Chapter 4: Elasticity

What will you learn in this chapter? • Concept of elasticity. • Calculate price elasticity of demand and supply using the mid‐point method. • Explain how the determinants of price elasticity of demand and supply affect the degree of elasticity. • Calculate cross‐price and income elasticities of demand, and interpret the sign of the elasticities.

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1© 2014 by McGraw‐Hill Education 1 Chapter 4 Elasticity © 2014 by McGraw‐Hill Education 2 What will you learn in this chapter? • Concept of elasticity. • Calculate price elasticity of demand and supply  using the mid‐point method. • Explain how the determinants of price  elasticity of demand and supply affect the  degree of elasticity. • Calculate cross‐price and income elasticities of  demand, and interpret the sign of the  elasticities. © 2014 by McGraw‐Hill Education 3 • Elasticity is a measure of the responsiveness to  a change in a market condition. • The concept applies to supply and demand. • It measures the response to a change in: – the price of the good. – the price of a related good. – income. What is elasticity? 2© 2014 by McGraw‐Hill Education 4 Price elasticity of demand Quantity of coffee (millions of cups) 1. When price Decreases by 25%... 2. quantity demanded increases by 50%. 0 0.50 1.00 1.50 2.00 2.50 3.00 5 10 15 20 Price ($) D A B • The price elasticity of demand measures the magnitude  of change in the quantity demanded from a change in  its price. In other words, it estimates price sensitivity. © 2014 by McGraw‐Hill Education 5 Calculating price elasticity • The midpoint method calculates the elasticity at  the midpoint of any two points. The formula is: ߝ ൌ %∆ೂ%∆ು ൌ ሺೂమషೂభሻ/ሾሺೂమశೂభሻ/మሿሺುమషುభሻ/ሾሺುమశುభሻ/మሿ where point 1 is ሺ ଵܲ, ܳଵሻ and point 2 isሺ ଶܲ, ܳଶሻ. • The midpoint elasticity is the difference of any  two numbers divided by their average. © 2014 by McGraw‐Hill Education 6 Active Learning: Calculating the price  elasticity of demand Find the price elasticity of demand using the  midpoint formula for the points along a demand  curve: ($10,350) and ($20, 150). 3© 2014 by McGraw‐Hill Education 7 • Consumers are more sensitive to price changes  for some goods and services than for others. • Many factors determine consumers’  responsiveness to price changes. – Availability of substitutes. – Degree of necessity. – Cost relative to income. – Adjustment time. – Scope of the market. Determinants of price elasticity of demand © 2014 by McGraw‐Hill Education 8 • All goods and services can be broadly  categorized based on elasticity. • The main categories are: – Elastic: A change in price causes a relatively large percentage change in quantity demanded.  – Inelastic: A change in price causes a relatively small percentage change in quantity demanded. Categorizing elasticities © 2014 by McGraw‐Hill Education 9Quantity 0 5 10 5 10 Price ($) At prices higher than $5, the quantity demanded is 0. D Price ($) Quantity 0 5 10 5 10 At any price, the quantity demanded is the same. D Consumers will buy any quantity at a price of $5 Categorizing elasticities At the extremes, demand can be either perfectly elastic or  perfectly inelastic. Perfectly elastic (|εd| = ∞) Perfectly inelastic (|ε d | = 0) 4© 2014 by McGraw‐Hill Education 10 Categorizing elasticities 10 0 1 2 3 4 5 6 7 8 9 1 2 3 4 5 6 7 8 9 10 Price ($) Quantity Elastic (|εd | >1) quantity demanded increases by 60% . quantity demanded increases by 20%. D Inelastic (|εd | < 1) 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 Price ($) Quantity D Between these two extremes, the elasticities are divided into  three categories. Quantity quantity demanded increases by 40%. Unit‐elastic (|εd | = 1) 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 Price ($) D When price declines by the same amount (say 40%) © 2014 by McGraw‐Hill Education 11 • Knowing whether the demand for a good is  elastic or inelastic is extremely useful in  business. – Allows managers to determine whether a price  increase will cause total revenue to rise or fall. • Total revenue is the amount that a firm  receives from the sale of goods and services. – Total revenue (TR) equals price paid (P) multiplied  by quantity sold (Q), or TR = P x Q. Using price elasticity of demand © 2014 by McGraw‐Hill Education 12 Using price elasticity of demand Quantity Price ($) 1. As price Increases 0 50 100 150 200 250 300 350 400 450 500 2 4 6 8 10 12 14 16 18 20 2. quantity decreases. 2+3= total revenue after the price change. 