Elasticity and Its Application                                                                                            ...
The Elasticity of Demand    • Elasticity           – Measure of the responsiveness of quantity             demanded or qua...
The Elasticity of Demand    • Price elasticity of demand           – Percentage change in quantity demanded             di...
The Elasticity of Demand    • Determinants of price elasticity of demand           – Availability of close substitutes    ...
The Elasticity of Demand    • Determinants of price elasticity of demand           – Definition of the market             ...
The Elasticity of Demand    • Computing the price elasticity of demand           – Percentage change in quantity demanded ...
The Elasticity of Demand    • Variety of demand curves           – Demand is elastic                   • Price elasticity ...
The Elasticity of Demand    • Variety of demand curves           – Demand is perfectly inelastic                   • Price...
Figure 1The Price Elasticity of Demand (a, b)          (a) Perfectly Inelastic Demand:                                    ...
Figure 1The Price Elasticity of Demand (c)                                      (c) Unit Elastic Demand: Elasticity       ...
Figure 1 The Price Elasticity of Demand (d, e) (d) Elastic demand:                                                    (e) ...
Demand Elasticity and Revenue    • Total revenue, TR           – Amount paid by buyers and received by             sellers...
Figure 2Total Revenue             Price                        $4             P                                           ...
Figure 3How Total Revenue Changes When Price Changes (a) The case of inelastic demand                                     ...
Income Elasticity of Demand    • Income elasticity of demand           – How much the quantity demanded of a             g...
Income Elasticity of Demand    • Normal goods           – Positive income elasticity           – Necessities              ...
Cross-Price Elasticity of Demand    • Cross-price elasticity of demand           – How much the quantity demanded of one  ...
The Elasticity of Demand    • Substitutes           – Goods typically used in place of one             another           –...
The Elasticity of Supply    • Price elasticity of supply           – How much the quantity supplied of a good             ...
Applications    • Which of the following insurance policies      has the highest price elasticity of      demand?         ...
Applications: Economics is everywhere    • Now you should be able to understand…           – Why some people pay more than...
Applications: Economics is Everywhere    • How would Omaha Steaks perform during      a recession as compared to McDonald’...
The Elasticity of Supply    • Elastic supply           – Quantity supplied responds substantially             to changes i...
The Elasticity of Supply    • Computing price elasticity of supply           – Percentage change in quantity supplied     ...
The Elasticity of Supply    • Variety of supply curves           – Supply is unit elastic                   • Price elasti...
The Elasticity of Supply    • Variety of supply curves           – Supply is perfectly inelastic                   • Price...
Figure 5The Price Elasticity of Supply (a, b)         (a) Perfectly Inelastic Supply:                                     ...
Figure 5The Price Elasticity of Supply (c)                                    (c) Unit Elastic Supply: Elasticity Equals 1...
Figure 5The Price Elasticity of Supply (d, e)          (d) Elastic Supply: Elasticity Is                                 (...
Applications    • Why Did OPEC Fail to Keep the Price of      Oil High?           – Increase in prices 1973-1974, 1971-198...
Figure 8A Reduction in Supply in the World Market for Oil    (a) The Oil Market in the Short Run                          ...
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Ch05

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Ch05

  1. 1. Elasticity and Its Application PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 1permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  2. 2. The Elasticity of Demand • Elasticity – Measure of the responsiveness of quantity demanded or quantity supplied – To a change in one of its determinants • Price elasticity of demand – How much the quantity demanded of a good – Responds to a change in the price of that good© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 2permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  3. 3. The Elasticity of Demand • Price elasticity of demand – Percentage change in quantity demanded divided by the percentage change in price • Elastic demand – Quantity demanded responds substantially to changes in price • Inelastic demand – Quantity demanded responds only slightly to changes in price© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 3permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  4. 4. The Elasticity of Demand • Determinants of price elasticity of demand – Availability of close substitutes • Goods with close substitutes – more elastic demand – Necessities vs. luxuries • Necessities – inelastic demand • Luxuries – elastic demand© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 4permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  5. 5. The Elasticity of Demand • Determinants of price elasticity of demand – Definition of the market • Narrowly defined markets – more elastic demand – Time horizon • Demand is more elastic over longer time horizons© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 5permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  6. 6. The Elasticity of Demand • Computing the price elasticity of demand – Percentage change in quantity demanded divided by percentage change in price – Use absolute value (drop the minus sign) • Midpoint method – Two points: (Q1, P1) and (Q2, P2) (Q2 − Q1 )/[(Q2 + Q1 )/ 2 ] Price elasticity of demand = (P2 − P )/[(P2 + P )/ 2 ] 1 1© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 6permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  7. 