ECO1000 Economics Semester One, 2004 Lecture Four.

ECO1000EconomicsSemester One, 2004

Lecture Four

Class test 1 reminder (for internals) April 7 Test open from 5 pm-8pm 25 questions Based on lectures & all workshop

activities Make sure you have

Graph paper Rulers and pens Calculator Text book etc.

Lecture 6 Room Change The week after next, we miss a Friday due

to Good Friday. To minimise disruption we have moved the

lecture to Thursday April 8 in L209 at 10 am for 1 hour.

This is the morning after your class test, and will allow you the chance to let me know how you went.

Outline or Plan of the Lecture Material Covered:

Module Two, Part Two Reading: Text Chapter

5 plus Study Guide Chapter 5

Topics Considered: Elasticity

Purpose or Objectives of the Lecture

You will learn about: What elasticity is The determinants of elasticity of demand The determinants of elasticity of supply The application of the concept

Relevant Economic Principles 3. Rational People Think at the Margin 4. People Respond to Incentives 6. Markets Are Usually a Good Way to

Organise Activity

Revenue

Total amount from the sale of a good or service Calculated as price/unit x quantity

sold

Profit = revenue - costs Economic profit = total revenue -

explicit and implicit costs

Revenue in a Competitive Market

Price

Quantity

S0

P0

Q0

D0

= Revenue = P0 x Q0

A Change in Demand & Revenue

Price

Quantity

S0

P0

Q0

D0

= Revenue0 = P0 x Q0

= Revenue1 = P1 x Q1

Q1

P1

D1

0

A Change in Supply & Revenue

Price

Quantity

S0

P0

Q0

D0

= Revenue0 = P0 x Q0

= Revenue1 = P1 x Q1

Q1

P1

S1

The size of revenue change depends on the responsiveness of quantity demanded or quantity supplied to one of its determinants.

QD not very responsive to change in Price

QD very responsive*P0

P1

Increase in QD very small

Increase in QD very large

Price

QuantityQ0 Q1 Q0* Q1

*

Elasticity

Elasticity of Demand Elasticity of demand is a measure of

responsiveness of the quantity demanded of a good to a change in: price of that good (own price elasticity) income (income elasticity) the price of another good (cross-price elasticity)

Why Economists Are Interested In Elasticity Elasticity allows us to compare two different

markets. We can quantify differences in markets for

different goods even if the units of measurement are different.

Eg. We can say that oil demand is twice as sensitive to price changes as wheat demand even though oil is measured in gallons and wheat in tonnes.

Calculating Elasticity Basic Terms/Notation:

Change in own price of good:P Change in quantity: Q Change in income: I Change in the price of another good: Pother good

Basic Formula Own-Price Elasticity:

%ΔQ ÷ %ΔP Income Elasticity:

%ΔQ ÷ %ΔI

Applications of these formulae are presented in the following slides.

Own Price Elasticity

If the price of a good increases by 10% and the quantity demanded decreases by 20%

The own price elasticity of demand =

210

20

P

QNumber is always negative because of the law of demand

What does the Result Mean?

01 2 3 4 5

Inelastic{ Elastic

This good is relatively elastic (responsive to changes in price)

Elasticity (2) is greater than 1 (ignore the sign when considering relative elasticity)

Change in qty greater than change in price

To Help Interpret the Result…

01 2 3 4 5

Inelastic{ Elastic

Notice: there are no negative values. This is because we always view our elasticity number as an absolute value.

Income Elasticity

If average income increases by 8% and the quantity demanded decreases by 2%

Then income elasticity of demand =

25.08

2

I

QNumber is negative. Therefore, the good must be inferior.

What Does the Result Mean?

01 2 3 4 5

This good is relatively income inelastic because the elasticity is less than 1 (not very responsive to changes in income)

0.25 lies here in the inelastic section (remember to ignore the negative sign)

Another Example

If average income decreases by 4% and the quantity demanded decreases by 6%

Then the income elasticity of demand =

5.14

6

I

Q

This good is relatively income elastic because elasticity is greater than 1 (responsive)

Number is positive. Therefore, it must be a normal good.

What Happens When You Are Given Prices and Quantities Rather Than Percentage Changes? Answer:

You must first work out the percentage changes, then calculate the elasticity.

Suppose We Have the Following Changes:

Price($)

Quantity/wk

80

1200

The price increases by $20/unit

D

100

800

20

400

The quantity demanded decreases by 400/wk

Calculating the Percentage Change in Price:

P = P1 - P0 = 100 - 80 = +20

% Change = P/P0 x 100 =

(20/80) x 100 = 0.25 x 100 = 25%

The price has increased by 25% in relation to the initial price

Calculating the percentage change in quantity

Q = Q1 - Q0 = 800 - 1200 = - 400

% Change in Q = Q/Qo =

- 400/1200 x 100 = - 0.33 x 100 = - 33%

Quantity has decreased by 33 percent

Calculating Final Elasticity

Elasticity = Q/P = -33.33/ 25 = -1.33

The percentage change in quantity was larger than the percentage change in price.

