Elasticity (1)

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Elasticity (1)

  1. 1. ELASTICITYElasticity is the concept economists use to describe the steepness or flatness of curves or functions.In general, elasticity measures the responsiveness of one variable to changes in another variable.Elasticity slide 1
  2. 2. PRICE ELASTICITY OF DEMANDMeasures the responsiveness of quantity demanded to changes in a good’s own price.The price elasticity of demand is the percent change in quantity demanded divided by the percent change in price that caused the change in quantity demanded.Elasticity slide 2
  3. 3. FACTS ABOUT ELASTICITYIt’s always a ratio of percentage changes.That means it is a pure number -- there are no units of measurement on elasticity.Price elasticity of demand is computed along a demand curve. Elasticity is not the same as slope.Elasticity slide 3
  4. 4. LOTS OF ELASTICITIES!THERE ARE LOTS OF WAYS TO COMPUTE ELASTICITIES. SO BEWARE! THE DEVIL IS IN THE DETAILS.MOST OF THE AMBIGUITY IS DUE TO THE MANY WAYS YOU CAN COMPUTE A PERCENTAGE CHANGE. BE ALERT HERE. IT’S NOT DIFFICULT, BUT CARE IS NEEDED.Elasticity slide 4
  5. 5. What’s the percent increase in price here because of the shift in supply? S price SpE = $2.50 pE = $2 D QE Q CIGARETTE MARKETElasticity slide 5
  6. 6. IS IT: A) [.5/2.00] times 100? B) [.5/2.50] times 100? C) [.5/2.25] times 100?Elasticity slide 6
  7. 7. From time to time economists have used ALL of these measures of percentage change -- including the “Something else”!Notice that the numerical values of the percentage change in price is different for each case: Go to hidden slideElasticity slide 7
  8. 8. A) [.5/2.00] times 100 = 25 percentB) [.5/2.50] times 100 = 20 percentC) [.5/2.25] times 100 = 22.22 percentElasticity slide 8
  9. 9. Economists usually use the “midpoint” formula (option C), above) to compute elasticity in cases like this in order to eliminate the ambiguity that arises if we don’t know whether price increased or decreased.Elasticity slide 9
  10. 10. Using the Midpoint Formula % change in Q Elasticity = % change in P % change in p = change in P times 100. average P ∆P ) × 100 % change in p = ( PMEAN For the prices $2 and $2.50, the % change in p is approx. 22.22 percent.Elasticity slide 10
  11. 11. What’s the percent change in Q due to the shift in supply? S price SpE’ = $2.50pE = $2.00 D QE’ = 7QE = 10 Q (millions) CIGARETTE MARKET Elasticity slide 11
  12. 12. Use the midpoint formula again. % change in Q Elasticity = % change in P change in Q % change in Q = average Q ∆Q % change in Q = ( ) × 100 Q MEAN For the quantities of 10 and 7, the % change in Q is approx. -35.3 percent. (3/8.5 times 100)Elasticity slide 12
  13. 13. NOW COMPUTE ELASTICITY % change in p = 22.22 percent % change in Q = -35.3 percent E = -35.3 / 22.22 = -1.6 (approx.)Elasticity slide 13
  14. 14. But you can do the other options as well: A) If you use the low price, and its corresponding quantity, as the base values, then elasticity = 1.2 B) If you use the high price, and its corresponding quantity, as the base values, then elasticity = 2.1 (approx.) C) And the midpoint formula gave 1.6 (approx.) SAME PROBLEM...DIFFERENT ANSWERS!!!Elasticity slide 14
  15. 15. MORE ELASTICITYQUANTITY PRICE P COMPUTATIONS 0 10 14 1 9 12 Compute elasticity between Compute elasticity between 2 8 10 prices of $9 and $8. prices of $9 and $8. 3 7 8 4 6 6 5 5 4 6 4 2 7 3 0 Q 8 2 0 2 4 6 8 10 12 14 9 1 10 0 Elasticity slide 15
