Chapter 3 Elasticity and Its Application Source: Retrieved and edited from the power point slide of Andreea CHIRITESCU Eastern Illinois University. In this chapter, look for the answers to these questions:  What is elasticity? What kinds of issues can elasticity help us understand?  What is the price elasticity of demand?  How is it related to the demand curve?  How is it related to revenue & expenditure?  What is the price elasticity of supply?  How is it related to the supply curve?  What are the income and cross-price elasticities of demand? Elasticity Measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants. When we talk about elasticity, that responsiveness is always measured in percentage terms. The elasticity of demand 3 types of the demand elasticity  The price elasticity of demand  The income elasticity of demand  The Cross-price elasticity of demand The Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. The price elasticity of demand ( 𝐸𝑝𝑑 ) is the percentage change in quantity demanded divided by the percentage change in the price.

𝐸𝑝𝑑 =

Computing the price elasticity of demand  Percentage change in quantity demanded divided by percentage change in price  Use absolute value (drop the minus sign)  There are 2 methods to compute the elasticity Point Elasticity: 𝐸𝑝𝑑 =

x

Midpoint method (Arc Elasticity) Two points: (Q1, P1) and (Q2, P2)

(Q2  Q1 )/[(Q 2  Q1 )/ 2 ] Price elasticity of demand = (P  P )/[(P  P )/ 2 ] 2 1 2 1 So, 𝐸𝑝𝑑 =

x

Example: If the price of an ice cream cone increases from $1.00 to $2.00 and the amount you buy falls from 8 to 4 cones. Use the point elasticity formula to calculate the price elasticity of demand. Changes in Quantity Demanded An increase in the price of ice-cream cone results in a movement along the demand curve. Price of Ice-Cream Cones

2

Quantity of Ice-Cream Cones

Example: If the price of an ice cream cone increases from $1.00 to $2.00 and the amount you buy falls from 10 to 8 cones. Use the arc elasticity formula to calculate the price elasticity of demand.

Example: Why is Epd negative?

Note: Price elasticity of demand is Percentage change in quantity demanded divided by the percentage change in price. Elastic demand or inelastic demand  Elastic demand: Quantity demanded responds substantially to changes in price.  Inelastic demand: Quantity demanded responds only slightly to changes in price. Determinants of price elasticity of demand a. Availability of close substitutes - Goods with close substitutes – more elastic demand b. Necessities vs. luxuries - Necessities – inelastic demand - Luxuries – elastic demand c. Definition of the market - Narrowly defined markets – more elastic demand d. Time horizon - Demand is more elastic over longer time horizons

3

Example 1: Breakfast Cereal vs. Sunscreen The prices of both of these goods rise by 20%. For which good does 𝑄𝑑 drop the most? Why?

Lesson: Price elasticity is higher when close substitutes are available. Example 2: “Blue Jeans” vs. “Clothing” The prices of both goods rise by 20%. For which good does 𝑄𝑑 drop the most? Why?

Lesson: Price elasticity is higher for narrowly defined goods than for broadly defined ones. Example 3: Insulin vs. Caribbean Cruises The prices of both of these goods rise by 20%. For which good does 𝑄𝑑 drop the most? Why?

Lesson: Price elasticity is higher for luxuries than for necessities. 4

Example 4: Gasoline in the Short Run vs. Gasoline in the Long Run The price of gasoline rises 20%. Does 𝑄𝑑 drop more in the short run or the long run? Why?

Lesson: Price elasticity is higher in the long run than the short run. The Determinants of Price Elasticity: A Summary The price elasticity of demand depends on:  The extent to which close substitutes are available  Whether the good is a necessity or a luxury  How broadly or narrowly the good is defined  The time horizon—elasticity is higher in the long run than the short run, especially for non-durable goods. The Variety of Demand Curves I. Inelastic Demand - Quantity demanded does not respond strongly to price changes. - Price elasticity of demand is less than one. II. Elastic Demand - Quantity demanded responds strongly to price changes. - Price elasticity of demand is greater than one. III. Perfectly Inelastic - Quantity demanded does not respond to price changes. - Demand curve is vertical IV. Perfectly Elastic - Quantity demanded changes infinitely with any change in price. - Demand curve is horizontal 5

V. Unit Elastic (ค่าความยืดหยุน่ คงที)่  Quantity demanded changes by the same percentage as the price. The flatter the demand curve, the greater the price elasticity of demand The Price Elasticity of Demand (a) Perfectly Inelastic Demand: Elasticity Equals to 0

(b) Inelastic Demand: Elasticity Is Less Than 1

 The price elasticity of demand determines whether the demand curve is steep or flat.  Note that all percentage changes are calculated using the midpoint method.

