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The answer relies on elasticity “Elasticity” is similar to “responsiveness” Price Elasticity of Demand – a measure of how responsive quantity demanded is to a price change Price Elasticity of Supply – a measure of how responsive quantity supplied is to a price change Price Elasticity of Demand : Price Elasticity of Demand Mathematically… Example : Example What is the price elasticity of demand for CDs? At a price of $14 per CD, there are 10,000 CDs sold When the price is decreased to $12 per CD, 11,000 CDs are sold Price per CD Thousands of CDs D $14 $12 10 11 Keep this in mind… : Keep this in mind… Because price and quantity are inversely related, the price elasticity of demand will be negative This is because a price decrease will cause an increase in quantity demanded (and vice versa) Most of the time, then, I will refer to the absolute value of the elasticity The magnitude is most important Categories of Price Elasticity of Demand : Categories of Price Elasticity of Demand Inelastic Demand – a change in price has very little effect on the quantity demanded (-1 < ED < 0) These goods are often necessities Elastic Demand – a change in the price has a relatively large effect on the quantity demanded (ED < -1) These are often more “unnecessary” Unit-Elastic Demand – the percentage change in quantity demanded equals the percentage change in price (ED = -1) Slide 7: 0 -1 Inelastic Unit-Elastic Elastic Elasticity of Demand Elasticity… : Elasticity… Varies along the demand curve for the same product You respond differently if the price changes from 1 cent to 2 cents, than you do if the price changes from $5 to $10 (both are 100% increases) Varies across products Regardless of where we are on the demand curve, you might expect the demand for milk to be less elastic than the demand for BMWs Slide 9: Demand Curve More Elastic More Inelastic P Q Elasticity and Total Revenue : Elasticity and Total Revenue Total Revenue – the amount of money a firm collects through sales TR = Price * Quantity How is Total Revenue related to Elasticity? Recall that a lower price leads to an increase in quantity demanded… Whether Total Revenue increases or decreases change (due to a price decrease) will depend on whether the percentage increase in the quantity demanded is less than or greater than the price decrease Slide 11: Unit Elastic Inelastic Elastic P Q TR Q What Does this Graph Show? : What Does this Graph Show? Should you increase or decrease price to increase Total Revenue??? In the elastic portion of the demand curve, the % change in quantity demanded is greater than the % change in price, so you should decrease price in order to increase total revenue In the inelastic portion of the demand curve, the % change in quantity demanded is less than the % change in price, so you should increase price in order to increase total revenue Total revenue is maximized at the unit elastic point Constant-Elasticity Demand Curves : Constant-Elasticity Demand Curves For a downward sloping linear demand curve, the price elasticity changes as you move along the demand curve Some demand curves have an elasticity that does NOT vary along the demand curve Perfectly Elastic Demand Curve – an increase in price reduces the quantity demanded to zero (horizontal demand curve) Perfectly Inelastic Demand Curve – price changes have no effect on the quantity demanded (vertical demand curve) Slide 14: Q P P Q D D Perfectly Elastic Demand Perfectly Inelastic Demand Determinants of the Price Elasticity of Demand : Determinants of the Price Elasticity of Demand Availability of Substitutes – the more substitutes are available for a good, the more elastic the demand (if the price increases, you might be likely to switch to another good) Proportion of a Consumer’s Budget Spent on the Good – the larger the percentage of a consumer’s budget, the greater the price sensitivity (ex. comparison shopping for cars) Time – the longer you have to make your choice, the more elastic your demand will be (ex. what if your refrigerator breaks down?) Slide 16: Price Elasticity of Supply Mathematically… Slide 17: Categories of Price Elasticity of Supply Inelastic Supply – a change in price has very little effect on the quantity supplied (0 < ES < 1) Elastic Supply – a change in the price has a relatively large effect on the quantity supplied (ES > 1) Unit-Elastic Supply – the percentage change in quantity supplied equals the percentage change in price (ES = 1) Slide 18: 0 1 Elastic Unit-Elastic Inelastic Elasticity of Supply Elasticity of Supply Also Varies… : Elasticity of Supply Also Varies… Just as the elasticity of demand varied both along the demand curve and across products, so does the elasticity of supply Slide 20: Supply Curve More Elastic More Inelastic P Q Slide 21: Constant-Elasticity Supply Curves For an upward sloping linear supply curve, the price elasticity changes as you move along the supply curve Some supply curves have an elasticity that does NOT vary along the supply curve Perfectly Elastic Supply Curve – at the right price, any amount of the product will be