Microeconomics: elasticity and its applications
- 1. Copyright © 2006 Thomson Learning 5 Elasticity and Its Applications
- 2. Copyright © 2006 Thomson Learning Learning Objectives In this chapter you will • Learn the meaning of the elasticity of demand • Examine what determines the elasticity of demand • Learn the meaning of the elasticity of supply • Examine what determines the elasticity of supply • Apply the concept of elasticity in three very different markets
- 3. Copyright © 2006 Thomson Learning Learning Objectives You should be able to • Calculate the price and income elasticity of demand • Distinguish between the price elasticity of demand for necessities and luxuries • Calculate the price elasticity of supply • Distinguish between an inelastic and elastic supply curve • Demonstrate the impact of the price elasticity of demand on total revenue
- 4. Copyright © 2006 Thomson Learning Concept of Elasticity • When studying how some event or policy affects a market, we discuss not only the direction of the effects but their magnitude as well. • Elasticity is a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants.
- 5. Copyright © 2006 Thomson Learning The Own Price Elasticity of Demand • The own price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price. • The own price elasticity of demand for any good measures how willing consumers are to move away from the good as its price rises. • Demand for a good is said to be elastic or price sensitive if the quantity demanded responds substantially to changes in the price.
- 6. Copyright © 2006 Thomson Learning The Own Price Elasticity of Demand and its Determinants • Availability of Close Substitutes: Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others. • Necessities versus Luxuries: Necessities tend to have relatively inelastic demands, whereas luxuries have relatively elastic demands. • Proportion of Income Devoted to the Product: If the price of a furniture rises by 10 per cent, this is likely to have a greater effect on demand for this furniture than a similar 10 per cent increase in the price of an ice cream.
- 7. Copyright © 2006 Thomson Learning Computing the Price Elasticity of Demand • For example, suppose that a 10 per cent increase in the price of a packet of breakfast cereal causes the amount bought to fall by 20 per cent. • The own price elasticity is 2 reflecting that the change in the quantity demanded is proportionately twice as large as the change in the price.
- 8. Copyright © 2006 Thomson Learning Computing the Own Price Elasticity of Demand: The Midpoint Method • If the price of an ice cream cone increases from $2.00 to $2.20 and the amount people buy falls from 10 to 8 cones, then the own price elasticity of demand would be calculated as: • A 1% increase in the price of an ice cream will decrease the demand on an ice cream by 2.4%, ceteris paribus.
- 9. Interpreting the Own Price Elasticity of Demand If elasticity coefficient is: Demand is said to be: % in quantity is: Greater than 1.0 Elastic Greater than % in price Equal to 1.0 Unitary elastic Same as % in price Less than 1.0 Inelastic Less than % in price
- 10. Because the own price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.
- 11. Figure 4.1 The Price Elasticity of Demand (a) Perfectly Inelastic Demand: Elasticity Equals 0 € 5 4 Quantity Demand of insulin 100 0 1. An increase in price . . . 2. . . . leaves the quantity demanded unchanged. Price
- 12. Figure 4.1 The Price Elasticity of Demand (b) Inelastic Demand: Elasticity Is Less Than 1 Quantity 0 € 5 90 Demand 1. A 22% increase in price . . . Price 2. . . . leads to an 11% decrease in quantity demanded. 4 100
- 13. Figure 4.1 The Price Elasticity of Demand 2. . . . leads to a 22% decrease in quantity demanded. (c) Unit Elastic Demand: Elasticity Equals 1 Quantity 4 100 0 Price € 5 80 1. A 22% increase in price . . . Demand
- 14. Figure 4.1 The Price Elasticity of Demand (d) Elastic Demand: Elasticity Is Greater Than 1 Demand Quantity 4 100 0 Price € 5 50 1. A 22% increase in price . . . 2. . . . leads to a 67% decrease in quantity demanded.
- 15. Figure 4.1 The Price Elasticity of Demand (e) Perfectly Elastic Demand: Elasticity Equals Infinity Quantity 0 Price € 4 Demand of rice 2. At exactly €4, consumers will buy any quantity. 1. At any price above €4, quantity demanded is zero. 3. At a price below €4, quantity demanded is infinite.
- 16. Copyright © 2006 Thomson Learning Elasticity of a Linear Demand Curve
- 17. Copyright © 2006 Thomson Learning Total Expenditure, Total Revenue and the Price Elasticity of Demand • We are interested in the amount paid by buyers of the good which will in turn represent the total revenue that sellers receive. • Total expenditure is the amount paid by buyers, computed as the price of the good times the quantity purchased.
- 18. Copyright © 2006 Thomson Learning Figure 4.2 Total Revenue Copyright©2003 Southwestern/Thomson Learning Demand Quantity Q P 0 Price P × Q = €400 (revenue) €4 100
- 19. Copyright © 2006 Thomson Learning Total Expenditure, Total Revenue and the Price Elasticity of Demand For businesses, having some understanding of the price elasticity of demand is important in decision making. If a firm is thinking of changing price how will the demand for its product react? When demand is inelastic, price and total expenditure move in the same direction. When demand is elastic, price and total expenditure move in opposite directions. If demand is unit elastic, total expenditure remains constant when the price changes.
