Chapter 4: Elasticity

1
Chapter 4 Elasticity
Elasticity of Demand
It measures the responsiveness of quantity
demanded (or demand) with respect to changes in
its own price (or income or the price of some
other commodity).
2
Why is Elasticity Important?

• How does a firm go about determining the price at
  which they should sell their product in order to
  maximize total revenue?
• Total Revenue Price Quantity

3

• You are a marketing manager for Intel
• A new computer chip has been developed
• Decision to Be Made
• Do you sell the new chip at a high price (400)?
• Do you sell the new chip at a low price (200)?

4
Demand and Total Revenue
400
Price (dollars per chip)
300
200
Da
100
40 80 120
Quantity (millions of chips per year)
5
Demand and Total Revenue
400
Price (dollars per chip)
300
200
100
Db
40 60 80 120
Quantity (millions of chips per year)
6
Demand and Total Revenue
Price (dollars per chip)
Price (dollars per chip)
Da
Db
Quantity (millions of chips per year)
Quantity (millions of chips per year)
7
Slope Depends on Units of Measurement

• In these two examples, we can compare the slopes
  of the demand curves
• We cannot do so if we are dealing with different
  goods and services. Or whenever the unit of
  measurement has been changed.

8
Effect of a change of unit of measurement on Slope
Price
10
9
8
7
6
5
4
3
2
1
0
9
10
11
12
1
2
3
4
5
6
7
8
Quantity
9
Slope Depends on Units of Measurement

• In these two examples, we can compare the slopes
  of the demand curves
• We cannot do so if we are dealing with different
  goods and services. Or, whenever the unit of
  measurement has been changed.

• Elasticity is independent of the units of
  measurement.

10

• Price elasticity of demand
• A measure of the responsiveness of the quantity
  demanded of a good to a change in its own price
  (ceteris paribus).

11
Elasticity A Units-Free Measure
Price Elasticity of Demand
12
Calculating Elasticity

• The changes in price and quantity are expressed
  as percentages of the average price and average
  quantity.
• This way we avoid having two values for the price
  elasticity of demand for the same range of the
  demand curve

13
Example Suppose, quantity demanded changes from
150 to 100 when Price increases from 5 to 10
dollars. Find out the price elasticity of demand
for this specific range of the demand curve.
14
Calculating the Elasticity of Demand
Original point
410
Price (dollars per chip)
390
Da
36 44
Quantity (millions of chips per year)
15
Calculating the Elasticity of Demand
Original point
410
Price (dollars per chip)
New point
390
Da
36 44
Quantity (millions of chips per year)
16
Calculating the Elasticity of Demand
Original point
410
Price (dollars per chip)
New point
390
Da
36 44
Quantity (millions of chips per year)
17
Original point
410
Price (dollars per chip)
400
Pave 400
New point
390
Da
36 44
Quantity (millions of chips per year)
18
Calculating the Elasticity of Demand
Original point
410
Price (dollars per chip)
400
Pave 400
New point
Qave 40
390
Da
36 40 44
Quantity (millions of chips per year)
19
Calculating Elasticity
- 4
20
Inelastic and Elastic Demand

• Three demand curves that cover the entire range
  of possible elasticities of demand
• Perfectly inelastic
• Unit elastic
• Perfectly elastic

21

• Perfectly inelastic demand
• Implies that quantity demanded remains constant
  when price changes occur.
• Price elasticity of demand 0

22
D
Price
Elasticity 0
12
Perfectly Inelastic
6
0
Quantity
1
23
Unit elastic demand Implies that the percentage
change in quantity demanded equals the percentage
change in price. Price elasticity of demand -1
24
Unit Elastic Demand
Price
Elasticity -1
12
Unit Elasticity
6
D
Quantity
1 2 3
25

• Perfectly elastic demand
• Implies that if price increases by any
  percentage, quantity demanded will fall to 0 and
  if price decreases by any percentage, quantity
  will rise to infinity.
• Price elasticity of demand

26
Perfectly Elastic Demand
Price
Elasticity
12
D3
6
Perfectly Elastic
Quantity
27
Inelastic and Elastic Demand

• Inelastic demand
• Implies the percentage change in quantity
  demanded is less than the percentage change in
  price.
• In absolute sense, price elasticity of demand gt 0
  and lt 1
• Elastic demand
• Implies the percentage change in quantity
  demanded is greater than the percentage change in
  price.
• In absolute sense, price elasticity of demand gt 1

