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# Elasticity

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### Elasticity

1. 1. eStudy.us Elasticity and its Application copyright © michael .roberson@eStudy.us 2010, All rights reserved
2. 2. eStudy.us Price Elasticity of DemandPrice elasticity of demand measures how muchquantity demand responds to a change in pricemeasures the price sensitivity of consumersmeasures how willing consumers are to buy less of thegood as its price rises Percentage change in Qd %∆Qd Ed = = Percentage change in P %∆P copyright © michael .roberson@eStudy.us 2010, All rights reserved
3. 3. eStudy.us Price Elasticity of Demand P P rises by 10% P2 %∆Qd 20% = = 2 P1 %∆P 10% D Q2 Q1 Q Q falls by 20% P P rises by 10% P2 %∆Qd 5% = = .5 P1 %∆P 10% D Q2 Q1 Q Q falls by 5% copyright © michael .roberson@eStudy.us 2010, All rights reserved
4. 4. eStudy.us Price elasticity of demand Elastic demand - Quantity demanded responds substantially to changes in the price Ed 1 Ed 2 is Elastic Inelastic demand - Quantity demanded responds only slightly to changes in the price Ed 1 Ed .5 is Inelastic Unit elastics - Quantity demanded responds by the same as the change in the price Ed 1 copyright © michael .roberson@eStudy.us 2010, All rights reserved
5. 5. eStudy.us Midpoint FormulaMidpoint is the number halfway between the start& end values or the mean of those valuesUse the following information to calculate the priceelasticity of demand for hotel rooms:if P = \$7, Qd = 50if P = \$9, Qd = 30 copyright © michael .roberson@eStudy.us 2010, All rights reserved
6. 6. eStudy.us Midpoint Formula Use the following information to calculate the price elasticity of demand for hotel rooms: if P = \$7, Qd = 50 then changes to P = \$9, Qd = 30 q0 q1 50 30 q0 q1 50 30 20 % Qd 2 2 40 .50Ed 2 % P \$2 .25 p0 p1 \$7 \$9 \$8 p0 p1 \$7 \$9 2 2 copyright © michael .roberson@eStudy.us 2010, All rights reserved
7. 7. eStudy.us DeterminantsDeterminants of price elasticity of demand – Availability of close substitutes: goods with close substitutes are more elastic demand – Necessities vs. luxuries • Necessities are more inelastic demand • Luxuries are more elastic demand – Definition of the market • Narrowly defined markets are more elastic • Broadly defined market are more inelastic – Time horizon • More elastic over longer time horizons • More inelastic over shorter time horizons copyright © michael .roberson@eStudy.us 2010, All rights reserved
8. 8. eStudy.us DeterminantsDeterminants of price elasticity of demand – Availability of close substitutes ½ ton pick-up trucks (GM, Ford, Chrysler) + Toyota – Necessities vs. luxuries (Toyota vs. Mercedes) – Definition of the market (Transportation vs. Automobiles) – Time horizon (running car vs. broken car) copyright © michael .roberson@eStudy.us 2010, All rights reserved
9. 9. eStudy.us Elasticity of GasolineShort Run vs. Long Run elasticity of Gasoline When price doubles: – Tomorrow you will: Increasingly Elasticity Purchase about the same amount – With in the next few months you will: • Purchase a more fuel efficient car • Car pool – Over the next few years you may: • Move closer to work • Find a job closer to home copyright © michael .roberson@eStudy.us 2010, All rights reserved
10. 10. eStudy.us Elasticity of GasolineAvailable Gasoline Substitutes When price doubles: – and you live in the country: Increasingly Elasticity Purchase about the same amount – or you live in a small city: • Ride a bike • Car pool – or you live in a large city: • Car pool (HOV) • Train • Bus copyright © michael .roberson@eStudy.us 2010, All rights reserved
