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Elasticity

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  • Tells us percentage change in quantity demanded for each 1% increase in price
  • Ask student to draw the graph for extreme case.
  • Do not consider the cost side, only the income earned for firms
  • Graphically, at any point on a demand curve sellers’ total revenue (buyers’ total expenditure) is the area of a rectangle . Width equal to quantity demanded .Height equal to price
  • Another equation is helpful to understand the concept: (dq/dp ) * (p/q)
  • Example: pepsi and cola
  • Example: corn in Iowa compared with corn in US Example: Pepsi compared with soda drink
  • Example: salt, milk, eggs, gas, medical care and so on – necessity diamond, tourism to China and so on – luxurious
  • Necessity is not meaning “necessary to survive”. Cigarette is an example. It is inelastic demanded.
  • While the sign of the cross-price elasticity helps us distinguish
  • Transcript

    • 1. Overview
      • Elasticity calculation and interpretation
      • Difference between elastic, inelastic, and unitary elastic demand/supply
      • Prediction on revenue change in response to a change in price
      • Elasticity varies as one moves along a straight-line demand curve
      • Determinants of price elasticity of demand/supply
      • Income elasticity
      • Cross price elasticity of demand
    • 2. Motivation to Study Elasticity
      • The Problem with Rate Change
      • --
      • is not a good measure of price sensitivity
        • Doesn’t tell whether a change in price or a change in quantity demanded is a relatively large or relatively small change
          • Relative means compared to value of price or quantity before change
    • 3. Elasticity - Concept
      • Elasticity approach improves on the problems with rate of change
        • By comparing percentage change in quantity demanded with percentage change in price
      • Price elasticity of demand ( )for a good is percentage change in quantity demanded divided by percentage change in price
        • always be a negative number
        • Use the midpoint
      • Price elasticity of demand tells us percentage change in quantity demanded caused by a 1% rise in price as we move along a demand curve from one point to another
    • 4. Part 1: Price Elasticity of Demand - Calculation
      • Base value for percentage changes in price or quantity is always midway between initial value and new value
      • Denominator
      • - Define the percentage change in price from any value P 0 to any other value P 1 as
      • Numerator:
        • When quantity demanded changes from Q 0 to Q 1 , percentage change is calculated as
    • 5. (Own) Price Elasticity of Demand
      • Or written as
    • 6. Price Elasticity of Demand -- Categorize Goods
      • Inelastic Demand
        • Price elasticity of demand between 0 and -1
      |% Change in Quantity Demanded| < |% Change in Price|
      • Extreme Case: Perfectly Inelastic Demand
        • Price elasticity of demand equal to 0
    • 7. Categorizing Goods by Elasticity
      • Elastic Demand
        • Price elasticity of demand with absolute value > 1
      |% Change in Quantity Demanded| > |% Change in Price|
      • Extreme Case: Perfectly (infinitely) Elastic Demand
        • Price elasticity of demand approaching minus infinity
      • Another Special Case: Unitary Elastic Demand
        • Price elasticity of demand equal to -1
    • 8. Figure 1: Extreme Cases of Demand D (b) D Perfectly Inelastic Demand (a) Quantity Price per Unit 1 2 3 4 20 40 60 80 100 Quantity 20 40 60 80 100 1 2 3 4 Price per Unit Perfectly Elastic Demand
    • 9. Figure 2: Relationship between demand slope and elasticity Quantity PRICE Perfectly elastic Perfectly inelastic Relatively Inelastic Demand Relatively Elastic Demand
    • 10. Elasticity and Total Revenue
      • Total revenue (TR) of all firms is defined as
          • TR = P x Q
      • Rule: when two numbers are both changing, percentage change in their product is (approximately) the sum of their individual percentage changes
        • Applying this to total revenue
      • Example: assume demand is unitary elastic and Q rises by 10%
        • % Change in TR = 10% + (-10%) = 0
    • 11. Figure 3(a): When does it pay to raise the price?
      • Price increases from P 0 to P 1 and quantity demanded decreases from Q 0 to Q 1
      Quantity PRICE Demand P 1 P 0 Q 1 Q 0
    • 12. Figure 3(b): When does it pay to raise the price?
      • How about revenue change?
      Quantity PRICE Demand P 1 P 0 Q 1 Q 0 Change in total revenue = P 1 Q 1 -P 0 Q 0
    • 13. Figure 3(c): When does it pay to raise the price?
      • How much is the change in total revenue?
      Quantity PRICE Demand P 1 P 0 Q 1 Q 0 Change in total revenue = P 1 Q 1 -P 0 Q 0 Loss = P 0 *(Q 0 - Q 1 ) = P 0 Δ Q Gain = Q 1 (P 1 – P 0 ) = Q 1 Δ P
    • 14. When does it pay to raise the price? SUPPOSE DEMAND IS INELASTIC SO THAT THE % CHANGE IN QUANTITY IS SMALLER THAN THE % CHANGE IN PRICE LOSS GAIN
    • 15. Figure 4 Effects of Price Changes on Expenditure
    • 16. Elasticity & Straight-Line Demand Curves
      • Look at percentage change in P
      • Look at percentage change in Q
      • As we move upward and leftward by equal distances, percentage change in quantity rises
        • Percentage change in price falls
      •  Elasticity of demand varies along a straight-line demand curve
        • Demand becomes more elastic as we move upward and leftward
    • 17. 1 2 3 D Quantity Price and since equal quantity decreases (horizontal arrows) are larger and larger percentage decreases . . . Since equal peso increases (vertical arrows) are smaller and smaller percentage increases . . . demand becomes more and more elastic as we move leftward and upward along a straight-line demand curve.
    • 18. PRICE QUANTITY As P increases, Q falls, elasticity gets bigger | E D | > 1 elastic | E D | = 1 Unit elastic | E D | < 1 inelastic 25 5
