Micro Ch4 Elasticities

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IB Econ Micro Elasticity

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Elasticities:

Elasticities IB Economics

Slide2:

The concept of elasticity If you were planning to have a pizza for dinner and saw a sign in your favourite pizza restaurant that read, 'Due to increases in the cost of cheese - all items on the menu have been increased by BD4.000 until further notice' would you still go in and order pizza for dinner? Suppose you notice the fuel indicator on your car pointing to 'Empty.' As you pull into the gas station, you see the price of petrol has risen by 500 fils a litre. Do you still get petrol? The answers to these questions may well depend on the price elasticity of demand.

Slide3:

The concept of price elasticity We have already learned about the law of demand - the economic principle says that says we will buy less of a good if the price rises. You can probably think of many goods you buy that would meet the law of demand. However, there are other goods that seem to defy the law of demand. That may be due to the price elasticity of the good. What is the price elasticity of demand? It is a measure of the responsiveness of quantity demanded to a price change . In other words, if the price of good changes, do we change the quantity we buy and how much?

Slide4:

The concept of price elasticity The reason this is an important concept is because firms can use it to decide on their pricing policies – they need to know what will happen to the amount they sell if they increase (or decrease) the price of their products/service Christmas has just finished and I am a manager of a firm that wants to get rid of remaining stock however I still want to maximise my revenue and profit. If I knew the price elasticity of my products I could work that out

Slide5:

Watch this mjmfoodie video http://www.youtube.com/watch?v=4oj_lnj6pXA

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Price elasticity of demand – how do we work it out? Lets illustrate this with a simple example A price of a bar of chocolate falls from 40p to 36p and as a consequence demand rises from 1000 bars per week to 1200 bars per week The price of the chocolate has changed by 4p which is a percentage of 4/40 = 1/10 = 10% (-) The quantity has changed by 200 (from 1000 to 1200) which is a percentage of 200/1000 = 1/5 = 20% We can now work out the price elasticity using the formula Percentage change in quantity demanded Percentage change in price In this example that’s + 20 = -2 -10 Economists would say that this product is relatively price elastic because a small change in price (10%) brought about a bigger change in the quantity demanded (20%)

Slide7:

What does our PeD answer mean? When price falls we expect to see an extension of demand (remember that movement along the curve) and When price rises we expect to see a contraction of demand We know there is an inverse or negative relationship between price and demand which should always give us a negative value for PeD (abbreviation for Price elasticity of demand) We ignore the sign but focus on the coefficient of elasticity (the coefficient is just the number) So…the answer to our last example was -2. We ignore the negative and concentrate on the coefficient of 2

Slide8:

Values for PED Where the % change in demand is greater than % change in price – demand is elastic Change in demand is very sensitive to the change in price Where the % change in demand is less than % change in price – demand is inelastic Change in demand is not sensitive to change in price If PED = 0 then demand is perfectly inelastic - demand does not change when the price changes If PED is between 0 and 1 then demand is inelastic If PED = 1 then demand is said to unit elastic (the % change in price is equal to the % change in demand) If Ped > 1 , then % change in demand is bigger than the % change in price – i.e. demand is elastic Remember that elasticity always compares the size of the change (price % vs demand %) – Is the price change bigger or smaller than the demand change

Slide9:

TIP. Can’t remember the formula? Try remembering that you need to Q before you can have a P! Reminder of how we do it Step 1 - work out the percentage change in quantity demanded New quantity – Old quantity x 100 Old quantity Step 2 - work out the percentage change in price New price – Old price x 100 Old price Step 3 - Use the formula below Percentage change in quantity demanded Percentage change in price Step 4 - Forget the negative Step 5 - How big is your answer? Between 0 and 1 – price inelastic demand 1 – unitary price elastic demand Above 1 – price elastic demand

Slide10:

Inelastic demand curve An inelastic demand curve will look like this A good way of remembering this is the first letter of I nelastic is I – I is vertical and the inelastic demand curve is close to vertical. Lets look at how changes in price would affect a firm’s revenue when the product is price inelastic Quantity Demanded Price D

Slide11:

Quantity Demanded Price £200 400 % change in demand = 50/350 = 14.3% % change in price = 200/400 = 50% Elasticity? 14.3/50 = 0.286 (less than 1 is inelastic) 350 £400 Inelastic demand curve – affect on revenue The price was £400 and now it is £200 The quantity was 350 but is now 400 What is the elasticity?

