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Elasticity and its Application
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Price Elasticity of Demand
Price elasticity of demand measures how much
quantity demand responds to a change in price
measures the price sensitivity of consumers
measures how willing consumers are to buy less of the
good as its price rises
Ed
=
Percentage change in
quantity demanded
Percentage change in price
=
%∆Qd
%∆P
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A
B
%∆Qd
%∆P
%∆Qd
%∆P
%∆Qd
C
%∆P
Price Elasticity of Demand
=
20%
10%
= 2
=
5%
10%
= .5
=
10%
10%
= 1
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Price elasticity of demand
Elastic demand - Quantity demanded responds
substantially to a change in the price
Ed  1
Ed  2 is Elastic
Inelastic demand - Quantity demanded responds
slightly to a change in the price
Ed  1
Ed  .5 is Inelastic
Unit elastics - Quantity demanded responds by the
same percentage change in the price
Ed  1
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Price elasticity of demand
Own Price Elasticity
of Demand
Product
Gas
A
0.5
Inelastic
Luxury Car
B
2.0
Elastic
Steak
C
8.0
Elastic
Hamburger
D
0.05 Inelastic
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Midpoint Formula
Midpoint is the number halfway between the start
& end values or the mean of those values
Use the following information to calculate the price
elasticity of demand for hotel rooms:
if P = $7,
Qd
= 50
if P = $9, Qd = 30
Price
Calculates Ed at the
midpoint
$9
$7
30
50
Quantity
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Midpoint Formula
Use the following information to calculate the price
elasticity of demand for hotel rooms:
if P = $7, Qd = 50 then changes to P = $9, Qd = 30




 q0  q1  
  q0  q1   


2
%Q d



Ed 

%P




  p0  p1  
   p0  p1   


2







 50  30  
  50  30      20 
 


2
 .50

40
 




2
 .25

   $2 

 

