Elasticity and Its Applications

1
Elasticity and Its Applications

• Chapter 5

2
Elasticity . . .

• . . . is a measure of how much buyers and
  sellers respond to changes in market conditions.
  . .
• . . . allows us to analyze supply and demand
  with greater precision.

3
Three Types of Elasticities

• Price elasticity of demand
• Income elasticity of demand
• Price elasticity of supply

4
Price Elasticity of Demand

• Price elasticity of demand is the percentage
  change in quantity demanded given a one percent
  change in the price.

5
Ranges of Elasticity

• Inelastic Demand
• ä Quantity demanded does not respond strongly
  to price changes.
• Elastic Demand
• ä Quantity demanded responds strongly to
  changes in price.

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Ranges of Elasticity

• Perfectly Inelastic
• ä Quantity demanded does not respond to price
  changes.
• Perfectly Elastic
• ä Quantity demanded changes infinitely with
  any change in price.
• Unit Elastic
• ä Quantity demanded changes by the same
  percentage as the price.

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The Price Elasticity of Demand
8
The Price Elasticity of Demand Perfectly
Inelastic
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The Price Elasticity of Demand Perfectly Elastic
10
The Price Elasticity of Demand Unit Elastic
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The Price Elasticity of Demand Elastic Demand
Price
5
4
Demand
1. A 22
increase
in price...
Quantity
100
0
50
2. ...leads to a 67 decrease in quantity
demanded.
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The Price Elasticity of Demand Inelastic Demand
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Determinants of Price Elasticity of Demand

• Demand tends to be more elastic . . .
• . . . if the good is a luxury.
• . . . the longer the time period.
• . . . the larger the number of close
  substitutes.
• . . . the more narrowly defined the market.

14
Determinants of Price Elasticity of Demand

• Demand tends to be more inelastic . . .
• . . . if the good is a necessity.
• . . . the shorter the time period.
• . . . the fewer the number of close substitutes.
• . . . the more broadly defined the market.

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Computing the Price Elasticity of Demand

• The price elasticity of demand is computed as the
  percentage change in the quantity demanded
  divided by the percentage change in price.

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Computing the Price Elasticity of Demand

• The price elasticity of demand is computed as the
  percentage change in the quantity demanded
  divided by the percentage change in price.

17
Computing the Price Elasticity of Demand
Price
5
4
Demand
Quantity
100
0
50
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Computing the Price Elasticity of Demand
Price
5
4
Demand
Quantity
100
0
50
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Computing the Price Elasticity of Demand
Price
5
4
Demand
Quantity
100
0
50
20
Computing the Price Elasticity of Demand
Price
5
4
Demand
Demand is price elastic
Quantity
100
0
50
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Elasticity and Total Revenue

• Total revenue is the amount paid by buyers and
  received by sellers of a good.
• Computed as the price of the good times the
  quantity sold.
• TR P X Q

22
Elasticity and Total Revenue
Price
4
P X Q 400

P
(total revenue)
Demand
Quantity
0
100
23
Elasticity and Total Revenue

• With an elastic demand curve, an increase in the
  price leads to a decrease in quantity demanded
  that is proportionately larger. Thus, total
  revenue decreases.

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Elasticity and Total Revenue Elastic Demand
Price
Price
5
4
Demand
Demand
Revenue 100
Quantity
0
50
Quantity
0
20
25
Elasticity and Total Revenue

• With an inelastic demand curve, an increase in
  price leads to a decrease in quantity that is
  proportionately smaller. Thus, total revenue
  increases.

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Elasticity and Total Revenue Inelastic Demand
Price
Price
3
Revenue 240
1
Demand
Demand
Revenue 100
Quantity
0
80
Quantity
0
100
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Income Elasticity of Demand

• Income elasticity of demand measures how much the
  quantity demanded of a good responds to a change
  in consumers income.
• It is computed as the percentage change in the
  quantity demanded divided by the percentage
  change in income.

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Computing Income Elasticity
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Computing Income Elasticity
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Income Elasticity... Types

• Higher income raises the quantity demanded for
  normal goods but lowers the quantity demanded for
  inferior goods.

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Income Elasticity... Types

• Goods consumers regard as necessities tend to be
  income inelastic.
• ä Examples include food, fuel, clothing,
  utilities, and medical services.

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Income Elasticity... Types

• Goods consumers regard as luxuries tend to be
  income elastic.
• ä Examples include sports cars, furs, and
  expensive foods.

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Quick Quiz!

• Define the price elasticity of demand.

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Quick Quiz!

• Explain the relationship between total revenue
  and elasticity of demand.

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Price Elasticity of Supply

• Price elasticity of supply is the percentage
  change in quantity supplied resulting from a one
  percent change in price.

