Elasticity and its application

Other elasticities: price elasticity of supply, income and cross-price elasticities of demand 1... taking the bus or subway − Consumers can easily purchase a substitute, we think of dem

Principles of Economics

Session IV Elasticity and its

Application

Overview

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?

Other elasticities: price elasticity of supply, income

and cross-price elasticities of demand

1

Learning Objectives

By the end of this session, students should

understand:

– the meaning of the elasticity of demand

– what determines the elasticity of demand

– the meaning of the elasticity of supply

– what determines the elasticity of supply

– the concept of elasticity in three very different

markets (the market for wheat, the market for oil, and the market for illegal drugs)

2

Part I Elasticity

Elasticity and its Application

4

 Many things in life are replaceable, or have

substitutes:

− E.g.: renting DVDs vs going out to a movie, riding

bikes vs taking the bus or subway

− Consumers can easily purchase a substitute, we think

of demand as being responsive  a small change in

price causes many people to switch from one good

to another Elasticity I

5

In contrast, many things in life are irreplaceable or

have few good substitutes:

− E.g Electricity, water, and a hospital emergency

room visit, etc

− Consumers are unresponsive, or unwilling to change

their behavior, even when the price of the good or service changes

Elasticity II

ELASTICITY AND ITS APPLICATION 6

Your “average”- looking boyfriend vs …

vs

Elasticity III

− Measure how much consumers and producers

change their behavior when prices (or income) change

A Scenario

You design websites for local businesses

You charge $200 per website,

and currently design 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 design as many

websites if you raise your price

How many fewer websites? How much will your

revenue fall, or might it increase?

8

Source: Mankiw (2011)

9

Definition of Elasticity

Basic idea:

Elasticity measures how much one variable responds

to changes in another variable

– One type of elasticity measures how much demand

for your websites will fall if you raise your price

Definition:

Elasticity is a numerical measure of the

responsiveness of Q d or Q s to one of its

determinants

10

Price Elasticity of Demand

Price elasticity of demand measures how much Q d

responds to a change in P

Price elasticity

of demand =

Percentage change in Q d Percentage change in P

 Loosely speaking, it measures the price-sensitivity of

buyers’ demand

Example:

12

Price Elasticity of Demand

Along the D curve, P and Q

move in opposite directions,

which would make price

elasticity negative

We will drop the minus sign

and report all price elasticities

Source: Mankiw (2011)

13

Calculating Percentage Changes

Standard method: (End

value - start value)/start value *100

A B vs B A?

This method provides

different answers depending on where you start!

200

14

Calculating Percentage Changes

We use the midpoint method:

The midpoint is the number halfway between the start & end values, the average of those values

It doesn’t matter which value you use as the “start” and

which as the “end” – you get the same answer either

way!

end value – start value

midpoint x 100%

15

Calculating Percentage Changes

Using the midpoint method, the % change

in P equals

The % change in Q equals

The price elasticity of demand equals

Exercise IV-1:

Calculate an elasticity

Use the following information to calculate the price

elasticity of demand for hotel rooms (use midpoint

18

What Determines Price Elasticity?

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%

– The good for which Qd falls the most (in percent) has

the highest price elasticity of demand

Which good is it? Why?

– What lesson does the example teach us about the

determinants of the price elasticity of demand?

19

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?

– Breakfast cereal has close substitutes

(e.g., eggs, pancakes, waffles, leftover pizza),

so buyers can easily switch if the price rises

– Sunscreen has no close substitutes,

so consumers would probably not

buy much less if its price rises

Lesson: Price elasticity is higher when close

substitutes are available

20

Example 2:

Insulin vs Caribbean Cruises

The prices of both of these goods rise by 20%

For which good does Qd drop the most? Why?

– To millions of diabetics, insulin is a necessity

A rise in its price would cause little or no decrease in demand

– A cruise is a luxury If the price rises,

some people will forego it

Lesson: Price elasticity is higher for luxury goods

than for necessities

21

Example 3:

Gasoline in the Short Run vs the Long Run

The price of gasoline rises by 20% Does Qd drop more

in the short run or in the long run? Why?

– There’s not much people can do in the

short run, other than ride the bus or carpool

– In the long run, people can buy smaller cars

or live closer to where they work

Lesson: Price elasticity is higher in the long run than

in the short run

Part II Demand Curve & Price Elasticity

Elasticity and its Application

23

The Variety of Demand Curves

The price elasticity of demand is closely related to the slope of the demand curve

Rule of thumb:

The flatter the curve, the bigger the elasticity

The steeper the curve, the smaller the elasticity

Five different classifications of D curves.…

29

Elasticity of a Linear Demand Curve

The slope of a linear demand curve is constant,

but its elasticity is not

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Price Elasticity and Total Revenue

Continuing from the initial scenario, if you raise your

price from $200 to $250, would your revenue rise or fall?

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 greater?

