Transcript Chapter 5

Chapter 5
Elasticity and Its Applications
Ratna K. Shrestha
Overview
Elasticity
 Elasticity of Demand
 Elasticity of Supply
 Cross Price Elasticity
 Income Elasticity of Demand
 Applications of Elasticity

Elasticity . . .
Elasticity is a measure of how much buyers
and sellers respond to changes in market
conditions.
 This measure allows us to analyze supply and
demand with greater precision.
 More precisely, it is the percentage (%)
change in something. . . given a one percent
(1%) change in something else.
(1) Price Elasticity of Demand
P
P1
P2
Demand
ED =
% change in the quantity
demanded given a one
% change in its price.
A
B
Q1 Q2
Q
Ranges of Elasticity . . .
 Perfectly
Inelastic (ED = 0): Consumers are
“completely unresponsive” to price changes.
Elastic (ED = - ): Consumers are
“infinitely responsive” to price changes.
 Perfectly
Elastic (ED = -1): Consumer’s response
is “equal to” change in price in percentage
terms.
 Unit
Elasticity of Demand Illustrated
Perfectly Inelastic
ED = 0
P2
Even if price
increases a lot
quantity demanded
stays the same at Q1.
P1
Q1
Elasticity of Demand Illustrated
P
A small increase in price
will cause demand to drop
off completely.
P1
Perfectly Elastic ED = - 
Q
Determinants of
Price Elasticity of Demand
Demand tends to be more elastic:
 if the good is a luxury;
 the longer the time period;
 the greater the number of close substitutes;
 the more narrowly defined the market.
Ex: Demand for a car (broad market) vs.
Toyota Corolla (narrowly market). Obviously
demand for a Toyota car is more elastic
than the demand for a car in general. Why?
Determinants of
Price Elasticity of Demand
Demand tends to be more inelastic:
 if the good is a necessity;
 the shorter the adjustment time;
 if there are few good substitutes; and
 the more broadly defined the market.
Short-Run Vs. Long-Run Elasticity


In general, demand is much more price elastic in
the long run.
Consumers take time to adjust consumption
habits. E.g.,if the price of gasoline increases,
you cannot decrease your driving right away. It
takes time for you to move closer to your school
or work or switch to energy efficient vehicles.
More substitutes are usually available in the long
run. Moreover if the price of Toyota Corolla goes
up you can switch to Honda Civic easily. But if
the price of food goes up, is there anything you
can switch to?
Short-Run and Long-Run
Demand Curves
Price
DSR
•People cannot easily adjust
consumption in short run.
•In the long run, people tend to drive
smaller and more fuel efficient cars.
Alternative energy cars (e.g., battery
operated) may also be available.
DLR
Quantity of Gas
Computing Elasticity Coefficient
Price Elasticity
=
of Demand, ED
=
=
Percentage Change in
Quantity Demanded
Percentage Change
in Price
% Q
% P
=
(Q2 – Q1)/Q1
(P2 – P1)/P1
Q/Q
P/P
Computing Elasticity Coefficient
Demand for
Ice Cream
(8 - 10) / 10
ED =
($2.2 - $2.0)/$2.0
2.20
-(20%)
=
2.00
8
10
= -2.0
(10%)
Demand is Elastic
because ED > 1
Elasticity and Total Revenue
Over the Elastic Range of prices and quantity
the relationship between price and total
revenue (TR) is INDIRECT
If ED  > 1 then
P
Q
and
TR
Elasticity and Total Revenue
Over the Inelastic Range of prices and
quantity the relationship between price
and total revenue is DIRECT
ED  < 1 then
P
Q
and TR
Price Elasticity and a Linear
Demand Curve
Given a linear demand curve
 Elasticity (at a point) depends on slope and on
the values of P and Q at that point.
 The top portion of demand curve is elastic. At
the point where Q=0, you are not consuming
anything so a small change in P can trigger you
to buy a lot—perfectly elastic.
 The bottom portion of demand curve is inelastic.
At the point where Q=8, you are already
consuming the maximum you want and so a
small change in P will not affect your demand at
all—perfectly inelastic.
Price Elasticity of Demand
Price
ED = -
4
Elastic
Demand Curve
Q = 8 – 2P
ED = -1
2
Inelastic
ED = 0
4
8
Q
Price Elasticity of Demand
 The steeper the demand curve, the more
inelastic the good. In this case, the change in
your demand for a given price change is
smaller.
 The flatter the demand curve, the more elastic
the good.
 One interesting observation in the case of a
linear demand curve is that even though its
slope is constant the elasticity is not. Why??
Policy Questions



As a curator of an art museum, would you raise
or lower the admission fee if you are running
short of funds?
As the CEO of Telus, would you increase the
price of local or international calls?
Which policy: hike tax on basic cars or BMWs do
you think is more effective in raising revenue?
(2) Income Elasticity
The percentage change in the quantity
demanded given a one percent change in
income.
% Change in Demand
Income Elasticity
of Demand, YD =
%Change in Income
=
Q/Q
I /I
Income Elasticity... Types
YD



YD > 0 Normal Goods
YD < 0 Inferior Goods
= 0 Income-neutral Goods
Most of the goods are normal goods. But there
are some goods which are inferior.
If you income goes up, will you consider to
purchase a car and hence make less bus rides.
What kind of goods do people buy especially
during recession when their income go down?
Income Elasticity... Types
Goods consumers regard as “necessities” tend
to be income inelastic...
– Examples include: food, fuel, clothing,
utilities, & medical services.
 Goods consumers regard as “luxuries” tend to
be income elastic...
– Examples include: Sports cars, furs, and
expensive foods.

