04 Elasticity McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc All rights reserved Chapter Objectives Price Elasticity of Demand Total Revenue Te st Elasticity on a Linear Demand Cu rve Price Elasticity and the Total-Rev enue Curve Determinants of P rice Elasticity o f Demand Price Elasticity o f Supply Cross Elasticity Income Elasticity Consumer and Pr oducer Surplus Last Word Key Terms End Show 6-2 • Price Elasticity of Demand and How It Can Be Applied • The Usefulness of the Total Revenue Test for Price Elasticity of Demand • Price Elasticity of Supply and How It Can Be Applied • Cross Elasticity of Demand and Income Elasticity of Demand • Consumer Surplus, Producer Surplus, and Efficiency Losses Copyright 2008 The McGraw-Hill Companies Price Elasticity of Demand Price Elasticity of Demand Total Revenue Te st Elasticity on a Linear Demand Cu rve Price Elasticity and the Total-Rev enue Curve Determinants of P rice Elasticity o f Demand Price Elasticity o f Supply Cross Elasticity Income Elasticity Consumer and Pr oducer Surplus Last Word Think about it……… The law of demand says consumers will buy more when prices go down and less when prices go up … HOW MUCH MORE OR LESS? DOES IT MATTER? To whom? Price elasticity, with respect to demand, provides an answer Key Terms End Show 6-3 Copyright 2008 The McGraw-Hill Companies Price Elasticity of Demand Price Elasticity of Demand Total Revenue Te st Elasticity on a Linear Demand Cu rve Price Elasticity and the Total-Rev enue Curve Determinants of P rice Elasticity o f Demand Price Elasticity o f Supply Cross Elasticity Income Elasticity Consumer and Pr oducer Surplus Last Word Measures Responsiveness to Price Changes Elasticity Coefficient= % delta Q divided by % delta P P 01 02 Elasticity = 5, therefore, relatively inelastic… P1 P2 D Q1 Q2 Key Terms End Show 6-4 Copyright 2008 The McGraw-Hill Companies Q PRICE ELASTICITY OF DEMAND Price Elasticity of Demand Total Revenue Te st Elasticity on a Linear Demand Cu rve Price Elasticity and the Total-Rev enue Curve Determinants of P rice Elasticity o f Demand Price Elasticity o f Supply Cross Elasticity Income Elasticity Consumer and Pr oducer Surplus Last Word Commonly Expressed as… P The percentage change in quantity The percentage change in price %∆Q d %∆ P P2 P1 Key Terms Q2 Q1 End Show 6-5 Copyright 2008 The McGraw-Hill Companies D Elasticity is Q Price Elasticity of Demand Total Revenue Te st Elasticity on a Linear Demand Cu rve Price Elasticity and the Total-Rev enue Curve Determinants of P rice Elasticity o f Demand Price Elasticity o f Supply Cross Elasticity Income Elasticity Consumer and Pr oducer Surplus Last Word Price Elasticity of Demand • Measuring Responsiveness to Price Changes • Relatively Elastic or Inelastic • Price-Elasticity Coefficient and Formula O 6.1 Ed = Key Terms End Show 6-6 Percentage Change in Quantity Demanded of Product X Percentage Change in Price of Product X Copyright 2008 The McGraw-Hill Companies Price Elasticity of Demand Price Elasticity of Demand Total Revenue Te st Elasticity on a Linear Demand Cu rve Price Elasticity and the Total-Rev enue Curve Determinants of P rice Elasticity o f Demand Price Elasticity o f Supply Cross Elasticity Income Elasticity Consumer and Pr oducer Surplus Last Word • Formula Restated Ed = End Show 6-7 Original Quantity Demanded of X ÷ Change in Price of X Original Price of X • Using Averages • Midpoint Formula Ed = Key Terms Change in Quantity Demanded of X Change in Quantity Sum of Quantities/2 Copyright 2008 The McGraw-Hill Companies ÷ W 6.1 Change in Price Sum of Prices/2 Price Elasticity of Demand Total Revenue Te st Elasticity on a Linear Demand Cu rve Price Elasticity and the Total-Rev enue Curve Determinants of P rice Elasticity o f Demand Price Elasticity o f Supply Cross Elasticity Income Elasticity Consumer and Pr oducer Surplus Last Word Price Elasticity of Demand • Why Use Percentages? • Elimination of the Minus Sign • Interpretations of Ed Elastic Demand Ed = 04 02 =2 Ed = 01 02 = 02 02 =1 Inelastic Demand Unit Elasticity Key Terms Ed = End Show 6-8 Copyright 2008 The McGraw-Hill Companies Price Elasticity of Demand Price Elasticity of Demand Total Revenue Te st Elasticity on a Linear Demand Cu rve Price Elasticity and the Total-Rev enue Curve Determinants of P rice Elasticity o f Demand Price Elasticity o f Supply Cross Elasticity Income Elasticity Consumer and Pr oducer Surplus Last Word Extreme Cases Perfectly Inelastic Demand P Q Perfectly Elastic Demand P 6-9 Perfectly Inelastic Demand (Ed = 0) Key Terms End Show D1 Copyright 2008 The McGraw-Hill Companies Perfectly Elastic Demand (Ed = ∞) D2 Q Price Elasticity of Demand