# Elasticity and Its Applications

Figure 1 The Price Elasticity of Demand (e) Perfectly Elastic Demand: Elasticity Equals Infinity 0 Quantity Price \$4 Demand 2. At exactly \$4, consumer...

Elasticity and Its Applications

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Elasticity . . . • … allows us to analyze supply and demand with greater precision. • … is a measure of how much buyers and sellers respond to changes in market conditions

THE ELASTICITY OF DEMAND • Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

• Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.

The Price Elasticity of Demand and Its Determinants • • • •

Availability of Close Substitutes Necessities versus Luxuries Definition of the Market Time Horizon

The Price Elasticity of Demand and Its Determinants • Demand tends to be more elastic : • • • •

the larger the number of close substitutes. if the good is a luxury. the more narrowly defined the market. the longer the time period.

Computing the Price Elasticity of Demand • The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.

Price elasticity of demand =

Percentage change in quantity demanded Percentage change in price

Computing the Price Elasticity of Demand Price elasticity of demand =

Percentage change in quantity demanded Percentage change in price

• Example: If the price of an ice cream cone increases from \$2.00 to \$2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as: (10  8)  100 20% 10  2 (2.20  2.00)  100 10% 2.00

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities • The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change. (Q2  Q1) / [(Q2  Q1) / 2] Price elasticity of demand = (P2  P1) / [(P2  P1) / 2]

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities • Example: If the price of an ice cream cone increases from \$2.00 to \$2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:

(10  8) 22% (10  8) / 2   2.32 (2.20  2.00) 9.5% (2.00  2.20) / 2 Copyright © 2004 South-Western/Thomson Learning

The Variety of Demand Curves • Inelastic Demand • Quantity demanded does not respond strongly to price changes. • Price elasticity of demand is less than one.

• Elastic Demand • Quantity demanded responds strongly to changes in price. • Price elasticity of demand is greater than one.

Computing the Price Elasticity of Demand (100 - 50) (100  50)/2 ED  (4.00 - 5.00) (4.00  5.00)/2

Price

\$5 4

0

67 percent   -3 - 22 percent

Demand

50

100 Quantity

The Variety of Demand Curves • Perfectly Inelastic • Quantity demanded does not respond to price changes.

• Perfectly Elastic • Quantity demanded changes infinitely with any change in price.

• Unit Elastic • Quantity demanded changes by the same percentage as the price. Copyright © 2004 South-Western/Thomson Learning

The Variety of Demand Curves • Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.

Figure 1 The Price Elasticity of Demand

(a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand \$5

4 1. An increase in price . . .

0

100

Quantity

2. . . . leaves the quantity demanded unchanged.

Figure 1 The Price Elasticity of Demand

(b) Inelastic Demand: Elasticity Is Less Than 1 Price

\$5 4 1. A 22% increase in price . . .

Demand

0

90

100

Quantity

2. . . . leads to an 11% decrease in quantity demanded.

Figure 1 The Price Elasticity of Demand

(c) Unit Elastic Demand: Elasticity Equals 1 Price

\$5

4 Demand

1. A 22% increase in price . . .

0

80

100

Quantity

2. . . . leads to a 22% decrease in quantity demanded.

Figure 1 The Price Elasticity of Demand

(d) Elastic Demand: Elasticity Is Greater Than 1 Price

\$5 4

Demand

1. A 22% increase in price . . .

0

50

100

Quantity

2. . . . leads to a 67% decrease in quantity demanded.

Figure 1 The Price Elasticity of Demand

(e) Perfectly Elastic Demand: Elasticity Equals Infinity Price 1. At any price above \$4, quantity demanded is zero. \$4

Demand 2. At exactly \$4, consumers will buy any quantity.

0 3. At a price below \$4, quantity demanded is infinite.

Quantity

Total Revenue and the Price Elasticity of Demand • Total revenue is the amount paid by buyers and received by sellers of a good. • Computed as the price of the good times the quantity sold. TR = P x Q

Figure 2 Total Revenue Price

\$4

P × Q = \$400 (revenue)

P

0

Demand

100

Quantity

Elasticity and Total Revenue along a Linear Demand Curve • With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases.

Figure 3 How Total Revenue Changes When Price Changes: Inelastic Demand

Price

Price … leads to an Increase in total revenue from \$100 to \$240

An Increase in price from \$1 to \$3 …

\$3

Revenue = \$240 \$1 Demand

Revenue = \$100 0

100

Quantity

Demand 0

80

Quantity

Elasticity and Total Revenue along a Linear Demand Curve • With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.

