Elasticity and its Application
5 In this chapter,
© 2009 South-Western, a part of Cengage Learning, all rights reserved C H A P T E R
§ What are the income and cross-price elasticities of
2
A scenario…
Your costs are rising (including the opportunity cost of your time), so you consider raising the price to $250. The law of demand says that you won’t sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase?
You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per month.
You charge $200 per website, and currently sell 12 websites per month. Your costs are rising (including the opportunity cost of your time), so you consider raising the price to $250. The law of demand says that you won’t sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase?
demand?
What is the price elasticity of supply? How is it related to the supply curve?
Elasticity and its A pplication Elasticity and its A pplication E conomics
§
How is it related to the demand curve? How is it related to revenue & expenditure?
§ What is the price elasticity of demand?
elasticity help us understand?
In this chapter, look for the answers to these questions: look for the answers to these questions: § What is elasticity? What kinds of issues can
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1 You design websites for local businesses.
§ Basic idea:
ELASTICITY AND ITS APPLICATION
3 Elasticity
ELASTICITY AND ITS APPLICATION
4 Price Elasticity of Demand
P Q D P
1 Example:
1 Q
Price elasticity of demand equals
§ One type of elasticity measures how much
5 Price Elasticity of Demand
§ Loosely speaking, it measures
Price elasticity of demand =
§ Price elasticity of demand measures
§ Definition: Elasticity is
demand for your websites will fall if you raise your price.
ELASTICITY AND ITS APPLICATION
Price Elasticity of Demand Along a D curve, P and Q move in
Along a D curve, P and Q move in opposite directions, which would make opposite directions, which would make price elasticity negative. price elasticity negative.
We will drop the minus sign and report all We will drop the minus sign and report all price elasticities as positive numbers. price elasticities as positive numbers.
ELASTICITY AND ITS APPLICATION
6 Calculating Percentage Changes
Standard method of computing the Demand for percentage (%) change: your websites end value – start value
P
x 100% start value
B $250
Going from A to B,
A $200
the % change in P equals
D
($250–$200)/$200 = 25%
Q
8
12 ELASTICITY AND ITS APPLICATION
7 Calculating Percentage Changes Problem :
Demand for your websites
P
From A to B,
B P
rises 25%, Q falls 33%,
$250
elasticity = 33/25 = 1.33
A $200
From B to A,
D P
falls 20%, Q rises 50%,
Q
elasticity = 50/20 = 2.50
8
12 ELASTICITY AND ITS APPLICATION
8
Calculating Percentage Changes
So, we instead use the :
§ midpoint method § The midpoint is § It doesn’t matter which value you use as the
“start” and which as the “end” – you get the same answer either way!
ELASTICITY AND ITS APPLICATION
9 Calculating Percentage Changes
§ Using the midpoint method, the % change
in P equals The % change in Q equals
§ § The price elasticity of demand equals
ELASTICITY AND ITS APPLICATION
10
1
1 A C T I V E L E A R N I N G A C T I V E L E A R N I N G
Calculate an elasticity Calculate an elasticity
Use the following information to calculate the price elasticity of demand for hotel rooms:
d
if P = $70, Q = 5000
d
if P = $90, Q = 3000
11 To learn the determinants of price elasticity, we look at a series of examples. Each compares two common goods. In each example: § Suppose the prices of both goods rise by 20%.
§
ELASTICITY AND ITS APPLICATION
13 W hat determines price elasticity?
ELASTICITY AND ITS APPLICATION
14 EXA M PLE 1:
For which good does
Lesson:
§
drop the most? Why?
Q d
“Blue Jeans” vs. “Clothing” § The prices of both goods rise by 20%.
The good for which Q
§ Lesson:
drop the most? Why?
Q d
For which good does
Breakfast cereal vs. Sunscreen § The prices of both of these goods rise by 20%.
determinants of the price elasticity of demand?
§ What lesson does the example teach us about the
falls the most (in percent) has the highest price elasticity of demand. Which good is it? Why?
d
ELASTICITY AND ITS APPLICATION
15 EXA M PLE 2:
EXA M PLE 3: Insulin vs. Caribbean Cruises § The prices of both of these goods rise by 20%. d Q
For which good does drop the most? Why?
