demand for a good to a
  change in the price of a substitute or a
  complement, other things remaining the same. The
  formula
• Percentage change in quantity demanded
• Percentage change in price of substitute or
  complement

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Cross Elasticity of Demand

• The cross elasticity of demand for a substitute
  is positive
• The cross elasticity of demand for a complement
  is negative
• In other words, we need to know not just the
  magnitude but also the direction of impact

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Income Elasticity of Demand

• The income elasticity of demand measures how the
  quantity demanded of a good responds to a change
  in income, other things being equal. The formula
• Percentage change in quantity demanded
• Percentage change in income

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Income Elasticity of Demand

• If the income elasticity of demand is greater
  than 1, demand is income elastic and the good is
  a normal good.
• If the income elasticity of demand is greater
  than zero but less than 1, demand is income
  inelastic and the good is a normal good.
• If the income elasticity of demand is less than
  zero (negative), the good is an inferior good.

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Price Elasticity of Supply

• The elasticity of supply measures the
  responsiveness of the quantity supplied to a
  change in the price of a good when all other
  influences on selling plans remain the same. The
  formula
• Percentage change in quantity supplied
• Percentage change in price

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Price Elasticity of Supply

• Supply is perfectly inelastic if the supply curve
  is vertical and the elasticity of supply is 0
• Supply is unit elastic if the supply curve is
  linear and passes through the origin (Note that
  slope is irrelevant
• Supply is perfectly elastic if the supply curve
  is horizontal and the elasticity of supply is
  infinite

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Factors affecting Elasticity of Supply

• Resource substitution possibilities
• The easier it is to substitute among the
  resources used to produce a good or service, the
  greater is its elasticity of supply.
• The time frame for supply decisions
• The more time that passes after a price change,
  the greater is the elasticity of supply.

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Applications

• Salt is a major ingredient in most dishes. As a
  chef, would you reduce the substantially the
  amount of salt used if its price triple?
• The oil companies in HK have been criticized as
  being too responsive in raising price when world
  energy prices shoot up, but slow in reacting in
  the other direction. Why?