28
Elasticity Along a Straight-Line Demand Curve
500
Price (dollars per chip)
400
300
250
200
100
0 40 80 100 120 160
200
Quantity (millions of chips per year)
29
Elasticity Along a Straight-Line Demand Curve
Elasticity -4
500
Lowering the price from 500 to 300 results in a
price elasticity of demand of -4.
Elastic
Price (dollars per chip)
400
300
250
200
100
0 40 80 100 120 160
200
Quantity (millions of chips per year)
30
Elasticity Along a Straight-Line Demand Curve
500
Lowering the price from 200 to 0 results in a
price elasticity of demand of -1/ 4.
Price (dollars per chip)
400
Inelastic
300
250
200
Elasticity -1/4
100
0 40 80 100 120 160
200
Quantity (millions of chips per year)
31
Elasticity Along a Straight-Line Demand Curve
500
Lowering the price from 500 to 0 results in a
price elasticity of demand of -1.
Elasticity gt 1
Price (dollars per chip)
400
Elasticity 1
300
250
200
Elasticity lt 1
100
0 40 80 100 120 160
200
Quantity (millions of chips per year)
32
Elasticity, Total Revenueand Expenditure
TR P x Q

• Elastic demand a 1 percent decrease in price
  will result in a greater than 1 percent increase
  in quantity demanded.
• Total revenue will increase
• Unit elastic demand a 1 percent decrease in
  price will result in a 1 percent increase in
  quantity demanded
• Total revenue will not change

33
Elasticity, Total Revenueand Expenditure

• Inelastic demand a 1 percent decrease in price
  will result in a less than 1 percent increase in
  quantity demanded.
• Total revenue will decrease

34
Elasticity, Total Revenueand Expenditure

• Total Revenue Test
• Price elasticity of demand can be estimated by
  observing the change in total revenue that
  results from a price change (ceteris paribus).

35
Elasticity, Total Revenue Expenditure

• Total Revenue Test
• Price cut and total revenue increases
• demand is elastic.
• Price cut and total revenue decreases
• demand is inelastic
• Price cut and total revenue does not change
• demand is unit elastic

36
500
400
Price (dollars per chip)
300
250
200
D
100
0 100 200
TR P x Q
37
500
400
Price (dollars per chip)
300
250
200
D
100
0 100 200
25
20
Total Revenue (billions of dollars)
15
10
TR
5
0 100 200
Quantity (millions of chips per year)
38
Elastic demand
500
400
Price (dollars per chip)
Unit elastic
300
250
200
Inelastic demand
100
0 100 200
Maximum total revenue
25
20
Total Revenue (billions of dollars)
15
When demand is inelastic, price cut
decreases total revenue
When demand is elastic, price cut
increases total revenue
10
5
0 100 200
Quantity (millions of chips per year)
39
More Elasticities of Demand

• Cross elasticity of demand
• Measures the responsiveness of the demand for
  a good to a change in the price of a substitute
  or complement good.

40
Income Elasticity of Demand

• Income elasticity
• Measures the responsiveness of the demand to a
  change in income.

41
Income Elasticity of Demand

• Income elasticity can be
• 1) Greater than 1 (normal good, income elastic)
• luxury goods - ocean cruises, jewelry
• 2) Between zero and 1 (normal good, income
  inelastic)
• necessities - food, clothing
• 3) Less than zero (inferior good)
• potatoes, rice

42
Unit Tax and Tax Burden
Price
10
S2
9
S1
8
7
6
5
2
4
3
2
1
0
9
10
11
1
2
3
4
5
6
7
8
Quantity
43
Unit Tax and Tax Burden
Price
10
S2
Consumers part
9
S1
8
7
6
2
5
4
3
2
Suppliers part
1
0
9
10
11
1
2
3
4
5
6
7
8
Quantity
44
Elasticity and Tax Burden Perfectly Inelastic
Demand
Price
10
S2
Consumers part
9
S1
8
7
6
2
5
4
3
2
1
0
9
10
11
1
2
3
4
5
6
7
8
Quantity
45
Elasticity and Tax Burden Perfectly Elastic
Demand
Price
10
S2
9
S1
Producers part
8
7
6
5
4
2
3
2
1
0
9
10
11
1
2
3
4
5
6
7
8
Quantity
46
Elasticity and Tax Burden Perfectly Elastic
Supply
Price
10
Consumers part
9
8
7
S2
6
2
5
S1
4
3
2
1
0
9
10
11
1
2
3
4
5
6
7
8
Quantity
47
Elasticity and Tax Burden Perfectly inelastic
Supply
Price
S1
10
9
Producers part
8
7
6
5
4
3
2
2
1
0
9
10
11
1
2
3
4
5
6
7
8
Quantity
48
Chapter 5
Marginal Utility Consumer Choice
49
Utility
The satisfaction or enjoyment a person obtains
from consuming a good.
Util
A hypothetical unit used to measure how much
utility a person obtains from consuming a good.
50
Marginal Utility
The change in total utility a person derives from
consuming an additional unit of a good.
Total Utility
The total number of utils a person derives from
consuming a specific quantity of a good.
51
Law of Diminishing Marginal Utility
The idea that as more of a good is consumed, the
utility a person derives from each additional
unit diminishes.
52
Total and Marginal Utility
53
Water-Diamond Paradox
How much people value a good depends upon the
utils they derive from the last unit consumed or
the Marginal Utility.
54
Making selection from a given budget
55
Making selection from a given budget
56
20 Sale on Clothing
57
MU/P Equalization Principle
58
Consumer Surplus
The difference between the maximum amount a
person would be willing to pay for a good or
service and the amount the person actually pays.
59
Price
10
8
6
3
D
1
2
3
0
Quantity
60
Price
3
D
0
Quantity
61
Chapter 6
Price Ceilings and Price Floors
62
Civilian Goods
Defense Goods
63
S2
Price ()
S1
10
Price Ceiling
4
D
10
7
Quantity (1,000)
64
S2
Price ()
10
Price Ceiling
4
D
10
7
4
Excess Demand or Shortage
Quantity (1,000)
65
Price ()
S1
Excess Supply or Surplus
S2
Price Floor
4
2
D
10
12
14
Quantity (1,000)
66
Price ()
Excess Supply or Surplus
S2
Price Floor
4
2
D
10
12
14
Quantity (1,000)
67
Chapter 8