It depends on the price elasticity of demand

31

Price Elasticity and Total Revenue

If the demand is elastic, then price elasticity of

demand is greater than 1 That is,

% change in Q > % change in P

The fall in revenue from lower Q is greater than the

increase in revenue from higher P, so revenue falls

higher P

Decreased revenue due to

lower Q

Source: Mankiw (2011)

33

Price Elasticity and Total Revenue

If demand is inelastic, then

price elast 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

Revenue = P x Q

Price elasticity

of demand =

Percentage change in Q Percentage change in P

34

Price Elasticity and Total Revenue

Now, demand is inelastic:

When D is inelastic, a price increase causes revenue to rise

Demand for your websites

increased revenue due to

higher P

decreased revenue due to

lower Q

Source: Mankiw (2011)

Exercise IV-2:

Elasticity and Expenditure/revenue

A Pharmacies raise the price of insulin by 10% Does

the total expenditure on insulin rise or fall?

B As a result of a fare war, the price of a luxury cruise

falls by 20% Does luxury cruise companies’ total

revenue rise or fall?

35

Source: Mankiw (2011)

Case Study

Teen Smoking Facts:

– Each day 3,000 children smoke their first cigarette

– At least 3 million adolescents are smokers

– Tobacco use primarily begins in early adolescence, typically

by age 16

– Almost all first use occurs before high school graduation

– 20 percent of American teens smoke

– Roughly 6 million teens in the US today smoke despite the

knowledge that it is addictive and leads to disease

– Of every 100,000 15 year old smokers, tobacco will

prematurely kill at least 20,000 before the age of 70

38 Source: http://www.smoking-facts.net/Teen-Smoking-Facts.html

Case Study

Teen Smoking Facts: (cont’d)

– Of the 3,000 teens who started smoking today, nearly 1,000 will eventually die as a result from smoking

– Adolescent girls who smoke and take oral birth control pills greatly increase their chances of having blood clots and

strokes

How to reduce the quantity of smoking demanded?

39

Part III Supply Curve & Price Elasticity

Elasticity and its Application

43

Price Elasticity of Supply

Price elasticity of supply measures how much Q s

Example:

Source: Mankiw (2011)

45

The Variety of Supply Curves

The slope of the supply curve is closely related to

price elasticity of supply

Rule of thumb:

The flatter the curve, the bigger the elasticity

The steeper the curve, the smaller the elasticity

Five different classifications.…

46

The Determinants of Supply

Elasticity

The more easily sellers can change the quantity they

produce, the greater the price elasticity of supply

– Example: Supply of beachfront property is harder to vary and thus less elastic than supply of new cars

For many goods, price elasticity of supply

is greater 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

Exercise IV-3:

Elasticity and Changes in Equilibrium

The supply of beachfront property is inelastic The

supply of new cars is elastic

Suppose population growth causes demand for both

goods to double (i.e at each price, Q d doubles)

For which product will P change the most?

For which product will Q change the most?

47

How the Price Elasticity of Supply

Can Vary

Supply often becomes less

elastic as Q rises,

due to capacity limits

elasticity

< 1

Source: Mankiw (2011)

51

Other Elasticities

Income elasticity of demand: measures the response

of Qd to a change in consumer income

Income elasticity

of demand =

Percent change in Q d

Percent change in income

 Recall from Chapter 4: An increase in income causes

an increase in demand for normal goods

 Hence, for normal goods, income elasticity > 0

 For inferior goods, income elasticity < 0

52

Other Elasticities

Cross-price elasticity of demand:

measures the response of demand for one good to

changes in the price of another good

For substitutes, cross-price elasticity > 0

(e.g., an increase in price of beef causes an increase in demand for chicken)

For complements, cross-price elasticity < 0

(e.g., an increase in price of computers causes a

decrease in demand for software)

Cross-price elast

of demand =

% change in Q d for good 1

% change in price of good 2

Quiz 1: True or False?

When the price of knee braces increased by 25

percent, the Brace Yourself Company increased its

quantity supplied of knee braces per week by 75

percent BYC's price elasticity of supply of knee

braces is 0.33

53

Quiz 2: True or False?

If a firm is facing elastic demand, then the firm should decrease price to increase revenue

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Summary I

Elasticity measures the responsiveness of

Qd or Qs to one of its determinants

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 in the short run

Summary II

Price elasticity of demand equals percentage change

When it’s less than one, demand is “inelastic.” When greater than one, demand is “elastic.”

When demand is inelastic, total revenue rises when

price rises When demand is elastic, total revenue

falls when price rises

Demand is less elastic in the short run,

for necessities, for broadly defined goods,

or for goods with few close substitutes

58

Summary III

Price elasticity of supply equals percentage change in

When it’s less than one, supply is “inelastic.” When

greater than one, supply is “elastic.”

Price elasticity of supply is greater in the long run

than in the short run

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Summary IV

The income elasticity of demand measures how much quantity demanded responds to changes in buyers’

incomes

The cross-price elasticity of demand measures how

much demand for one good responds to changes in the price of another good

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Evaluation of the Session

Choose the most appropriate words below to fill in the blanks

– ( ) is the responsiveness of buyers to changes in

price elasticity of supply, price elasticity of demand, total

revenue, income elasticity of demand