Slide12:

Quantity Demanded Price £200 400 Total revenue = price x quantity = 400 x 350 = £140,000 New Total revenue = price x quantity = 200 x 400 = £80,000 350 £400 Inelastic demand curve – affect on revenue When the firm puts the price down to 200 it sells more; it sells 400 instead of 350 units What is happening to the revenue? Revenue decreases from £140,000 to £80,000 When a product’s PED is inelastic and the price falls the firm will face falls in revenue Remember - We only know that revenue falls; we can’t tell whether it has made more or less profit because we do not know its costs Profit = Total Revenue – Total Costs

Slide13:

Price £200 400 £100 1200 % change in demand = 200% (800/400) % change in price = 50% (100/200) Price elasticity of demand = -4 (more than 1 = elastic) Forget the negative! Elastic demand curve An elastic demand curve looks like this. Remember that elastic begins with an E – an has horizontal lines and an elastic curve is close to horizontal The price was £200 and is now £100 What is the elasticity?

Slide14:

Price £200 400 £100 1200 Total revenue when price = £200 = £80,000 Total revenue when price = £100 = £120,000 Elastic demand curve – the affect on revenue A firm with an elastic product sells 400 units when the selling price is £200 The firm decreases its selling price to £100 and sells 1200 units What happened to its revenue? The revenue changes from £80,000 to £120,000 When the selling price of a product that has an elastic PED is decreased the revenue increases (they sell more) . Remember - We can’t tell whether it has made more or less profit because we do not know its costs Profit = Total Revenue – Total Costs

Slide15:

White board practice Draw two diagrams next to each other with exactly the same scale Draw one with an elastic demand curve (only) One with an inelastic demand curve (only) Now see what happens to the revenue/change in quantity when the price falls`( use the same starting price and the same end price on both ) Now complete student workpoints 4.1 and 4.2 on Pages 48 and 49

Slide16:

Quantity Price £200 600 £300 £400 Perfectly Inelastic and Elastic demand curves We need to think about elasticity as a continuum (a scale) – at one end of the scale there is perfectly inelastic and at the other perfectly elastic. Then in-between there will be different degrees of elasticity (or inelasticity). Perfectly inelastic is really only a theoretical extreme – no product is ever likely to be perfectly inelastic. The same goes for perfectly elastic. Products will always lie somewhere between these two extremes. Price 400 1200 £200 Quantity Perfectly Inelastic Curve Perfectly Elastic Curve Unit elastic Perfectly elastic Perfectly Inelastic Inelastic elastic

Slide17:

This table summarises all that we have seen so far When the answer to our Ped calculation is What it is called What it means Effect on a firm’s total revenue of a price cut What does the demand curve look like? 0 Perfectly inelastic When price changes there is no effect on demand Price falls, demand does not change and total revenue falls Between 0 and 1 Inelastic Demand is relatively unresponsive to change in price Total revenue falls 1 Unit elastic The change in price brings about the same proportionate change in demand Revenue remains the same Above 1 Elastic A fall in price means the amount demanded is proportionately more than the price cut Total revenue increases Infinity Perfectly elastic A fall in price leads to an infinite level of demand A fall in price leads to huge increases in total revenue

Slide18:

A mathematical note about elasticity It is a common mistake to think that elasticity is a measure of the slope of the demand curve This is not true The PED will reduce as the price falls This is logical if you think about it – you will be more price sensitive to a change in price of a good that is high price than you would be to a change in price of a low price good This is shown in this diagram

Slide19:

Factors that determine price elasticity of demand (determinants) The availability of substitutes if there are plenty of substitutes available and the firm puts the price up people will go elsewhere – the demand curve will be elastic. If there are no substitutes or very few the demand curve will be inelastic because consumers do not have the choice to go elsewhere. A firm could make its curve more inelastic by building brand loyalty Time if a consumer needs a product immediately or in the near future then they may accept a price change and not go elsewhere however if they have time to wait then they can go elsewhere. Initially the product will be price inelastic but in the long term may be elastic. E.g. people with oil powered central heating suffered when oil prices went up – they had to pay the higher prices however in the long term they may change their heating systems to alternative sources.

