Elasticity of Demand

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ELASTICITY : 

Elasticity slide 1 ELASTICITY Elasticity is the concept economists use to describe the steepness or flatness of curves or functions. In general, elasticity measures the responsiveness of one variable to changes in another variable.

PRICE ELASTICITY OF DEMAND : 

Elasticity slide 2 PRICE ELASTICITY OF DEMAND Measures the responsiveness of quantity demanded to changes in a good’s own price. The price elasticity of demand is the percent change in quantity demanded divided by the percent change in price that caused the change in quantity demanded.

FACTS ABOUT ELASTICITY : 

Elasticity slide 3 FACTS ABOUT ELASTICITY It’s always a ratio of percentage changes. That means it is a pure number -- there are no units of measurement on elasticity. Price elasticity of demand is computed along a demand curve. Elasticity is not the same as slope.

LOTS OF ELASTICITIES! : 

Elasticity slide 4 LOTS OF ELASTICITIES! THERE ARE LOTS OF WAYS TO COMPUTE ELASTICITIES. SO BEWARE! THE DEVIL IS IN THE DETAILS. MOST OF THE AMBIGUITY IS DUE TO THE MANY WAYS YOU CAN COMPUTE A PERCENTAGE CHANGE. BE ALERT HERE. IT’S NOT DIFFICULT, BUT CARE IS NEEDED.

What’s the percent increase in price here because of the shift in supply? : 

Elasticity slide 5 What’s the percent increase in price here because of the shift in supply? pE = $2 QE S D Q price S' CIGARETTE MARKET

Slide 6: 

Elasticity slide 6 IS IT: A) [.5/2.00] times 100? B) [.5/2.50] times 100? C) [.5/2.25] times 100?

Slide 7: 

Elasticity slide 7 From time to time economists have used ALL of these measures of percentage change -- including the “Something else”! Notice that the numerical values of the percentage change in price is different for each case: Go to hidden slide

Slide 8: 

Elasticity slide 8 A) [.5/2.00] times 100 = 25 percent B) [.5/2.50] times 100 = 20 percent C) [.5/2.25] times 100 = 22.22 percent

Economists usually use the “midpoint” formula (option C), above) to compute elasticity in cases like this in order to eliminate the ambiguity that arises if we don’t know whether price increased or decreased. : 

Elasticity slide 9 Economists usually use the “midpoint” formula (option C), above) to compute elasticity in cases like this in order to eliminate the ambiguity that arises if we don’t know whether price increased or decreased.

Using the Midpoint Formula : 

Elasticity slide 10 Using the Midpoint Formula Elasticity = % change in p = times 100. % change in p = For the prices $2 and $2.50, the % change in p is approx. 22.22 percent.

What’s the percent change in Q due to the shift in supply? : 

Elasticity slide 11 What’s the percent change in Q due to the shift in supply? pE = $2.00 QE = 10 S D Q (millions) price S' pE’ = $2.50 CIGARETTE MARKET QE’ = 7

Use the midpoint formula again. : 

Elasticity slide 12 Use the midpoint formula again. Elasticity = % change in Q = % change in Q = For the quantities of 10 and 7, the % change in Q is approx. -35.3 percent. (3/8.5 times 100)

NOW COMPUTE ELASTICITY : 

Elasticity slide 13 NOW COMPUTE ELASTICITY % change in p = 22.22 percent % change in Q = -35.3 percent E = -35.3 / 22.22 = -1.6 (approx.)

Slide 14: 

Elasticity slide 14 But you can do the other options as well: A) If you use the low price, and its corresponding quantity, as the base values, then elasticity = 1.2 B) If you use the high price, and its corresponding quantity, as the base values, then elasticity = 2.1 (approx.) C) And the midpoint formula gave 1.6 (approx.) SAME PROBLEM...DIFFERENT ANSWERS!!!

MORE ELASTICITY COMPUTATIONS : 

Elasticity slide 15 MORE ELASTICITY COMPUTATIONS Q P QUANTITY PRICE 0 10 1 9 2 8 3 7 4 6 5 5 6 4 7 3 8 2 9 1 10 0 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14

Slide 16: 

Elasticity slide 16 The % change in Q = The % change in P = Therefore elasticity = USE THE MIDPOINT FORMULA. Go to hidden slide

Slide 17: 

Elasticity slide 17 The % change in Q = 66.67 = 1 / 1.5 times 100 The % change in P = 11.76 = 1 / 8.5 times 100 Therefore elasticity = -66.67 / 11.76 = -5.67 (approx.)

Slide 18: 

Elasticity slide 18 Q P QUANTITY PRICE 0 10 1 9 2 8 3 7 4 6 5 5 6 4 7 3 8 2 9 1 10 0 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14

Now we try different prices : 

Elasticity slide 19 Now we try different prices Q P QUANTITY PRICE 0 10 1 9 2 8 3 7 4 6 5 5 6 4 7 3 8 2 9 1 10 0 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14

Slide 20: 

Elasticity slide 20 The % change in Q = The % change in P = Therefore elasticity = Go to hidden slide

Slide 21: 

Elasticity slide 21 The % change in Q = 13.33 = 1 / 7.5 times 100 The % change in P = 40 = 1 / 2.5 times 100 Therefore elasticity = -13.33 / 40 = -.33 (approx.)

