Chapter 5 Part 1

Elasticity

Elasticity of DemandElasticity of DemandElasticity Elasticity – a measure of the – a measure of the

responsiveness of Qd or Qs to changes in responsiveness of Qd or Qs to changes in market conditionsmarket conditions

Price Elasticity of DemandPrice Elasticity of Demand – measure of – measure of how much the Qd responds to a change in how much the Qd responds to a change in the Pthe P

Computed as: Computed as: % change in Qd% change in Qd

% change % change in Pin P

Elastic v. Inelastic DemandElastic v. Inelastic Demand

D for a good is D for a good is elasticelastic if the Qd responds if the Qd responds substantially to a change in P substantially to a change in P

Examples: McDonald’s hamburgersExamples: McDonald’s hamburgers

D for a good is D for a good is inelasticinelastic if the Qd if the Qd responds only slightly to a change in Presponds only slightly to a change in P

Examples: InsulinExamples: Insulin

Determinants of Price Elasticity of DDeterminants of Price Elasticity of DAvailability of Close Substitutes - goods Availability of Close Substitutes - goods

w/ close substitutes tend to be more w/ close substitutes tend to be more elastic; goods w/o close substitutes tend to elastic; goods w/o close substitutes tend to be more inelastic Ex: butterbe more inelastic Ex: butter

Necessities vs. Luxuries – necessities Necessities vs. Luxuries – necessities tend to have inelastic demands; luxuries tend to have inelastic demands; luxuries tend to have elastic demands Ex: gas tend to have elastic demands Ex: gas vs. sailboatvs. sailboat

Cont’dCont’dDefinition of the Market – broad categories Definition of the Market – broad categories

have fairly inelastic demands, narrowly have fairly inelastic demands, narrowly defined markets usually are more elastic defined markets usually are more elastic Ex: food vs. Green appleEx: food vs. Green apple

Time Horizon – goods tend to have more Time Horizon – goods tend to have more elastic demands over long time periods. elastic demands over long time periods. Ex: P of gas rises, Qd barely falls for a Ex: P of gas rises, Qd barely falls for a while, but in the long run D falls while, but in the long run D falls substantiallysubstantially

Rank the following items from most Rank the following items from most to least elastic…to least elastic…

BeefBeefSaltSaltEuropean vacationEuropean vacationSteakSteakHonda AccordHonda AccordDijon MustardDijon Mustard

Results…?Results…?

European VacationEuropean VacationHonda AccordHonda AccordSteakSteakDijon MustardDijon MustardBeefBeefsaltsalt

Computing the Price Elasticity of Demand

The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.

P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed

P ercen tag e ch an g e in p rice

Computing the Price Elasticity of Demand

Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as:

( )

( . . ).

1 0 81 0

1 0 0

2 2 0 2 0 02 0 0

1 0 0

2 0 %

1 0 %2

P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed

P ercen tag e ch an g e in p rice

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 (or just take the absolute value)

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities

The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the price change.

The midpoint is the number halfway between the start & end values, the average of those values.

MIDPOINT FORMULA:

2 1 2 1

2 1 2 1

( ) /[( ) / 2]Price elasticity of demand =

( ) /[( ) / 2]

Q Q Q Q

P P P P

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities

Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:

(10 8)22%(10 8) / 2

2.32(2.20 2.00) 9.5%

(2.00 2.20) / 2

Types of Elasticities

When the price elasticity of demand is >1, demand is elastic

When the price elasticity of demand is <1, the demand is inelastic.

When the price elasticity of demand is = 1, the demand has unit elasticity.

Another way to think about it…

If the ΔQd(%) > ΔP(%) then it’s ELASTIC If the ΔQd(%) < ΔP(%) then it’s INELASTIC

The Variety of Demand Curves Perfectly Inelastic

Quantity demanded does not respond to price changes.

Perfectly Elastic Quantity demanded changes infinitely with any

change in price. Unit Elastic

Quantity demanded changes by the same percentage as the price.

Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.

But it is not the same thing as the slope!

Perfectly Inelastic Demand

(a) Perfectly Inelastic Demand: Elasticity Equals 0

$5

4

Quantity

Demand

1000

1. Anincreasein price . . .

2. . . . leaves the quantity demanded unchanged.

Price

Inelastic Demand

(b) Inelastic Demand: Elasticity Is Less Than 1

Quantity0

$5

90

Demand1. A 22%increasein price . . .

Price

2. . . . leads to an 11% decrease in quantity demanded.

4

100

Unit Elastic Demand

2. . . . leads to a 22% decrease in quantity demanded.

(c) Unit Elastic Demand: Elasticity Equals 1

Quantity

4

1000

Price

$5

80

1. A 22%increasein price . . .

Demand

Elastic Demand

(d) Elastic Demand: Elasticity Is Greater Than 1

Demand

Quantity

4

1000

Price

$5

50

1. A 22%increasein price . . .

2. . . . leads to a 67% decrease in quantity demanded.

Perfectly Elastic Demand

(e) Perfectly Elastic Demand: Elasticity Equals Infinity

Quantity0

Price

$4 Demand

2. At exactly $4,consumers willbuy any quantity.

1. At any priceabove $4, quantitydemanded is zero.

3. At a price below $4,quantity demanded is infinite.

Total Revenue and Price Elasticity of Demand

Total revenue is the amount paid by buyers and received by sellers of a good.

Computed as the price of the good times the quantity sold.

TR = P x Q TR is also called Total Expenditure or TE!!

Total Revenue

Demand

Quantity

Q

P

0

Price

P × Q = $400(revenue)

$4

100

When the price is $4, consumers will demand 100 units, and spend $400 on this good.

TR TEST If D is inelastic: P rises, Qd falls > TR rises

P falls, Qd rises > TR falls If D is elastic: P rises, Qd falls > TR falls

P falls, Qd rises > TR rises

If D is unit elastic: P rises, Qd falls > TR –

P falls, Qd rises > TR –

How Total Revenue Changes When Price Changes: Inelastic Demand

Demand

Quantity0

Price

Revenue = $100

Quantity0

Price

Revenue = $240

Demand$1

100

$3

80

An Increase in price from $1 to $3 …

… leads to an Increase in total revenue from $100 to $240

How Total Revenue Changes When Price Changes: Elastic Demand

Demand

Quantity0

Price

Revenue = $200

$4

50

Demand

Quantity0

Price

Revenue = $100

$5

20

An Increase in price from $4 to $5 …

… leads to an decrease in total revenue from $200 to $100

Note that with each price increase, the Law of Demand still holds – an increase in price leads to a decrease in the quantity demanded. It is the change in TR that varies!