§ Lesson:
ELASTICITY AND ITS APPLICATION
16 EXA M PLE 4:
Gasoline in the Short Run vs. Gasoline in the Long Run d § The price of gasoline rises 20%. Does Q drop
more in the short run or the long run? Why?
§ Lesson:
ELASTICITY AND ITS APPLICATION
17 The Determinants of Price Elasticity:
A Summary The price elasticity of demand depends on:
ELASTICITY AND ITS APPLICATION
18
The V ariety of Demand Curves The price elasticity of demand is closely related
§ to the slope of the demand curve.
Rule of thumb: §
Five different classifications of D curves.… §
ELASTICITY AND ITS APPLICATION
19 “Perfectly inelastic demand” (one extreme case)
% change in Q Price elasticity
= = of demand % change in P
P D
curve:
D P
1 Consumers’
price sensitivity:
Q
Elasticity: Q
1 ELASTICITY AND ITS APPLICATION
20 “Inelastic demand”
% change in Q Price elasticity
= = of demand % change in P
P D
curve:
P
1 Consumers’
price sensitivity:
D Q
Elasticity: Q
1 ELASTICITY AND ITS APPLICATION
21
“Unit elastic demand”
% change in Q Price elasticity
= = of demand % change in P
P D
curve:
P
1 Consumers’
price sensitivity:
D Q
Elasticity: Q
1 ELASTICITY AND ITS APPLICATION
22 “Elastic demand”
% change in Q Price elasticity
= = of demand % change in P
P D
curve:
P
1 Consumers’
price sensitivity: D
Q
Elasticity: Q
1 ELASTICITY AND ITS APPLICATION
23 “Perfectly elastic demand” (the other extreme)
% change in Q Price elasticity
= = of demand % change in P
P D
curve:
P D
1 Consumers’
price sensitivity:
Q
Elasticity: Q
1 ELASTICITY AND ITS APPLICATION
24
Elasticity of a Linear Demand Curve P
The slope of a linear $30 demand curve is
20 constant, but its
10 elasticity is not.
Q
$0
20
40
60 ELASTICITY AND ITS APPLICATION
25 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:
Which of these two effects is bigger? § It depends on the price elasticity of demand.
ELASTICITY AND ITS APPLICATION
26 Price Elasticity and Total Revenue
Percentage change in Q Price elasticity
= of demand Percentage change in P
Revenue = P x Q
If demand is elastic, then §
ELASTICITY AND ITS APPLICATION
27
Price Elasticity and Total Revenue
Elastic demand Demand for
(elasticity = 1.8) P your websites If P = $200,
Q
= 12 and
$250
revenue = ______
$200
If P = $250,
D Q
= 8 and revenue = _______
Q
When D is elastic,
8
12
a price increase causes revenue to ________.
ELASTICITY AND ITS APPLICATION
28 Price Elasticity and Total Revenue
Percentage change in Q Price elasticity
= of demand Percentage change in P
Revenue = P x Q
If demand is inelastic, then §
In our example, suppose that Q only falls to 10 § (instead of 8) when you raise your price to $250.
ELASTICITY AND ITS APPLICATION
29 Price Elasticity and Total Revenue
Now, demand is Demand for inelastic: your websites elasticity = 0.82 P
If P = $200,
Q
= 12 and
$250
revenue = ______
$200
If P = $250,
Q D
= 10 and revenue = ______ When D is inelastic, Q
10
12
a price increase causes revenue to _______.
ELASTICITY AND ITS APPLICATION
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2 A C T I V E L E A R N I N G
2 A C T I V E L E A R N I N G Elasticity and expenditure/revenue 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?
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2 A C T I V E L E A R N I N G A C T I V E L E A R N I N G Answers Answers
2
32 A PPLICA TION:
Does Drug Interdiction Increase or Decrease Drug-Related Crime? One side effect of illegal drug use is crime:
§ Users often turn to crime to finance their habit.
We examine two policies designed to reduce § illegal drug use and see what effects they have on drug-related crime.
For simplicity, we assume the total dollar value § of drug-related crime equals total expenditure on drugs.
Demand for illegal drugs is inelastic, due to § addiction issues.
