Lecture Principles of Microeconomics - Chapter 4: Elasticities. After reading this chapter, you should be able to answer the following questions: What is price elasticity of demand? What are categories of demand elasticity and what factors influence them? What is the relationship between demand elasticity and total revenue? What is income elasticity of demand? What is cross elasticity of demand? What is price elasticity of supply? What are categories of supply elasticity and what factors influence them?
Chapter Elasticities McGrawưHill/Irwin Copyrightâ2009byTheMcGrawưHillCompanies,Inc.AllRightsReserved Learning Objectives ã What is price elasticity of demand? • What are categories of demand elasticity and what factors influence them? • What is the relationship between demand elasticity and total revenue? • What is income elasticity of demand? • What is cross elasticity of demand? • What is price elasticity of supply? • What are categories of supply elasticity and what factors influence them? 4-2 Price Elasticity of Demand Price elasticity of demand Percentage change in quantity demanded Percentage change in price • Price elasticity of demand measures consumers’ responsiveness to price changes • How much quantity demanded will change if price changes • Ignore the negative sign since it’s always there 4-3 Categories of Demand Elasticity • • If price elasticity of demand >1: % change in quantity demanded > % change in price Elastic demand • • If price elasticity of demand Price Point A Point B $8 $7 Demand 100 220 Quantity 4-5 Inelastic Demand Curve • A large percentage change in price: • A small percentage change in quantity • The price elasticity of demand between Point A and Point B is low • Price elasticity of demand < Price Point A $10 Point B $4 100 110 Quantity 4-6 Perfectly Inelastic Demand Curve • Quantity demanded is constant and does not respond to price changes • Price elasticity of demand = • This demand curve violates the Law of Demand • Unrealistic demand curve Price Quantity 4-7 Perfectly Elastic Demand Curve • Quantity demanded is extremely responsive to price changes • The smallest price change causes infinite change in quantity demanded • Price elasticity of demand = infinity Price $4 Quantity 20 4-8 Unit Elastic Demand Curve • Any percentage change in price causes the same percentage change in quantity demanded • Price elasticity of demand = • Elasticity is the same but not the slope along the demand curve 4-9 Elasticity Along a Straight Line Demand Curve • • • • At the top of demand curve: When the quantity is near zero a small absolute increase in quantity demanded means a huge percentage increase in quantity demanded The price elasticity of demand is huge At the bottom of demand curve: When price is near zero a small absolute increase in price means a huge percentage increase in price The price elasticity of demand is tiny Price Elasticity =infinity Demand Elasticity =0 Quantity = Price = Quantity 10 4-10 Factors That Influence Demand Elasticity Time: • Consumers are more flexible in the long run than in the short term • The price elasticity of demand is higher the more time consumers have to adjust to price changes Share of income spent on good: • The greater the percentage of income spent on a good, the more price elasticity of demand for that good 19 4-19 Factors That Influence Demand Elasticity Addiction: • Fear of being addicted to a good can result in high price elasticity of demand • However, for a consumer already addicted to the good, price elasticity of demand will be low 20 4-20 Do You Know? • How does the price elasticity of demand vary along a straight line demand curve? Price elasticity decreases moving along a straight line demand curve from the top to the bottom • How does a decrease in price affect total revenue when demand is inelastic? Total revenue will decrease • How substitutes affect price elasticity of demand? A greater availability of substitutes makes demand more elastic 21 4-21 Income Elasticity of Demand Income elasticity of demand measures how quantity demanded responds to changes in income Price elasticity of income Percentage change in quantity demanded Percentage change in income • Income elasticity is positive for normal goods • Income elasticity is negative for inferior goods 22 4-22 Cross Elasticity of Demand Cross elasticity of demand measures how the change in price of one good impacts the demand for another good Cross elasticity of demand Percentage change in quantity demanded of good A Percentage change in price of good B • Cross elasticity of demand for substitutes is positive • Cross elasticity of demand for complements is negative 23 4-23 Price Elasticity of Supply Price elasticity of supply measures responsiveness of quantity supplied to price changes Price elasticity of supply Percentage change in quantity supplied Percentage change in price • Due to the Law of Supply, price elasticity of supply is always positive 24 4-24 Categories of Supply Elasticity • • • • Elastic supply = quantity supplied that is very responsive to price changes If price elasticity of supply > % change in quantity supplied > % change in price • • Inelastic supply = quantity supplied is relatively unresponsive to price changes If price elasticity of supply < % change in quantity supplied < % change in price • • • Unit elastic supply If price elasticity of supply = % change in quantity supplied = % change in price 25 4-25 Behind Price Elasticity of Supply Costs: • Low costs result in relatively high price elasticity of supply Capacity: • Additional productive capacity makes increases price elasticity of supply Specialized inputs: • Goods that need specialized inputs for production have lower price elasticity of supply in the short term 26 4-26 Behind Price Elasticity of Supply Government permission: • Need to obtain legal permission to expand operations reduces firm’s price elasticity of supply Ability to fire workers: • Not being able to fire workers reduces firm’s price elasticity of supply 27 4-27 Behind Price Elasticity of Supply Time: • Price elasticity of supply is greater in the long run than in the short term • Longer time offers firms flexibility and possibility of innovations 28 4-28 Do You Know? • When is income elasticity of demand negative? Income elasticity of demand is negative for inferior goods i.e Goods which consumers buy less with higher income • What does the cross elasticity of demand measure? Cross elasticity of demand measures how the change in price of one good impacts the demand for another good • What is the sign of price elasticity of supply and why does it have this sign? Supply elasticity is positive since as price increases, quantity supplied rises and as price decreases, quantity supplied falls 29 4-29 Summary • Price elasticity of demand measures how quantity demanded responds to price changes • Elastic demand = consumers very responsive to price changes • Inelastic demand = consumers not responsive to price changes • Unit elastic demand = quantity demanded changes by the same percentage as change in price • Factors that influence demand elasticity: availability of substitutes, product definition, share of income spent on the good, necessities vs luxuries, time and strong complements • Effect of change in price on total revenue depends on the category of demand elasticity 30 4-30 Summary • Price elasticity of income measures how quantity demanded responds to income changes • Cross elasticity of demand measures how the change in price of one good impacts the demand for another good • Price elasticity of supply measures responsiveness of quantity supplied to price changes • Elastic supply = quantity supplied very responsive to price changes • Inelastic demand = quantity supplied not responsive to price changes • Unit elastic demand = quantity supplied changes by the same percentage as change in price • Factors that influence supply elasticity: costs, capacity, time, flexibility of doing business 31 4-31 Coming up Analyzing policies with market forces of supply and demand 32 4-32 Appendix: calculating demand elasticity Price elasticity of demand Percentage change in quantity demanded = Percentage change in price = (Q1 Q0 ) (Q1 Q0 ) / ( P1 P0 ) ( P1 P0 ) / Where Q1= new quantity, Q0= old quantity P1= new price, P0= old price 33 4-33 ... this box 500 600 14 We are here on the demand curve Quantity 4- 14 Price Elasticity of Demand and Total Revenue Price Elasticity of Effect of a Demand Price Increase Effect of a Price Decrease... elasticity of demand? • What is price elasticity of supply? • What are categories of supply elasticity and what factors influence them? 4- 2 Price Elasticity of Demand Price elasticity? ?of demand... Percentage change in price? ?of good B • Cross elasticity of demand for substitutes is positive • Cross elasticity of demand for complements is negative 23 4- 23 Price Elasticity of Supply Price elasticity of supply