7. The Elasticity of Demand • Variety of demand curves – Demand is elastic • Price elasticity of demand > 1 – Demand is inelastic • Price elasticity of demand < 1 – Demand has unit elasticity • Price elasticity of demand = 1© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 7permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  8. 8. The Elasticity of Demand • Variety of demand curves – Demand is perfectly inelastic • Price elasticity of demand = 0 • Demand curve is vertical – Demand is perfectly elastic • Price elasticity of demand = infinity • Demand curve is horizontal • The flatter the demand curve – The greater the price elasticity of demand – But elasticity is NOT just the slope, but also the position on the curve© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 8permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  9. 9. Figure 1The Price Elasticity of Demand (a, b) (a) Perfectly Inelastic Demand: (b) Inelastic Demand: Elasticity Is Elasticity Equals 0 Less Than 1 Price Price 1. An Demand 1. A 22% 2. … leads increase in to an 11% increase price… decrease in in price… quantity $5 $5 demanded 4 4 2. …leaves the quantity Demand demanded unchanged 0 100 0 90 100 Quantity Quantity The price elasticity of demand determines whether the demand curve is steep or flat. Note that all percentage changes are calculated using the midpoint method.© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 9permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  10. 10. Figure 1The Price Elasticity of Demand (c) (c) Unit Elastic Demand: Elasticity Equals 1 Price Demand $51. A 22% 4increasein price… 2. … leads to a 22% decrease in quantity demanded 0 80 100 Quantity The price elasticity of demand determines whether the demand curve is steep or flat. Note that all percentage changes are calculated using the midpoint method.© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 10permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  11. 11. Figure 1 The Price Elasticity of Demand (d, e) (d) Elastic demand: (e) Perfectly elastic demand: Elasticity > 1 Elasticity equals infinity Price Price 1. At any price A 22% above $4, quantity increase demanded is zero 2. At exactly $4, in price… consumers will $5 buy any quantity 4 Demand $4 Demand 2. … leads to a 3. At a price 67% decrease below $4, quantity in quantity demanded demanded is infinite 0 50 100 0 Quantity Quantity The price elasticity of demand determines whether the demand curve is steep or flat. Note that all percentage changes are calculated using the midpoint method.© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 11permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  12. 12. Demand Elasticity and Revenue • Total revenue, TR – Amount paid by buyers and received by sellers of a good – Price of the good times the quantity sold (P ˣ Q) • For a price increase – If demand is inelastic, TR increases – If demand is elastic, TR decreases© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 12permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  13. 13. Figure 2Total Revenue Price $4 P Demand 0 100 Quantity Q The total amount paid by buyers, and received as revenue by sellers, equals the area of the box under the demand curve, P × Q. Here, at a price of $4, the quantity demanded is 100, and total revenue is $400.© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 13permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  14. 14. Figure 3How Total Revenue Changes When Price Changes (a) The case of inelastic demand (b) The case of elastic demand Price Price $5 $5 A A 4 4 Demand Demand B B 0 90 100 Quantity 0 70 100 Quantity The impact of a price change on total revenue (the product of price and quantity) depends on the elasticity of demand. In panel (a), the demand curve is inelastic. In this case, an increase in the price leads to a decrease in quantity demanded that is proportionately smaller, so total revenue increases. Here an increase in the price from $4 to $5 causes the quantity demanded to fall from 100 to 90. Total revenue rises from $400 to $450. In panel (b), the demand curve is elastic. In this case, an increase in the price leads to a decrease in quantity demanded that is proportionately larger, so total revenue decreases. Here an increase in the price from $4 to $5 causes the quantity demanded to fall from 100 to 70. Total revenue falls from $400 to $350.© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 14permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  15. 15. Income Elasticity of Demand • Income elasticity of demand – How much the quantity demanded of a good responds to a change in consumers’ income – Percentage change in quantity demanded • Divided by the percentage change in income© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 15permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  16. 16. Income Elasticity of Demand • Normal goods – Positive income elasticity – Necessities • Smaller income elasticities – Luxuries • Large income elasticities • Inferior goods – Negative income elasticities© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 16permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  17. 17. Cross-Price Elasticity of Demand • Cross-price elasticity of demand – How much the quantity demanded of one good responds to a change in the price of another good – Percentage change in quantity demanded of the first good • Divided by the percentage change in price of the second good© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 17permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  18. 18. The Elasticity of Demand • Substitutes – Goods typically used in place of one another – Positive cross-price elasticity • Complements – Goods that are typically used together – Negative cross-price elasticity© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 18permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  19. 19. The Elasticity of Supply • Price elasticity of supply – How much the quantity supplied of a good responds to a change in the price of that good – Percentage change in quantity supplied • Divided by the percentage change in price – Depends on the flexibility of sellers to change the amount of the good they produce© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 19permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  20. 