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Ranges of Elasticity

• Perfectly Elastic
• ES
• Relatively Elastic
• ES gt 1
• Unit Elastic
• ES 1

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Ranges of Elasticity

• Relatively Inelastic
• ES lt 1
• Perfectly Inelastic
• ES 0

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Price Elasticity of Supply Perfectly Inelastic
Supply
Supply
5
4
1. An
increase
in price...
100
0
2. ...leaves the quantity supplied unchanged.
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Price Elasticity of Supply Inelastic Supply
5
4
110
100
2. ...leads to a 10 increase in quantity
supplied.
40
Price Elasticity of Supply Unit Elastic Supply
5
4
100
125
2. ...leads to a 22 increase in quantity
supplied.
41
Price Elasticity of Supply Elastic Supply
5
4
100
200
2. ...leads to a 67 increase in quantity
supplied.
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Price Elasticity of Supply Perfectly Elastic
Supply
1. At any price
above 4, quantity
5
supplied is infinite.
4
2. At exactly 4,
producers will
supply any quantity.
100
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Determinants of Elasticity of Supply

• Ability of sellers to change the amount of the
  good they produce.
• ä Beach-front land is inelastic.
• ä Books, cars, or manufactured goods are
  elastic.
• Time period.
  ä Supply is more elastic in the long run.

44
Computing the Price Elasticity of Supply

• The price elasticity of supply is computed as the
  percentage change in the quantity supplied
  divided by the percentage change in price.

45
Computing the Price Elasticity of Supply

• The price elasticity of supply is computed as the
  percentage change in the quantity supplied
  divided by the percentage change in price.

46
Quick Quiz!

• Define the elasticity of supply.

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Quick Quiz!

• Explain why the price elasticity of supply might
  be different in the long run than the short run.

48
Application of Elasticity

• Can good news for farming be bad news for
  farmers?
• ä What happens to wheat farmers and the market
  for wheat when university agronomists discover
  a new wheat hybrid that is more productive than
  existing varieties?

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Application of Elasticity

• Examine whether the supply or demand curve
  shifts.
• Determine the direction of the shift of the
  curve.
• Use the supply-and-demand diagram to see how the
  market equilibrium changes.

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An Increase in Supply in the Market for Wheat
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An Increase in Supply in the Market for Wheat
Price of Wheat
S1
3
Demand
Quantity of Wheat
100
0
52
An Increase in Supply in the Market for Wheat
Price of Wheat
1. When demand is inelastic, an increase in
supply...
S1
S2
3
Demand
Quantity of Wheat
100
0
53
An Increase in Supply in the Market for Wheat
Price of Wheat
1. When demand is inelastic, an increase in
supply...
S1
S2
3
2
Demand
Quantity of Wheat
100
0
110
54
An Increase in Supply in the Market for Wheat
Price of Wheat
1. When demand is inelastic, an increase in
supply...
S1
S2
2. ...leads to a large fall in price...
3
2
Demand
Quantity of Wheat
100
0
110
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An Increase in Supply in the Market for Wheat
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Compute Elasticity
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Compute Elasticity
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Compute Elasticity
Demand is inelastic
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Quick Quiz!

• Elasticity is defined as . . .
• Price elasticity of demand is . . .
• Income elasticity of demand is . . .
• Price elasticity of supply is . . .

60
Quick Quiz!

• What is the relationship between elasticity and
  total revenue?
• What is the relationship between elasticity and
  income?

61
Conclusion

• Price elasticity of demand measures how much the
  quantity demanded responds to changes in the
  price.
• If a demand curve is elastic, total revenue falls
  when the price rises.
• If it is inelastic, total revenue rises as the
  price rises.

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Conclusion

• The price elasticity of supply measures how much
  the quantity supplied responds to changes in the
  price.
• In most markets, supply is more elastic in the
  long run than in the short run.

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Elasticity and Its Applications

• End of Chapter 5

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Figure 5-1a
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Figure 5-1b
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Figure 5-1c
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(d) Elastic Demand Elasticity Is Greater Than 1
Figure 5-1d
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Figure 5-1e
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Price
4
P X Q 400

P
(revenue)
Demand
Quantity
0
100
Figure 5-2
71
Figure 5-3
72
Figure 5-4
73
Price
Elasticity is
7
larger
than 1.
6
5
Elasticity is
4
smaller
than 1.
3
2
1
12
2
4
6
8
10
14
0
Figure 5-5
Quantity
74
Price
15
Elasticity is small
(less than 1).
12
Elasticity is large
(greater than 1).
4
3
Quantity
100
200
500
0
525
Figure 5-7
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Figure 5-8
76
(a) The Oil Market in the Short Run
(b) The Oil Market in the Long Run
Price of Oil
Price of Oil
1. In the short run, when supply
1. In the long run,
and demand are inelastic,
when supply and
a shift in supply...
demand are elastic,
a shift in supply...
S
2
S
1
S
2
S
1
P2
2. ...leads to a small increase in price.
2. ...leads
P2
to a large
P1
increase
P1
in price.
Demand
Demand
Quantity of Oil
0
Quantity of Oil
0
Figure 5-9
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(a) Drug Interdiction
(b) Drug Education
Price of
Price of
Drugs
Drugs
1. Drug education reduces
1. Drug interdiction reduces
the demand for drugs...
the supply of drugs...
S
Supply
2
S
1
P
P
1
2
P
P
1
2
2. ...which
2. ...which
raises the
reduces
price...
the price...
D
Demand
1
D
2
Quantity of Drugs
0
Q
Q
Q
Q
Quantity of Drugs
0
2
1
2
1
3. ...and reduces the
3. ...and reduces the
quantity sold.
quantity sold.
Figure 5-10