Elasticity and its Amazing Application

1
Elasticity and its Amazing Application

• ?What is elasticity?
• ?What are the different types of elasticities?
• ?How are they calculated?
• ?What do these results represent?
• ?How are the concepts of elasticity and total
  revenue (TR) related?

2
Elasticity of Demand

• After introducing demand in Ch. 4, we noted that
  consumers tend to demand MORE of a good when...
• Their incomes INCREASE
• The prices of complements of the good are LOWER
• The prices of substitutes for the good are HIGHER
• These were only qualitative results, not
  quantitative. To MEASURE how much consumers
  respond to changes in the above variables,
  economists use the concept of elasticity.

3
DEMAND for a good is said to be

• ELASTIC if the quantity demanded responds
  significantly to a change in price
• INELASTIC if the quantity demanded responds only
  slightly to a change in price
• ?concept check?
• What price are we referring to here? The price
  of the good itself, a complementary good, a
  substitute good?

4
What factors influence how eeeelastic or
inelastic demand for a good may be?

• The availability of close substitutes Goods
  with close substitutes tend to have MORE ELASTIC
  demand because it is easier for consumers to
  switch between goods.
• Necessities VS. Luxuries Necessities tend to
  have more INELASTIC demands and luxuries more
  ELASTIC demands. Why do you think this might be
  the case?

5
More Factors

• Definition of the market more narrowly defined
  markets (such as ice cream) are more ELASTIC
  because it is easier to find substitutes for the
  good. Broader markets are more INELASTIC for the
  opposite reason. What would be an example of a
  broadly defined market?
• Time horizon Goods tend to have more ELASTIC
  demand over long time periods. Consider gasif
  prices risewhy is the demand for gas INELASTIC
  in the short-run, but relatively more ELASTIC as
  time goes on?

6
Calculating Price Elasticity

• Price elasticity
• of demand ? quantity demanded ?
  price
• For example, suppose that a 10 increase in the
  price of a pizza causes the quantity of pizzas
  bought to drop by 20. What would the value of
  price elasticity be? What does this show?

7
Answer

• Hopefully you said that a price elasticity value
  of 2 shows that the change in quantity demanded
  is twice as large as the change in price!
• What about if a 10 decrease in the price of
  pizza caused a 10 increase in the quantity of
  pizza demanded? What would be the value of price
  elasticity of demand?

8
Midpoint Method for Calculating Percentage
Changes and Elasticity

• If you try to calculate the price elasticity of
  demand between two points of a curve, there is a
  problem the elasticity moving from point A to B
  seems different than the elasticity moving from
  point B to A.
• To avoid this problem, we use the midpoint method
  of calculation.

9
Example

• Point A Price 4 Quantity 120
• Point B Price 6 Quantity 80
• Moving from point A to point B, the ? in price
  is 50 and the ? in QD is 33 yielding a price
  elasticity value of .66
• Moving the opposite direction (from B to A)what
  is the price elasticity value?

10
Example continued

• Answer 1.5 (elastic demand)
• How do we reconcile this discrepancy?
• WELL midpoint analysis here we come
• The standard approach in finding a percentage
  change is to divide the change by the initial
  level.
• Instead, the midpoint method computes a
  percentage change by dividing the change by the
  midpoint (or avg.) of the initial and final
  points.

11
Midpoint Analysis ANSWER(using same example)

• In our example, the midpoint between point A and
  point B
• Midpoint Price 5 Quantity 100
• This method leads us to see a 40 increase in the
  price of pizza leading to a 40 drop in pizza
  demanded. This produces a price elasticity value
  of 1.

12
Formal Formula ?

• We can express the midpoint method for
  calculating the price elasticity between two
  points (Q1, P1) and (Q2, P2)
• Price Elasticity
• of Demand (Q2 Q1)/(Q2 Q1)/2
• (P2 P1)/(P2 P1)/2

13
Formal Formulamore

• 1.) What does the numerator of the price
  elasticity formula represent?
• 2.) What does the denominator of the price
  elasticity formula represent?

14
Answers

• 1.) The numerator is the percentage change in
  quantity demanded computed using the midpoint
  method.
• 2.) The denominator is the percentage change in
  price computed using the midpoint method.
• Dividing these two values gives us the price
  elasticity of demand.

15
Positive or Negative?

• When calculating price elasticity of demand, we
  drop the minus sign and report all price
  elasticities as POSITIVE numbers.
• In other words, we always take the absolute value
  of price elasticities of demand.

16
Price Elasticity of Demand Values and Categories

• If the price elasticity of demand is
• lt 1 ? demand for the good is INELASTIC
• 1 ? demand for the good is UNIT ELASTIC
• gt 1 ? demand for the good is ELASTIC

17
We love GRAPHS!!!

• What would a graph of an ELASTIC demand curve
  look like?

18
More graphs

• What about an INELASTIC demand curve?

19
Perfect!

• What about a PERFECTLY ELASTIC demand curve?

20
Or

• And what about a PERFECTLY INELASTIC demand
  curve?

21
Total Revenue and Price Elasticity of Demand

• When studying supply or demand in a market, were
  often interested in total revenue.
• Total Revenue P Q
• (TR is the amount paid by buyers and received by
  sellers of the good).

