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03 elasticity

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03 elasticity

  1. 1. BellringerBellringer Which of the following goods do you think theWhich of the following goods do you think the government would be most likely to be concernedgovernment would be most likely to be concerned its price and why?its price and why? Mankiw Chapter 5 - Elasticity
  2. 2. Reminder: Article nextReminder: Article next weekweek start of class, topics: ???start of class, topics: ???
  3. 3. ElasticElastic  Elastic DemandElastic Demand  Very responsiveVery responsive to price changeto price change  Most normalMost normal goodsgoods  Rare purchasesRare purchases  Big budgetBig budget  Many substitutesMany substitutes  Why important toWhy important to think about as athink about as a firm?firm? Price/month Quantity D-nice apartments 1000 500 100 1000 5000 10,000
  4. 4. InelasticInelastic  Inelastic DemandInelastic Demand  Not responsive toNot responsive to price changeprice change  Few substitutesFew substitutes  Small part of budgetSmall part of budget  Most goods, close toMost goods, close to needsneeds  Ex: lifesaversEx: lifesavers  Why doesWhy does government oftengovernment often control prices ofcontrol prices of inelastic goods?inelastic goods?  Illegal drugs?Illegal drugs? Price/dose Quantity D-dialysis100 1 2 3 200 300 400 500 600 700
  5. 5. In RealityIn Reality A B C
  6. 6. 7 EXAMPLE 1:EXAMPLE 1: Breakfast cereal vs. SunscreenBreakfast cereal vs. Sunscreen  The prices of both of these goods rise by 20%.The prices of both of these goods rise by 20%. For which good doesFor which good does QQdd drop the most? Why?drop the most? Why?  Breakfast cereal has close substitutesBreakfast cereal has close substitutes ((e.ge.g., pancakes, waffles, leftover pizza),., pancakes, waffles, leftover pizza), so buyers can easily switch if the price rises.so buyers can easily switch if the price rises.  Sunscreen has no close substitutes,Sunscreen has no close substitutes, so consumers would probably notso consumers would probably not buy much less if its price rises.buy much less if its price rises.  Lesson:Lesson: Price elasticity is higher when close substitutes are available.
  7. 7. 8 EXAMPLE 2:EXAMPLE 2: “Blue Jeans” vs.“Blue Jeans” vs. “Clothing”“Clothing” The prices of both goods rise by 20%.The prices of both goods rise by 20%. For which good doesFor which good does QQdd drop the most? Why?drop the most? Why?  For a narrowly defined good such asFor a narrowly defined good such as blue jeans, there are many substitutesblue jeans, there are many substitutes (khakis, shorts, Speedos).(khakis, shorts, Speedos).  There are fewer substitutes available forThere are fewer substitutes available for broadly defined goods.broadly defined goods. (There aren’t too many substitutes for clothing,(There aren’t too many substitutes for clothing, other than living in a nudist colony.)other than living in a nudist colony.)  Lesson:Lesson: Price elasticity is higher for narrowlyPrice elasticity is higher for narrowly defined goods than broadly defined ones.defined goods than broadly defined ones.
  8. 8. 9 EXAMPLE 3:EXAMPLE 3: Insulin vs. CaribbeanInsulin vs. Caribbean CruisesCruises The prices of both of these goods rise by 20%.The prices of both of these goods rise by 20%. For which good doesFor which good does QQdd drop the most? Why?drop the most? Why?  To millions of diabetics, insulin is a necessity.To millions of diabetics, insulin is a necessity. A rise in its price would cause little or noA rise in its price would cause little or no decrease in demand.decrease in demand.  A cruise is a luxury. If the price rises,A cruise is a luxury. If the price rises, some people will forego it.some people will forego it.  Lesson:Lesson: Price elasticity is higher forPrice elasticity is higher for luxuries than for necessities.luxuries than for necessities.
  9. 9. 10 How to calculate Price Elasticity ofHow to calculate Price Elasticity of DemandDemand  Price elasticity of demandPrice elasticity of demand measuresmeasures how muchhow much QQdd responds to a change inresponds to a change in PP.. Price elasticity of demand = Percentage change in Qd Percentage change in P  Loosely speaking, it measures the price- sensitivity of buyers’ demand.
