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# Chapter 5

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### Chapter 5

1. 1. PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University Elasticity CHAPTER 1© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2. 2. Price Elasticity of Demand • Elasticity –Sensitivity of one market variable to another • Slope = ΔP/ΔQD –Not a measure of price sensitivity of demand • Depends on the arbitrary units of measurement • Doesn’t tell us the significance of ΔP or ΔQD 2 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3. 3. Price Elasticity of Demand • Price elasticity of demand (ED) –Sensitivity of quantity demanded to price –Percentage change in quantity demanded caused by a 1 percent change in price –The greater the elasticity value the more sensitive quantity demanded is to price 3 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. % % % % D D Q E P    Change in Quantity Demanded Elasticity of Demand = Change in Price
4. 4. Price Elasticity of Demand • Midpoint formula, percentage change in a variable • Change in the variable divided by the average of the old and new values • When calculating elasticity values from data on prices and quantities 4 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.         1 0 1 0 1 0 1 0 % 2 % 2 Change in Price = Change in Quantity Demanded = P P P P Q Q Q Q              
5. 5. Figure Using the Midpoint Formula for Elasticity 5 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 Quantity of Avocados per Week Price per Avocado \$1.00 \$1.50 4,500 5,500 D A B 1. Using the midpoint formula, the percentage drop in price is \$0.50/\$1.25 = 0.40 or 40% … 2. and the percentage rise in quantity is 1,000 / 5,000 = 0.2 or 20%. 3. Elasticity of demand for the move from A to B is 20% / 40% = 0.5
6. 6. Categorizing Demand • Inelastic demand –ED between 0 and 1 –Quantity demanded is relatively insensitive to price changes • Elastic demand: ED > 1 –Quantity demanded is relatively sensitive to price changes • Unit elastic demand: ED = 1 –Quantity demanded changes by the same percentage as the price 6 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
7. 7. Categorizing Demand • Perfectly inelastic demand –ED = 0 –Vertical demand curve • Perfectly (infinitely) elastic demand –ED approaching infinity –Horizontal demand curve 7 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
8. 8. Figure Categories of Demand Behavior (a, b) 8 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 (a) Inelastic Demand (ED < 1) (b) Elastic Demand (ED > 1) Q P 95 105 Price rises by 20% D Quantity falls by less than 20% \$11 9 Q P Price rises by 20% D 85 115 Quantity falls by more than 20% \$11 9
9. 9. Figure Categories of Demand Behavior (c, d, e) 9 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 (c) Unit-Elastic Demand (ED = 1) (e) Perfectly Elastic Demand (ED = ∞) Q P 90 110 Price rises by 20% D Quantity falls by 20% \$11 9 (d) Perfectly Inelastic Demand (ED = 0) Q P 9 \$11 D 100 Price rises Quantity doesn’t change Q P Consumers will buy any quantity at \$9, none at a higher price D \$9
10. 10. Straight-Line Demand Curves • Straight-line demand curve –Demand becomes less elastic (ED gets smaller) • As we move downward and rightward –Slope of demand is constant 10 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
11. 11. Figure How Elasticity Changes along a Straight-Line Demand Curve 11 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Quantity of Laptops Price 1,500 \$2,000 5,000 15,000 Each time P drops by another \$500, the percentage drop is larger. Each time Q rises by another 10,000, the percentage rise is smaller. D A 1,000 35,00025,000 C B Elasticity falls as we move rightward along a straight-line demand curve.