22
Total Revenue and Inelastic Demand

• With and inelastic demand curve, an ? in price
  leads to a ? in quantity demanded that is
  proportionally SMALLER.

23
? price causes TR to INCREASE
24
Total Revenue and Elastic Demand

• With an elastic demand curve, an ? in price leads
  to a ? in quantity demanded that is
  proportionally LARGER.

25
? price causes TR to DECREASE
26
Slope vs. Elasticity

• The slope of a linear demand curve is constant,
  but elasticity is NOT!
• At points with a low price and high quantity, the
  demand curve is INELASTIC.
• At points with a high price and a low quantity,
  the demand curve is ELASTIC.
• (see page 97 in textgood example)

27
Other Demand Elasticities

• 2.) Income Elasticity of Demand
• 3.) Cross-price Elasticity of Demand

28
Income Elasticity of Demand

• Measures how the quantity demanded changes as
  consumer income changes.
• Income elasticity
• of demand ? quantity demanded
• ? income

29
Do you remember?

• In Chapter 4, we said that most goods are of what
  type?

30
Answer

• ? Normal Goods meaning that an increase in
  consumer income will cause MORE of the good to be
  demanded (an increase in QD)
• They are not
• ? Inferior Goods meaning that an increase in
  consumer income will cause LESS of the good to be
  demanded (a decrease in QD)

31
Cross-price Elasticity of Demand

• Measures how the quantity demanded of one good
  changes as the price of another good changes.
• Cross-price elasticity
• of demand ? quantity demanded good 1
• ? price good 2

32
A revisit of or - ??

• With cross-price elasticity of demand, whether it
  is NEGATIVE or POSITIVE depends on whether the
  two goods in question are complements or
  substitutes.
• Which value do you think is associated with
  substitute goods?

33
POSITIVE!!!

• Hopefully you said that the cross-price
  elasticity of demand for substitute goods is
  positive.
• Example An increase in hot dog prices induces
  people to grill hamburgers. Since the PRICE of
  hot dogs and the QD of hamburgers move in the
  SAME direction, the cross-price elasticity of
  demand is POSITIVE.

34
And NEGATIVE!!??

• What about a negative cross-price elasticity of
  demand?
• This result would indicate that the goods are
  complements.
• Example Computers and software this negative
  value would indicate that an increase in the
  price of computers causes a decrease in the
  quantity of software demanded.

35
SUPPLY

• The supply curve also can be described with the
  concept of elasticity.
• The ELASTICITY OF SUPPLY measures how much the
  quantity supplied (QS) responds to changes in
  price.

36
Equation

• Price elasticity
• of supply ? quantity supplied
• ? price
• EX Suppose that in increase in the price of
  milk from 2.85 to 3.15 a gallon raises the
  amount that dairy farmers produce from 9,000 to
  11,000 gallonsuse the midpoint method and
  calculate the price elasticity of supply.

37
Answer

• Hopefully your calculations look like the
  following
• ? price (3.15 2.85)/3.00 100 10
• ? QS (11,000 9,000)/10,000 100
  20
• Price elasticity of supply 20/10 2

38
Amazing supply graphs!

• You should be able to determine what ELASTIC,
  INELASTIC, PERFECTLY ELASTIC, and PERFECTLY
  INELASTIC supply curves would look like!

39
Elastic Supply Curve
40
Inelastic Supply Curve
41
Perfectly Elastic Supply Curve
42
Perfectly Inelastic Supply Curve
43
Short-run vs. Long-run

• Price elasticity of supply is usually more
  ELASTIC over the long-run and more INELASTIC in
  the short-run.
• Over short periods of time, firms cannot easily
  change the size of their factories to make more
  or less of a good. In the long-run, firms can
  build new factories or close old ones, enter
  markets or shut down.

44
Lets see what youve got

• Sample AP Questions on Elasticity

45
Question 1

• 1.) A firm increases the price of its product and
  finds that its total revenue increases. Which of
  the following best describes why this has
  happened?
• A. The firms supply has increased.
• B. The firm has an elastic demand.
• C. The firm has a unit elastic demand.
• D. The firm has an inelastic demand.
• E. The firm has decreased its quantity supplied.

46
Question 2

• 2.) If a firm faces an elastic demand for its
  product and the price of the product drops, the
  firm can expect that
• A. the quantity sold will decrease and the
  total revenue will increase.
• B. the quantity sold will increase and the
  total revenue will increase.
• C. the quantity sold will decrease and the
  total revenue will decrease.
• D. the quantity sold will increase and the
  total revenue will decrease.
• E. the quantity sold and the total revenue will
  not change.

47
Question 3

• 3.) If a firm faces a relatively inelastic
  demand for its product and the price of the
  product rises, the firm can expect that
• A. total revenues will increase and profit will
  increase.
• B. total revenues will increase and profit will
  decrease.
• C. total revenues will decrease and profit will
  increase.
• D. total revenues will decrease and profit will
  decrease.
• E. total revenues will decrease and the effect
  on profits are indeterminate without additional
  information.