Measuring Responsiveness: Elasticity in Economics

1. ECONOMICS: EXPLORE & APPLYby Ayers and Collinge Chapter 15“Elasticity: Measuring Responsiveness”

2. Learning Objectives • Discuss how elasticity is used to measure the responsiveness. • Compute the elasticity of demand. • Describe the conditions under which a price change would increase, decrease, or not change a firm’s revenue. • Discuss the significance of the income elasticity of demand, the cross elasticity of demand, and the elasticity of supply.

3. Learning Objectives • Explain how elasticity determines who ultimately pays a sales tax. • Discuss how the war on drugs increases crime associated with drug use.

4. 15.1COMPUTING ELASTICITY • Elasticity measures how one variable changes as a result of another variable changing. • All elasticities arise from this same formula. • Different elasticities merely name the variables differently. Elasticity = Percentage change in one variable (Y) Percentage change in another variable (X)

5. Computing Elasticity • Elasticity has a broad range of applications. • Price elasticity of demand • Price elasticity of supply • Cross price elasticity • Income Elasticity

6. Midpoints Formula • The measure of percentage changes is provided by the midpoints formula. • The formula computes a percentage change as the change in the variable divided by an amount halfway between the starting and ending amount. Percentage change in Y= change in Y/Y midpoint Divided by Percentage change in X=change in X/X midpoint

7. 15.2THE ELASTICITY OF DEMAND • The elasticity of demand measures the responsiveness of quantity demanded to changes in price. • It is sometimes referred to as the price elasticity of demand. • Since price and quantity demanded are inversely related, the computation of elasticity of demand will always result in a negative value. • For convenience, the elasticity of demand is stated as an absolute value, meaning the minus sign is ignored.

8. The Elasticity of Demand • The elasticity of demand is not the same as the slope of demand. • The slope of demand divides the change in price by the change quantity, without reference to percentages. • The slope measures absolute changes, while elasticity measures percentage changes.

9. Classifying the Elasticity of Demand • Inelastic demand has an elasticity coefficient whose value lies between 0 and 1. • Unit elastic demand has an elasticity coefficient whose value equals 1. • Elastic demand has an elasticity coefficient whose value is greater than 1. • Other things being equal, the more substitutes there are for a product, or the greater the fraction a product takes of a person’s budget to buy the product, the greater will be its elasticity of demand.

10. Unit Elastic Inelastic Elastic 0 1 The Range of the Elasticity of Demand This value can range from zero to infinity (in absolute value) Elasticity of Demand

11. Estimates of Demand Elasticities

12. Elasticity and Total Revenue Total Revenue = Price  Quantity TR TR constant When P TR Depending upon the elasticity

13. Total revenue = price x quantity which is the area of the shaded rectangle. Price Demand Quantity demanded Total Revenue $ Quantity

14. The Effect of a Change in Total Revenue

15. Elasticity and Total Revenue • The longer the time period that quantity demanded adjusts, the greater the elasticity of demand. • Time lets people adjust, to substitute towards goods that have become relatively less expensive and away from those that become relatively more expensive. • The elasticity of demand will vary along most demand curves. Along a downward sloping, straight line demand curve, demand is unit elastic at the midpoint, elastic above the midpoint, and inelastic below the midpoint.

16. Elastic Inelastic Elasticity Varies along Linear Demand Curves Price ($’s) Midpoint: Unit Elastic Demand Quantity

17. Demand and Total Revenue

18. Computing the Elasticity of Demand Table 4A-2

19. Elasticity =9 Elasticity =2.33 Elasticity =1 Elasticity =.43 Elasticity =.11 Demand, Elasticity, Total Revenue, and Marginal Revenue A Total Revenue 5 Dollars B 4 C 3 D 2 E 1 Demand F 0 Quantity 1 2 3 4 5 Marginal Revenue

20. Total revenue is maximized when demand is unit elastic. Demand, Elasticity, Total Revenue, and Marginal Revenue Total Revenue Dollars Elastic Each firm produces in the elastic range of its demand curve. Unit Elastic Inelastic Demand Quantity Marginal Revenue

