Chapter 5 Part 1 Elasticity Elasticity of Demand

Chapter 5 Part 1 Elasticity

Elasticity of Demand Elasticity – a measure of the responsiveness of Qd or Qs to changes in market conditions l Price Elasticity of Demand – measure of how much the Qd responds to a change in the P l. Computed as: % change in Qd % change in P l

Elastic v. Inelastic Demand D for a good is elastic if the Qd responds substantially to a change in P l Examples: Mc. Donald’s hamburgers l D for a good is inelastic if the Qd responds only slightly to a change in P l Examples: Insulin l

Determinants of Price Elasticity of D Availability of Close Substitutes - goods w/ close substitutes tend to be more elastic; goods w/o close substitutes tend to be more inelastic Ex: butter l Necessities vs. Luxuries – necessities tend to have inelastic demands; luxuries tend to have elastic demands Ex: gas vs. sailboat l

Cont’d Definition of the Market – broad categories have fairly inelastic demands, narrowly defined markets usually are more elastic Ex: food vs. Green apple l Time Horizon – goods tend to have more elastic demands over long time periods. Ex: P of gas rises, Qd barely falls for a while, but in the long run D falls substantially l

Rank the following items from most to least elastic… Beef l Salt l European vacation l Steak l Honda Accord l Dijon Mustard l

Results…? European Vacation l Honda Accord l Steak l Dijon Mustard l Beef l salt l

Computing the Price Elasticity of Demand l The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.

Computing the Price Elasticity of Demand l Example: If the price of an ice cream cone increases from $2. 00 to $2. 20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as:

l l Along a D curve, P and Q move in opposite directions, which would make price elasticity negative. We will drop the minus sign and report all price elasticities as positive numbers (or just take the absolute value)

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities l l The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the price change. The midpoint is the number halfway between the start & end values, the average of those values.

MIDPOINT FORMULA:

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities l Example: If the price of an ice cream cone increases from $2. 00 to $2. 20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:

Types of Elasticities l l l When the price elasticity of demand is >1, demand is elastic When the price elasticity of demand is <1, the demand is inelastic. When the price elasticity of demand is = 1, the demand has unit elasticity.

Another way to think about it… l l If the ΔQd(%) > ΔP(%) then it’s ELASTIC If the ΔQd(%) < ΔP(%) then it’s INELASTIC

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

l l 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. But it is not the same thing as the slope!

Perfectly Inelastic Demand (a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand $5 4 1. An increase in price. . . 0 100 Quantity 2. . leaves the quantity demanded unchanged.

Inelastic Demand (b) Inelastic Demand: Elasticity Is Less Than 1 Price $5 4 1. A 22% increase in price. . . Demand 0 90 100 Quantity 2. . leads to an 11% decrease in quantity demanded.

Unit Elastic Demand (c) Unit Elastic Demand: Elasticity Equals 1 Price $5 4 Demand 1. A 22% increase in price. . . 0 80 100 Quantity 2. . leads to a 22% decrease in quantity demanded.

Elastic Demand (d) Elastic Demand: Elasticity Is Greater Than 1 Price $5 4 Demand 1. A 22% increase in price. . . 0 50 100 Quantity 2. . leads to a 67% decrease in quantity demanded.

Perfectly Elastic Demand (e) Perfectly Elastic Demand: Elasticity Equals Infinity Price 1. At any price above $4, quantity demanded is zero. $4 Demand 2. At exactly $4, consumers will buy any quantity. 0 3. At a price below $4, quantity demanded is infinite. Quantity

Total Revenue and Price Elasticity of Demand l l 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 TR is also called Total Expenditure or TE!!

Total Revenue Price When the price is $4, consumers will demand 100 units, and spend $400 on this good. $4 P × Q = $400 (revenue) P 0 Demand 100 Q Quantity

TR TEST l l l If D is inelastic: P rises, Qd falls > TR rises P falls, Qd rises > TR falls If D is elastic: P rises, Qd falls > TR falls P falls, Qd rises > TR rises If D is unit elastic: P rises, Qd falls > TR – P falls, Qd rises > TR –

How Total Revenue Changes When Price Changes: Inelastic Demand Price An Increase in price from $1 to $3 … … leads to an Increase in total revenue from $100 to $240 $3 Revenue = $240 $1 Demand Revenue = $100 0 100 Quantity Demand 0 80 Quantity

How Total Revenue Changes When Price Changes: Elastic Demand Price An Increase in price from $4 to $5 … … leads to an decrease in total revenue from $200 to $100 $5 $4 Demand Revenue = $200 0 50 Revenue = $100 Quantity 0 20 Quantity Note that with each price increase, the Law of Demand still holds – an increase in price leads to a decrease in the quantity demanded. It is the change in TR that varies!