#### Transcript Elastic Demand

Elasticity THE LAW OF DEMAND SAYS... Consumers will buy more when prices go down and less when prices go up HOW MUCH MORE OR LESS? DOES IT MATTER? 2 Elasticity Elasticity shows how sensitive quantity is to a change in price. 1. Elasticity of Demand Elasticity of Demand• Measurement of consumers responsiveness to a change in price. • What will happen if price increase? How much will it effect Quantity Demanded Who cares? • Used by firms to help determine prices and sales • Used by the government to decide how to tax Inelastic Demand Inelastic Demand INelastic = Quantity is INsensitive to a change in price. •If price increases, quantity 20% demanded will fall a little •If price decreases, quantity demanded increases a little. In other words, people will continue to buy it. 5% A INELASTIC demand curve is steep! (looks like an “I”) Examples: •Gasoline •Milk •Diapers •Chewing Gum •Medical Care •Toilet paper Inelastic Demand General Characteristics of INelastic Goods: 20% •Few Substitutes •Necessities •Small portion of income •Required now, rather than later •Elasticity coefficient less than 1 5% PRICE ELASTICITY OF DEMAND Extreme Case Perfectly Inelastic Demand P D1 Ed = 0 Q When a price change results in no change whatsoever in the quantity demanded, that good is said to be perfectly inelastic. An example: A diabetics need for insulin. 9 Elastic Demand Elastic Demand Elastic = Quantity is sensitive to a change in price. •If price increases, quantity demanded will fall a lot •If price decreases, quantity demanded increases a lot. In other words, the amount people buy is sensitive to price. An ELASTIC demand curve is flat! Examples: •Soda •Boats •Beef •Real Estate •Pizza •Gold Elastic Demand General Characteristics of Elastic Goods: • Many Substitutes • Luxuries • Large portion of income • Plenty of time to decide • Elasticity coefficient greater than 1 PRICE ELASTICITY OF DEMAND Extreme Case When a small price change causes buyers to increase or decrease their purchases drastically the good is said to be perfectly elastic. Foreign currency exchange. Example: If one firm increased the price of dollars, above market equilibrium – no one would buy from that firm. They would buy from cheaper alternatives. Perfectly Elastic Demand P Ed = 0 D2 Q 13 PRICE ELASTICITY OF DEMAND Refinement – The Midpoint Formula Ed = Change in quantity Sum of Quantities/2 Change in price Sum of prices/2 14 Elastic or Inelastic? BeefGasolineReal EstateMedical CareElectricityGold- What about the Elastic- 1.27 demand for insulin for INelastic - .20 diabetics? Elastic- 1.60 INelastic - .31 What if % change in INelastic - .13 quantity demanded equals % change in price? Elastic - 2.6 Perfectly INELASTIC (Coefficient = 0) Unit Elastic (Coefficient =1) 45 Degrees PRICE ELASTICITY & TOTAL REVENUE Price Elasticity is... Inelastic from 0 to 1 Typical of necessities one must have Elastic from 1 to Typical of luxuries one wants Unit elastic when exactly = 1 Price change does not reduce total revenue 16 Total Revenue Test Uses elasticity to show how changes in price will affect total revenue (TR). (TR = Price x Quantity) Elastic Demand• Price increase causes TR to decrease • Price decrease causes TR to increase Inelastic Demand• Price increase causes TR to increase • Price decrease causes TR to decrease Unit Elastic• Price changes and TR remains unchanged Ex: If demand for milk is INelastic, what will happen to expenditures on milk if price increases? PRICE ELASTICITY & TOTAL REVENUE When prices are low, TR So is total revenue Quantity Demanded 18 PRICE ELASTICITY & TOTAL REVENUE Total revenue rises with price to a point... P TR D Q Quantity Demanded 19 PRICE ELASTICITY & TOTAL REVENUE P Total revenue rises with price to a point... then declines D Q Quantity Demanded 20 PRICE ELASTICITY & TOTAL REVENUE P Total revenue rises with price to a point... D Q then declines Quantity Demanded 21 PRICE ELASTICITY & TOTAL REVENUE P Total revenue rises with price to a point... then declines TR Total Revenue Test D Q Quantity Demanded 22 PRICE ELASTICITY & TOTAL REVENUE P Total revenue rises with price to a point... Inelastic Demand then declines TR D Q Inelastic Demand Quantity Demanded 23 PRICE ELASTICITY & TOTAL REVENUE P Total revenue rises with price to a point... then declines TR Elastic Demand Inelastic Demand D Q Elastic Inelastic Demand Demand Quantity Demanded 24 PRICE ELASTICITY & TOTAL REVENUE P Total revenue rises with price to a TR point... then declines Unit Elastic Elastic Demand Inelastic D Demand Q Elastic Inelastic Demand Demand Quantity Demanded 25 Is the range between A and B, elastic, inelastic, or unit elastic? 