Total Revenue Te st Elasticity on a Linear Demand Cu rve Price Elasticity and the Total-Rev enue Curve Determinants of P rice Elasticity o f Demand Price Elasticity o f Supply Cross Elasticity Income Elasticity Consumer and Pr oducer Surplus Last Word Key Terms End Show 6-10 • • • • • Determinants of Price Elasticity of Demand Substitutability Proportion of Income Luxuries versus Necessities Time Applications: – Large Crop Yields – Excise Taxes – Decriminalization of Illegal Drugs Copyright 2008 The McGraw-Hill Companies Summary of Price Elasticity of Demand Price Elasticity of Demand: A Summary Absolute Value of Elasticity Coefficient Demand Is: Impact on Total Revenue of a: Description Price Increase Price Decrease Qd changes by a larger percentage than does price Total Revenue decreases Total Revenue increases Greater than (Ed > 1) Elastic or relatively elastic Equal to (Ed = 1) Unit or unitary Qd changes by elastic the same percentage as does price Total revenue is unchanged Total revenue is unchanged Less than (Ed < 1) Inelastic or relatively inelastic Total revenue increases Total revenue decreases LO2 Qd changes by a smaller percentage than does price 4-16 Price Elasticity of Supply Price Elasticity of Demand Total Revenue Te st Elasticity on a Linear Demand Cu rve Price Elasticity and the Total-Rev enue Curve Determinants of P rice Elasticity o f Demand Price Elasticity o f Supply Cross Elasticity Income Elasticity Consumer and Pr oducer Surplus Last Word Es = Percentage Change in Quantity Supplied of Product X Percentage Change in Price of Product X Perfectly Inelastic Supply Market Period: Not Enough Time to Shift Resources P Greatest Price Impact Sm Pm P0 Key Terms D1 D2 End Show Q0 6-17 Copyright 2008 The McGraw-Hill Companies Q O 6.2 Price Elasticity of Supply Price Elasticity of Demand Total Revenue Te st Elasticity on a Linear Demand Cu rve Price Elasticity and the Total-Rev enue Curve Determinants of P rice Elasticity o f Demand Price Elasticity o f Supply Cross Elasticity Income Elasticity Consumer and Pr oducer Surplus Last Word Es = Percentage Change in Quantity Supplied of Product X Percentage Change in Price of Product X Inelastic Supply Es < Short Run: Resources Not Easily Shifted to Alternative Uses P Lower Price Impact Ss Ps P0 Key Terms D1 D2 End Show Q0 Qs 6-18 O 6.2 Copyright 2008 The McGraw-Hill Companies Q Price Elasticity of Supply Price Elasticity of Demand Total Revenue Te st Elasticity on a Linear Demand Cu rve Price Elasticity and the Total-Rev enue Curve Determinants of P rice Elasticity o f Demand Price Elasticity o f Supply Cross Elasticity Income Elasticity Consumer and Pr oducer Surplus Last Word Es = Percentage Change in Quantity Supplied of Product X Percentage Change in Price of Product X Elastic Supply Es > Long Run: Resources Easily Shifted to Alternative Uses P Sl Least Price Impact Pl P0 Key Terms D1 D2 End Show Q0 Ql 6-19 Copyright 2008 The McGraw-Hill Companies Q O 6.2 Applications of Elasticity of Supply • Antiques • Inelastic supply • Reproductions • More elastic supply • Volatile gold prices • Inelastic supply LO3 4-20 Cross Elasticity of Demand Price Elasticity of Demand Total Revenue Te st Elasticity on a Linear Demand Cu rve Price Elasticity and the Total-Rev enue Curve Determinants of P rice Elasticity o f Demand Price Elasticity o f Supply Cross Elasticity Income Elasticity Consumer and Pr oducer Surplus Last Word Key Terms End Show 6-21 Exy = Percentage Change in Quantity Demanded of Product X Percentage Change in Price of Product Y • Substitute Goods – Positive Sign • Complementary GoodsNegative Sign • Independent Goods – Zero or Near-Zero Value Copyright 2008 The McGraw-Hill Companies Income Elasticity of Demand Price Elasticity of Demand Total Revenue Te st Elasticity on a Linear Demand Cu rve Price Elasticity and the Total-Rev enue Curve Determinants of P rice Elasticity o f Demand Price Elasticity o f Supply Cross Elasticity Income Elasticity Consumer and Pr oducer Surplus Last Word Ei = Percentage Change in Quantity Demanded Percentage Change in Income • Normal Goods – Positive Sign • Inferior GoodsNegative Sign Key Terms End Show 6-22 Copyright 2008 The McGraw-Hill Companies Ex,y and Ei Cross and Income Elasticities of Demand Value of Coefficient Cross elasticity: Positive (Ewz > 0) Negative (Exy < 0) Description Quantity demanded of W changes in same direction as change in price of Z Type of Good(s) Substitutes Quantity demanded of X changes in Complements opposite direction from change in price of Y Income elasticity: Positive (Ei >0) Quantity demanded of the product changes in same direction as change in income Normal or superior Negative (Ei