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Our Friend Elasticity
Our Friend Elasticity
Or, how I learned to love percentages
Or, how I learned to love percentages
Measuring Responsiveness or Sensitivity
Measuring Responsiveness or Sensitivity
• Slope– Unit dependent
• Currency • Quantities
– No Starting Point
• Percentages– Unit free– Relational
• Slope– Unit dependent
• Currency • Quantities
– No Starting Point
• Percentages– Unit free– Relational
Computing ElasticityComputing Elasticity
• Price elasticity of demand = %change in quantity demanded/% change in price
• Income elasticity of demand = %change in demand/% change in income
• Cross-price elasticity of demand = %change in demand/% change in the price of a related good
• Price elasticity of demand = %change in quantity demanded/% change in price
• Income elasticity of demand = %change in demand/% change in income
• Cross-price elasticity of demand = %change in demand/% change in the price of a related good
An Intuitive Approach to Elasticity
An Intuitive Approach to Elasticity
• Since price elasticity is always zero (law of demand) we ignore the negative sign and take the absolute value of price elasticity.
• Ep > 1 Responsive or elastic – %ΔQd > %ΔP a small %ΔP creates a large %ΔQd
• Ep < 1 Not responsive or inelastic– %ΔQd < %ΔP a large %ΔP creates a small %ΔQd
• Ep = 1 unit elastic– %ΔQd = %ΔP a given %ΔP creates an equal %ΔQd
• Since price elasticity is always zero (law of demand) we ignore the negative sign and take the absolute value of price elasticity.
• Ep > 1 Responsive or elastic – %ΔQd > %ΔP a small %ΔP creates a large %ΔQd
• Ep < 1 Not responsive or inelastic– %ΔQd < %ΔP a large %ΔP creates a small %ΔQd
• Ep = 1 unit elastic– %ΔQd = %ΔP a given %ΔP creates an equal %ΔQd
So????Price and Total Revenue
TR= P X Q
So????Price and Total Revenue
TR= P X Q• Ep > 1 Responsive or elastic
– %ΔQd > %ΔP if P goes down (up) total revenue goes up (down)
• Ep < 1 Not responsive or inelastic– %ΔQd < %ΔP if P goes down (up) total revenue goes
down (up)
• Ep = 1 unit elastic– %ΔQd = %ΔP if P goes down (up) total revenue stays
the same
• Ep > 1 Responsive or elastic – %ΔQd > %ΔP if P goes down (up) total revenue goes
up (down)
• Ep < 1 Not responsive or inelastic– %ΔQd < %ΔP if P goes down (up) total revenue goes
down (up)
• Ep = 1 unit elastic– %ΔQd = %ΔP if P goes down (up) total revenue stays
the same
Figure 2 Total RevenueFigure 2 Total Revenue
Copyright©2003 Southwestern/Thomson Learning
Demand
Quantity
Q
P
0
Price
P × Q = $400(revenue)
$4
100
Determinants of Price Elasticity
Determinants of Price Elasticity
• Availability of close substitutes
• Necessity versus luxury
• Definition of the market
• Time horizon
• Percentage of consumer budget
• Availability of close substitutes
• Necessity versus luxury
• Definition of the market
• Time horizon
• Percentage of consumer budget
Price Elasticity – Using Numbers
Price Elasticity – Using Numbers
Ep = %ΔQd/ %ΔP
= (Q2- Q1)/[(Q2+ Q1)/2]
(P2- P1)/[(P2+ P1)/2]
Ep = %ΔQd/ %ΔP
= (Q2- Q1)/[(Q2+ Q1)/2]
(P2- P1)/[(P2+ P1)/2]
Calculating Price Elasticitymputing the Price Elasticity of Demand
Demand is price elastic
$5
4Demand
Quantity1000 50
-3percent 22-percent 67
5.00)/2(4.005.00)-(4.00
50)/2(10050)-(100
ED
Price
Linear Demand Curve:ElasticityLinear Demand Curve:Elasticity
Linear Demand
0
1
2
3
4
5
6
7
8
0 2 4 6 8 10 12 14
Quantity
Pri
ce
Elasticity of Other Demand CurvesElasticity of Other Demand Curves
• Perfectly Elastic
• Perfectly Inelastic
• Unit Elastic
• Perfectly Elastic
• Perfectly Inelastic
• Unit Elastic
Figure 1 The Price Elasticity of DemandFigure 1 The Price Elasticity of 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.
Figure 1 The Price Elasticity of DemandFigure 1 The Price Elasticity of Demand
Copyright©2003 Southwestern/Thomson Learning
(a) Perfectly Inelastic Demand: Elasticity Equals 0
$5
4
Quantity
Demand
1000
1. Anincreasein price . . .
2. . . . leaves the quantity demanded unchanged.