  16. 16. USE THE MIDPOINT FORMULA. The % change in Q = The % change in P =Therefore elasticity = Go to hidden slide Elasticity slide 16
  17. 17. The % change in Q = 66.67 = 1 / 1.5 times 100 The % change in P = 11.76 = 1 / 8.5 times 100Therefore elasticity = -66.67 / 11.76 = -5.67 (approx.) Elasticity slide 17
  18. 18. QUANTITY PRICE P 14 So elasticity between these prices So elasticity between these prices 0 10 is -5.67. is -5.67. 12 1 9 2 8 10 3 7 8 4 6 6 5 5 4 6 4 2 7 3 0 Q 8 2 0 2 4 6 8 10 12 14 9 1 10 0 Elasticity slide 18
  19. 19. Now we try different pricesQUANTITY PRICE 0 10 P 1 9 14 2 8 12 Compute elasticity between Compute elasticity between 3 7 10 prices of $3 and $2. prices of $3 and $2. 4 6 8 6 5 5 4 6 4 2 7 3 Q 0 8 2 0 2 4 6 8 10 12 14 9 1 10 0 Elasticity slide 19
  20. 20. The % change in Q =The % change in P =Therefore elasticity = Go to hidden slideElasticity slide 20
  21. 21. The % change in Q = 13.33 = 1 / 7.5 times 100 The % change in P = 40 = 1 / 2.5 times 100Therefore elasticity = -13.33 / 40 = -.33 (approx.) Elasticity slide 21
  22. 22. QUANTITY PRICE P 14 0 10 12 1 9 10 So elasticity between these So elasticity between these 2 8 prices is -.33. 8 prices is -.33. 3 7 6 4 6 4 5 5 2 6 4 0 7 3 Q 0 2 4 6 8 10 12 14 8 2 9 1 10 0 Elasticity slide 22
  23. 23. ELASTICITY IS NOT SLOPE!QUANTITY PRICE P Note that elasticity is different Note that elasticity is different 0 10 14 at the two points even though at the two points even though 1 9 12 the slope is the same. the slope is the same. (Slope = -1) (Slope = -1) 2 8 10 3 7 8 E = -5.67 4 6 6 E = -.33 5 5 4 6 4 2 7 3 0 Q 8 2 0 2 4 6 8 10 12 14 9 1 10 0 Elasticity slide 23
  24. 24. TERMS TO LEARNDemand is ELASTIC when the numerical value of elasticity is greater than 1.Demand is INELASTIC when the numerical value of elasticity is less than 1.Demand is UNIT ELASTIC when the numerical value of elasticity equals 1.NOTE: Numerical value here means “absolute value.”Elasticity slide 24
  25. 25. LIKE THIS!QUANTITY PRICE P 14 0 10 12 1 9 Demand is elastic here. 10 Demand is elastic here. 2 8 8 3 7 6 Demand is inelastic here. Demand is inelastic here. 4 6 4 5 5 2 6 4 0 Q 7 3 0 2 4 6 8 10 12 14 8 2 9 1 10 0 Elasticity slide 25
  26. 26. There is an important relationship between what happens to consumers’ spending on a good and elasticity when there is a change in price.Spending on a good = P Q.Because demand curves are negatively sloped, a reduction in P causes Q to rise and the net effect on PQ is uncertain, and depends on the elasticity of demand.Elasticity slide 26
  27. 27. At P = $9, spending is $9 (= 1 times $9). At P = $8, spending is $16 ( = 2 times $8). When price fell from $9 to $8, spending rose. Q mustQUANTITY PRICE haveincreased by a larger percent than P decreased. So... 0 10 P 1 9 14 2 8 12 3 7 10 Demand is elastic here. Demand is elastic here. 4 6 8 5 5 6 6 4 4 7 3 2 8 2 0 Q 9 1 0 2 4 6 8 10 12 14 10 0 Elasticity slide 27
  28. 28. At P = $3, spending is $21 (= 7 times $3). At P = $2, spending is $16 ( = 8 times $2). When price fell from $3 to $2, spending fell. Q must have increased by a smaller percent than P decreased. So...QUANTITY PRICE P 0 10 14 1 9 12 2 8 10 3 7 8 4 6 Demand is inelastic here. Demand is inelastic here. 6 5 5 4 6 4 2 7 3 0 8 2 Q 0 2 4 6 8 10 12 14 9 1 10 0 Elasticity slide 28
  29. 29. There is an easy way to tell whether demand is elastic or inelastic between any two prices.If, when price falls, total spending increases, demand is elastic.If, when price falls, total spending decreases, demand is inelastic.Elasticity slide 29