20. Applications • Which of the following insurance policies has the highest price elasticity of demand? A. Home insurance B. Auto insurance – liability only C. Auto insurance – comprehensive D. Auto insurance underwritten by Bonilla Insurance Group© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 20permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  21. 21. Applications: Economics is everywhere • Now you should be able to understand… – Why some people pay more than others for the same flight on a plane – Why restaurants give senior discounts – Why some businesses give out coupons to customers – Why some gas stations charge higher prices than others – Why no two students pay the same amount for the same degree – Who pays a higher price?© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 21permitted in a
  22. 22. Applications: Economics is Everywhere • How would Omaha Steaks perform during a recession as compared to McDonald’s? • Why did the “second Texas oil boom” begin in 2008 (not 650 million years ago)?© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 22permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  23. 23. The Elasticity of Supply • Elastic supply – Quantity supplied responds substantially to changes in the price • Inelastic supply – Quantity supplied responds only slightly to changes in the price • Determinant of price elasticity of supply – Time period • Supply is more elastic in long run© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 23permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  24. 24. The Elasticity of Supply • Computing price elasticity of supply – Percentage change in quantity supplied divided by percentage change in price – Always positive • Midpoint method – Two points: (Q1, P1) and (Q2, P2) (Q2 − Q1 ) / [(Q2 + Q1 ) / 2 ] Price elasticity of supply = (P2 − P ) / [(P2 + P ) / 2 ] 1 1© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 24permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  25. 25. The Elasticity of Supply • Variety of supply curves – Supply is unit elastic • Price elasticity of supply = 1 – Supply is elastic • Price elasticity of supply > 1 – Supply is inelastic • Price elasticity of supply < 1© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 25permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  26. 26. The Elasticity of Supply • Variety of supply curves – Supply is perfectly inelastic • Price elasticity of supply = 0 • Supply curve – vertical – Supply is perfectly elastic • Price elasticity of supply = infinity • Supply curve – horizontal© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 26permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  27. 27. Figure 5The Price Elasticity of Supply (a, b) (a) Perfectly Inelastic Supply: (b) Inelastic Supply: Elasticity Is Elasticity Equals 0 Less Than 1 Price Price 1. An Supply 1. A 22% Supply increase increase in price… in price… $5 $5 2. … leads to 4 2. …leaves 4 a 10% increase the quantity in quantity supplied supplied unchanged 0 100 0 100 110 Quantity Quantity The price elasticity of supply determines whether the supply curve is steep or flat. Note that all percentage changes are calculated using the midpoint method.© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 27permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  28. 28. Figure 5The Price Elasticity of Supply (c) (c) Unit Elastic Supply: Elasticity Equals 1 Price 1. A 22% Supply increase in price… $5 4 2. … leads to a 22% increase in quantity supplied 0 100 125 Quantity The price elasticity of supply determines whether the supply curve is steep or flat. Note that all percentage changes are calculated using the midpoint method.© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 28permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  29. 29. Figure 5The Price Elasticity of Supply (d, e) (d) Elastic Supply: Elasticity Is (e) Perfectly Elastic Supply: Greater Than 1 Elasticity Equals Infinity Price Price 1. At any 1. A 22% price above increase $4, quantity 2. At exactly $4, Supply supplied is in price… producers will infinite $5 supply any quantity 4 2. … leads to $4 Supply a 67% increase 3. At any price in quantity below $4, quantity supplied supplied is zero 0 100 50 0 Quantity Quantity The price elasticity of supply determines whether the supply curve is steep or flat. Note that all percentage changes are calculated using the midpoint method.© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 29permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  30. 30. Applications • Why Did OPEC Fail to Keep the Price of Oil High? – Increase in prices 1973-1974, 1971-1981 – Short-run: supply and demand are inelastic • Decrease in supply: large increase in price – Long-run: supply and demand are elastic • Decrease in supply: small increase in price© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 30permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  31. 31. Figure 8A Reduction in Supply in the World Market for Oil (a) The Oil Market in the Short Run (b) The Oil Market in the Long Run 1. In the short run, when supply 1. In the long run, when supply and demand are inelastic, a shift and demand are elastic, a shift Price Price in supply. . . in supply. . . S2 2. … leads S1 to a small S2 S1 P2 increase in price 2. … leads to P2 P1 a large P1 increase in price Demand Demand 0 Quantity 0 Quantity When the supply of oil falls, the response depends on the time horizon. In the short run, supply and demand are relatively inelastic, as in panel (a). Thus, when the supply curve shifts from S1 to S2, the price rises substantially. By contrast, in the long run, supply and demand are relatively elastic, as in panel (b). In this case, the same size shift in the supply curve (S1 to S2) causes a smaller increase in the price.© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 31permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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