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Lecture 3

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Lecture 3

  1. 1. Chapter ThreeMore on demand: elasticities
  2. 2. Elasticity Learning Objectives• What is the best way of measuring the responsiveness of demand?• What is the best way of measuring the responsiveness of supply?
  3. 3. 1. THE PRICE ELASTICITY OF DEMANDLearning Objectives2. Explain the concept of price elasticity of demand and its calculation.3. Explain what it means for demand to be price inelastic, unit price elastic, price elastic, perfectly price inelastic, and perfectly price elastic.4. Explain how and why the value of the price elasticity of demand changes along a linear demand curve.5. Understand the relationship between total revenue and price elasticity of demand.6. Discuss the determinants of price elasticity of demand.
  4. 4. Elasticity• The elasticity of demand is the percentage decrease in quantity that results from a small percentage increase in price.• Represented by the Greek letter Epsilon ε• A one-percent increase in price will increase total revenue when the elasticity of demand is less than one – defined as an inelastic demand• A price increase will decrease total revenue when the elasticity of demand is greater than one is defined as an elastic demand
  5. 5. Elasticity• The price elasticity of demand is the percentage change in quantity demanded of a particular good or service divided by the percentage change in the price of that good or service, all other things unchanged. eD = % change in quantity demanded % change in price
  6. 6. 1.1 Computing the Price Elasticity of Demand• arc elasticity is a measure of elasticity based on percentage changes relative to the average value of each variable between two points. ∆Q / Q EQUATION 1.2 eD = ∆P / P
  7. 7. Movement from Point A to B (or B to A)A shows that a $.10 change in price changes the number of rides per day by B 20,000.
  8. 8. Figure 3.1. Elasticities for Linear Demand
  9. 9. 1.3 The Price Elasticity of Demand and Changes in Total Revenue• Total Revenue (TR=P*Q) is a firm’s output multiplied by the price at which it sells that output.• Price elastic refers to a situation in which the absolute value of the price elasticity of demand is greater than 1.• Unit price elastic refers to a situation in which the absolute value of the price elasticity of demand is equal to 1.• Price inelastic refers to a situation in which the absolute value of the price of elasticity of demand is less than 1.
  10. 10. Changes in Total Revenue and a Linear Demand Curve Elastic Region A Unit elastic B Inelastic Region E F
  11. 11. Price ElasticAn increase in price ... reduces total revenue.A reduction in price... Increases total revenue. Total revenue moves in the direction of the quantity change. Price InelasticAn increase in price… Increases total revenue.A reduction in price… Reduces total revenue. Total revenue moves in the direction of the price change. Unit price ElasticAn increase in price… No change in total revenue.A reduction in price… No change in total revenue. Total revenue does not change as price changes.
  12. 12. 1.4 Constant Price Elasticity of Demand Curves• Perfectly inelastic (insensitive to price changes) refers to a situation in which the price elasticity of demand is zero.• Perfectly elastic (sensitive to price changes) refers to a situation in which the price elasticity of demand is infinite.
  13. 13. Constant Elasticity Examples
  14. 14. 1.5 Determinants of the Price Elasticity of Demand• Availability of substitutes – If there are lots of close substitute goods to choose from consumers can switch easily• Importance in household budgets – Price of good relative to income• Time – In the short run it is often difficult to find substitutes.
  15. 15. 2. RESPONSIVENESS OF DEMAND TO OTHER FACTORSLearning Objectives2. Explain the concept of income elasticity of demand and its calculation.3. Classify goods as normal or inferior depending on their income elasticity of demand.4. Explain the concept of cross price elasticity of demand and its calculation.5. Classify goods as substitutes or complements depending on their cross price elasticity of demand.
  16. 16. 2.1 Income Elasticity of Demand• Income elasticity of demand is the percentage change in quantity demanded at a specific price divided by the percentage change in income that produced the demand change, all other things unchanged. EQUATION 2.1 % change in quantity demanded eY = % change in income
  17. 17. 2.1 Income Elasticity of Demand Normal Good (e.g. DVD’s) An increase in income… Increases demand. A decrease in income… Decreases demand. Inferior Good (e.g. used clothing) An increase in income… Decreases demand. A decrease in income… Increases demand.
  18. 18. 2.2 Cross Price Elasticity of Demand• Cross price elasticity of demand is the percentage change in the quantity demanded of one good or service at a specific price divided by the percentage change in the price of a related good or service. EQUATION 2.2 % change in quantity demanded of good A e A, B = % change in price of good B
  19. 19. 2.2 Cross Price Elasticity of Demand Normal Good (e.g. DVD’s) An increase in PB… Increases demand for good A. A decrease in PB… Decreases demand for good A. Inferior Good (e.g. used clothing) An increase in PB… Decreases demand for good A. A decrease in PB… Increases demand for good A.
  20. 20. 3. PRICE ELASTICITY OF SUPPLYLearning Objectives2. Explain the concept of elasticity of supply and its calculation.3. Explain what it means for supply to be price inelastic, unit price elastic, price elastic, perfectly price inelastic, and perfectly price elastic.4. Explain why time is an important determinant of price elasticity of supply.5. Apply the concept of price elasticity of supply to the labor supply curve.
  21. 21. 3. PRICE ELASTICITY OF SUPPLY• Price elasticity of supply is the ratio of the percentage change in quantity supplied of a good or service to the percentage change in its price, all other things unchanged. EQUATION 3.1 % change in quantity supplied es = % change in price
  22. 22. Increase in Apartment Rents Depends on HowResponsive Supply Is S1 R1 S2 R2 R0 D1 D2 Q0 Q1 Q2
  23. 23. Increase in Apartment Rents Depends on How Responsive Supply Is S eS = ∞ S eS = 0
  24. 24. 3.1 Time: An Important Determinant of the Elasticity of Supply• In the short run supply is likely to be inelastic.• In the long run supply is likely to be more elastic.
  25. 25. Selected Elasticity Estimates Product Price Income Product Cross price elasticity elasticity elasticityFood -2.58 0.20 Alcohol with respect to -0.05(long-run) the price of heroinBeer -0.90 to -1.50 0.40 Fuel with respect to the -0.48 price of transportHeroin -1.00 0.00 Beer with respect to the 0.00 price of wineCoke -1.90 0.60 Poultry with respect to 0.23 the price of ground beefPepsi -2.22 1.72 Coke with respect to 0.61 the price of PepsiGasoline -0.10 ----- Pepsi with respect to 0.80(short-run) the price of CokeTransportation -2.08 -----(long-run)
  26. 26. Selected Elasticity Estimates Product Price elasticity of supply Physicians (specialist) -0.30 Physicians (primary 0.00 care) Physician (young 0.20 male) Physicians (young 0.50 female) Milk (short run) 0.36 Milk (long run) 0.50 Child care labor 2.00
  27. 27. Elasticity of supply• The percentage increase in quantity supplied resulting from a small percentage increase in price.• Analogous to the elasticity of demand – A unit-free measure of the responsiveness of supply to a price change – Defined as the percentage increase in quantity supplied resulting from a small percentage increase in price.
  28. 28. Supply and Demand Changes Learning Objectives• What are the effects of changes in supply and demand on price and quantity?• What is a useful approximation of these changes?
  29. 29. When the price of a complement changes…• What happens to the equilibrium price and quantity of the good?• How much do the price and quantity traded change in response to a change in demand?• The equilibrium price p* is given determined at the point where the quantity supplied equals to the quantity demanded, or by the solution to the equation: qd(p*)=qs(p*)

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