Top Banner
PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University Elasticity and Its Application 1 © 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.
31
Welcome message from author
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
Page 1: Ch05

PowerPoint Slides prepared by: Andreea CHIRITESCU

Eastern Illinois University

Elasticity and Its Application

1© 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.

Page 2: Ch05

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

2© 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.

Page 3: Ch05

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

3© 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.

Page 4: Ch05

The Elasticity of Demand

• Determinants of price elasticity of demand– Availability of close substitutes

• Goods with close substitutes – more elastic demand

– Necessities vs. luxuries• Necessities – inelastic demand• Luxuries – elastic demand

4© 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.

Page 5: Ch05

The Elasticity of Demand

• Determinants of price elasticity of demand– Definition of the market

• Narrowly defined markets – more elastic demand

– Time horizon• Demand is more elastic over longer time

horizons

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.

Page 6: Ch05

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)

6

])/P)/[(PP(P])/Q)/[(QQ(Q

22

1212

1212

demand of elasticity Price

© 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.

Page 7: Ch05

The Elasticity of Demand

• Variety of demand curves– Demand is elastic

• Price elasticity of demand > 1

– Demand is inelastic• Price elasticity of demand < 1

– Demand has unit elasticity• Price elasticity of demand = 1

7© 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.

Page 8: Ch05

The Elasticity of Demand

• Variety of demand curves– Demand is perfectly inelastic

• Price elasticity of demand = 0• Demand curve is vertical

– Demand is perfectly elastic• Price elasticity of demand = infinity• Demand curve is horizontal

• The flatter the demand curve– The greater the price elasticity of demand– But elasticity is NOT just the slope, but also the position on the curve

8© 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.

Page 9: Ch05

Figure 1

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.

The Price Elasticity of Demand (a, b)(a) Perfectly Inelastic Demand:

Elasticity Equals 0

Price

Quantity 0

Demand

100

$5

4

1. An increase in price…

2. …leaves

the quantity

demanded

unchanged

(b) Inelastic Demand: Elasticity Is Less Than 1

Price

Quantity 0

$5

4

1. A 22%

increase

in price…

2. … leads to an 11% decrease in quantity demanded

Demand

10090

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.

Page 10: Ch05

Figure 1

10© 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.

The Price Elasticity of Demand (c)(c) Unit Elastic Demand: Elasticity Equals 1

Price

Quantity 0

$5

41. A 22%

increase

in price…2. … leads to a 22% decrease in quantity demanded

Demand

10080

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.

Page 11: Ch05

Figure 1

11© 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.

The Price Elasticity of Demand (d, e)(d) Elastic demand:

Elasticity > 1

Price

Quantity 0

$5

4

A 22%

increase

in price…

2. … leads to a 67% decrease in quantity demanded

Demand

10050

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

Price

Quantity 0

Demand $4

1. At any price

above $4, quantity

demanded is zero 2. At exactly $4,

consumers will

buy any quantity

3. At a price

below $4, quantity

demanded is infinite

Page 12: Ch05

Demand Elasticity and Revenue

• Total revenue, TR – Amount paid by buyers and received by

sellers of a good

– Price of the good times the quantity sold (P ˣ Q)

• For a price increase– If demand is inelastic, TR increases

– If demand is elastic, TR decreases

12© 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.

Page 13: Ch05

Figure 2

13© 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.

Total Revenue

P

Q

Quantity 0

Demand

Price

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.

100

$4

Page 14: Ch05

Figure 3

14© 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.

How Total Revenue Changes When Price Changes(a) The case of inelastic demandPrice

Demand

100The 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

Price

$5

Demand B B

Quantity 0Quantity 0 100

A A

70

4

90

4

$5

Page 15: Ch05

Income 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

15© 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.

Page 16: Ch05

Income Elasticity of Demand

• Normal goods– Positive income elasticity

– Necessities• Smaller income elasticities

– Luxuries• Large income elasticities

• Inferior goods– Negative income elasticities

16© 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.

Page 17: Ch05

Cross-Price 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

17© 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.

Page 18: Ch05

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

18© 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.

