Chapter 5 Elasticity and Its Applications Ratna K. Shrestha.

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

ED =

% change in the quantity demanded given a one % change in its price.

A

B

DemandP

Q

P1

P2

Q1 Q2

Ranges of Elasticity . . .

Perfectly Inelastic (ED = 0): Consumers are “completely unresponsive” to price changes.

Perfectly Elastic (ED = - ): Consumers are “infinitely responsive” to price changes.

Unit Elastic (ED = -1): Consumer’s response is “equal to” change in price in percentage terms.

Elasticity of Demand Illustrated

Perfectly InelasticED = 0

P2

P1

Even if priceincreases a lot quantity demanded stays the same at Q1.

Q1

Elasticity of Demand Illustrated

Perfectly Elastic ED = -

P1

A small increase in price will cause demand to drop off completely.

Q

P

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

DSR

DLR

•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.

Quantity of Gas

Price

Computing Elasticity Coefficient

Price Elasticityof Demand, ED

=

Percentage Change in Quantity Demanded

Percentage Change in Price

% Q =

% P =

Q/Q

P/P

=(Q2 – Q1)/Q1

(P2 – P1)/P1

Computing Elasticity Coefficient

Demand forIce Cream

2.20

2.00

108

ED

(10%)

-(20%)

=(8 - 10) / 10

=

($2.2 - $2.0)/$2.0

= -2.0

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

Q

Price

4

8

2

4

ED = -1

ED = 0

ED = -

Elastic

Inelastic

Demand Curve

Q = 8 – 2P

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

Q/Q

Income Elasticityof Demand, YD

=% Change in Demand

%Change in Income

=I /I

The percentage change in the quantity demanded given a one percent change in income.

Income Elasticity... Types

YD > 0 Normal Goods

YD < 0 Inferior Goods

YD = 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).

Depending on how this relationship exists, the two goods may be complements or substitutes.

m

b

b

m

mm

bbcross P

Q

Q

P

PP

QQE

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

The % change in quantity supplied

resulting from a one % change in price.

Price

Q

A

B

P1

P2

Q1 Q2

S

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

Perfectly Inelastic

Perfectly Elastic

P

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

Elasticityof 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.

SA

DA

Price

Quantity of Wheat

$4.00

2000

Consider which direction the curve shifts.

SA

DA

Price

Quantity

$4.00

2000

SB

Technologycauses an increasein supply.

Use Supply-and-Demand diagram to see how the market changes.

SA

DA

Price

Quantity

$4.00

2000

SB

2400

$2.60

Compute Elasticity

ED =(2400 - 2000) / (2000)

($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

SA

DA

Price

Quantity

$4.00

2000

SB

2400

$2.60

TRSA = $8,000

TRSB = $5,760!

Bad news for the farmers

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...