Transcript Chapter 6

SLIDES
BY
CHAPTER
6
SOLINA LINDAHL
Elasticity
FOOD FOR THOUGHT….
SOME GOOD BLOGS AND OTHER SITES TO GET THE JUICES FLOWING:
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What you will
learn in this chapter
 Why economists use elasticity to measure
responsiveness to changes in prices or incomes
 Why the price elasticity of demand, the income
elasticity of demand, and the cross-price elasticity of
demand are important indicators of consumer
behavior in response to changes in prices and income
 Why the price elasticity of supply is an important
indicator of producer behavior in response to changes
in price
 What factors influence the size of these various
elasticities
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PRICE ELASTICITY OF DEMAND
Even for ambulance rides: We know there is an
inverse relationship between price and quantity
demanded.
But how much does quantity demanded change
when price changes?
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PRICE ELASTICITY OF DEMAND
A demand curve is elastic when an
increase in price reduces the quantity
demanded a lot (and vice versa).
When the same increase in price reduces
quantity demanded just a little, then the
demand curve is inelastic.
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DEMAND FOR AMBULANCE RIDES
Price of ambulance
ride
When price rises to
$210 per ride, world
demand falls to 9.9
million rides per year
(point B).
How do we categorize
this—is demand elastic
or not?
B
$21
A
20
D
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Quantity of ambulance rides (millions)
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PRICE ELASTICITY OF DEMAND
The more responsive quantity demanded is to a change in price, the
more elastic is the demand curve.
Price
The same
price
increase
…
$50
$40
Elastic demand
Inelastic demand
20
75 80
… causes a small decrease in
quantity demanded if demand is
inelastic.
… causes a big decrease in
quantity demanded if
demand is elastic.
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ELASTICITY RULE
Elasticity
slope BUT:
If two linear demand (or supply) curves
run through a common point, then at any
given quantity, the curve that is FLATTER is
MORE ELASTIC.
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DEFINING AND MEASURING
ELASTICITY
Price elasticity of demand = the
percentage change in quantity demanded
divided by the percentage change in
price.
Price elasticity of demand =
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% change in quantity demanded
% change in price
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DEFINING AND MEASURING
ELASTICITY
Example:
If the price of oil increases by 10% and the
quantity demanded falls by 5%, then the price
elasticity of demand for oil is:
-5%
= -0.5
10%
Note: since we know that price and quantity
demanded will always move in opposite
directions (law of demand) we usually drop the
minus sign (for price elasticity of demand
ONLY).
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USING THE MIDPOINT FORMULA
There is a problem: Our percent change
calculation depends on our choice of
starting point.
To solve this problem, we calculate the price
elasticity of demand using the midpoint
formula for percentage changes.
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THE MIDPOINT METHOD
Instead of dividing by the initial quantity or price,
we’ll use the average quantity or price.
Change in X
% change in X =
x100
Average Value of X
Where
Starting value of X + Final Value of X
Average value of X =
2
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MATHEMATICS OF DEMAND
ELASTICITY
Example: At the initial price of $10, the
quantity demanded is 100. When the price
rises to $20, the quantity demanded is 90.
90 -100
x100 = -10.5%
(100 + 90)
2
% change in quantity demanded =
20 -10
% change in price =
x100 = 66.6%
(10 + 20)
2
-10.5%
Price elasticity of demand =
= -0.15
66.6%
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LEARN BY DOING: PRACTICE QUESTION
If the price of a sushi roll
drops from $8 to $4 and
sales rise from 20 to 40 units,
what is the (absolute value)
of the price elasticity of
demand?
a) 0.5
b) 0.66
c) 1
d) 2
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ESTIMATING ELASTICITIES
Economists (and many others) are interested in
price elasticity of demand.
Estimating elasticity is crucial to understanding
and predicting market outcomes.
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INTERPRETING THE PRICE ELASTICITY
OF DEMAND
Classification of price elasticity of demand:
A good can have a price elasticity as low as
zero or as high as infinity.
If the |Ed| < 1, the demand curve is inelastic.
If the |Ed| > 1, the demand curve is elastic.
If the |Ed| = 1, the demand curve is unit elastic.
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EXTREMELY LOW ELASTICITY OF
DEMAND
(a) Perfectly Inelastic demand: price
elasticity of demand = 0
Price of snake
antivenom
(per dose)
D
$3
An increase in
price…
$2
… leaves
the quantity
demanded
unchanged.
0
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EXTREMELY HIGH PRICE ELASTICITY
OF DEMAND
Price elastic demand: price elasticity of
demand = ∞
Price of pink
tennis balls
(per dozen)
At exactly $5,
consumers will
buy any quantity.
At any price above
$5, quantity
demanded is zero.
D
$5
2
At any price below
$5, quantity
demanded is
infinite.
0
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Quantity of pink tennis balls
(dozens per year)
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UNIT ELASTICITY OF DEMAND
(a) Unit-elastic demand: price elasticity of demand = 1
Price of crossing
(Toll)
B
$1.10
A 20%
increase in
the price . .
.
