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Elasticity and its Applications

Elasticity and its Applications. In this chapter you will…. Learn the meaning of the elasticity of demand. Examine what determines the elasticity of demand. Learn the meaning of the elasticity of supply. Examine what determines the elasticity of supply.

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Elasticity and its Applications

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  1. Elasticity and its Applications

  2. In this chapter you will… • Learn the meaning of the elasticity of demand. • Examine what determines the elasticity of demand. • Learn the meaning of the elasticity of supply. • Examine what determines the elasticity of supply. • Apply the concept of elasticity in three different markets.

  3. THE ELASTICITY OF DEMAND • … allows us to analyze supply and demand with greater precision. • … is a measure of how much buyers and sellers respond to changes in market conditions

  4. Price Elasticity of Demand • Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. • Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.

  5. The Price Elasticity of Demand and Its Determinants • Availability of Close Substitutes • Necessities versus Luxuries • Definition of the Market • Time Horizon

  6. The Price Elasticity of Demand and Its Determinants • Demand tends to be more elastic: • the larger the number of close substitutes. • if the good is a luxury. • the more narrowly defined the market. • the longer the time period.

  7. P e r c e n t a g e c h a n g e i n q u a n t i t y d e m a n d e d P r i c e e l a s t i c i t y o f d e m a n d = P e r c e n t a g e c h a n g e i n p r i c e Computing the Price Elasticity of Demand • The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.

  8. The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities • The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change. • point Method: A Better Way to Calculate Percentage Changes and Elasticities (Q2 - Q1)/ [(Q2 + Q1)/ 2] Price elasticity of demand = (P2 - P1)/ [(P2 + P1)/ 2]

  9. Mid point method The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities • From Point A to Point B: Price rise = 50% and Quantity fall = 33% • From Point B to Point A: Price fall = 33% and Quantity rise = 50% • Point A: Price = $4 Quantity = 120 • Point B: Price = $6 Quantity = 80 (80 - 120) / [(80 + 120)/ 2] Price elasticity of demand = (6 - 4)/ [(6 + 4)/ 2] = 1

  10. A Variety of Demand Curves • Inelastic Demand • Quantity demanded does not respond strongly to price changes. • Price elasticity of demand is less than one. • Elastic Demand • Quantity demanded responds strongly to changes in price. • Price elasticity of demand is greater than one.

  11. A Variety of Demand Curves • Perfectly Inelastic • Quantity demanded does not respond to price changes. • Perfectly Elastic • Quantity demanded changes infinitely with any change in price. • Unit Elastic • Quantity demanded changes by the same percentage as the price.

  12. A Variety of Demand Curves • Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.

  13. Demand $5.00 $4.00 100 2. …leaves the quantity demanded unchanged. Figure 5-1 a): Perfectly Inelastic Demand E = 0 Price 1. An increase in price… 0 Quantity

  14. Demand $5.00 $4.00 90 2. … Leads to a 11% decrease in quantity demanded. Figure 5-1 b): Inelastic Demand E < 1 Price 1. A 22% increase in price… 0 100 Quantity

  15. Demand $5.00 $4.00 80 2. … Leads to a 22% decrease in quantity demanded. Figure 5-1 c): Unit Elastic Demand E = 1 Price 1. A 22% increase in price… 0 100 Quantity

  16. Demand $5.00 $4.00 50 2. … Leads to a 67% decrease in quantity demanded. Figure 5-1 d): Elastic Demand E > 1 Price 1. A 22% increase in price… 0 100 Quantity

  17. 1. At any price above $4, quantity demanded is zero. Demand 3. At any price below $4, quantity demanded is infinite. 2. At exactly $4, consumers will buy any quantity. Figure 5-1 e): Perfectly Elastic Demand E =  Price $4.00 0 Quantity

  18. Total Revenue and the Price Elasticity of Demand • Total revenue is the amount paid by buyers and received by sellers of a good. • Computed as the price of the good times the quantity sold. TR = P x Q

  19. Demand Figure 5-2: Total Revenue Price $4.00 P x Q = $400 (revenue) 100 0 Quantity

  20. P x Q = $400 (revenue) Demand Figure 5-3: How Total Revenue Changes When Prices Changes: Inelastic Demand Price $3.00 $1.00 P x Q = $100 (revenue) 100 80 0 Quantity

  21. Demand Revenue = $200 Revenue = $100 Figure 5-4: How Total Revenue Changes When Prices Changes: Elastic Demand Price Change in Total Revenue when Price Changes $5.00 $4.00 20 50 0 Quantity

  22. Elasticity and Total Revenue along a Linear Demand Curve • With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.

  23. Table 5-1. Elasticity and Total Revenue along a Linear Demand Curve

  24. Elasticity is larger than 1. Elasticity is smaller than 1. Figure 5-5: A Linear Demand Curve Price 7 6 5 4 3 2 1 Quantity 4 0 14 2 12 6 8 10

  25. Other Demand Elasticities • Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. • It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

  26. Other Demand Elasticities • Types of Goods • Normal Goods • Inferior Goods • Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.