1+2= total revenue before the price change. Price effect Quantity effect D 12 3 An increase in price affects total revenue in two ways. 5© 2014 by McGraw‐Hill Education 13 Using price elasticity of demand 0 1 2 3 4 5 1 2 3 4 5 6 7 8 109 Price ($) Quantity (thousands) When demand is elastic, the quantity effect outweighs the price effect. D Price effect Quantity effect 0 1 2 3 4 5 1 2 3 4 5 6 7 8 109 Price ($) Quantity (thousands) When demand is inelastic, the price effect outweighs the quantity effect. D Price effect Quantity effect The magnitude of the price and quantity effects  are determined by the elasticity of demand. © 2014 by McGraw‐Hill Education 14 Active Learning: Calculating the change in  total revenue Find the change in total revenue using the following two  points along a demand curve: ($20, 150) and ($10,350). © 2014 by McGraw‐Hill Education 15 Using price elasticity of demand P ($) Q TR ($) 50 0 0 45 1 45 40 2 80 35 3 105 30 4 120 25 5 125 20 6 120 15 7 105 10 8 80 5 9 45 0 10 0 Inelastic demand: decreasing price revenue Elastic demand: decreasing revenue price Total revenue ($) 0 25 50 75 100 125 21 3 4 5 6 7 8 9 10 QuantityQuantity 0 Price ($) 5 10 15 20 25 30 35 40 45 50 1 2 3 4 5 6 7 8 9 10 D The relationship between P, Q, TR, and εd is  summarized as follows. 6© 2014 by McGraw‐Hill Education 16 • The concept of elasticity can also be applied to  supply. • The price elasticity of supply measures producers’  response (in quantity) to a change in price. – Uses same midpoint formula but replaces quantity  demanded with quantity supplied. – Elasticity is always positive. – Same interpretation: • Elastic: εs >1. • Unit Elastic: εs =1. • Inelastic: εs <1. Price elasticity of supply © 2014 by McGraw‐Hill Education 17 • Producers are more sensitive to price changes  for some goods and services than for others. • Many factors determine producers’  responsiveness to price changes. – Availability of inputs. – Flexibility of the production process. – Adjustment time. Determinants of price elasticity of supply © 2014 by McGraw‐Hill Education 18 Cross‐price elasticity of demand • The cross‐price elasticity of demand is a measure of  how the quantity demanded of one good changes when  the price of a different good changes. • The midpoint formula calculates the elasticity between  the quantity demanded of good A and the price of good  B: ߝ஺,஻ ൌ %∆ೂಲ%∆ುಳ ൌ ሺೂమషೂభሻ/ሾሺೂమశೂభሻ/మሿሺುమషುభሻ/ሾሺುమశುభሻ/మሿ • The cross‐price elasticity of demand can be positive or  negative. – ߝ஺,஻>0: the two goods are substitutes. – ߝ஺,஻<0: the two goods are complements. 7© 2014 by McGraw‐Hill Education 19 Income elasticity of demand  • The income elasticity of demand is a measure of how  much the quantity demanded changes in response to a  change in consumers’ incomes. • The midpoint formula calculates the elasticity between  the quantity demanded of a good and consumer’s  income: ߝூ ൌ %∆ೂ%∆಺ ൌ ሺೂమషೂభሻ/ሾሺೂమశೂభሻ/మሿሺ಺మష಺భሻ/ሾሺ಺మశ಺భሻ/మሿ • The income elasticity of demand can be positive or  negative. – ߝூ>0: the good is normal. If ߝூ>1, then it is a luxury. – ߝூ<0: the good is inferior. © 2014 by McGraw‐Hill Education 20 Active Learning: Calculating the income  elasticity of demand • When consumers’ income is $100, they buy 250  units of a good. When consumers’ income  increases to $200, they buy 500. Find the income  elasticity of demand using the midpoint formula. • Is the good inferior or normal? • Is it a luxury good? © 2014 by McGraw‐Hill Education 21 Four measures of elasticity Measure Equation Negative Positive More elastic Less elastic % change in quantity demanded % change in price Always Never Over time, for substitutable goods and luxury items In the short run, for unique and necessary items % change in quantity supplied % change in price Always Over time, with flexible production In the short run, with production constraints % change in quantity demanded of A % change in price of B For comple- ments For substitutes For near perfect substitutes and strong complements For loosely related goods % change in quantity demanded % change in income For inferior goods For normal goods For luxury items with close substitutes For unique and necessary items Never 8© 2014 by McGraw‐Hill Education 22 Summary • Elasticity is the first of several concepts used to  apply the concepts of supply and demand to  business and policy questions. – Indicates the sensitivity of quantity to a change in: • Price. • Price of a related good. • Income. • The price elasticity of demand can be used to  set prices so firms can maximize revenue.