- 20. Figure 4.3 How Total Revenue Changes When Price Changes: Inelastic Demand Demand Quantity 0 Price Revenue = €100 Quantity 0 Price Revenue = €240 Demand €1 100 €3 80 An Increase in price from €1 to €3 … … leads to an Increase in total revenue from €100 to €240
- 21. Figure 4.4 How Total Revenue Changes When Price Changes: Elastic Demand Demand Quantity 0 Price Revenue = €200 €4 50 Demand Quantity 0 Price Revenue = €100 €5 20 An Increase in price from €4 to €5 … … leads to an decrease in total revenue from €200 to €100
- 22. Copyright © 2006 Thomson Learning Figure 4.5 Application of Demand Elasticity: Price Sensitivity in the Passenger Train Market Why Does the Price of Train Travel Vary at Different Times of the Day? Panel (a) represents the market for train travel between 6.00am and 9.00am between two major cities, while panel (b) represents the same market after 9.00am.
- 23. Assignment 4 Consider public policy aimed at smoking. a. Studies indicate that the price elasticity of demand for cigarettes is about 0.4. If a pack of cigarettes currently costs $5 and the government wants to reduce smoking by 20 percent, by how much should it increase the price? b. If the government permanently increases the price of cigarettes, will the policy have a larger effect on smoking one year from now or five years from now? c. Studies also find that teenagers have a higher price elasticity of demand than adults. Why might this be true?
- 24. Copyright © 2006 Thomson Learning Income Elasticity of Demand • The income elasticity of demand measures how the quantity demanded changes as consumer income changes.
- 25. Interpreting the Income Elasticity of Demand If the income elasticity is equal to: The good is classified as: Greater than 1.0 A luxury and a normal good Less than 1.0 but greater than 0.0 A necessity and a normal good Less than 0.0 An inferior good!
- 26. Copyright © 2006 Thomson Learning Cross Price Elasticity of Demand • The cross-price elasticity of demand measures how the quantity demanded of one good changes as the price of another good changes.
- 27. Interpreting the Cross Price Elasticity of Demand If the cross price elasticity is equal to: The good is classified as: Positive Substitutes Negative Complements Zero Independent
- 28. Copyright © 2006 Thomson Learning Price Elasticity of Supply • The price elasticity of supply measures how much the quantity supplied of a good responds to changes in the price of that good. • Elasticity can take any value greater than or equal to 0. The closer to 0 the more inelastic, and the closer to infinity the more elastic.
- 29. Copyright © 2006 Thomson Learning The Determinants of Price Elasticity of Supply • The Time Period: Supply is usually more elastic in the long run than in the short run. • Productive Capacity: How far they are using this capacity depends on the state of the economy. In periods of strong economic growth, firms may be operating at or near full capacity. • The Size of the Firm/Industry: Supply may be more elastic in smaller firms or industries than in larger ones. For example when a large furniture manufacture increases its purchases of raw materials, it can drive up unit price and unit costs.
- 30. Copyright © 2006 Thomson Learning Computing the Price Elasticity of Supply • Suppose that a 10 per cent increase in the price of bicycles causes the amount of bicycles supplied to the market to rise by 15 per cent. • The quantity supplied moves proportionately one and a half times as much as the price.
- 31. Figure 4.6 The Price Elasticity of Supply (a) Perfectly Inelastic Supply: Elasticity Equals 0 €5 4 Supply Quantity 100 0 1. An increase in price . . . 2. . . . leaves the quantity supplied unchanged. Price
- 32. Figure 4.6 The Price Elasticity of Supply (b) Inelastic Supply: Elasticity Is Less Than 1 110 €5 100 4 Quantity 0 1. A 22% increase in price . . . Price 2. . . . leads to a 10% increase in quantity supplied. Supply
- 33. Figure 4.6 The Price Elasticity of Supply (c) Unit Elastic Supply: Elasticity Equals 1 125 €5 100 4 Quantity 0 Price 2. . . . leads to a 22% increase in quantity supplied. 1. A 22% increase in price . . . Supply
- 34. Figure 4.6 The Price Elasticity of Supply (d) Elastic Supply: Elasticity Is Greater Than 1 Quantity 0 Price 1. A 22% increase in price . . . 2. . . . leads to a 67% increase in quantity supplied. 4 100 €5 200 Supply
- 35. Figure 4.6 The Price Elasticity of Supply (e) Perfectly Elastic Supply: Elasticity Equals Infinity Quantity 0 Price €4 Supply 3. At a price below €4, quantity supplied is zero. 2. At exactly €4, producers will supply any quantity. 1. At any price above €4, quantity supplied is infinite.
- 36. Copyright © 2006 Thomson Learning Figure 4.7 How the Price Elasticity of Supply Can Vary
- 37. Copyright © 2006 Thomson Learning Total Revenue and the Price Elasticity of Supply • Total revenue is the amount received by sellers of a good, computed as the price of the good times the quantity sold.
- 38. Copyright © 2006 Thomson Learning Figure 4.8 How Total Revenue Changes When Price Changes: Inelastic Supply
- 39. Copyright © 2006 Thomson Learning Figure 4.9 How Total Revenue Changes When Price Changes: Elastic Supply
- 40. Copyright © 2006 Thomson Learning Quiz 1 • Next week, October 15, 2023 • Chapter 4: The market forces of supply and demand • Chapter 5: Elasticity and its applications