Figure 4 How Total Revenue Changes When Price Changes: Elastic Demand

Price

Price … leads to an decrease in total revenue from \$200 to \$100

An Increase in price from \$4 to \$5 …

\$5 \$4 Demand

Demand Revenue = \$200

0

50

Revenue = \$100

Quantity

0

20

Quantity

Elasticity of a Linear Demand Curve

Income Elasticity of Demand • Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. • It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

Computing Income Elasticity

Percentage change in quantity demanded Income elasticity of demand = Percentage change in income

Income Elasticity • Types of Goods • Normal Goods • Inferior Goods

• Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.

Income Elasticity • Goods consumers regard as necessities tend to be income inelastic • Examples include food, fuel, clothing, utilities, and medical services.

• Goods consumers regard as luxuries tend to be income elastic. • Examples include sports cars, furs, and expensive foods.

THE ELASTICITY OF SUPPLY • Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good. • Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price.

Figure 6 The Price Elasticity of Supply

(a) Perfectly Inelastic Supply: Elasticity Equals 0 Price Supply \$5 4 1. An increase in price . . .

0

100

Quantity

2. . . . leaves the quantity supplied unchanged.

Figure 6 The Price Elasticity of Supply

(b) Inelastic Supply: Elasticity Is Less Than 1 Price Supply \$5 4 1. A 22% increase in price . . .

0

100

110

Quantity

2. . . . leads to a 10% increase in quantity supplied.

Figure 6 The Price Elasticity of Supply

(c) Unit Elastic Supply: Elasticity Equals 1 Price Supply \$5 4 1. A 22% increase in price . . .

0

100

125

Quantity

2. . . . leads to a 22% increase in quantity supplied.

Figure 6 The Price Elasticity of Supply

(d) Elastic Supply: Elasticity Is Greater Than 1 Price Supply \$5 4 1. A 22% increase in price . . .

0

100

200

Quantity

2. . . . leads to a 67% increase in quantity supplied.

Figure 6 The Price Elasticity of Supply

(e) Perfectly Elastic Supply: Elasticity Equals Infinity Price 1. At any price above \$4, quantity supplied is infinite. \$4

Supply 2. At exactly \$4, producers will supply any quantity.

0 3. At a price below \$4, quantity supplied is zero.

Quantity

Determinants of Elasticity of Supply • Ability of sellers to change the amount of the good they produce. • Beach-front land is inelastic. • Books, cars, or manufactured goods are elastic.

• Time period. • Supply is more elastic in the long run.

Computing the Price Elasticity of Supply • The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price. Percentage change in quantity supplied Price elasticity of supply = Percentage change in price

APPLICATION of ELASTICITY • Can good news for farming be bad news for farmers? • What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties?

THE APPLICATION OF SUPPLY, DEMAND, AND ELASTICITY • Examine whether the supply or demand curve shifts. • Determine the direction of the shift of the curve. • Use the supply-and-demand diagram to see how the market equilibrium changes.

Figure 8 An Increase in Supply in the Market for Wheat Price of Wheat

2. . . . leads to a large fall in price . . .

1. When demand is inelastic, an increase in supply . . . S1

S2

\$3 2

Demand 0

100

110

Quantity of Wheat

3. . . . and a proportionately smaller increase in quantity sold. As a result, revenue falls from \$300 to \$220. Copyright©2003 Southwestern/Thomson Learning

Compute the Price Elasticity of Supply

100  110 (100  110) / 2 ED  300 .  2.00 (300 .  2.00) / 2 0.095   0.24 0.4 Supply is inelastic Copyright © 2004 South-Western/Thomson Learning

Summary • Price elasticity of demand measures how much the quantity demanded responds to changes in the price. • Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. • If a demand curve is elastic, total revenue falls when the price rises. • If it is inelastic, total revenue rises as the price rises. Copyright © 2004 South-Western/Thomson Learning

Summary • The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income. • The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good. • The price elasticity of supply measures how much the quantity supplied responds to changes in the price. . Copyright © 2004 South-Western/Thomson Learning

Summary • In most markets, supply is more elastic in the long run than in the short run. • The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. • The tools of supply and demand can be applied in many different types of markets.