Slide 22: 

Elasticity slide 22 Q P QUANTITY PRICE 0 10 1 9 2 8 3 7 4 6 5 5 6 4 7 3 8 2 9 1 10 0 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14

ELASTICITY IS NOT SLOPE! : 

Elasticity slide 23 ELASTICITY IS NOT SLOPE! Q P Note that elasticity is different at the two points even though the slope is the same. (Slope = -1) QUANTITY PRICE 0 10 1 9 2 8 3 7 4 6 5 5 6 4 7 3 8 2 9 1 10 0 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14

TERMS TO LEARN : 

Elasticity slide 24 TERMS TO LEARN Demand is ELASTIC when the numerical value of elasticity is greater than 1. Demand is INELASTIC when the numerical value of elasticity is less than 1. Demand is UNIT ELASTIC when the numerical value of elasticity equals 1. NOTE: Numerical value here means “absolute value.”

LIKE THIS! : 

Elasticity slide 25 LIKE THIS! Q P QUANTITY PRICE 0 10 1 9 2 8 3 7 4 6 5 5 6 4 7 3 8 2 9 1 10 0 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14

Slide 26: 

Elasticity slide 26 There is an important relationship between what happens to consumers’ spending on a good and elasticity when there is a change in price. Spending on a good = P Q. Because demand curves are negatively sloped, a reduction in P causes Q to rise and the net effect on PQ is uncertain, and depends on the elasticity of demand.

Slide 27: 

Elasticity slide 27 Q P At P = $9, spending is $9 (= 1 times $9). At P = $8, spending is $16 ( = 2 times $8). When price fell from $9 to $8, spending rose. Q must haveincreased by a larger percent than P decreased. So... QUANTITY PRICE 0 10 1 9 2 8 3 7 4 6 5 5 6 4 7 3 8 2 9 1 10 0 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14

Slide 28: 

Elasticity slide 28 Q P At P = $3, spending is $21 (= 7 times $3). At P = $2, spending is $16 ( = 8 times $2). When price fell from $3 to $2, spending fell. Q must have increased by a smaller percent than P decreased. So... QUANTITY PRICE 0 10 1 9 2 8 3 7 4 6 5 5 6 4 7 3 8 2 9 1 10 0 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14

Slide 29: 

Elasticity slide 29 There is an easy way to tell whether demand is elastic or inelastic between any two prices. If, when price falls, total spending increases, demand is elastic. If, when price falls, total spending decreases, demand is inelastic.

But total spending is easy to see using a demand curve graph: : 

Elasticity slide 30 But total spending is easy to see using a demand curve graph: Q P The shaded area is P times Q, or total spending when P = $9. QUANTITY PRICE 0 10 1 9 2 8 3 7 4 6 5 5 6 4 7 3 8 2 9 1 10 0 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14

Slide 31: 

Elasticity slide 31 Q P The shaded area is P times Q or total spending when P = $8. QUANTITY PRICE 0 10 1 9 2 8 3 7 4 6 5 5 6 4 7 3 8 2 9 1 10 0 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14

Slide 32: 

Elasticity slide 32 Q P Total spending is higher at the price of $8 than it was at the price of $9. = loss in TR due to fall in P = gain in TR due to rise in Q QUANTITY PRICE 0 10 1 9 2 8 3 7 4 6 5 5 6 4 7 3 8 2 9 1 10 0 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14

Slide 33: 

Elasticity slide 33 Q P The shaded area is total spending (total revenue of sellers) when P = $3. QUANTITY PRICE 0 10 1 9 2 8 3 7 4 6 5 5 6 4 7 3 8 2 9 1 10 0 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14

Slide 34: 

Elasticity slide 34 Q P Total revenue of sellers (total spending by buyers) falls when price falls from $3 to $2. QUANTITY PRICE 0 10 1 9 2 8 3 7 4 6 5 5 6 4 7 3 8 2 9 1 10 0 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14

Here’s a convenient way to think of the relative elasticity of demand curves. : 

Elasticity slide 35 Here’s a convenient way to think of the relative elasticity of demand curves. p Q p* Q*

Examples of elasticity : 

Elasticity slide 36 Examples of elasticity Doctors through the AMA restrict the supply of physicians. How does this affect the incomes of doctors as a group? A labor union negotiates a higher wage. How does this affect the incomes of affected workers as a group? MSU decides to raise the price of football tickets. How is income from the sale of tickets affected? Airlines propose to raise fares by 10%. Will the boost increase revenues?

MORE ... : 

Elasticity slide 37 MORE ... MSU is considering raising tuition by 7%. Will the increase in tuition raise revenues of MSU? CATA recently raised bus fares in the Lansing area. Will this increase CATA’s total receipts?

Slide 38: 

Elasticity slide 38 The answers to all of these questions depend on the elasticity of demand for the good in question. Be sure you understand how and why!

DETERMINANTS OF DEMAND ELASTICITY : 

Elasticity slide 39 DETERMINANTS OF DEMAND ELASTICITY The more substitutes there are available for a good, the more elastic the demand for it will tend to be. [Related to the idea of necessities and luxuries. Necessities tend to have few substitutes.] The longer the time period involved, the more elastic the demand will tend to be. The higher the fraction of income spent on the good, the more elastic the demand will tend to be.

OTHER ELASTICITY MEASURES : 

Elasticity slide 40 OTHER ELASTICITY MEASURES In principle, you can compute the elasticity between any two variables. Income elasticity of demand Cross price elasticity of demand Elasticity of supply

Slide 41: 

Elasticity slide 41 Each of these concepts has the expected definition. For example, income elasticity of demand is the percent change in quantity demand divided by a percent change income: EINCOME = Income elasticity of demand will be positive for normal goods, negative for inferior ones.

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