A
0.90
D
0
900
1,100
Quantity of
crossings
(per day)
. . . generates a 20% decrease
in the quantity of crossings
demanded.
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INELASTIC DEMAND
(b) Inelastic demand: price elasticity of demand = 0.5
Price of crossing
(Toll)
B
A 20% increase
in the price . . .
$1.10
A
0.90
D
2
0
950 1,050
Quantity of
crossings
(per day)
. . . generates a 10% decrease in the
quantity of crossings demanded.
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ELASTIC DEMAND
(c) Elastic demand: price elasticity of demand = 2
Price of crossing
(Toll)
B
$1.10
A 20%
increase in
the price . . .
A
0.90
D
3
0
800
1,200
Quantity of
crossings
(per day)
… generates a 40%
decrease in the quantity
of crossings demanded.
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LEARN BY DOING: APPLICATION VIDEO
In this pragmatic and moving talk, Kevin Bales
explains the business of modern slavery, analyzes
the price of humans… and implies that price and
income elasticity data offer hope. (18 minutes)
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ELASTICITY AND TOTAL REVENUE
Total revenue: price times quantity
demanded (sold).
TR = P × Q
Sellers need to know how elastic their good
is so they can plan.
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TOTAL REVENUE BY AREA
Price of
crossing
$0.90
Total revenue = price ×
quantity = $990
0
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EFFECT OF A PRICE INCREASE ON
TOTAL REVENUE
Price of
crossing
Price effect of price
increase: higher price
for each unit sold.
$1.10
Quantity effect
of price
increase: fewer
units sold.
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0.90
B
A
0
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ELASTICITY AND TOTAL REVENUE
When demand is inelastic, the price effect
dominates the quantity effect
So an increase in price will cause only a
slight reduction in the quantity demanded.
In this instance, total revenue will rise when
the price rises (and vice versa).
What happens if salt prices go up? TR will likely rise.
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LEARN BY DOING: PRACTICE QUESTION
If price falls from $60 to $40, total revenue changes by
_______, so demand is _______.
a) $240; inelastic
b) $480; elastic
c) $360; inelastic
d) $120; elastic
Price
$60
$40
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ELASTICITY AND TOTAL REVENUE
When demand is elastic, the quantity effect
dominates the price effect.
So an increase in price will cause significant
reduction in the quantity demanded.
In this instance, total revenue will fall when the
price rises (and vice versa).
What happens if airfare goes up? TR will likely fall.
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ELASTICITY AND TOTAL REVENUE
When demand is unitelastic, the quantity effect
equals the price effect.
So an increase in price
exactly balances the
reduction in the quantity
demanded.
In this instance, total
revenue doesn’t change.
What happens if tire prices
goes up? TR will not change.
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DEMAND SCHEDULE AND TOTAL
REVENUE
Price
Elastic
$10
9
8
7
6
5
4
3
2
1
Unit-elastic
Inelastic
0
1
2
3
4
5
6
7
Demand Schedule and Total
Revenue for a Linear Demand Curve
Quantity
Total
demanded revenue
Price
$0
10
$0
1
9
9
2
8
16
3
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21
4
6
24
5
5
25
6
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9
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0
0
D
8
9 10
Quantity
Total
revenue
$25
24
21
16
9
0
0
1
2
3
4
5
Demand is elastic: a
higher price reduces
total revenue
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The price elasticity of
demand changes along
the demand curve.
9 10
Quantity
Demand is inelastic: a
higher price increase
total revenue
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LEARN BY DOING: PRACTICE QUESTION
The elasticity of demand for
eggs has been estimated to be
0.1. If egg producers raise their
prices by 10 percent, what will
happen to their total revenue?
a) It will increase.
b) It will decrease.
c) It won’t change.
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LEARN BY DOING: PRACTICE QUESTION
If a fashionable clothing store
raised its prices by 25%, what does
that tell you about the store’s
estimate of the elasticity of
demand for its products?
a) They think it’s elastic.
b) They think it’s inelastic.
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WHAT FACTORS DETERMINE THE
PRICE ELASTICITY OF DEMAND?
1. The availability of close substitutes is very
important.
Fewer substitutes makes it harder for
consumers to adjust Q when P changes,
so demand is inelastic.
Many substitutes? Switching brands when
prices change is EASY, so demand is
elastic.
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LEARN BY DOING: PRACTICE QUESTION
When the patent expires
on a brand-name drug
and five generic drugs
come on the market,
what happens to
elasticity of demand?
a) It rises.
b) It falls.
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WHAT FACTORS DETERMINE THE
PRICE ELASTICITY OF DEMAND?
2. Whether the good is a necessity or a
luxury also affects the elasticity of
demand.
For necessities, we do not change Q much
when P changes.
For luxuries, we are more sensitive to P
changes.
vs.
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WHAT FACTORS DETERMINE THE
PRICE ELASTICITY OF DEMAND?
3. The share of income spent on the good
matters.
We are less sensitive to price changes
when the good feels cheap.
We are more sensitive to price changes
when the good feels expensive.
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WHAT FACTORS DETERMINE THE
PRICE ELASTICITY OF DEMAND?