(c) Unit Elastic Demand: Elasticity to Equals 1

6

(d) Elastic demand: Elasticity > 1

(e) Perfectly elastic demand: Elasticity equals infinity

 The price elasticity of demand determines whether the demand curve is steep or flat.  Note that all percentage changes are calculated using the midpoint method. Elasticity  The price elasticity of demand determines whether the demand curve is steep or flat.  Note that all percentage changes are calculated using the midpoint method. Variety of demand curves D

|E P| = 0 D

0 < |E P| < 1 D

|E P| = 1 D

1 < |E P| < ∞ D

|E P| = ∞

7

Elasticity of a Linear Demand Curve (graph)

The slope of a linear demand curve is constant, but its elasticity is not. The demand schedule in the table was used to calculate the price elasticity of demand by the midpoint method. At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic. Example: When price increase from $4 to $5

8

Example: When price increase from $2 to $3

Example: When price increase from $3 to $4

The Elasticity of Demand  Linear demand curve:  Constant slope - Rise over run  Different price elasticity  Points with low price & high quantity: Inelastic demand  Points with high price & low quantity: Elastic demand 9

Total revenue (TR) - Amount paid by buyers and received by sellers of a good. Price of the good times the quantity sold (P ˣ Q) - For a price increase: If demand is inelastic, TR increases If demand is elastic, TR decreases

The total amount paid by buyers, and received as revenue by sellers, equals the area of the box under the demand curve, P × Q. Here, at a price of $4, the quantity demanded is 100, and total revenue is $400. How Total Revenue Changes When Price Changes (a) The case of inelastic demand

(b) The case of elastic demand

10

The impact of a price change on total revenue (the product of price and quantity) depends on the elasticity of demand. In panel (a), the demand curve is inelastic. In this case, an increase in the price leads to a decrease in quantity demanded that is proportionately smaller, so total revenue increases. Here an increase in the price from $4 to $5 causes the quantity demanded to fall from 100 to 90. Total revenue rises from $400 to $450. In panel (b), the demand curve is elastic. In this case, an increase in the price leads to a decrease in quantity demanded that is proportionately larger, so total revenue decreases. Here an increase in the price from $4 to $5 causes the quantity demanded to fall from 100 to 70. Total revenue falls from $400 to $350. Elasticity of a Linear Demand Curve (schedule)

The slope of a linear demand curve is constant, but its elasticity is not. The demand schedule in the table was used to calculate the price elasticity of demand by the midpoint method. At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic. The Elasticity of Demand and Total revenue  When demand is inelastic (elasticity < 1) - Price and total revenue move in the same direction  When demand is elastic (elasticity > 1) - Price and total revenue move in opposite directions  If demand is unit elastic (elasticity = 1) - Total revenue remains constant when the price changes

11

The Price Elasticity of Demand 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! The Determinants of Price Elasticity: A Summary The price elasticity of demand depends on: the extent to which close substitutes are available whether the good is a necessity or a luxury how broadly or narrowly the good is defined the time horizon—elasticity is higher in the long run than the short run, especially for non-durable goods.

Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. >> The percentage change in the quantity demanded divided by the percentage change in income.

𝐸𝑦𝑑 =

Point Elasticity:

Arc (Midpoint) Elasticity:

𝐸𝑦𝑑 =

𝐸𝑦𝑑 =

x

x

12

Income Elasticity  Types of Goods - If 𝐸𝑦𝑑 is positive >>Normal Goods - If 𝐸𝑦𝑑 is negative > >Inferior Goods  Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.  Normal goods - Positive income elasticity - Necessities: Smaller income elasticities  Luxuries - Larger income elasticities  Inferior goods - Negative income elasticities Determinants of the Income Elasticity of Demand - Goods consumers regard as necessities tend to be income inelastic Ex. Food, fuel, clothing, utilities, medical services (𝐸𝑦𝑑 is positive and 1) Example: When John’s income increases from 1000 baht to 2000 baht, the quantity demanded for Pepsi increases from 100 cans to 200 cans. - Use the point elasticity formula to calculate the income elasticity of demand for Pepsi. - Is Pepsi a normal or inferior good? Explain.

13

Cross-price elasticity of demand: How much the quantity demanded of one good responds to a change in the price of another good. - Percentage change in quantity demanded of the first good - Divided by the percentage change in price of the second good

𝐸𝑐𝑑 =

Point Elasticity:

Arc (Midpoint) Elasticity:

𝐸𝑐𝑑 =

x

𝐸𝑐𝑑 =

x

Types of Goods  Substitutes - Goods typically used in place of one another - Positive cross-price elasticity (𝐸𝑐𝑑 is positive)  Complements - Goods that are typically used together - Negative cross-price elasticity (𝐸𝑐𝑑 is negative) 14

Example: When Coke price goes up from 13 Baht to 15 Baht, the market quantity demanded for Pepsi increases from 100 cans to 200 cans. - Use the arc elasticity formula to calculate the cross price elasticity of demand for Pepsi. - Are Pepsi and Coke substitutes or compliments? Explain. A Summary: The Determinants of Price Elasticity The price elasticity of demand depends on: 1. The extent to which close substitutes are available 2. Whether the good is a necessity or a luxury 3. How broadly or narrowly the good is defined 4. The time horizon—elasticity is higher in the long run than the short run, especially for non-durable goods.