Slide20:

Factors that determine price elasticity of demand (determinants) Whether the product is a luxury or a necessity – necessities need to be bought regardless of the price and therefore tend to be more inelastic than luxuries The proportion of income spent on a good if a product is fairly low priced and takes up little of our total income we will continue to buy it even if the price rises because it has little affect on our standard of living e.g. daily newspaper, chewing gum etc. These products would be relatively price inelastic . If a product is expensive and buying it would be a large proportion of our income then we may not buy it if the price went up because it would affect our standard of living. This type of product is likely to be price elastic e.g. cars, houses etc. For each of the following pairs of goods identify the one that you would expect to have the higher price elasticity of demand and explain your choice referring to at least one of the determinants of elasticity Heineken beer and beer; 2. A prescription tablet to reduce blood pressure and a tablet to reduce headache pain; 3. Milk and Orange juice

Slide21:

Price elasticity and the incidence of tax Quite often when market forces are not working effectively to allocate resources government will intervene through taxes or subsidies A subsidy is a payment by government to producers to encourage production of goods or services A tax is a way of discouraging consumption (petrol) or raising revenue If a firm is taxed it will pass some (or all) of this onto the consumer (this is called an indirect tax such as VAT ). The proportion of tax that is passed on is called the incidence of tax Government has to be careful not to tax goods that are elastic If prices go up consumers will reduce the quantity demanded Producers in that industry will produce less and make people unemployed Since governments are not keen on unemployment they tend to place taxes on inelastic goods We look at tax in a lot more detail in the next chapter Complete student point 4.4. page 52

Slide22:

Pajholden videos Price elasticity of demand part 1 http://www.youtube.com/user/pajholden#p/search/0/MNiEHvw6TTg Price elasticity of demand part 2 http://www.youtube.com/user/pajholden#p/search/3/DB6rmbAegvE

Slide23:

Time for you to do some work!! Look through your notes and pages Complete Exam Q’s 1 & 2 on P61 (timed!) With the help of examples explain the determinants of price elasticity of demand (10 marks) A business person wants to increase her revenues. Using appropriate diagrams, explain why knowledge of price elasticity of demand would be useful. (10 marks)

Slide24:

Cross price elasticity of demand (XED) and Income elasticity of demand (YeD)

Slide25:

Income elasticity of demand (Yed) Before we were measuring the responsiveness of demand to a change in the price level. This time we are seeking to measure the responsiveness of demand to changes in income In most cases we would expect demand for goods and services to rise when we have more income – we would call these normal goods Sometimes the demand for certain goods falls as income rises – these are inferior goods Consumers with extra income may prefer to trade up to a more desirable brand With more income demand will rise if the good is normal With more income demand will fall if the good is inferior

Slide26:

Income elasticity of demand (Yed) Remember when we look at elasticity we are comparing % changes If demand is said to be income inelastic it does not mean that there is less demand or it doesn’t change if income rises Demand will rise but at a much lower proportion than the rise in income Negative income elasticity means that demand falls when income rises (inferior good) Income elastic means that demand rises at a higher proportion than the rise in income Why is this useful? When economies grow their average incomes tend to rise. It is quite likely that firms will expect increasing demands for their goods and services and it is good to know how much of an increase they will see.

Slide27:

How do we measure income elasticity of demand The formula for income elasticity of demand is very similar to the Ped Percentage change in quantity demanded Percentage change in income Remember Q before you P still applies! So the Q (quantity) goes over the P (price). An example – if there was a 5% rise in income which brought about a 7% rise in demand for CDs then income elasticity would be 7 / 5 = +1.4 This time we do have to take note of the sign – if its positive then it’s a normal good, if its negative then its inferior Positive YED means the good is normal Negative YED means the good is inferior

Slide28:

The range of values for YED When the coefficient is more than 1 mean that demand is income elastic When the coefficient is between 0 and 1 mean it is relatively income inelastic When the sign is negative the good is an inferior good Remember to look at the co-efficient and the sign separately In times of rapid growth we expect demand for income elastic products, typically more luxury products such as holidays, restaurant food, clothing and jewellery, to rise at a faster rate than income. Employment in these industries is also likely to grow faster than other industries. The opposite is true in a recession. Complete student workpoint 4.6 on page 56

Slide29:

Cross price elasticity of demand (XPed) This concept examines the extent to which changes in the price of one good affect demand for another good If you ran a business selling BMWs then changes to prices of similar cars such as Mercedes would affect your levels of sales The products need to be fairly close substitutes or a complementary good for this to happen Rises in costs of petrol may affect sales of cars Cross price elasticity explores how much demand might change The formula is Percentage change in quantity demanded of good A Percentage change in price of good B If we use our example of BMW and Mercedes and say that if when Mercedes reduced their price by 10% demand for BMW fell by 12% this gives us XPed of -10 / -12 = +1.2 The fact that the answer is positive shows us that these are competing goods or substitutes. The higher the cross price elasticity the closer they are substitutes. Q before u P!