Page 19: Ch05

The Elasticity of Supply

• Price elasticity of supply– How much the quantity supplied of a good

responds to a change in the price of that good

– Percentage change in quantity supplied• Divided by the percentage change in price

– Depends on the flexibility of sellers to change the amount of the good they produce

19© 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.

Page 20: Ch05

Applications

• Which of the following insurance policies has the highest price elasticity of demand? A. Home insurance

B. Auto insurance – liability only

C. Auto insurance – comprehensive

D. Auto insurance underwritten by Bonilla Insurance Group

20© 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.

Page 21: Ch05

Applications: Economics is everywhere

• Now you should be able to understand… – Why some people pay more than others for the

same flight on a plane– Why restaurants give senior discounts– Why some businesses give out coupons to

customers– Why some gas stations charge higher prices

than others– Why no two students pay the same amount for

the same degree– Who pays a higher price?

21© 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

Page 22: Ch05

Applications: Economics is Everywhere

• How would Omaha Steaks perform during a recession as compared to McDonald’s?

• Why did the “second Texas oil boom” begin in 2008 (not 650 million years ago)?

22© 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.

Page 23: Ch05

The Elasticity of Supply

• Elastic supply– Quantity supplied responds substantially

to changes in the price

• Inelastic supply– Quantity supplied responds only slightly to

changes in the price

• Determinant of price elasticity of supply– Time period

• Supply is more elastic in long run

23© 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.

Page 24: Ch05

The Elasticity of Supply

• Computing 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)

24© 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.

2 1 2 1

2 1 2 1

2

2Price elasticity of supply

(Q Q ) / [(Q Q ) / ]

(P P ) / [(P P ) / ]

Page 25: Ch05

The Elasticity of Supply

• Variety of supply curves– Supply is unit elastic

• Price elasticity of supply = 1

– Supply is elastic• Price elasticity of supply > 1

– Supply is inelastic• Price elasticity of supply < 1

25© 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.

Page 26: Ch05

The Elasticity of Supply

• Variety of supply curves– Supply is perfectly inelastic

• Price elasticity of supply = 0• Supply curve – vertical

– Supply is perfectly elastic• Price elasticity of supply = infinity• Supply curve – horizontal

26© 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.

Page 27: Ch05

Figure 5

27© 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.

The Price Elasticity of Supply (a, b)(a) Perfectly Inelastic Supply:

Elasticity Equals 0

Price

Quantity 0

Supply

100

$5

4

1. An

increase

in price…

2. …leaves

the quantity

supplied

unchanged

(b) Inelastic Supply: Elasticity Is Less Than 1

Price

Quantity 0

$5

4

1. A 22%

increase

in price…

2. … leads to

a 10% increase

in quantity

supplied

100 110

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.

Supply

Page 28: Ch05

Figure 5

28© 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.

The Price Elasticity of Supply (c)

(c) Unit Elastic Supply: Elasticity Equals 1

Price

Quantity 0

$5

4

1. A 22%

increase

in price…

2. … leads to

a 22% increase

in quantity

supplied

100 125

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.

Supply

Page 29: Ch05

Figure 5

29© 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.

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

Price

Quantity 0

$5

4

1. A 22%

increase

in price…

2. … leads to

a 67% increase

in quantity

supplied

100 50

(e) Perfectly Elastic Supply: Elasticity Equals Infinity

Price

Quantity 0

Supply $4

1. At any price above $4, quantity supplied is infinite

2. At exactly $4,

producers will

supply any quantity

3. At any price

below $4, quantity

supplied is zero

Supply

Page 30: Ch05

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• Decrease in supply: large increase in price

– Long-run: supply and demand are elastic• Decrease in supply: small increase in price

30© 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.

Page 31: Ch05

Figure 8

31© 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.

A Reduction in Supply in the World Market for Oil

Price Price

Demand

P2

(a) The Oil Market in the Short Run

Demand

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

S1

S2

P1

1. In the short run, when supply and demand are inelastic, a shift in supply. . .

2. … leads to a large increase in price

P2

S1S2

P1

1. In the long run, when supply and demand are elastic, a shift in supply. . .

2. … leads to a small increase in price

Quantity 0 Quantity 0