10 x 100 =$1000 Total Revenue 5 x 225 =$1125 Total Revenue A 50% B 125% Price decreased and TR increased, so… Demand is ELASTIC Elastic, Inelastic, or Unit Elastic? Price D $30 S 20 T 10 0 U 7 14 D U' Quantity Demanded (d) 27 Elasticity Practice 28 29 a) Calculate the producer surplus before the tax. . Producer surplus is the area above the supply curve and below the horizontal line indicating the price the producers receive. It represents the difference between the minimum price that producers are willing to accept and the price they actually receive summed over all units sold. Prior to the imposition of the tax, the price the producers receive is the market price of $5. As a result, producer surplus is equal to: ($5-$2)*90*1/2 = 135 30 (b) Now assume a per-unit tax of $2 is imposed whose impact is shown in the graph above. (i) Calculate the amount of tax revenue. Tax revenue is equal to the per unit tax amount ($2) multiplied by the number of units sold under the tax (60 calculators). So the tax revenue is equal to $120. 31 (b) Now assume a per-unit tax of $2 is imposed whose impact is shown in the graph above. (ii) What is the after-tax price that the sellers now keep? The price that consumers will pay after the imposition of the tax is $6. Net of the $2 tax, producers will receive $4 per unit sold. 32 (b) Now assume a per-unit tax of $2 is imposed whose impact is shown in the graph above. (iii) Calculate the producer surplus after the tax. As before, producer surplus is the area above the supply curve and below the horizontal line indicating the price the producers receive. Following the imposition of the tax, however, the price producers receive is $4 and the number of units sold is 60. As a result, producer surplus is equal to: ($4-$2)*60*1/2 = 60 33 (c) Is the demand price elastic, inelastic, or unit elastic between the prices of $5 and $6? Explain. An increase in price from $5 to $6 represents a percentage change of ($6-$5)/$5.50 = 18.18181% The resulting change in quantity demanded is a reduction from 90 units to 60 units, representing a percentage change of (60-90)/75 = -40% The demand elasticity over this range is then calculated as the ratio of the % change in quantity over the % change in price, or -40%/18.18181% = -2.2 Since the absolute value of elasticity is greater than 1, demand is considered elastic. 34 (d) Assuming no externalities, how does the tax affect allocative efficiency? Explain. In the absence of externalities, the tax will lead to allocative inefficiency. Prior to the tax, the sum of consumer and producer surplus was 270. Following the tax, the sum of consumer and producer surplus is 120, plus government revenues of 120, for a total surplus of 240. So the tax results in a reduction of total surplus of 30. As a result, the outcome is no longer allocatively efficient. 35 2. Price Elasticity of Supply Elasticity of Supply• Elasticity of supply shows how sensitive producers are to a change in price. Elasticity of supply is based on time limitations. Producers need time to produce more. INelastic = Insensitive to a change in price (Steep curve) • Most goods have INelastic supply in the short-run Elastic = Sensitive to a change in price (Flat curve) • Most goods have elastic supply in the long-run Perfectly Inelastic = Q doesn’t change (Vertical line) • Set quantity supplied The formula is for Price Elasticity of Supply Es = Change in quantity Sum of Quantities/2 Change in price Sum of prices/2 37 3. Cross-Price Elasticity of Demand • Cross-Price elasticity shows how sensitive a product is to a change in price of another good • It shows if two goods are substitutes or complements Exy = % change in quantity demanded of product “B” % change in price of product “A” P increases 20% Q decreases 15% • If coefficient is negative (shows inverse relationship) then the goods are complements • If coefficient is positive (shows direct relationship) then the goods are substitutes 4. Income-Elasticity of Demand • Income elasticity shows how sensitive a product is to a change in INCOME • It shows if goods are normal or inferior Ei = % change in quantity demanded % change in income Income increases 20%, and quantity decreases 15% then the good is a… INFERIOR GOOD • If coefficient is negative (shows inverse relationship) then the good is inferior • If coefficient is positive (shows direct relationship) then the good is normal Ex: If income falls 10% and quantity falls 20%… 1996 Micro FRQ #2 The Toledo arena holds a maximum of 40,000 people. Each year the circus performs in front of a sold out crowd. (a) Analyze the effect on each of the following of the addition of a fantastic new death-defying trapeze act that increases the demand for tickets. (i)The price of tickets (ii)The quantity of tickets sold (b) The city of Toledo institutes an effective price ceiling on tickets. Explain where the price ceiling would be set. Explain the impact of the ceiling on each of the following. (i) The quantity of tickets demanded (ii) The quantity of tickets supplied (c) Will everyone who attends the circus pay the ceiling 40 price set by the city of Toledo. Why or why not?