11. 11. eStudy.us Price Elasticity of DemandPrice elasticity of demand is closely related to theslope of the demand curve– the flatter the demand curve, the greater the elasticity– the steeper the demand curve, the lower the elasticity more elastic more inelastic P P P rises by 10% P rises by 10% P2 P2 P1 P1 D D Q2 Q1 Q Q2 Q1 Q Q falls by 20% Q falls by 5% copyright © michael .roberson@eStudy.us 2010, All rights reserved
12. 12. eStudy.us Other Demand Elasticities Price Demand― Demand is perfectly inelastic • Elasticity = 0 P1 1. an P0 • Demand curve – vertical • Increase in price leaves the quantity demanded unchanged 0 Q Quantity― Demand is perfectly elastic Price • Elasticity = infinity • Demand curve – horizontal P0 1. an • At P0 consumers will buy any quantity Demand 0 Quantity copyright © michael .roberson@eStudy.us 2010, All rights reserved
13. 13. eStudy.us Total revenue Total revenue (TR) - price of the good times the quantity sold The total amount paid by buyers, and received as revenue by sellers, equals the area of the Price box under the demand curve, P × Q. At price equal \$8, the quantity demanded is 100, and total revenue is \$800. \$8 TR P Q 1. an Demand \$800 \$8 100P \$800 0 100 Quantity Q copyright © michael .roberson@eStudy.us 2010, All rights reserved
14. 14. eStudy.us Demand Curve Elasticity of a linear demand curve Price \$7 Elastic E>1 6 5 4 1. an Inelastic 3 E<1 2 Demand 1 0 2 4 6 8 10 12 14 Quantity copyright © michael .roberson@eStudy.us 2010, All rights reserved
15. 15. eStudy.us Demand Curve Percentage Percentage Total revenue Change Change inPrice Quantity (Price ˣ Quantity) in Price Quantity Elasticity Description \$7 0 \$0 200% 15% = 13.0 Elastic 6 2 12 67% 18% 3.7 Elastic 5 4 20 40% 22% 1.8 Elastic 4 6 24 29% 29% 1.0 Unit elastic 3 8 24 22% 40% 0.6 Inelastic 2 10 20 18% 67% 0.3 Inelastic 1 12 12 15% 200% 0.1 Inelastic 0 14 0 copyright © michael .roberson@eStudy.us 2010, All rights reserved
16. 16. eStudy.us Demand CurveWhen demand is elastic: the fall in revenue from lowerquantity is greater than the increase in revenue fromhigher price, so revenue falls Elastic demand: An increase in price will decrease in total revenue Elastic demand: A decrease in price will increase in total revenue copyright © michael .roberson@eStudy.us 2010, All rights reserved
17. 17. eStudy.us Demand CurveWhen demand is inelastic, the fall in revenue fromlower quantity is smaller than the increase inrevenue from higher price, so total revenue rises Inelastic demand: An increase in price will increase in total revenue Inelastic demand: A decrease in price will decrease in total revenue copyright © michael .roberson@eStudy.us 2010, All rights reserved
18. 18. eStudy.us Drug InterdictionThe United States, Mexico, and most of South Americanhave been fighting the “Drug War” or several decades.This example illustrates two different interdictionmethod used during the fight.Assume the demand for illegal drugs is perfectlyinelastic, due to addiction copyright © michael .roberson@eStudy.us 2010, All rights reserved
19. 19. eStudy.us Supply InterdictionInterdiction Pricereduces the S1 D1supply of drugs.Since demand for P1 S0drugs is perfectlyinelastic, price risesResulting in an P0increase in totalspending on drugs,and in drug-related Drug Quantitycrime copyright © michael .roberson@eStudy.us 2010, All rights reserved
20. 20. eStudy.us Demand InterdictionEducation Pricereduces the D1 D0demand for S0drugs.Both price and P0quantity fall. P1Resulting in adecrease in totalspending ondrugs, and in Q1 Q0 Drug Quantitydrug-relatedcrime. copyright © michael .roberson@eStudy.us 2010, All rights reserved
21. 21. eStudy.us Income elasticity of demandIncome elasticity of demand: measures the responseof Qd to a change in consumer income %∆Qd EI = %∆ I ― For normal goods, income elasticity > 0 ― For inferior goods, income elasticity < 0Premium Cars %∆Qd 40% Normal Good EI = = = 4 %∆ I 10% Income Elastic copyright © michael .roberson@eStudy.us 2010, All rights reserved