• Costs of Production

68
What is a Fixed Cost?

• Cost to a firm that does not vary with the
  quantity of goods produced

69
What are examples of Fixed Costs?

• rent or mortgage
• a part of utilities

70
Fixed Costs are also known as..

• Sunk Cost

71
What is a Variable Cost?

• Cost that varies with the quantity of goods
  produced

72
What are examples of Variable Costs?

• workers wages
• raw materials
• some utilities
• some taxes

73
What is Labor Productivity?

• The output per laborer per hour

74
Under what condition is it cheaper to pay 10 an
hr. to a U.S. worker than 1 an hour to a foreign
worker?
75

• If the U.S. worker is more than 10 times as
  productive as the foreign worker

76
Why do labor costs per unit of output changes as
more units of labor are hired?

• Price of labor increases
• Quality of labor decreases
• Labor productivity Changes

77
Why do non-labor, variable costs per unit of
output increase as output increases?

• Resources become more scarce

78
Does the cost of all resources increase more than
production increases?

• No, the costs of some resources may vary
  proportionately with the level of production

79
What is Total Variable Cost?

• The sum of specific variable costs in the firms
  cost structure

80
Total Variable Costs

Q
81
What are Total Costs?

• Cost to the firm that includes both fixed and
  variable costs

82
Total Costs
TC

TVC
TFC
Q
83
What isAverage Total Cost?

• Total cost divided by the quantity of goods
  produced

84

TVC
TC
10
ATC
9
5/2 2.5
8
7
6
5
ATC
4
6/5 1.2
3
6
5
2
1
Q
1
2
3
4
5
6
7
8
9
10
0
85

10
9
8
7
ATC
6
5
4
3
2
1
Q
1
2
3
4
5
6
7
8
9
10
0
86
What isAverage Variable Cost?

• Total variable cost divided by the quantity of
  goods produced

87

10
9
TVC
8
7
6
5
4
3
2
1
Q
1
2
3
4
5
6
7
8
9
10
0
88

10
9
8
7
ATC
6
5
AVC
4
3
2
1
Q
1
2
3
4
5
6
7
8
9
10
0
89
What isAverage Fixed Cost?

• Total fixed cost divided by the quantity of goods
  produced

90
Costs
AFC
Quantity
90
91
What is Marginal Cost?

• The change in total cost associated with one more
  unit of production

92
If the only thing we observe is a change in total
cost associated with a small change in output
produced then MC is computed in the following way.
93

TC
10
MC
9
3/3 1
8
3
7
6
5
3
4
3
2
1
Q
1
2
3
4
5
6
7
8
9
10
0
94

TC
10
9
8
7
6
5
4
3
2
1
Q
1
2
3
4
5
6
7
8
9
10
0
95
TC, TVC, TFC
TFC
Q2
Q3
Q1
0
Q
ATC
MC
AVC
AFC
0
Q
96

10
MC
9
ATC
8
7
AVC
6
5
4
3
2
1
Q
1
2
3
4
5
6
7
8
9
10
0
97

10
MC
9
ATC
8
7
AVC
6
5
4
3
2
1
Q
1
2
3
4
5
6
7
8
9
10
0
98
What is the Short Run?

• A time period in which producers can change some,
  but not all of its resources

What is the Long Run?
The time period in which producers can change
quantities of all resources
99
Short-run Vs. Long-run Average Cost
per unit of Output
SRACD
SRACC
SRACA
SRACB
LRAC
Q2
Q
Q3
Q1
0
100
What are Economies of Scale?

• When a firm increases resources in the long run
  and ATC decreases

What are Diseconomies of Scale?
When a company increases resources in the long
run and ATC increases