  30. 30. But total spending is easy to see using a demand curve graph: PQUANTITY PRICE 14 0 10 12 The shaded area is P times Q, 1 9 The shaded area is P times Q, 2 8 10 or total spending when P = $9. or total spending when P = $9. 8 3 7 4 6 6 5 5 4 6 4 2 7 3 0 Q 0 2 4 6 8 10 12 14 8 2 9 1 10 0 Elasticity slide 30
  31. 31. P 14QUANTITY PRICE 12 The shaded area is P times Q The shaded area is P times Q or total spending when P = $8. or total spending when P = $8. 0 10 10 1 9 8 2 8 6 3 7 4 4 6 2 5 5 0 Q 6 4 0 2 4 6 8 10 12 14 7 3 8 2 9 1 10 0 Elasticity slide 31
  32. 32. = loss in TR = gain in TR due to due to fall in P rise in Q P 14 Total spending is higher at the priceQUANTITY PRICE Total spending is higher at the price 12 of $8 than it was at the price of $9. of $8 than it was at the price of $9. 0 10 10 1 9 8 2 8 6 3 7 4 4 6 5 5 2 6 4 0 Q 0 2 4 6 8 10 12 14 7 3 8 2 9 1 10 0 Elasticity slide 32
  33. 33. P 14QUANTITY PRICE The shaded area is total The shaded area is total 0 10 12 spending (total revenue of spending (total revenue of 1 9 10 sellers) when P = $3. sellers) when P = $3. 2 8 8 3 7 6 4 6 4 5 5 2 6 4 7 3 0 0 2 4 6 8 10 12 14 Q 8 2 9 1 10 0 Elasticity slide 33
  34. 34. PQUANTITY PRICE 14 0 10 12 Total revenue of sellers (total Total revenue of sellers (total 1 9 10 spending by buyers) falls when spending by buyers) falls when 2 8 price falls from $3 to $2. price falls from $3 to $2. 8 3 7 6 4 6 4 5 5 6 4 2 7 3 0 Q 8 2 0 2 4 6 8 10 12 14 9 1 10 0 Elasticity slide 34
  35. 35. Here’s a convenient way to think of the relative elasticity of demand curves. p relatively more elastic relatively more elastic at p* at p*p* relatively more inelastic relatively more inelastic at p* at p* Q Q*Elasticity slide 35
  36. 36. Examples of elasticity Doctors through the AMA restrict the supply of physicians. How does this affect the incomes of doctors as a group? A labor union negotiates a higher wage. How does this affect the incomes of affected workers as a group? MSU decides to raise the price of football tickets. How is income from the sale of tickets affected? Airlines propose to raise fares by 10%. Will the boost increase revenues?Elasticity slide 36
  37. 37. MORE ...MSU is considering raising tuition by 7%. Will the increase in tuition raise revenues of MSU?CATA recently raised bus fares in the Lansing area. Will this increase CATA’s total receipts?Elasticity slide 37
  38. 38. The answers to all of these questions depend on the elasticity of demand for the good in question. Be sure you understand how and why!Elasticity slide 38
  39. 39. DETERMINANTS OF DEMAND ELASTICITYThe more substitutes there are available for a good, the more elastic the demand for it will tend to be. [Related to the idea of necessities and luxuries. Necessities tend to have few substitutes.]The longer the time period involved, the more elastic the demand will tend to be.The higher the fraction of income spent on the good, the more elastic the demand will tend to be.Elasticity slide 39
  40. 40. OTHER ELASTICITY MEASURESIn principle, you can compute the elasticity between any two variables. Income elasticity of demand Cross price elasticity of demand Elasticity of supplyElasticity slide 40
  41. 41. Each of these concepts has the expected definition. For example, income elasticity of demand is the percent change in quantity demand divided by a percent change income: % change in QEINCOME = % change in IIncome elasticity of demand will be positive for normal goods, negative for inferior ones.Elasticity slide 41

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