  10. 10. Price Elasticity ofPrice Elasticity of DemandDemand Price elasticityPrice elasticity of demandof demand equalsequals P Q D Q2 P2 P1 Q1 P rises by 10% Q falls by 15% 15% 10% = 1.5 Price elasticity of demand = Percentage change in Qd Percentage change in P Example:
  11. 11. Price Elasticity ofPrice Elasticity of DemandDemand Along a D curve, P and Q move in opposite directions, which would make price elasticity negative. We will drop the minus sign and report all price elasticities as positive numbers. Along a D curve, P and Q move in opposite directions, which would make price elasticity negative. We will drop the minus sign and report all price elasticities as positive numbers. P Q D Q2 P2 P1 Q1 Price elasticity of demand = Percentage change in Qd Percentage change in P
  12. 12. Calculating PercentageCalculating Percentage Changes %Changes % P Q D $250 8 B $200 12 A Demand for iphones Standard method of computing the percentage (%) change: end value – start value start value x 100% Going from A to B, the % change in P equals ($250–$200)/$200 = 25% New – Old Old x 100%
  13. 13. Calculating PercentageCalculating Percentage ChangesChanges D $250 8 B $200 12 A Demand for iphones Problem: The standard method gives different answers depending on where you start. From A to B, P rises 25%, Q falls 33%, elasticity = 33/25 = 1.33 From B to A, P falls 20%, Q rises 50%, elasticity = 50/20 = 2.50 P Q
  14. 14. Calculating PercentageCalculating Percentage ChangesChanges So, we instead use theSo, we instead use the midpoint methodmidpoint method:: end value – start value midpoint x 100%  The midpoint is the number halfway between the start & end values, the average of those values.  It doesn’t matter which value you use as the “start” and which as the “end” – you get the same answer either way!
  15. 15. Calculating Percentage Changes  Using the midpoint method, the % changeUsing the midpoint method, the % change inin PP equalsequals $250 – $200 $225 x 100% = 22.2%  The % change in Q equals 12 – 8 10 x 100% = 40.0%  The price elasticity of demand equals 40/22.2 = 1.8
  16. 16. A C T I V E L E A R N I N GA C T I V E L E A R N I N G 11 Calculate an elasticityCalculate an elasticity Use the following information to calculate the price elasticity of demand for hotel rooms: if P = $70, Qd = 5000 if P = $90, Qd = 3000
  17. 17. A C T I V E L E A R N I N GA C T I V E L E A R N I N G 11 AnswersAnswers Use midpoint method to calculate % change in Qd (5000 – 3000)/4000 = 50% % change in P ($90 – $70)/$80 = 25% The price elasticity of demand equals 50% 25% = 2.0
  18. 18. SummarySummary
  19. 19. Q1 P1 D ““Perfectly inelastic demand”Perfectly inelastic demand” (one extreme case)(one extreme case) P Q P2 P falls by 10% Q changes by 0% 0% 10% = 0 Price elasticity of demand = % change in Q % change in P = Consumers’ price sensitivity: D curve: Elasticity: vertical none 0
  20. 20. D ““Inelastic demand”Inelastic demand” P Q Q1 P1 Q2 P2 Q rises less than 10% < 10% 10% < 1 Price elasticity of demand = % change in Q % change in P = P falls by 10% Consumers’ price sensitivity: D curve: Elasticity: relatively steep relatively low < 1
  21. 21. D ““Unit elastic demand”Unit elastic demand” P Q Q1 P1 Q2 P2 Q rises by 10% 10% 10% = 1 Price elasticity of demand = % change in Q % change in P = P falls by 10% Consumers’ price sensitivity: Elasticity: intermediate 1 D curve: intermediate slope
  22. 22. D ““Elastic demand”Elastic demand” P Q Q1 P1 Q2 P2 Q rises more than 10% > 10% 10% > 1 Price elasticity of demand = % change in Q % change in P = P falls by 10% Consumers’ price sensitivity: D curve: Elasticity: relatively flat relatively high > 1
  23. 23. D ““Perfectly elastic demand”Perfectly elastic demand” P Q P1 Q1 P changes by 0% Q changes by any % any % 0% = infinity Q2 P2 = Consumers’ price sensitivity: D curve: Elasticity: infinity horizontal extreme Price elasticity of demand = % change in Q % change in P =
  24. 24. One Final Test ofOne Final Test of elasticityelasticity  Revenue TestRevenue Test  TR = Price X QdTR = Price X Qd  If in Price causes an Total Revenue then D is inelastic (consumers don’t change Qd)  If in Price causes in Total Revenue then D is elastic (consumers do change Qd)
  25. 25. elastic inelastic EX 1 EX 2
  26. 26. Summarize

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