LECTURE

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LECTURE 4 MICROECONOMICSCHAPTER 5

• Elasticity of Demand
• Elasticity of Supply
• Applications

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Elasticity of Demand

• Elasticity How buyers respond to changes in
  prices
• If prices drop, consumers generally buy more (and
  vice-versa)
• If incomes rise, consumers generally will buy
  more (and vice-versa)
• Price Elasticity of Demand (PED)
• PED measures how much demand changes given a
  change in price.
• Goods are characterized as being highly elastic
  if a small change in price results in a large
  change in quantity demanded.
• Goods are characterized as being inelastic if a
  large change in price results in relatively
  small change in quantity demanded.

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Elasticity of Demand

• Factors influencing the PED
• Availability of close substitutes
• Necessities or Luxuries N tends to less elastic,
  L tends to be more elastic
• Nature of market narrow or broadly defined
• Narrowly defined markets tend to more elastic
  (vanilla ice cream)
• Broadly defined markets tend to be relatively
  inelastic (food)
• Time horizon changes in consumption patterns
  motivated by price changes

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Elasticity of Demand

• Computing Price Elasticity of Demand (PED)

Example If PED 2.5, the a 1 increase in price
will change QD by 2.5
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Elasticity of Demand

• Midpoint method
• Two points (Q1, P1) and (Q2, P2)

Why the Mid-Point method? The impact of Scale and
Distance Example Point A P1 4, Q1 120
Point B P2 6, Q2 80 PED (120 - 80)
/ (12080)/2 / (6 4) / (64)/2
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Elasticity of a Linear Demand Curve
1. an
The slope of a linear demand curve is constant,
but its elasticity is not. At points with a low
price and high quantity, the demand curve is
inelastic. At points with a high price and low
quantity, the demand curve is elastic.
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CONTINUE CHAPTER 5
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Elasticity along a Linear Demand Curve
The slope of a linear demand curve is constant,
but its elasticity is not. At points with a low
price and high quantity, the demand curve is
inelastic. At points with a high price and low
quantity, the demand curve is elastic.
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Elasticity of Demand

• Shape of Demand Curves (See Figure 1)
• Perfectly Elastic horizontal line
• Perfectly Inelastic vertical line
• Elasticity equals 1 everywhere a curve with a
  constant rate of change
• Straight Line Demand Curve PED varies (see
  Figure 4)

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Figure 1c Price Elasticity of Demand
(c) Unit elastic demand Elasticity 1
The price elasticity of demand determines whether
the demand curve is steep or flat. Note that all
percentage changes are calculated using the
midpoint method.
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Figure 1d, e Price Elasticity of Demand
(d) Elastic demand Elasticity gt 1
(e) Perfectly elastic demand Elasticity equals
infinity
The price elasticity of demand determines whether
the demand curve is steep or flat. Note that all
percentage changes are calculated using the
midpoint method.
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Elasticity of Demand

• Impact of PED on Total Revenue (TR) (See Figures
  2 and 3)
• TR Price (P) times Quantity (Q) P x Q
• Inelastic Demand Increase in P results in small
  decrease in Q increase in TR
• Elastic Demand Increase in P results in large
  decrease in Q decrease in TR
• Income Demand Elasticity
• Income IED DQD DI

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Total Revenue P Q
1. an
The total amount paid by buyers, and received as
revenue by sellers, equals the area of the box
under the demand curve, TR P Q.
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How total revenue changes when price changes (a)
(a) The Case of Inelastic Demand
1. an
1. an
In panel (a), the demand curve is inelastic. In
this case, an increase in the price leads to a
decrease in quantity demanded that is
proportionately smaller, so total revenue
increases.
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How total revenue changes when price changes (b)

• 3

(b) The Case of Elastic Demand
1. an
1. an
In panel (b), the demand curve is elastic. In
this case, an increase in the price leads to a
decrease in quantity demanded that is
proportionately larger, so total revenue
decreases..
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Cross-price Elasticity of Demand

• Measure of how much the quantity demanded of one
  good responds to a change in the price of another
  good
• Percentage change in quantity demanded of the
  first good divided by the percentage change in
  price of the second good
• Cross-Price CPED DQD1 DP2
• Substitutes Positive cross-price elasticity
• Complements Negative cross-price elasticity

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Elasticity of Supply

• Elasticity How sellers respond to changes in
  prices
• Law of Supply An increase in prices will lead to
  an increase in supply
• How much supply changes in response to a change
  in prices Price Elasticity of Supply (PES)
• The importance of time, characteristics of the
  good, and the production function
• Computing PES

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Elasticity of Supply

• Shape of Supply Curves (See Figure 5)
• Perfectly Elastic horizontal line
• Perfectly Inelastic vertical line
• Elasticity equals 1 everywhere a curve with a
  constant rate of change

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Applications of Supply, Demand and Elasticity

• Bumper crop for farmers
• Increase in supply
• If demand is inelastic prices will drop more
  than the increase in demand

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An increase in Supply in the Market for Wheat
When an advance in farm technology increases the
supply of wheat from S1 to S2, the price of wheat
falls.
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• OPEC and the Price of OIL
• Increase in Price of oil led to reduced
  consumption and long-term increases in energy
  efficiency leading to decrease in real price of
  oil as well as a decrease in per capita
  consumption and BTU per unit of GDP.
• Decrease in revenues led members of OPEC to cheat
  on quotas further downward pressure on oil
  prices.
• Ultimately, the path of prices is determined by
  both PED and PES.

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Effects of reduction in supply in world market
for oil
(a) The Oil Market in the Short Run
(b) The Oil Market in the Long Run
When the supply of oil falls, the response
depends on the time horizon. In the short run,
supply and demand are relatively inelastic, as in
panel (a). By contrast, in the long run, supply
and demand are relatively elastic, as in panel
(b). In this case, the same size shift in the
supply curve (S1 to S2) causes a smaller increase
in the price.
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Homework

• Questions for Review 1, 2, 3, 4
• Problems and Applications 2, 3, 9, 11

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Break Time