12. 12. Elasticity and Total Revenue • Total revenue (TR = P ˣ Q) –Price per unit (P) times quantity (Q) –The area of a rectangle with height equal to price and width equal to quantity demanded • A price increase –Inelastic demand, ED < 1, then TR ↑ –Elastic demand, ED > 1, then TR ↓ –Unit elastic demand, ED = 1, then TR doesn’t change 12 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
13. 13. Figure In panel (a), demand is inelastic, so a rise in price causes total revenue to increase. Specifically, at a price of \$9 (point A), total revenue is \$9 × 105 = \$945. When price rises to \$11 (point B), total revenue increases to \$11 × 95 = \$1,045. In panel (b), demand is elastic, so a rise in price causes total revenue to decrease. Specifically, at a price of \$9 (point A), total revenue is \$9 × 115 = \$1,035. When price rises to \$11 (point B), total revenue falls to \$11 × 85 = \$935. Elasticity and Total Revenue 13 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Q P D Q P D B 95 105 \$11 9 \$11 85 115 9A A B (a) Inelastic Demand (b) Elastic Demand
14. 14. Table Effects of Price Changes on Revenue 14 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1
15. 15. Determinants of Elasticity • Availability of substitutes –Close substitutes are available for a product –More elastic demand • Necessities versus luxuries –Necessities tend to have less elastic demand than luxuries • Importance in buyers’ budgets –Larger proportion of families’ budgets –More elastic demand 15 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
16. 16. Table Some Short-Run Price Elasticities of Demand 16 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2
17. 17. Determinants of Elasticity • Time horizon –The longer the time horizon, the more elastic the demand • Short-run elasticity –Measured just a short time after a price change • Long-run elasticity –Measured a year or more after a price change –Larger than short-run elasticity 17 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
18. 18. Table Short-Run versus Long-Run Elasticities 18 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3
19. 19. Table Adjustments After a Rise in the Price of Gasoline 19 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4
20. 20. Figure When the price of gasoline rises by \$1, the decrease in quantity demanded (and the price elasticity of demand) depends on how long we wait before measuring buyers’ response. If we waited just a few months after the price change, we’d move along demand curve DSR, from point A to point B. If we waited a year or longer, we’d move from point A to point E along demand curve DLR, with quantity demanded falling even more. Short-Run versus Long-Run Price Elasticity of Demand 20 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5 Quantity of Gasoline (millions of gallons per day) Price per gallon 2.00 \$3.00 320 400 DSR B DLR A 360 E
21. 21. Elasticity and Mass Transit • Elasticity and mass transit –Inelastic demand • Both short and long run –A rise in fares would likely raise mass- transit revenue for a city –Why cities don’t raise fares: • Elasticity estimates come from past data • Want to provide affordable transportation, reduce traffic congestion on city streets, and limit pollution 21 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22. 22. Price Elasticity of Supply • Price elasticity of supply –Percentage change in quantity supplied caused by a 1 percent change in its price –Sensitivity of quantity supplied to price changes • As we move along the supply curve 22 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. % % % % S Q P   Change in Quantity Supplied Elasticity of Supply = Change in Price Elasticity of Supply =
23. 23. Determinants of Supply Elasticity • Easier to find alternatives in production –The more elastic the supply • The narrow the market definition –The more elastic the supply • The longer the time horizon –The more elastic the supply • Long-run supply elasticities are greater than short-run supply elasticities 23 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
24. 24. Figure When the price of corn rises from \$4.50 to \$5.50 per bushel, the increase in quantity supplied (and the price elasticity of supply) depends on how long we wait before measuring the response. If we wait just a few months after the price change, we’d move along supply curve SSR, from point A to point B. If we wait a year or longer, we’d move along supply curve SLR, from point A to point C. The same rise in price causes a greater increase in quantity supplied after a year or longer, because farmers can make further adjustments in quantity supplied if given more time. Short-Run versus Long-Run Price Elasticity of Supply 24 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 Quantity (millions of bushels per week) Price per bushel 4.50 \$5.50 190 SSR 210 230 B SLR A C
25. 25. Income Elasticity of Demand • Income elasticity of demand –The percentage change in quantity demanded caused by a 1 percent change in income –Relative shift in the demand curve –Is > 0 for normal goods –Is < 0 for inferior goods 25 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. % % Change in Quantity Demanded Income elasticity = Change in Income
26. 26. Cross-Price Elasticity of Demand • Cross-price elasticity of demand –The percentage change in the quantity demanded of one good (X) • Caused by a 1 percent change in the price of another good (Z) –If > 0 → substitutes –If < 0 → complements 26 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. % % Change in Quantity Demanded of X Change in Price of Z
