CHAPTER 3 Elasticity A Measure of Responsiveness Prepared

CHAPTER 3 Elasticity: A Measure of Responsiveness Prepared by: Jamal Husein

The Concept of Elasticity u Elasticity is a measure of the responsiveness of people to changes in economic variables. u How large is the response of producers and consumers to changes in price? Before business firms and the government decide to change prices and taxes, they must anticipate the magnitude of response by those affected. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 2

Popular Elasticity Measures Popular measures of elasticity include: u Price elasticity of demand ( Ed ) u Price elasticity of supply ( Es ) u u Income elasticity of demand Cross elasticity of demand for related goods © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 3

Price Elasticity of Demand u Price elasticity of demand ( Ed ) measures the response of consumers to changes in price. Elasticity of Demand = Ed = © 2005 Prentice Hall Business Publishing % Change in quantity demanded Survey of Economics, 2/e % Change in Price O’Sullivan & Sheffrin 4

Computing Price Elasticity of Demand = Ed = © 2005 Prentice Hall Business Publishing % Change in quantity demanded % Change in Price Survey of Economics, 2/e O’Sullivan & Sheffrin 5

Using the Midpoint Formula to Compute Price Elasticity (Appendix ) u The midpoint formula is a more accurate measure of percentage changes. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 6

Interpreting the Value of Elasticity Demand Elasticity Magnitudes of Response to Change Price Changes Ed > 1 Elastic % QD > % P Responsive Ed < 1 Inelastic % QD < % P Unresponsive Ed = 1 Unitary elastic % QD = % P Proportional Type of Elasticity Substitutes Available Elastic Many Inelastic Few The main determinant of demand elasticity is the availability of substitutes for the good in question. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 7

Interpreting the Value of Elasticity Estimated price elasticities of demand for selected products Product Price elasticity of demand Salt 0. 1 Water 0. 2 Coffee 0. 3 Cigarettes 0. 3 Shoes and footwear 0. 7 Housing 1. 0 Automobiles 1. 2 Foreign travel 1. 8 Restaurant meals 2. 3 Air travel 2. 4 Motion pictures 3. 7 Specific brands of coffee 5. 6 © 2005 Prentice Hall Business Publishing u Survey of Economics, 2/e u The price elasticity for water (0. 20) suggests that a 10% increase in the price of water would decrease the quantity demanded by only 2%. The elasticity for specific brands of coffee (5. 6) suggests that a 10% increase in the price of a specific brand would decrease its quantity demanded by 56%. O’Sullivan & Sheffrin 8

Using the Price Elasticity of demand Applications: College Education u Suppose a university increases tuition from $4, 000 to $4, 400 (a 10% increase in price) and wants to predict how many fewer students will enroll as a result of the high price. The Ed of higher education is 1. 4. percentage change in quantity demanded = 1. 4 × 10% = 14% © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 9

Using the Price Elasticity of demand Predicting Changes in Quantity demanded u Suppose you run a campus film series, and you know that Ed is 2. 0. If you decide to increase price by 15%, you can use the following rearranged formula to predict Changes in Quantity demanded percentage change in quantity demanded = 2 × 15% = 30% © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 10

Using the Price Elasticity of demand Predicting Changes in Quantity demanded u How would a tax on beer affect highway deaths? The Ed for beer among adults is 1. 3. If a state imposes a beer tax that increases beer price by 20%, what would happen to the number of highway deaths among young adults? percentage change in quantity demanded = 1. 3 × 20% = 26% © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 11

Elasticity and Total Revenue (TR) u Elasticity of demand determines if an increase in price will cause the firm’s revenue to increase or decrease. Total Revenue = Price x Quantity sold u An increase in the price have two opposing effects n The good news about an increase in price is that a higher price will increase the revenue obtained from each unit sold. n The bad news is that at a higher price, fewer units are sold. Elasticity of demand tells us whether the good news dominates over the bad news. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 12

Predicting Changes in Total Revenue This graph shows the relationship between elasticity along a linear demand curve and total revenue. Note the following: u Revenue is maximum when Ed=1. © 2005 Prentice Hall Business Publishing u Along the elastic range of the demand curve, an increase in price leads to a decrease in total revenue. u Along the inelastic range, an increase in price leads to an increase in total revenue. Survey of Economics, 2/e O’Sullivan & Sheffrin 13

Predicting Changes in TR Elasticity and Total Revenue (TR) Type of demand Value of Ed Change in quantity versus change in price Effect of an increase in price on total revenue Elastic Greater than 1. 0 Larger percentage change in quantity Total revenue decreases Total revenue increases Inelastic Less than 1. 0 Smaller percentage change in quantity Total revenue increases Total revenue decreases Unitary elastic Equal to 1. 0 Same percentage change in quantity and price Total revenue does not change © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin Effect of a decrease in price on total revenue 14

Price Elasticity of Supply u Price elasticity of supply is a measure of the responsiveness in quantity supplied to changes in price. Elasticity of Supply = Es = © 2005 Prentice Hall Business Publishing % Change in quantity supplied % Change in Price Survey of Economics, 2/e O’Sullivan & Sheffrin 15

Computing Price Elasticity of Supply = Es = © 2005 Prentice Hall Business Publishing % Change in quantity supplied % Change in Price Survey of Economics, 2/e O’Sullivan & Sheffrin 16

Supply Elasticity and Time u Supply becomes more elastic over time. The increase in quantity supplied as a response to an increase in price is greater when supply is more elastic. Higher market prices give business firms an incentive to expand production and output. As time goes by, the ability of firms to expand productive capacity is greater, and supply becomes more elastic. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 17

Predicting Price Changes Using Elasticities u The price-change formula can be used to predict the change in price resulting from a change in demand. percentage change in demand percentage change in price = E s + Ed u For changes in price resulting from a change in supply: percentage change in supply percentage change in price = E s + Ed © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 18

Predicting Price Changes Using Elasticities: an Example u Assume that Ed=1. 5 and Es=2. 0, a rightward shift in demand by 35%, will increase price by the following percentage: % demand % P = E s + Ed © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 19