22. 22. eStudy.us Cross-price elasticity of demandCross-price elasticity of demand: measures the responseof demand for one good to changes in the price ofanother good %∆Qx Ex/y = %∆Py— For substitutes, cross-price elasticity > 0 (increase in price of beef causes an increase in demand for chicken)― For complements, cross-price elasticity < 0 (an increase in price of jelly causes decrease in demand for peanut butter) copyright © michael .roberson@eStudy.us 2010, All rights reserved
23. 23. eStudy.us Price Elasticity of SupplyPrice elasticity of supply measures how muchquantity supplied, Qs, responds to a change in pricePrice elasticity of supply measures sellers’price-sensitivity. Percentage change in Qs %∆Qs Es = = Percentage change in P %∆P copyright © michael .roberson@eStudy.us 2010, All rights reserved
24. 24. eStudy.us Elasticity of SupplyPrice elasticity of supply – Elastic supply - Quantity supplied responds substantially to changes in the price • Elasticity >1 – Inelastic supply - Quantity supplied responds only slightly to changes in the price • Elasticity < 1 – Unit elastic supply - Quantity supplied responds only equally to changes in the price • Elasticity =1 copyright © michael .roberson@eStudy.us 2010, All rights reserved
25. 25. eStudy.us Price Elasticity of Supply P S P rises by 8% P1 16% P0 = 2.0 8% Which is elasticity Q Q0 Q 1 Q rises by 16% copyright © michael .roberson@eStudy.us 2010, All rights reserved
26. 26. eStudy.us Supply CurvesThe slope of the supply curve is closely related to priceelasticity of supply • The flatter the curve, the bigger the elasticity • The steeper the curve, the smaller the elasticity more elastic more inelastic P P S S P1 P1 P0 P0 Q0 Q1 Q Q0 Q1 Q copyright © michael .roberson@eStudy.us 2010, All rights reserved
27. 27. eStudy.us Elasticity of Supply― Perfectly Inelastic Supply Price Supply• Sellers’ are not price sensitive• Es=0 P1 P0 1. an• An increase in price leaved Qs unchanged 0 Q0 Quantity― Perfectly Elastic Supply Price• At exactly P0, producers will supply any quantity• Es=infinity P0 1. an Supply• Supply curve – horizontal 0 Quantity copyright © michael .roberson@eStudy.us 2010, All rights reserved
28. 28. eStudy.us Determinants of Supply Elasticity— The more easily sellers can change the quantity they produce, the greater the price elasticity of supply. Example: Supply of beachfront property is harder to vary and thus less elastic than supply of new cars.— Time period: For many goods, price elasticity of supply is greater in the long run than in the short run, because firms can build new factories, or new firms may be able to enter the market. Example: Supply of classrooms are generally fixed in the short run but school can build a new facility in time. copyright © michael .roberson@eStudy.us 2010, All rights reserved
29. 29. eStudy.us Good news for farmers?New hybrid of corn – increase production per acre • Supply curve shifts to the right • Higher production quantity leads to lower price • Demand is inelastic so total revenue falls Price 1. When demand is inelastic, an increase in supply. S0 S1 P0 3. A proportionately smaller P1 increase in quantity sold. As 2. Which leads a result, revenue falls. to a large fall in price. Demand 0 Q0 Q1 Quantity copyright © michael .roberson@eStudy.us 2010, All rights reserved
30. 30. eStudy.us A winning football teamYour football team trades for an all pro quarterback • Supply seats and the supply curve remain fixed • More wins leads to higher demand (higher attendance) • Inelastic supply leads to very high ticket prices Price Supply P1 1. an P0 D1 D0 0 Q0 Quantity copyright © michael .roberson@eStudy.us 2010, All rights reserved