The good is relatively elastic because elasticity is greater than 1

The quantity demanded is quite responsive to the change in price.

A Good Way to Remember How to Calculate Percentage Change

(New Price or Quantity – Old Price or Quantity)

Old Price or Quantity

Line means “divided by”

X 100

The Full Elasticity Formula (long version)

0

01

0

01

PPP

QQQ

Simplifying Yields… When dividing a fraction you take the

reciprocal and multiply yielding a simpler formula:

01

0

0

01

PP

PX

Q

QQ

What Causes Elasticity to Differ Across Goods?

Some goods & services tend to have greater changes in quantity in response to price changes usually things people can do without

Others have relatively small changes in quantity in response to price changes essential, highly desired or addictive things

The Same Price Change With Two Different Levels of Elasticity

Price($)

Quantity/wk

80

1200

D0

100

1080

20

400

D1

120

800

Comparing the Elasticity of Two Goods

Elasticity of D0 = -1.33 (from earlier calculation)

For D1 elasticity equals:

01

0

0

01

PP

PX

Q

QQ

80100

80

1200

12001080

X

20

80

1200

120X

=

1

4

10

1X

= -0.4= =

Points to Note The steeper curve generally indicates

relative inelasticity The quantity of goods/services

demanded are less responsive to changes in price

However, elasticity also changes along a demand curve.

Why Elasticity Changes Along a Line

Price($)

Quantity/wk

80

1200

Same price change of $20/unit

D

100

800

20

400

Same change in quantity demanded of 400/wk

20

400

24002000

50

30

Comparing the Elasticity

Elasticity when P goes from 30 to 50 = 0.25 Elasticity when P goes from 80 to 100 = 1.33 (calculated using the formula below)

01

0

0

01

PP

PX

Q

QQ

Comparing the TwoScenario 1 vs Scenario 2

Relatively large change in quantity in response to a relatively small change in price

Comparatively responsive

Somewhat elastic

Relatively small change in quantity despite the relatively large in price

Comparatively unresponsive

Much more inelastic

Points to Note Even though the price and quantity

changed by the same amounts (400 units and $20) the elasticity is different.

This is because elasticity is based on relative changes to both price and quantity. That is, percentage changes.

When quantities are high, the relative change will be smaller and vice versa

This Can Be Shown on the Following Demand Curve:

Price

Quantity

Elasticity equals 1 (unit elastic)

Elasticity less than 1 (inelastic)

Elasticity greater than 1 (elastic)

D

What Makes Goods More Inelastic?

Uniqueness (few substitutes) Necessity (versus discretionary spending) Non-durables (hard to postpone

consumption) Account for small proportion of household

incomes (people keep buying them) Little time to adjust to price changes

The Effect on Revenue

The Change in Revenue for an Elastic Good (assume supply has shifted)

Price($)

Quantity/wk

80

1200

D0

100

800

Revenue 1 = 1200 x 80 = $96,000/wk

Revenue 2 = 100 x 800 = $80,000

Change in revenue = -$16,000/wk

The Change in Revenue for an Inelastic Good

Price($)

Quantity/wk

80

1200

D0

100

1080

D1

Revenue 1 = $96,000

Revenue 2 = 1080 x 100 = $108,000

Change in revenue = + $12,000/wk

Revenue and Elasticity If a good or service is relatively inelastic,

then an increase in the price will lead to an increase in revenue

If a good or service is relatively elastic, then an increase in price will lead to a decrease in revenue

Elasticity of Supply

Calculated in the same way as own-price elasticity

Elasticity of Supply is Affected by… Whether firms are operating at full capacity

(can’t respond to price increases) Whether firms can switch to other products Assessment of whether price change is long

term or short term (should they bother?) Ease of storage of product (stockpiling) Time lag from decision to actual production

A Change in Quantity & Price

Price($)

Quantity/wk

80

1000

The price increases by $20/unit

S100

1200

20

200

The quantity supplied increases by 200/wk

Elasticity of Supply

0

0

0

01

1 PP

PX

Q

QQ

80100

80

1000

10001200

X20

80

1000

200X=

1

4

5

1X = 0.8=

Points to Note

Elasticity of supply is always positive increase in price is associated with increase in

quantity In this case elasticity is relatively inelastic The percentage change in price was

much greater than the consequent percentage change in quantity

At lower quantities, the outcome would be different, as in the demand example

Conclusions Elasticity is a measure of the

responsiveness of demand and supply to changes in their determinants.

A good that has elasticity < 1 is inelastic A good that has elasticity > 1 is elastic We ignore the negative sign and treat the

result of our elasticity calculation as an absolute number

In Light of the Objectives for this Lecture…

We now know: That elasticity is a measure of responsiveness or

sensitivity That elasticity of demand and supply is

determined by certain factors (eg. few substitutes may cause demand to be inelastic)

That elasticity is an additional analytical tool that may be added to our supply and demand model developed last week.

Next Week Next Week’s Lecture:

Material Covered: Module Two, Part Three Reading: Text Chapter 6 Plus Hakes and Parry

Chapter 6 Topics: Markets and Government Policy

THE END