supplied (horizontal supply curve) Perfectly Inelastic Supply Curve – price changes have no effect on the quantity supplied, which is likely a fixed amount (vertical supply curve) Slide 22: Q P P Q S S Perfectly Elastic Supply Perfectly Inelastic Supply Slide 23: Determinants of the Price Elasticity of Supply Both depend on how easy it is to alter output when price changes Cost of Supplying Additional Output – if it is costly to increase output, then a price increase won’t cause the firm to expand output significantly (therefore, supply is inelastic) Time – how long does the firm have to make the output change? The longer the time, the more elastic the supply Other Elasticity Measures : Other Elasticity Measures Income Elasticity of Demand – a measure of the responsiveness of demand to changes in income Cross-Price Elasticity of Demand- a measure of how responsive one good’s quantity demanded is to a change in the price of another good (i.e. how do brand X’s sales respond to changes in the price of brand Y) Income Elasticity of Demand : Income Elasticity of Demand Normal Good – a good with an income elasticity greater than zero Why is the elasticity greater than zero? Because the demand curve shifts out with income increases Most goods are normal goods Inferior Good – a good with an income elasticity less than zero Why is the Income Elasticity of Demand negative? Because the demand curve shifts in with income increases Cross-Price Elasticity of Demand : Cross-Price Elasticity of Demand Substitutes – if an increase in the price of one good leads to an increase in the demand for another good, they are substitutes The Cross-Price Elasticity is POSITIVE Example: Coke and Pepsi have a positive cross-price elasticity Complements – if an increase in the price of one good leads to a decrease in the demand for another good, they are complements The Cross-Price Elasticity is NEGATIVE Example: Peanut butter and jelly or hot dogs and buns Elasticity Examples : Elasticity Examples To help us think about elasticity concepts, we are going to look at four different industries/products: Cars, soft drinks, cereal, and beer Your book has a ton of other examples When you look at the elasticities, try to explain the differences among brands and products Substitutability, proportion of income spent on the item, and time to make your decision Elasticity of Automobiles : Elasticity of Automobiles Price elasticity of demand: BMW 735i = -9.376 Honda Accord = -51.637 Ford Escort = -106.497 Cross-price elasticity of demand: BMW 735i & Lexus LS400 = 0.336 BMW 735i & Honda Accord = 0.203 BMW 735i & Ford Escort = 0.009 Which cars are close substitutes? What role does income play? Which consumers are most price sensitive? Elasticity of Breakfast Cereal : Elasticity of Breakfast Cereal Price elasticity of demand: Kellogg’s Corn Flakes = -3.379 Lucky Charms = -2.536 Rice Krispies = -2.340 Cross-price elasticity of demand: Corn Flakes & Wheaties = 0.242 Corn Flakes & Lucky Charms = 0.019 Corn Flakes & Cinnamon Toast Crunch = 0.026 Lucky Charms & Cin. Toast Crunch = 0.102 Elasticity of Soft Drinks : Elasticity of Soft Drinks Price elasticity of demand: Coke (2-liter bottle) = -3.89 7-Up (2-liter bottle) = -4.25 Mountain Dew (2-liter bottle) = -3.75 Cross-price elasticity of demand: Coke & Pepsi = 0.63 Coke & Mountain Dew = 0.12 Coke & Diet Coke = 0.81 Elasticity of Beer : Elasticity of Beer Price elasticity of demand: Miller Lite = -2.10 Budweiser = -3.80 Heineken = -0.42 Cross-price elasticity of demand: Miller Lite & Bud Light = 1.26 Miller Lite & Heineken = 0.12 MGD & Bud = 1.68 Questions to think about? : Questions to think about? Why is the price elasticity of the Ford Escort lower than the BMW? Why is the price elasticity of cereal less than the price elasticity of cars? Why is the cross-price elasticity greater for Corn Flakes & Wheaties than it was for Corn Flakes & Lucky Charms? Are Miller Lite and Bud Light closer substitutes than Miller Lite and Heineken? Slide 33: Income IncomeProduct Elasticity Product Elasticity Private education 2.46 Physicians’ services 0.75 Automobiles 2.45 Coca-Cola 0.68 Wine 2.45 Beef 0.62 Owner-occupied housing 1.49 Food 0.51 Furniture 1.48 Coffee 0.51 Dental service 1.42 Cigarettes 0.50 Restaurant meals 1.40 Gasoline and oil 0.48 Shoes 1.10 Rental housing 0.43 Chicken 1.06 Beer 0.27 Spirits (“hard” liquor) 1.02 Pork 0.18 Clothing 0.92 Flour –0.36 Selected Income Elasticities of Demand In-Class Problem to Solve : In-Class Problem to Solve Last year, Homer had an income of $40,000 from his job at the Springfield Nuclear Power Plant. At that level of income, Homer consumed 15 units of Good X. This year, Homer received a $15,000 raise. After his raise, he consumed 18 units of Good X. Using the above information, please calculate Homer’s income elasticity of demand. Is Good X a normal or inferior good? If Homer’s boss gave him an additional 10% raise, what would happen to Homer’s consumption of Good X? Solutions : Solutions Normal good => EI > 0 You do not have the permission to view this presentation. In order to view it, please contact the author of the presentation.