Slide30:

Range of results for XED If the result is negative the goods are complements If the coefficient (the number) is high the are very close complements If the result is positive the goods are substitutes If the coefficient is high the goods are close substitutes Remember to look at the coefficient separately from the sign PlayStation and games are complementary goods. If the price of the games go up this may affect the demand for the PlayStation itself. The result would be negative. If the coefficient is high they are close complements Complete student workpoint 4.5 on page 54

Slide31:

Pajholden videos Income elasticity of demand http://www.youtube.com/watch?v=LHv4SnEUcZA Cross elasticity of demand http://www.youtube.com/user/pajholden#p/search/4/blA5cFnq8Bw

Slide32:

Time for you to do some work!! Read through pages 53-56 Complete all of the student workpoints Complete Exam Q3 & 5 on P61

Slide33:

Price Elasticity of Supply (PES)

Watch the holden video:

Watch the holden video http://www.youtube.com/user/pajholden#p/search/2/20b_zVHmZG0 Price elasticity of supply

Slide35:

Price elasticity of supply (PeS) So far we have looked at how changes in price have affected demand Now we are looking at how changes in price affect supply We know that if businesses believe they can make more profit they will supply more and we have already said that as prices rise supply also rises but by how much? The formula is once again very similar Percentage change in quantity supplied Percentage change in price Just as with PED the resultant answer will always have the same sign so we can ignore it It will always be positive because there is a positive relationship between price and quantity Again, the size of the coefficient indicates the degree to which supply is elastic Answers below 1 are price inelastic supply – supply is relatively unresponsive to changes in price Answers above 1 are price elastic supply – supply is responsive to changes in price

Slide36:

Price elasticity of supply (PeS) If a supply curve is elastic it will look like this (remember the E for elastic has horizontal lines so elastic is close to horizontal) If a supply curve is inelastic it will look like this (remember that the I for Inelastic is vertical so inelastic is close to vertical) The elasticity of the supply curve makes a big difference to changes in equilibrium price and quantity. It may be that there is a large increase in demand but it is not possible to supply more very quickly. For example a farmer growing tomatoes – tomatoes take time to grow and he will only have a certain amount of land Commodities such oil, tea, iron ore, wheat etc – unless there are large stocks available it is going to be very difficult to produce more to meet the increase in demand Vintage wines Many supply curves will be perfectly inelastic (vertical) in the short term

Slide37:

Factors affecting the price elasticity of supply (determinants) Time – time is the key factor in determining price elasticity. If market prices are rising the producer will want to take advantage of this to make more profit but it will take time to produce extra output Undiscovered resources – the supply of many raw materials is inelastic because mining firms need to explore and find new resources – even if they did know where to find the reserves it will take a long time to drill wells or dig new mines Availability of stocks – firms will hold stocks of finished goods however they tend to keep these stocks as low as possible – if stocks of products are available then the supply will be fairly elastic and be able to meet changes in demand The ease of switching between alternative - if a firm can switch from producing one product to another then the product will be supply elastic. For example an icecream manufacturer may use batch processes and be able to switch from chocolate to vanilla quite easy if the demand for vanilla rose

Slide38:

Factors affecting the price elasticity of supply The availability of spare capacity – if firms in a market are all working to capacity the good is likely to be supply inelastic – firms would need to buy new machinery, employ more people etc to be able to expand supply The number of firms in the market and ease with which firms can enter a market – remember that supply is the supply of all the firms in the market. If prices increase but firms in the market are already producing to capacity they are not going to be able to increase output quickly. Other firms may be attracted to the market but if the barriers to entry and exit are high they may decide not to enter the market. Supply will remain inelastic. If there are few barriers to entry or exit supply may be elastic. The ability to alter production methods – if firms can transfer quickly to alternative methods of production, for example more capital intensive production, then the supply curve will become more elastic.

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Factors affecting the price elasticity of supply Perfectly inelastic supply curves crop up on exam papers fairly often A perfectly inelastic supply curve is like this In these cases supply cannot increase even when the price rises (particularly in the short term) Examples Road space Land for building within a city Sports and entertainment venues (limited seats) Watch this pajholden video

Slide40:

Time for you to do some work!! Read through pages 56-60 Complete the following exam question With the help of examples, explain the determinants of price elasticity of supply (10 marks) Revise for multiple choice test tomorrow Multiple choice!

Slide41:

Pajholden videos Price elasticity of demand part 1 http://www.youtube.com/user/pajholden#p/search/0/MNiEHvw6TTg Price elasticity of demand part 2 http://www.youtube.com/user/pajholden#p/search/3/DB6rmbAegvE Price elasticity of supply http://www.youtube.com/user/pajholden#p/search/2/20b_zVHmZG0 Income elasticity of demand http://www.youtube.com/user/pajholden#p/search/1/LHv4SnEUcZA Cross elasticity of demand http://www.youtube.com/user/pajholden#p/search/4/blA5cFnq8Bw

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