  27. Other Demand Elasticities • Goods consumers regard as necessities tend to be income inelastic • Examples include food, fuel, clothing, utilities, and medical services. • Goods consumers regard as luxuries tend to be income elastic. • Examples include sports cars, furs, and expensive foods.

  28. P e r c e n t a g e c h a n g e i n q u a n t i t y d e m a n d e d I n c o m e e l a s t i c i t y o f d e m a n d = P e r c e n t a g e c h a n g e the price of good 2. i n Other Demand Elasticities • Cross-Price elasticity of demand measures how much the quantity demanded of a good responds to a change in the price of another good. • It is computed as the percentage change in the quantity demanded divided by the percentage change in the price of the second good.

  29. PRICE ELASTICITY OF SUPPLY • Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good. • Price elasticity of supply is the percentage change in quantity supplied given a percent change in the price.

  30. The Price Elasticity of Supply and Its Determinants • Ability of sellers to change the amount of the good they produce. • Beach-front land is inelastic. • Books, cars, or manufactured goods are elastic. • Time period. • Supply is more elastic in the long run.

  31. Computing the Price Elasticity of Supply • The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price.

  32. Computing the Price Elasticity of Supply • … using the midpoint method, we calculate the percent change in the price as (2.10 - 1.90) / 2.00 x 100 = 10% • Similarly, we calculate the percent change in the quantity supplied as (11 000 - 9000) / 10 000 x 100 = 20% • Suppose an increase in the price of milk from $1.90 to $2.10 a litre raises the amount that dairy farmers produce from 9000 to 11 000 L per month… 20% = 2.0 Price elasticity of supply = 10%

  33. Supply $5.00 $4.00 100 2. …leaves the quantity supplied unchanged. Figure 5-6 a): Perfectly Inelastic Supply E = 0 Price 1. An increase in price… 0 Quantity

  34. Supply $5.00 $4.00 110 2. …leads to a 10% increase in quantity supplied. Figure 5-6 b): Inelastic Supply E < 0 Price 1. A 22% increase in price… 0 100 Quantity

  35. Supply $5.00 $4.00 125 2. …leads to a 22% increase in quantity supplied. Figure 5-6 c): Unit Elastic Supply E = 1 Price 1. A 22% increase in price… 0 100 Quantity

  36. Supply $5.00 $4.00 200 2. …leads to a 67% increase in quantity supplied. Figure 5-6 d): Elastic Supply E > 1 Price 1. A 22% increase in price… 0 100 Quantity

  37. 1. At any price above $4, quantity supplied is infinite. Supply 3. At any price below $4, quantity supplied is zero. 2. At exactly $4, producers will supply any quantity. Figure 5-6 e): Perfectly Elastic Supply E =  Price $4.00 0 Quantity

  38. $15 Elasticity is less than 1 $12 Elasticity is greater than 1 $4 $3 500 100 200 525 Figure 5-7: How the price elasticity of supply can vary Price 0 Quantity

  39. THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITY • Good news bad news for farmers • OPEC • Drugs and crime

  40. 1. When demand is inelastic, an increase in supply… S1 S2 $2 2. … leads to a fall in price… Demand 110 3. …and a proportionately smaller increase in quantity sold. As a result revenue falls from $300 to $220. Figure 5-8: An Increase in Supply in the Market for Wheat Price of Wheat Increase in Supply $3 100 Quantity of Wheat

  41. 1. In the short run, when supply and demand are inelastic, a shift in supply… 1. In the long run, when supply and demand are elastic, a shift in supply… S1 S2 S2 S1 P2 P2 P1 P1 Demand 2. … leads to a large increase in price… 2. … leads to a small increase in price… Demand Figure 5-9: A Reduction in Supply in the World Market for Oil (a) Oil Market in the Short Run (b) Oil Market in the Long Run Price of Oil Price of Oil Quantity of Oil Quantity of Oil

  42. 1. Drug interdiction reduces the supply of drugs… 1. Drug education reduces the demand for drugs… S1 S2 Supply P2 P1 P2 P1 D1 2. … which reduces the price… 2. … which raises the price… D2 Demand Q2 Q1 Q2 3. … and reduces the quantity sold. 3. … and reduces the quantity sold. Figure 5-10: Policies to Reduce the of Illegal Drugs (a) Drug Interdiction (b) Drug Education Price of Drugs Price of Drugs Q1 Quantity of Drugs Quantity of Drugs

  43. Summary • Price elasticity of demand measures how much the quantity demanded responds to changes in the price. • Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. • If a demand curve is elastic, total revenue falls when the price rises. • If it is inelastic, total revenue rises as the price rises.

  44. Summary • The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income. • The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good. • The price elasticity of supply measures how much the quantity supplied responds to changes in the price.

  45. Summary • In most markets, supply is more elastic in the long run than in the short run. • The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. • The tools of supply and demand can be applied in many different types of markets.

  46. The End

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