4. The length of time elapsed since the price
change matters.
Less time to adjust means lower elasticity.
Over time consumers can adjust their behavior
by finding substitutes (making demand more
elastic).
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APPLICATIONS OF
ELASTICITY OF DEMAND
Why the war on drugs is hard to win:
Because demand for most illegal drugs is
inelastic, drug dealers earn greater revenue and
gain more power as the drug war becomes more
effective.
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OTHER DEMAND ELASTICITIES
The cross-price elasticity of demand
measures how sensitive the quantity
demanded of good A is to the price of
good B.
Cross-price elasticity of demand =
% change in quantity of A demanded
% change in price of B
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CROSS-PRICE ELASTICITY OF
DEMAND
For substitutes, cross-price elasticity of
demand is positive.
An increase in the price of one brand of
cookies will increase the demand for other
brands.
$
$$$
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CROSS-PRICE ELASTICITY OF
DEMAND
For complements, cross-price elasticity of
demand is negative.
An increase in the price of milk causes a
decrease in demand for Oreos.
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LEARN BY DOING: PRACTICE QUESTION
The price of good B increases by 4%,
causing the quantity demanded of good A
to decrease by 6%. The cross-price elasticity
of demand is _____, and the goods are
______.
a) 1.5; substitutes
b) –1.5; complements
c) 0.67; complements
d) –2.4; substitutes
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INCOME ELASTICITY OF DEMAND
The income elasticity of demand measures
how sensitive the quantity demanded of a
good is to changes in income.
Income elasticity of demand =
% change in quantity demanded
% change in income
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INCOME ELASTICITY OF DEMAND
The income elasticity of demand can be
used to distinguish normal from inferior
goods.
For normal goods, income elasticity is
positive.
For inferior goods, income elasticity is
negative.
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INCOME ELASTICITY OF DEMAND
Normal goods can be income-elastic or not.
For income-elastic goods, income elasticity
is greater than 1.
For income-inelastic goods, income
elasticity is positive but less than 1.
Vacations are income-elastic
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LEARN BY DOING: PRACTICE QUESTION
Tonya consumes 10 boxes of ramen noodles
a year when her yearly income is $40,000.
After her income falls to $30,000 a year, she
consumes 40 boxes of ramen noodles a
year. Calculate her income elasticity of
demand for ramen noodles.
a) 4.2
b) –4.2
c) –2.25
d) 2.25
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PRICE ELASTICITY OF SUPPLY
Usually, sellers offer more when prices are
higher, but how strong is that relationship?
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MEASURING THE PRICE ELASTICITY
OF SUPPLY
Similar to price elasticity of demand:
% change in quantity supplied
Price elasticity of supply =
% change in price
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TWO EXTREME CASES OF PRICE
ELASTICITY OF SUPPLY
(a) Perfectly inelastic supply:
price elasticity of supply = 0
(b) Perfectly elastic supply: price
elasticity of supply = ∞
Price of cell phone
frequency
Price of
pizza
S
1
$3,000
An increase
in price…
2,000
… leaves
the quantity
supplied
unchanged
0
At exactly $12,
producers will
produce any
quantity.
At any price
above $12,
quantity supplied
is infinite.
$12
S2
At any
price
below $12,
quantity
supplied is
0
Quantity of cell zero.
phone
frequencies
100
Quantity of pizzas
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PRICE ELASTICITY OF SUPPLY
Elasticity of supply captures the sensitivity of quantity supplied to changes in
price.
Price per
unit
Inelastic supply
Elastic supply
$50
The same
price
increase…
40
…causes a small increase in
quantity supplied if supply is
inelastic.
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Quantity
170
80 85
…causes a big increase in quantity
supplied if supply is elastic.
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ELASTICITY OF SUPPLY
A supply curve is elastic if a rise in price
increases the quantity supplied a lot (and
vice versa).
it’s inelastic if sellers change quantity just
little.
a
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WHAT FACTORS DETERMINE THE
PRICE ELASTICITY OF SUPPLY?
1. Availability of
inputs
If increased
production is very
expensive, then the
supply curve will be
inelastic.
If production can be
increased cheaply,
then the supply
curve will be elastic.
Ivory: increasing collection
costs, inelastic supply
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WHAT FACTORS DETERMINE THE
PRICE ELASTICITY OF SUPPLY?
2. Time
Price elasticity of supply increases as
producers have more time to respond to
price changes.
Long-run price elasticity of supply is
usually higher than the short-run
elasticity.
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LEARN BY DOING: PRACTICE QUESTION
Which supply
curve is the most
elastic?
a) S 1
b) S 2
c) S 3
d) S 4
Price
S1
S2
S3
S4
Quantity
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LEARN BY DOING: PRACTICE QUESTION
A computer manufacturer makes an
experimental computer chip that critics
praise, leading to a huge increase in the
demand for the chip. How elastic is supply
in the short run? What about the long run?
Graph both.
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LEARN BY DOING: DISCUSS
Will the same increase in the demand for
housing increase prices more in Manhattan or in
Des Moines, Iowa? Graph both.
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