ELASTICITY AND ITS APPLICATION
34
Policy 1: Interdiction
Interdiction reduces Price of the supply Drugs D
1 S of drugs.
1 Since demand
for drugs is inelastic,
P
1 Result: Q Quantity
1 of Drugs
ELASTICITY AND ITS APPLICATION
35 Policy 2: Education Price of
Education
Drugs
reduces the
D
1
demand for
S drugs. P
1 Result: Q Quantity
1 of Drugs
ELASTICITY AND ITS APPLICATION
36 Price Elasticity of Supply
Price elasticity = of supply
§ Price elasticity of supply measures Loosely speaking, it measures
§ Again, use the midpoint method to compute the
§ percentage changes.
ELASTICITY AND ITS APPLICATION
37
Price Elasticity of Supply P S
Example:
Price elasticity
P
1
of supply equals
Q Q
1 ELASTICITY AND ITS APPLICATION
38 The V ariety of Supply Curves The slope of the supply curve is closely related to
§ price elasticity of supply.
Rule of thumb: § § Five different classifications.…
ELASTICITY AND ITS APPLICATION
39 “Perfectly inelastic” (one extreme)
% change in Q Price elasticity
= = of supply % change in P
P S
curve:
S
Sellers’
P
price sensitivity:
1 Q
Elasticity: Q
1 ELASTICITY AND ITS APPLICATION
40
“Inelastic”
% change in Q Price elasticity
= = of supply % change in P
P S
curve:
S
Sellers’
P
price sensitivity:
1 Q
Elasticity: Q
1 ELASTICITY AND ITS APPLICATION
41 “Unit elastic”
% change in Q Price elasticity
= = of supply % change in P
P S
curve:
S
Sellers’
P
price sensitivity:
1 Q
Elasticity: Q
1 ELASTICITY AND ITS APPLICATION
42 “Elastic”
% change in Q Price elasticity
= = of supply % change in P
P S
curve:
S
Sellers’
P
price sensitivity:
1 Q
Elasticity: Q
1 ELASTICITY AND ITS APPLICATION
43
ELASTICITY AND ITS APPLICATION
44 S “Perfectly elastic” (the other extreme)
ELASTICITY AND ITS APPLICATION
45 The Determinants of Supply Elasticity
3
§ For which product will Q change the most?
§ For which product will P change the most?
§ Suppose population growth causes demand for both goods to double (at each price, Q d doubles).
The supply of new cars is elastic.
46 § The supply of beachfront property is inelastic.
Elasticity and changes in equilibrium
A C T I V E L E A R N I N G A C T I V E L E A R N I N G
P Q P
§ For many goods, price elasticity of supply is _________ in the long run than in the short run, because firms can build new factories, or new firms may be able to enter the market.
Example: Supply of beachfront property is harder to vary and thus less elastic than supply of new cars.
§ §
curve: Elasticity:
S
= Sellers’ price sensitivity:
% change in Q % change in P
of supply =
1 Price elasticity
1 Q
3 Elasticity and changes in equilibrium
3 A C T I V E L E A R N I N G
3 A C T I V E L E A R N I N G Answers Answers
Beachfront property (inelastic supply): P D D
1
2 Q
47
3 A C T I V E L E A R N I N G A C T I V E L E A R N I N G Answers Answers
3
New cars (elastic supply): P D D
1
2 Q
48 How the Price Elasticity of Supply Can Vary P S
$15
12
4 $3 Q
100 200 500 525
ELASTICITY AND ITS APPLICATION
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Other Elasticities : measures
§ Income elasticity of demand
Income elasticity = of demand
§ Recall from Chapter 4: An increase in income causes an increase in demand for a normal good. § Hence, for normal goods, income elasticity § For inferior goods, income elasticity
ELASTICITY AND ITS APPLICATION
50 Other Elasticities
§ Cross-price elasticity of demand :
measures Cross-price elast.
= of demand
§ For substitutes, cross-price elasticity
(e.g., an increase in price of beef causes an increase in demand for chicken) For complements, cross-price elasticity
§
(e.g., an increase in price of computers causes decrease in demand for software)
ELASTICITY AND ITS APPLICATION
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