Elasticity and Its Application

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PowerPoint Slides prepared by:

Andreea CHIRITESCU

Eastern Illinois University

The Elasticity of Demand

• Elasticity
• Measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants
• Price elasticity of demand
• How much the quantity demanded of a good responds to a change in the price of that good

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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The Elasticity of Demand

• Price elasticity of demand
• Percentage change in quantity demanded divided by the percentage change in price
• Elastic demand
• Quantity demanded responds substantially to changes in price
• Inelastic demand
• Quantity demanded responds only slightly to changes in price

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The Elasticity of Demand

• Computing the price elasticity of demand
• Percentage change in quantity demanded divided by percentage change in price
• Use absolute value (drop the minus sign)
• Midpoint method
• Two points: (Q₁, P₁) and (Q₂, P₂)

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Interpretation of PED

Exercise: The price of strawberry rises from $4 to $6 a box, and the quantity demanded decreases from 1,000 to 600 boxes a week.

A- Calculate the PED.

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B- Interpret your result in part A.

• 1% increase (or decrease) in the price will lead to an decrease (or increase) of 1.25% in the quantity demanded
• The PED is greater than 1, so the demand for strawberries is elastic.

Figure 1

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The Price Elasticity of Demand (a, b)

1. Perfectly Inelastic Demand:

Elasticity Equals 0

(b) Inelastic Demand: Elasticity Is Less Than 1

The price elasticity of demand determines whether the demand curve is steep or flat.

Note that all percentage changes are calculated using the midpoint method.

Figure 1

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The Price Elasticity of Demand (c)

(c) Unit Elastic Demand: Elasticity Equals 1

The price elasticity of demand determines whether the demand curve is steep or flat.

Note that all percentage changes are calculated using the midpoint method.

Figure 1

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The Price Elasticity of Demand (d, e)

(d) Elastic demand:

Elasticity > 1

The price elasticity of demand determines whether the demand curve is steep or flat.

Note that all percentage changes are calculated using the midpoint method.

(e) Perfectly elastic demand:

Elasticity equals infinity

The Elasticity of Demand

• Total revenue, TR
• Price of the good times the quantity sold (P ˣ Q)

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Figure 2

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Total Revenue

The total amount paid by buyers, and received as revenue by sellers, equals the area of the box under the demand curve, P × Q. Here, at a price of $4, the quantity demanded is 100, and total revenue is $400.

Figure 3

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How Total Revenue Changes When Price Changes

(a) The case of inelastic demand

The impact of a price change on total revenue (the product of price and quantity) depends on the elasticity of demand. In panel (a), the demand curve is inelastic. In this case, an increase in the price leads to a decrease in quantity demanded that is proportionately smaller, so total revenue increases. Here an increase in the price from $4 to $5 causes the quantity demanded to fall from 100 to 90. Total revenue rises from $400 to $450. In panel (b), the demand curve is elastic. In this case, an increase in the price leads to a decrease in quantity demanded that is proportionately larger, so total revenue decreases. Here an increase in the price from $4 to $5 causes the quantity demanded to fall from 100 to 70. Total revenue falls from $400 to $350.

(b) The case of elastic demand

B

B

A

A

The Elasticity of Demand

• Income elasticity of demand
• How much the quantity demanded of a good responds to a change in consumers’ income
• Percentage change in quantity demanded
• Divided by the percentage change in income

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The Elasticity of Demand

• Normal goods
• Positive income elasticity
• Necessities
• Smaller income elasticities
• Luxuries
• Large income elasticities
• Inferior goods
• Negative income elasticities

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The Elasticity of Demand

• Cross-price elasticity of demand
• How much the quantity demanded of one good responds to a change in the price of another good
• Percentage change in quantity demanded of the first good
• Divided by the percentage change in price of the second good

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The Elasticity of Demand

• Substitutes
• Goods typically used in place of one another
• Positive cross-price elasticity
• Complements
• Goods that are typically used together
• Negative cross-price elasticity

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The Elasticity of Supply

• Price elasticity of supply
• Percentage change in quantity supplied divided by percentage change in price
• Always positive
• Midpoint method
• Two points: (Q₁, P₁) and (Q₂, P₂)

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Figure 5

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The Price Elasticity of Supply (a, b)

(a) Perfectly Inelastic Supply: Elasticity Equals 0

(b) Inelastic Supply: Elasticity Is Less Than 1

The price elasticity of supply determines whether the supply curve is steep or flat.

Note that all percentage changes are calculated using the midpoint method.

Figure 5

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The Price Elasticity of Supply (c)

(c) Unit Elastic Supply: Elasticity Equals 1

The price elasticity of supply determines whether the supply curve is steep or flat.

Note that all percentage changes are calculated using the midpoint method.

Figure 5

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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The Price Elasticity of Supply (d, e)

The price elasticity of supply determines whether the supply curve is steep or flat.

Note that all percentage changes are calculated using the midpoint method.

(d) Elastic Supply: Elasticity Is Greater Than 1

(e) Perfectly Elastic Supply: Elasticity Equals Infinity

Figure 6

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How the Price Elasticity of Supply Can Vary

Because firms often have a maximum capacity for production, the elasticity of supply may be very high at low levels of quantity supplied and very low at high levels of quantity supplied. Here an increase in price from $3 to $4 increases the quantity supplied from 100 to 200. Because the 67 percent increase in quantity supplied (computed using the midpoint method) is larger than the 29 percent increase in price, the supply curve is elastic in this range. By contrast, when the price rises from $12 to $15, the quantity supplied rises only from 500 to 525. Because the 5 percent increase in quantity supplied is smaller than the 22 percent increase in price, the supply curve is inelastic in this range.

Applications

• Why Did OPEC Fail to Keep the Price of Oil High?
• Increase in prices 1973-1974, 1971-1981
• Short-run: supply and demand are inelastic (buyers and sellers cannot quickly adjust their behavior)
• Long-run: supply and demand are elastic

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Figure 8

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A Reduction in Supply in the World Market for Oil

(a) The Oil Market in the Short Run

When the supply of oil falls, the response depends on the time horizon. In the short run, supply and demand are relatively inelastic, as in panel (a). Thus, when the supply curve shifts from S₁ to S₂, the price rises substantially. By contrast, in the long run, supply and demand are relatively elastic, as in panel (b). In this case, the same size shift in the supply curve (S₁ to S₂) causes a smaller increase in the price.

(b) The Oil Market in the Long Run

Applications

• Demand Elasticity: Consumers find alternatives (e.g., energy efficiency, alternative energy sources) or reduce usage.
• Supply Elasticity: Non-OPEC producers increase production, entering the market to capitalize on high prices.

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Applications

• Drug Interdiction
• More federal agents→supply curve shifts left
• Price ↑, quantity ↓
• With inelastic demand: higher prices → higher revenue → more crime
• Drug Education Policy
• Reduces demand (curve shifts left)Price ↓, quantity ↓
• Lower revenues → less crime

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Exhibit 9

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Policies to Reduce the Use of Illegal Drugs

(a) Drug Interdiction

Drug interdiction reduces the supply of drugs from S₁ to S₂, as in panel (a). If the demand for drugs is inelastic, then the total amount paid by drug users rises, even as the amount of drug use falls. By contrast, drug education reduces the demand for drugs from D₁ to D₂, as in panel (b). Because both price and quantity fall, the amount paid by drug users falls

(b) Drug Education