Chapter 5: Elasticity

1. Chapter 5: Elasticity Elasticity: Measures impact of changes in: Price (own & related goods) Income Supply (factors)

2. Own-Price (Demand) Elasiticity • Economist use the (own) price elasticity of demand to summarize how responsive quantity demanded is to price • Demand curves are not always linear; and responsiveness can change with price

3. Movement along the Demand Curve • Variables that affect quantity demanded/movement of the demand curve • Own-Price of the Good (movement along D) • Price of Related Goods and Future Price of the Good • Income • For now: • Focus only movement along the D curve • Due to a change in the good’s price (its own price)

4. Movement along the Demand Curve • First: measuring how much quantity demanded changes when price changes • Why use the percentage change, rather than just the slope: • What if the demand curve is non-linear (curved) - > slope is not constant • What if the way price is measured changes? • Measuring in cents rather than $ -> slope will be 100 x greater in cents • $ or Euros -> slope will be different by exchange ratio

5. A Better Measure: Percentage Change Price Elasticity of Demand = - 50% / + 20%   = (-) 2.5

6. The Elasticity of Demand (Own-Price) What does the demand elasticity tell us • Demand is elastic • Elasticity > |1| (< -1) • % Change in Qty Demanded is very price responsive • Small increases -> large decreases in Qd and Revenues • Small decreases -> large increases in Qd and Revenues • Demand is unit elastic • Elasticity = |1| (=-1) • % change in Qd = % change in price -> no change in Revenues with price increases or decreases Demand is inelastic • Elasticity < |1| (-1 < έ < 0) • % Change in Qty Demanded is not very price responsive • Increases in price -> little change in Qd and larger increases in Revenu • Decreases -> little change in Qd and decreases in Revenues

7. Demand ElasticityOwn-Price (price of the good) • Always negative • First law of demand • Talk about it in absolute terms • Less than |1| -> inelastic • Not very price responsive • Equal to |1| -> unit elastic • % change in Qd = % change in price • More than |1| -> (highly) elastic • Very price responsive

8. Elasticity of Demand – Econometric StudiesOwn-price • Cigarettes (US)[41] • -0.3 to -0.6 (General) • -0.6 to -0.7 (Youth) – proportion of income? • Soft drinks • -0.8 to -1.0 (general)[51] (broadly defined) • -3.8 (Coca-Cola)[52] (narrow) • -4.4 (Mountain Dew)[52] (narrow) • Car fuel[45] • -0.25 (Short run) (same car – reduce trips) • -0.64 (Long run) (new car?)

9. 1 The price elasticity of demand – steep or flat D curve? (d) Elastic demand: Elasticity > 1 (e) Perfectly elastic demand: Elasticity equals infinity Price Price 1. an 1. an 1. At any price above $4, quantity demanded is zero • A 22% • increase • in price… 3. At any price below $4, quantity demanded is infinite $5 Demand $4 Demand 4 2. … leads to a 67% decrease in quantity demanded 2. At exactly $4, consumers will buy any quantity 50 100 0 0 Quantity Quantity The price elasticity of demand determines whether the demand curve is steep or flat. Note that all percentage changes are calculated using the midpoint method.

10. What Determines Demand Elasticity? • Own-price demand elasticity • Elastic Demand: > |1| (% ΔQd > %ΔP) • FLATTER! • Lots of substitutes available - > more price responsive • Good/close substitutes • More time to adjust to the price change (find substitutes) • Elasticity in the long-run > elasticity in the short-run • Inelastic Demand: < |1| (% ΔQd > %ΔP) • No close/good substitutes • STEEPER!!

11. What Affects the Magnitude of the (Own-Pirce) Demand Elasticity • Availability and closeness of substitutes • “better/closer” substitute makes switching easier • Results in either • Greater movement along the demand curve (own) • Greater shift of the demand curve (cross) • Time • More time to adjust, more options you can find • Long-run elasticity > short-run • Proportion of Income spent on the good • Larger proportion -> more sensitive to changes in Income

12. 2 Total revenue 1. an Price P ˣ Q=$400 (revenue) $4 P Demand 100 0 Quantity Q The total amount paid by buyers, and received as revenue by sellers, equals the area of the box under the demand curve, P × Q. Here, at a price of $4, the quantity demanded is 100, and total revenue is $400.

13. 4 Elasticity of a linear demand curve (graph) 1. an Price Elasticity is larger than 1 $7 6 5 4 Elasticity is smaller than 1 3 2 1 0 2 4 6 8 10 12 14 Quantity Demand The slope of a linear demand curve is constant, but its elasticity is not. The demand schedule in the table was used to calculate the price elasticity of demand by the midpoint method. At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic.

14. Elasticity and Total Revenue Unit elastic

15. The Elasticity of Demand • Total revenue and price elasticity of demand • Inelastic demand • Increase in price • Increase in total revenue • Elastic demand • Increase in price • Decrease in total revenue

16. Other Types of Elasticities • Generally 3 categories we are concerned about • Price elasticity • Own-price: • How quantity demanded changes with the (own) price • Cross-price • How quantity demanded changes with another (cross) good’s price changes • Income • How quantity demanded changes with a change in your income • Supply elasticity • How quantity supplied changes with a change in (own/market) price

17. The Elasticity of Demand • Cross-price elasticity of demand • Measure of how much the Demand Curve shifts when the price of a related good (subst or complement) changes • [∆Qx/Qx] / [∆Py/Py ] • Sign matters -> tells whether substitute or complement • Magnitude (<1 or >1) -> how “good” a substitute/essential a complement • Substitutes: Positive cross-price elasticity • >1 -> “close” or good substitute as big shift with small price change • Complements: Negative cross-price elasticity • >1 -> “essential” to be used/consumed together (cars and gas)

18. Elasticity Measures • 3 Major Types for Demand Elasticities • Own-price • Measures the change in quantity demanded with a change in the (own) good’s price • Always negative (F.L.O.D) • Always expressed in absolute value (as it’s always negative) • Cross-price • Measures the change in quantity demanded with a change in the price of a related good (e.g. complement or substitute) • Complement (-) Substitute (+) • Income • Measures the change in quantity demanded with a change in income • Normal/superiors goods (+) Inferior goods (-)

19. What Does the Magnitude of the Elasticity Tell Us? • Own-price • Larger absolute value (|e| > 1) • Large changes in Qd with small changes in price • Close substitutes exist (pepsi/coke) • Or much consumption is discretionary (micro-brews) • Cross-price • Large value (e >1) • Close (or good) substitute for good exists • Complements • Large absolute value (|e| > 1) • Consumption in fixed proportions • Income • >1 superior (luxury?) good • >0 normal • < 0 inferior (Animal beer)