    • 19. Small Summary Inelastic Demand Unitary Elastic Demand Elastic Demand Definition |E D | <1 |E D | =1 |E D | >1 Total Revenue Same direction as price change Does not change with price change Opposite direction from price Straight Line Demand Curve Lower segment Middle point Upper segment
    • 20. What Affects Elasticity? -- 1. Availability of Substitutes
      • Demand is more elastic
        • If close substitutes are easy to find and buyers can cut back on purchases of the good in question
      • Demand is less elastic
        • If close substitutes are difficult to find and buyers can not cut back on purchases of the good in question
    • 21. What Affects Elasticity? -- 2. Narrowness of Market
      • More narrowly we define a good, easier it is to find substitutes
        • More elastic is demand for the good
      • More broadly we define a good
        • Harder it is to find substitutes and the less elastic is demand for the good
      • Different things are assumed constant when we use a narrow definition compared with a broader definition
    • 22. What Affects Elasticity? -- 3.Necessities vs. Luxuries
      • The more “necessary” we regard an item, the harder it is to find a substitute
        • Expect it to be less price elastic
      • The less “necessary” (luxurious) we regard an item, the easier it can be substituted
        • Expect it to be more price elastic
      • Example?
    • 23. What Affects Elasticity? -- 4. Time Horizon
      • Short-run elasticity
        • Measured a short time after a price change
      • Long-run elasticity
        • Measured a year or more after a price change
      • Usually easier to find substitutes for an item in the long run than in the short run
        • Therefore, demand tends to be more elastic in the long run than in the short run
    • 24. What Affects Elasticity? -- 5. Importance in the Buyer’s Budget
      • The more of their total budgets that households spend on an item
        • The more elastic is demand for that item
      • The less of their total budgets that households spend on an item
        • The less elastic is demand for that item
    • 25. Figure 6 Some Short-Run Price Elasticities of Demand inelastic elastic
    • 26. Using Price Elasticity of Demand -- Mass Transit
      • Elasticity studies show that long-run demand for mass transit is inelastic
        • Therefore, a rise in fare would increase revenues
        • Would also decrease ridership and require the city to sacrifice other goals
          • To provide low-income households with affordable transportation
          • To manage traffic congestion by enough ridership
          • To limit air pollution in the city
          •  most cities do not raise transit fares
    • 27. Income Elasticity of Demand
      • Percentage change in quantity demanded divided by the percentage change in income
        • With all other influences on demand with the price of the good kept constant
      • Interpretation: percentage increase in quantity demanded for each 1% rise in income
    • 28. Income Elasticity of Demand vs. Price Elasticity of Demand
      • Price elasticity measures sensitivity of demand to price as we move along a demand curve from one point to another
      • Income elasticity tells us relative shift in demand curve—increase in quantity demanded at a given price
      • While a price elasticity is virtually always negative, income elasticity can be positive or negative
        • Normal goods
        • Inferior goods
    • 29. Income Elasticity of Demand
      • Economic necessity
        • Good with an income elasticity of demand between 0 and 1
      • Economic luxury
        • Good with an income elasticity of demand greater than 1
      • An implication
        • As income rises, proportion of income spent on economic necessities will fall
          • While proportion of income spent on economic luxuries will rise
      • But, it is important to remember that economic necessities and luxuries are categorized by actual consumer behavior
        • Not by our judgment of a good’s importance to human survival
    • 30. Figure 9 Some Income Elasticities Luxury (>1), Necessity (0<E Y <1), Normal (>0) and Inferior (<0) Goods defined by Income elasticties
    • 31. Part 3: Cross-Price Elasticity of Demand
      • Cross-price elasticity of demand
        • Percentage change in quantity demanded of one good (x) caused by a 1% change in price of another good (z)
          • While all other influences on demand remain unchanged
      • Sign of
        • Substitutes (+)
        • Complements (-)
      • Its size tells us how closely the two goods are related
          • A large absolute value for suggests that the two goods are close substitutes or complements
    • 32. Figure 10 Some Cross-Price Elasticities Complements (-) vs Substitutes (+) defined by sign of cross price elasticity
    • 33. Price Elasticity of Supply
      • Percentage change in quantity of a good supplied that is caused by a 1% change in the price of the good
        • With all other influences on supply held constant
    • 34. What Affects Price Elasticity of Supply?
      • Supply will tend to be more elastic when suppliers can switch to producing alternate goods more easily
        • How easy? Depends on
          • Nature of the good itself
          • Narrowness of the market definition—especially geographic narrowness
          • Time horizon—longer we wait after a price change, greater the supply response to a price change
    • 35. Price Elasticity of Supply
      • Extreme cases of supply elasticity
        • Perfectly inelastic supply curve is a vertical line
          • Many markets display almost completely inelastic supply curves over very short periods of time
        • Perfectly elastic supply curve is a horizontal line
    • 36. : Extreme Cases of Supply S P 1 P 2 S (a) Quantity per Period Price per Unit (b) Quantity per Period Price per Unit Perfectly Inelastic Supply Perfectly Elastic Supply

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