27. 27. The war on drugs: should we fight supply or demand? • Every year, the U.S. government –Sends about \$10 billion intervening in the market for illegal drugs • Most of this money is spent on efforts to restrict the supply of drugs 27 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
28. 28. Figure Panel (a) shows the market for heroin in the absence of government intervention. Total expenditures—and total receipts of drug dealers—are given by the area of the shaded rectangle. Panel (b) shows the effect of a government effort to restrict supply: Price rises, but total expenditure increases. Panel (c) shows a policy of reducing demand: Price falls, and so does total expenditure. The War on Drugs 28 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Quantity Price per unit P1 (a) D1 Quantity Price per unit (b) D1 Quantity Price per unit P1 (c) D1 S1 A P1 S1 A S2 B P2 Q2 Q1Q1 Q1 D2 S1 C Q3 P3 A
29. 29. The war on drugs: should we fight supply or demand? • No government intervention –Equilibrium: P1, Q1 –Total revenue by sellers = Total expenditure by buyers: P1 ˣ Q1 29 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
30. 30. The war on drugs: should we fight supply or demand? • Decreasing Supply –Vigilant customs inspections; arrest and stiff penalties for drug dealers; efforts to reduce drug traffic –Equilibrium: Higher price P2, Lower quantity Q2 –Demand: very price inelastic –Total revenue by sellers = Total expenditure by buyers = Higher, P2 ˣ Q2 30 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
31. 31. The war on drugs: should we fight supply or demand? • Decreasing Demand –Stiffer penalties on drug users; heavier advertising against drug use; greater availability of treatment centers for addicts; more effort against drug retailers –Equilibrium: Lower price P3, Lower quantity Q3 –Total revenue by sellers = Total expenditure by buyers = Lower, P3 ˣ Q3 31 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
32. 32. Forecasting Price in an Oil Crisis • Oil supply disruptions –Increased output by other producers (due to the rise in oil’s price or a decision by OPEC) offset some of the lost production • What if a major supply disruption occurred –And only a price hike could restore the market to equilibrium? –Elasticity 32 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
33. 33. Table Oil Supply Disruptions 33 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5
34. 34. Forecasting Price in an Oil Crisis • Initial equilibrium –Price = \$100 per barrel –Quantity = 90 million barrels per day • Suppose that 9 million barrels of oil were temporarily removed from the market –The supply curves shift leftward –Excess demand of 9 million barrels at the original price –The price will rise to restore market equilibrium 34 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
35. 35. Forecasting Price in an Oil Crisis • Very elastic supply and demand in the short run (unrealistic) –Only a relatively small price increase is needed to increase quantity supplied and decrease quantity demanded • Very inelastic supply and demand in the short run (realistic) –A much larger price increase is needed to restore market equilibrium 35 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
36. 36. Figure If either supply or demand is very elastic, only a relatively small price increase will be needed to restore equilibrium after decrease in supply. Panel (a) illustrates the case in which both supply and demand are very elastic. The leftward shift in the supply curve causes equilibrium price to rise from \$100 to \$102.50. Panel (b) has the same leftward shift in the supply curve, but with much less elastic supply and demand. A much larger rise in price (from \$100 to \$211) is needed to restore equilibrium after the decrease in supply. A Decrease in Oil Supply: Elastic versus Inelastic Demand 36 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Barrels per Day (millions) Price per Barrel (a) D Barrels per Day (millions) Price per Barrel (b) D \$100.00 S1 A\$102.50 90 S2 B 81 \$100.00 S1 \$211.00 90 S2 A B 81
37. 37. Spikes in Food Prices • From mid-2010 to mid-2011 –Prices for wheat, corn, soybeans, sugar, and other food crops spiked around the world –Increase in demand –Decrease in supply • Bad weather for crops in several parts of the world 37 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
38. 38. Spikes in Food Prices • Demand is inelastic –Staples like wheat or corn are commonly regarded as necessities –In large parts of the world only a small percentage of income is spent on these foods • Supply is inelastic (in the short run) –Farm output depends on • Planting decisions made many months earlier • Weather conditions while crops are growing 38 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
39. 39. Figure When the supply of wheat decreased from mid-2010 to mid-2011, creating an excess demand at the original price of \$4.16 per bushel, the price spiked upward. A large price rise was needed to eliminate the excess demand because both the supply and the demand for wheat are so inelastic in the short run. Bad Weather and Food Prices with Inelastic Supply and Demand 39 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 Quantity of wheat (millions of bushels per month) Price per Bushel D \$4.16 S2010 \$8.16 Q1 S2011 A B Q2

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