Price
Figure 6 The Price Elasticity of SupplyFigure 6 The Price Elasticity of Supply
Copyright©2003 Southwestern/Thomson Learning
(e) Perfectly Elastic Supply: Elasticity Equals Infinity
Quantity0
Price
$4 Supply
3. At a price below $4,quantity supplied is zero.
2. At exactly $4,producers willsupply any quantity.
1. At any priceabove $4, quantitysupplied is infinite.
Elasticity of SupplyElasticity of Supply• Price elasticity of supply = %change in quantity
supplied/% change in price
Es= %ΔQs/ %ΔP
= (Q2- Q1)/[(Q2+ Q1)/2]
(P2- P1)/[(P2+ P1)/2]• Perfectly elastic and inelastic supply• Relatively elastic, relatively inelastic and unit elastic
(crossing the Q or P axis or the origin)• Supply curves where elasticity varies
• Price elasticity of supply = %change in quantity supplied/% change in price
Es= %ΔQs/ %ΔP
= (Q2- Q1)/[(Q2+ Q1)/2]
(P2- P1)/[(P2+ P1)/2]• Perfectly elastic and inelastic supply• Relatively elastic, relatively inelastic and unit elastic
(crossing the Q or P axis or the origin)• Supply curves where elasticity varies
Figure 6 The Price Elasticity of SupplyFigure 6 The Price Elasticity of Supply
Copyright©2003 Southwestern/Thomson Learning
(a) Perfectly Inelastic Supply: Elasticity Equals 0
$5
4
Supply
Quantity1000
1. Anincreasein price . . .
2. . . . leaves the quantity supplied unchanged.
Price
Figure 6 The Price Elasticity of SupplyFigure 6 The Price Elasticity of Supply
Copyright©2003 Southwestern/Thomson Learning
(b) Inelastic Supply: Elasticity Is Less Than 1
110
$5
100
4
Quantity0
1. A 22%increasein price . . .
Price
2. . . . leads to a 10% increase in quantity supplied.
Supply
Figure 6 The Price Elasticity of SupplyFigure 6 The Price Elasticity of Supply
Copyright©2003 Southwestern/Thomson Learning
(d) Elastic Supply: Elasticity Is Greater Than 1
Quantity0
Price
1. A 22%increasein price . . .
2. . . . leads to a 67% increase in quantity supplied.
4
100
$5
200
Supply
Figure 6 The Price Elasticity of SupplyFigure 6 The Price Elasticity of Supply
Copyright©2003 Southwestern/Thomson Learning
(c) Unit Elastic Supply: Elasticity Equals 1
125
$5
100
4
Quantity0
Price
2. . . . leads to a 22% increase in quantity supplied.
1. A 22%increasein price . . .
Supply
• Determinants of elasticity of supply– Ability to increase or decrease production
(e.g Ellensburg agates, farm crops, automobiles)
– Time period
• Determinants of elasticity of supply– Ability to increase or decrease production
(e.g Ellensburg agates, farm crops, automobiles)
– Time period
Applications of ElasticityApplications of Elasticity
• Farmers : fallacy of composition and good crop/bad revenue years
• The economics of addictive drugs
• Pricing decisions and your future business
• Farmers : fallacy of composition and good crop/bad revenue years
• The economics of addictive drugs
• Pricing decisions and your future business
Figure 8 An Increase in Supply in the Market for WheatFigure 8 An Increase in Supply in the Market for Wheat
Copyright©2003 Southwestern/Thomson Learning
Quantity ofWheat
0
Price ofWheat
3. . . . and a proportionately smallerincrease in quantity sold. As a result,revenue falls from $300 to $220.
Demand
S1 S2
2. . . . leadsto a large fallin price . . .
1. When demand is inelastic,an increase in supply . . .
2
110
$3
100
Government and MarketsGovernment and Markets
• Price Controls– Price Ceilings (e.g. rent control)– Price Floors (e.g. water)
• Taxes– Who appears to pay the tax?
• Buyers “pay” tax• Sellers “pay” tax
– Who really pays the tax? Tax incidence and burden
• Price Controls– Price Ceilings (e.g. rent control)– Price Floors (e.g. water)
• Taxes– Who appears to pay the tax?
• Buyers “pay” tax• Sellers “pay” tax
– Who really pays the tax? Tax incidence and burden
• Case study – The payroll tax: Federal Insurance Contribution Act (FICA) for Social Security and Medicare
• Case study – The payroll tax: Federal Insurance Contribution Act (FICA) for Social Security and Medicare
Elasticity and Tax IncidenceElasticity and Tax Incidence
• Intuitive approach:– If the buyers can respond relatively more to
price changes more than suppliers, suppliers pay more of the tax.
– If the suppliers can respond relatively more than the buyers, then the buyers pay more of the tax.
• Intuitive approach:– If the buyers can respond relatively more to
price changes more than suppliers, suppliers pay more of the tax.
– If the suppliers can respond relatively more than the buyers, then the buyers pay more of the tax.
• Extreme examples:– Perfectly elastic demand– Perfectly elastic supply– Perfectly inelastic demand– Perfectly inelastic supply
• Less extreme examples (e.g. the luxury tax)
• Extreme examples:– Perfectly elastic demand– Perfectly elastic supply– Perfectly inelastic demand– Perfectly inelastic supply
• Less extreme examples (e.g. the luxury tax)