(3) Cross-Price Elasticity of Demand
 Measures the % change in the quantity
demanded of one good (good b) that results
from a one % change in the price of another
good (m).
Ecross
Qb Qb Pm Qb


Pm Pm Qb Pm
 Depending on how this relationship exists, the
two goods may be complements or substitutes.
Cross-Price Elasticity of Demand
 Complements: Cars and Tires
– Cross-price elasticity of demand is negative
 If price of cars increases, quantity
demanded of tires decreases (due to shift
in D curve to the left)
 Substitutes: Butter and Margarine
– Cross-price elasticity of demand is positive
 If price of butter increases, quantity of
margarine demanded increases
(4) Price Elasticity of Supply
Price
The % change in
quantity supplied
resulting from a one
% change in price.
S
B
P2
A
P1
Q1
Q2
Q
Ranges of Elasticity





Perfectly Elastic, E = infinite
Relatively Elastic, E > 1
Unit Elastic, E = 1
Relatively Inelastic, E < 1
Perfectly Inelastic, E = 0
Elasticity of Supply Illustrated
P
Perfectly Inelastic
Perfectly Elastic
Q
Determinants of
Elasticity of Supply

Flexibility or ability of sellers to change the
amount of the good they produce.
Beachfront land vs. books, cars,
manufactured goods, etc. The supply of
beachfront land is obviously fixed.
More elastic in the long run. For example
agricultural production. It takes time for the
farmers to respond (by producing more) to
an increase in price.
Computing Elasticity Coefficient
Elasticity
=
of Supply
% Q Supplied
% P
 Explain why the price elasticity of supply
might be different in the long run than in the
short run.
Applications of Elasticity
Application #1
“Can Good News for Farming Be Bad News
For Farmers?”
What happens to wheat farmers and the market
for wheat when UBC agronomists discover a
new wheat hybrid that is more productive than
existing varieties?
Examine whether the supply or demand curve
shifts due to UBC’s discovery.
Price
SA
$4.00
DA
2000
Quantity of Wheat
Consider which direction
the curve shifts.
SA
Price
SB
Technology
causes an
increase
in supply.
$4.00
DA
2000
Quantity
Use Supply-and-Demand diagram to
see how the market changes.
SA
Price
SB
$4.00
$2.60
DA
2000 2400
Quantity
Compute Elasticity
(2400 - 2000) / (2000)
ED =
($2.60 - $4.00) /($4.00)
= 0.57 (Inelastic)
 Recall that in the inelastic range, P and TR
move in the same direction.
Observe the Change in Total Revenue
Price
SA
SB
$4.00
TRSA = $8,000
$2.60
TRSB = $5,760!
DA
 Bad news for the
farmers
2000 2400 Quantity
Applications of Elasticity
Application #2
“Does a War on Drug Dealers Reduce
Drug-Related Crime?”
What happens to drug-related crime such as
theft and violent behavior when police and
custom officers impose higher penalties and
stricter enforcement on drug dealers?
Apply Comparative Statics
Going after drug dealers reduces supply of
drugs such as heroin (shift left).
The price of illegal drugs will increase.
Since the demand for addictive drugs is
inelastic, drug users will need to spend more in
total dollars on drugs.
 Drug-related crime will increase!
Drug Education Policy?
Educating the public with regard to the bad
effects of drug use will shifts demand for illegal
drugs to the left.
As a result, the price of illegal drugs will
decrease.
Since the demand for addictive drugs is
inelastic, drug users spend less in total dollars
on drugs.
 Drug-related crime will decrease!
Applications of Elasticity
Application #3
“Why did OPEC fail to keep the price of oil
high in the long run?”
While the OPEC cartel has been successful in
achieving short run bursts in oil prices, over
the long run these high oil prices have not
been maintained.
Apply Comparative Statics
OPEC’s cartel policy consists of restricting the
supply of oil, shifting the supply for crude oil to
the left.
This will increase the price of oil.
In the short run, the demand for oil is inelastic.
 A higher price for oil will increase the total
revenue of OPEC.
Apply Comparative Statics
In the long run, the demand for oil and the
supply of oil becomes more elastic. This will
tend to dampen oil prices.
 Why is oil inelastic in the short run?
– oil is a necessity item
– adding to the supply of oil is difficult
 Over time elasticity increases due to
conservation, alternate energy sources...