21. The Extremes of Elasticity Dollars Dollars Dollars 6 Demand Demand 3 Demand 1 2 4 12 Quantity Quantity Quantity 1. Perfectly Inelastic Elasticity = 0 2. Unit Elastic Elasticity =1 3. Perfectly Elastic Elasticity = 

22. 15.3INCOME AND CROSS ELASTICITIES OF DEMAND • The income elasticity of demand measures how demand responds to income. • It is computed by dividing the percentage change in quantity demanded, by the percentage in income. • A positive income elasticity indicates the good is a normal good. • A negative income elasticity of demand indicates the good is inferior.

23. Income and Cross Elasticities of Demand • The cross elasticity of demand measures how the demand for one good responds to changes in the price of another good. • It is computed by dividing the percentage change in quantity demanded of one good, by the percentage in the price of another good. • A positive cross elasticity indicates the goods are substitutes • A negative cross elasticity of demand indicates the goods are complements.

24. 15.4THE ELASTICITY OF SUPPLY The elasticity of supply measures the responsiveness of quantity supplied to price. Elasticity of supply can fall within the following three ranges: Inelastic Supply: Elasticity of supply lies between 0 and 1. Unit Elastic Supply: Elasticity of supply = 1. Elastic Supply: Elasticity of supply is greater than 1.

25. The Extremes of Supply Elasticity Supply Dollars Dollars Dollars Supply Supply Quantity Quantity Quantity 1. Perfectly Inelastic Elasticity = 0 2. Unit Elastic Elasticity =1 3. Perfectly Elastic Elasticity = 

26. 15.5TAX SHIFTING AND THE ELASTICITIES OF SUPPLY AND DEMAND • When a product is taxed, how much of that tax will the buyers pay, and how much of the tax will the sellers pay? The answer to that question of who ultimately shoulders the tax burden depends upon the demand and supply elasticities of the product taxed. • Usually the tax burden is shared between producers and consumers. • Consumers pay more of the tax if demand is relatively less elastic than supply. • Producers pay more of the tax if demand is relatively more elastic than supply.

27. Supply plus Tax #2 Consumers pay more. #1 The tax changes the market equilibrium to a higher price and a lower quantity. Tax #2 sellers receive less. Partial Tax Shifting Dollars Supply Demand Cigarettes

28. 15.6 EXPLORE & APPLYCRIME AND THE MARKET FOR DRUGS Supply with Drug War Pdw #1 The drug war changes the market equilibrium, causing a higher price and lower quantity of output. Dollars #2 The revenue increases from the higher price Supply in Free Market Pfm #3 far exceeds the revenue decreases from the lower quantity Demand Qdw Qfm

29. elasticity elasticity of demand inelastic unit elastic demand elastic demand total revenue perfectly inelastic unit elastic throughout perfectly elastic income elasticity of demand cross elasticity of demand elasticity of supply inelastic supply unit elastic supply elastic supply tax burden tax shifting Terms along the Way

30. Test Yourself • The formula for all elasticities is the • change in one variable divided by the change in another variable. • change in one variable minus the change in another variable. • percentage change in one variable divided by the percentage change in another variable. • percentage change in one variable minus the percentage change in another variable.

31. Test Yourself 2. Which of the following price elasticities of demand illustrates elastic demand? • 0.6 • 0.85 • 1.0 • 1.2

32. Test Yourself 3. The responsiveness of quantity demanded to changes in price • increases over time. • decreases over time. • is not affected by passage of time. • first decreases, but then increases over time.

33. Test Yourself 4. If consumers buy 9 gizmos at a price of $9, and 10 gizmos at a price of $8, then demand is • elastic. • unit elastic. • inelastic. • proto-elastic

34. Test Yourself 5. An income elasticity of demand that is positive indicates a good that is • normal. • inferior. • a substitute. • a complement.

35. Test Yourself 6. A cross elasticity of demand that is negative indicates that • two goods are substitutes. • two goods are complements. • one good is a substitute and the other is a complement. • both goods are normal.

36. The End! Next Chapter 16 “Consumer Behavior"