 $7  $9     $8 
  $7  $9   


2


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Elasticity Determinants
Determinants of price elasticity of demand
– Availability of close substitutes: goods with close
substitutes are more elastic demand
– Necessities vs. luxuries
• Necessities have more inelastic demand
• Luxuries have more elastic demand
– Definition of the market
• Narrowly defined markets are more elastic
• Broadly defined market are more inelastic
– Time horizon
• More elastic over longer time horizons
• More inelastic over shorter time horizons
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Elasticity Determinants
Determinants of price elasticity of demand
– Availability of close substitutes
½ ton pick-up trucks (GM, Ford, Chrysler) + Toyota
the addition of Toyota increased demand elasticity
– Necessities vs. luxuries (Toyota vs. Mercedes)
Mercedes brand is more price elastic than Toyota
– Definition of the market (Transportation vs. Automobiles)
Automobiles are more elastic an transportation in general
– Time horizon (running car vs. broken car)
– with a broken car you have less time to shop, reducing elasticity
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Elasticity of Gasoline
Time Horizon: Elasticity of Gasoline
When price doubles:
Purchase about the same amount
– With in the next few months you may:
• Purchase a more fuel efficient car
• Car pool
– Over the next few years you may:
• Move closer to work
• Find a job closer to home
Increasingly Elasticity
– Tomorrow you will:
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Elasticity of Gasoline
Available Substitutes: Elasticity of Gasoline
When price doubles:
Purchase about the same amount
– or you live in a small city:
• Ride a bike
• Car pool
– or you live in a large city:
• Car pool (HOV)
• Train
• Bus
Increasingly Elasticity
– and you live in the country:
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Price Elasticity of Demand
Price elasticity of demand is closely related to the
slope of the demand curve
– the flatter the demand curve, the greater the elasticity
– the steeper the demand curve, the lower the elasticity
Ed  2 is Elastic
Ed  .5 is Inelastic
P
P2
P1
D
Q2
Q1
Q falls by 20%
Q
P rises by 10%
P rises by 10%
P
P2
P1
D
Q2
Q1
Q
Q falls by 5%
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Other Demand Elasticities
― Perfectly inelastic demand
• Elasticity = 0
• Demand curve is vertical
• Increase in price leaves the
quantity demanded unchanged
― Demand is perfectly elastic
• Elasticity = infinity
• Demand curve is horizontal
• At a given price, P0, consumers will
buy any quantity
Price
Demand
P1
P0
1. an
0
Q
Quantity
Price
P0
0
1. an
Demand
Quantity
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Total revenue and Demand
Total revenue (TR) - price of the good times the
quantity sold
The total amount paid by buyers, and received
as revenue by sellers, equals the area of the
box under the demand curve, P × Q.
At price equal $8, the quantity demanded is
100, and total revenue is $800.
Price
TR  P  Q
$8
1. an
$800
0
$800  $8 100
Demand
100
Quantity
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Elasticity and the Demand Curve
Elasticity of a linear demand curve
Price
Elastic
E>1
$7
6
𝐸𝑑 =
67%
= 3.7
18%
18%
5
4
1. an
3
18%
Inelastic
𝐸𝑑 =
= 0.3
E<1
67%
2
67%
Demand
1
0
2 4
67%
6
8 10 12 14
18%
Quantity
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Price
$7
Quantity
x
0
Elasticity and the Demand Curve
Total revenue
(Price ˣ Quantity)
=
$0
6
2
12
5
4
20
4
6
24
3
8
24
2
10
20
1
12
12
0
14
0
Percentage
Change
in Quantity
200%
Percentage
Change in
Price
÷
15%
=
Elasticity
Description
13.0
Elastic
67%
18%
3.7
Elastic
40%
22%
1.8
Elastic
29%
29%
1.0
Unit elastic
22%
40%
0.6
Inelastic
18%
67%
0.3
Inelastic
15%
200%
0.1
Inelastic
Using the midpoint formula
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Elasticity and the Demand Curve
When demand is elastic:
an increase in price will decrease total revenue
a decrease in price will increase total revenue
When demand is inelastic:
an increase in price will increase total revenue
a decrease in price will decrease total revenue
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Drug Interdiction
The United States, Mexico, and most of South American
have been fighting a “Drug War” for several decades.
This example illustrates two different interdiction
methods used during the fight.
Assume the demand for illegal drugs is perfectly
inelastic, due to addiction
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Interdiction
reduces the
supply of drugs.
Since demand for
drugs is perfectly
inelastic, price rises
Resulting in
increased spending
for drugs, and in
drug-related crime
Supply Interdiction
Price
D1
P1
S1
S0
P0
Q
Drug Quantity
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Education
reduces the
demand for
drugs.
Both price and
quantity fall.
Resulting in a
decreased
spending for drugs,
which makes drug
smuggling less
desirable
Demand Interdiction
Price
D1
D0
S0
P0
P1
Q1
Q0
Drug Quantity
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Income elasticity of demand
Income elasticity of demand: measures the response
of demand to a change in consumer income
%∆Qd
EI =
%∆ I
― For normal goods, income elasticity (EI) > 0
― For inferior goods, income elasticity (EI) < 0
Hamburgers
EI =
%∆Qd
%∆ I
=
Inferior Good
8%
= 0.8
Income Inelastic
10%
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Cross-price elasticity of demand
Cross-price elasticity of demand: measures the response
of demand for one good to changes in the price of
another good
%∆Qx
Ex/y =
%∆Py
%∆Q
%∆Q
20%
4%
hamburger
peanut
butter
=
%∆P
%∆P
=
chicken
jelly
10%
2.0
= 0.4
— For substitutes, cross-price elasticity > 0
(an increase in the price of chicken causes an increase in
demand for hamburger)
― For complements, cross-price elasticity < 0
(an increase jelly price causes decrease in demand for peanut
butter)
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Price Elasticity of Supply
Price elasticity of supply measures how much
quantity supplied, Qs, responds to a change in price
Price elasticity of supply measures sellers’
price-sensitivity.
Es
=
Percentage change in Qs
Percentage change in P
=
%∆Qs
%∆P
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Elasticity of Supply
Price elasticity of supply
– Elastic supply - Quantity supplied responds
substantially to changes in the price
• Elasticity >1
– Inelastic supply - Quantity supplied responds only
slightly to changes in the price
• Elasticity < 1
– Unit elastic supply - Quantity supplied responds
only equally to changes in the price
• Elasticity =1
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P
Price Elasticity of Supply
S
P rises by 8%
P1
16%
= 2.0
Es =
8%
P0
Which is elastic
Q0 Q1
Q rises by 16%
Q
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Supply Curves
The slope of the supply curve is closely related to price
elasticity of supply
• The flatter the curve, the bigger the elasticity
• The steeper the curve, the smaller the elasticity
more elastic
P
more inelastic
S
P
P1
P1
P0
P0
Q0
Q1
Q
S
Q0 Q1
Q
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Elasticity of Supply
― Perfectly Inelastic Supply
• Sellers’ are not price sensitive
• Es = 0, supply curve is vertical
• An increase in price leaves
Price
P1
P0
Supply
1. an
quantity supplied unchanged
0
― Perfectly Elastic Supply
• At a given price, P0, producers
will supply any quantity
• Es = infinity
• Supply curve is horizontal
Q0
Quantity
Price
P0
0
1. an
Supply
Quantity
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Determinants of Supply Elasticity
— The more easily sellers can change the quantity they
produce, the greater the price elasticity of supply.
Example: Supply of beachfront property is harder to vary and
thus less elastic than the supply of new cars.
— Time period: Price elasticity of supply is greater in
the longer a firm has to make changes, because
firms can build new factories, or new firms may be
able to enter the market over long time period
Example: Supply of classrooms are generally fixed in the short
run but schools can build a new facility with more time
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A winning football team
Your football team trades for an all pro quarterback
• The supply of seats and the supply curve remain fixed
• More wins leads to higher demand (higher attendance)
• which leads to much higher ticket prices
Price
$190
Supply
1. an
$112
D1
D0
0
76,125
Stadium Capacity
Ticket Price (2011)
Avg. Ticket Price ('12 - '16)
Per game seat added revenue
Number of home games
Home game seat revenue
Seasons played
Revenue with top player
Salary
Owner Profit
76,125
$112
$190
$5,937,750
8
$47,502,000
4
$190,008,000
$100,000,000
$90,008,000
Quantity
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Price of Gasoline
Summer gasoline demand
• As supply is fixed based on full refining capacity
• All else equal, as summer arrives demand increase (D1)
• which leads to much higher gasoline prices
Price
P1
Supply
1. an
P0
0
D1
D0
Q0
Quantity
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Good news for farmers?
A new corn technology increases production per acre
• Supply curve shifts to the right
• Higher production quantity leads to lower price
• Demand is inelastic so total revenue falls
1. When demand is inelastic,
an increase in supply.
Price
S0
S1
P0
2. Which leads
to a large fall
in price.
P1
3. A proportionately smaller
increase in quantity sold. As a
result, revenue falls.
D0
0
Q0 Q1
Quantity
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