Elasticity and its application

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 7 Elasticity IV Elasticity: the responsiveness of buyers and sellers to changes in price (or income) A useful concept − 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. [...]... 21 Elasticity and its Application Part II Demand Curve & Price Elasticity 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.… 23 “Perfectly Inelastic” Demand % change in Q Price elasticity. ..Price Elasticity of Demand Price elasticity of demand measures how much Qd responds to a change in P Price elasticity of demand Percentage change in Qd = Percentage change in P  Loosely speaking, it measures the price-sensitivity of buyers’ demand 10 Price Elasticity of Demand Price elasticity of demand Example: Price elasticity of demand equals Percentage change in Qd... price elasticity of demand 30 Price Elasticity and Total Revenue Price elasticity = of demand % change in Q % change in P Revenue = P x Q 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 31 Price Elasticity and Total Revenue  When... revenue to fall Elastic demand (elasticity = 1.8) If P = $200, Q = 12 and revenue = $2400 If P = $250, Q = 8 and revenue = $2000 Demand for your websites P increased revenue due to higher P Decreased revenue due to lower Q $250 $200 D 8 Source: Mankiw (2011) 12 Q 32 Price Elasticity and Total Revenue Price elasticity = of demand Percentage change in Q Percentage change in P  If demand is inelastic, then... (2011) 11 Price Elasticity of Demand Price elasticity of demand Percentage change in Qd = Percentage change in P P 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 as positive numbers Source: Mankiw (2011) P2 P1 D Q2 Q1 Q 12 Calculating Percentage Changes Price elasticity of demand Percentage... 10% Q 27 “Perfectly Elastic” demand any % % change in Q Price elasticity = infinity = = of demand 0% % change in P P D curve: horizontal Consumers’ price sensitivity: extreme Elasticity: infinity Source: Mankiw (2011) D P2 = P1 P changes by 0% Q2 Q1 Q changes by any % Q 28 Elasticity of a Linear Demand Curve The slope of a linear demand curve is constant, but its elasticity is not P 200% E = = 5.0... Elastic Demand % change in Q Price elasticity = = of demand % change in P D curve: intermediate slope Consumers’ price sensitivity: intermediate Elasticity: 1 Source: Mankiw (2011) 10% 10% =1 P P falls by 10% P1 P2 D Q1 Q2 Q Q rises by 10% 26 Elastic Demand > 10% % change in Q Price elasticity >1 = = of demand 10% % change in P P D curve: relatively flat Consumers’ price sensitivity: relatively high Elasticity: ... “start” and which as the “end” – you get the same answer either way! 14 Calculating Percentage Changes Using the midpoint method, the % change in P equals $250 – $200 $225 x 100% = 22.2% The % change in Q equals 12 – 8 10 x 100% = 40.0% The price elasticity of demand equals 40/22.2 = 1.8 15 Exercise IV-1: Calculate an elasticity Use the following information to calculate the price elasticity of demand... change in Q Price elasticity = = of demand % change in P D curve: vertical Consumers’ price sensitivity: none Elasticity: 0 Source: Mankiw (2011) P 0% 10% =0 D P falls P1 by 10% P2 Q1 Q changes by 0% Q 24 Inelastic Demand < 10% % change in Q Price elasticity . 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. 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