The elasticity of supply Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good. >> The percentage change in quantity supplied divided by a percentage change in price.

𝐸𝑆 =

Computing price elasticity of supply - Percentage change in quantity supplied divided by percentage change in price: Always positive - Midpoint method Two points: (Q1, P1) and (Q2, P2)

Price elasticity of supply =

(Q2  Q1 )/[(Q 2  Q1 )/ 2 ] (P2  P1 )/[(P2  P1 )/ 2 ] 15

 Point Elasticity:

𝐸𝑆 =

 Arc (Midpoint) Elasticity:

𝐸𝑆 =

x

x

Variety of supply curves - Supply is unit elastic: Price elasticity of supply = 1 - Supply is elastic: Price elasticity of supply > 1 - Supply is inelastic: Price elasticity of supply < 1 - Supply is perfectly inelastic: Price elasticity of supply = 0 (Supply curve – vertical) - Supply is perfectly elastic: Price elasticity of supply = infinity (Supply curve – horizontal) The Price Elasticity of Supply (a) Perfectly Inelasticity Supply: Elasticity equals 0

(b) Inelastic Supply: Elasticity is less than 1

16

(c) Unit Elastic Supply: Elasticity equals 1

(d) Elastic Supply: Elasticity is greater than 1

(b) Perfectly Elastic Supply: Elasticity Equals Infinity

Note: that all percentage changes are calculated using the midpoint method. **The price elasticity of supply determines whether the supply curve is steep or flat. Elastic supply - Quantity supplied responds substantially to changes in the price Inelastic supply - Quantity supplied responds only slightly to changes in the price 17

Determines Price elasticity of supply  Depends on the flexibility of sellers to change the amount of the good they produce  Ability of sellers to change the amount of the good they produce.  Beach-front land is inelastic.  Books, cars, or manufactured goods are elastic.  Time period  Supply is more elastic in the long run. Supply curve: Different price elasticities  Points with low price & low quantity - Elastic supply - Capacity for production not being used  Points with high price & high quantity - Inelastic supply How the Price Elasticity of Supply Can Vary

Because firms often have a maximum capacity for production, the elasticity of supply may be very high at low levels of quantity supplied and very low at high levels of quantity supplied. Here an increase in price from $3 to $4 increases the quantity supplied from 100 to 200. Because the 67 percent increase in quantity supplied (computed using the midpoint method) is larger than the 29 percent increase in price, the supply curve is elastic in this range. By contrast, when the price rises from $12 to $15, the quantity supplied rises only from 500 to 525. Because the 5 percent increase in quantity supplied is smaller than the 22 percent increase in price, the supply curve is inelastic in this range. 18

Example: Use midpoint method to calculate : % change in 𝑄𝑑 , % change in P, and the price elasticity of demand . Use the following information price elasticity of demend for hotel rooms: if P = $70, 𝑄 𝑑 = 5,000 and if P = $90, 𝑄 𝑑 = 3,000

Price Elasticity and Total Revenue - Continuing our scenario, if you raise your price from $200 to $250, would your revenue rise or fall? Revenue = P x Q - A price increase has two effects on revenue:  Higher P means more revenue on each unit you sell.  But you sell fewer units (lower Q), due to law of demand. - Which of these two effects is bigger?  It depends on the price elasticity of demand. Price Elasticity of Demand = Revenue = If demand is elastic, then:

The fall in revenue from lower Q is greater than the increase in revenue from higher P, so revenue falls. 19

Price Elasticity of Demand = Revenue = - If demand is inelastic, then price elasticity of demand < 1 % change in Q < % change in P - The fall in revenue from lower Q is smaller than the increase in revenue from higher P, so revenue rises. - In our example, suppose that Q only falls to 10 (instead of 8) when you raise your price to $250.

20

Active Learning: Elasticity and expenditure/revenue A. Pharmacies raise the price of insulin by 10%. Does total expenditure on insulin rise or fall?

B. As a result of a fare war, the price of a luxury cruise falls 20%. Does luxury cruise companies’ total revenue rise or fall?

21

Suppose there is a technological improvement in growing rice. Step 1: Examine whether the supply or demand curve shifts. Step 2: Determine the direction of the shift of the curve. Step 3: Use the supply-and-demand diagram to see how the market equilibrium changes.

Applications 1:  Can Good News for Farming Be Bad News for Farmers? - New hybrid of wheat – increase production per acre 20%  Supply curve shifts to the right  Higher quantity; lower price  Demand – inelastic An Increase in Supply in the Market for Wheat

22

Applications 2: Why Did OPEC Fail to Keep the Price of Oil High?  Increase in prices 1973-1974, 1971-1981  Short-run: supply and demand are inelastic - Decrease in supply: large increase in price  Long-run: supply and demand are elastic - Decrease in supply: small increase in price A Reduction in Supply in the World Market for Oil (a) The Oil Market in the Short Run

(b) The Oil Market in the Long Run

23