5/6/2023 CHAPTER 3: ELASTICITY 1. Elasticity of demand 2. Elasticity of supply 3. Applications 1. Elasticity of Demand 1.1. Price elasticity of demand 1.2. Cross elasticity of demand 1.3. Income elasticity of demand 1.1. Price elasticity of demand • Price elasticity of demand (Edp) measures how much Qd responds to a change in P. • The percentage change in quantity demanded resulting from 1% change in price. • Loosely speaking, it measures the price-sensitivity of buyers’ demand. 1 5/6/2023 Calculating Edp • Standard method; • Midpoint method. Standard method Edp = % change in Qd % change in Midpoint method in Qd Edp = %%change change in % change = (end value – start value/midpoint) x 100% Note: Ed < 0, |Ed| The Determinants of Price Elasticity • • • • The extent to which close substitutes are available Whether the good is a necessity or a luxury How broadly or narrowly the good is defined The time horizon—elasticity is higher in the long run than the short run 2 5/6/2023 “Perfectly inelastic demand” (one extreme case) Price elasticity = of demand % change in Q % change in P P D curve: vertical 0% = 10% =0 D P1 Consumers’ price sensitivity: none P2 P falls by 10% Elasticity: 0 Q Q1 Q changes by 0% “Inelastic demand” Price elasticity = of demand % change in Q % change in P < 10% 10% <1 P D curve: relatively steep P1 Consumers’ price sensitivity: relatively low Elasticity: <1 = P2 D P falls by 10% Q Q1 Q2 Q rises less than 10% “Unit elastic demand” Price elasticity = of demand % change in Q % change in P 10% 10% =1 P D curve: intermediate slope P1 Consumers’ price sensitivity: intermediate Elasticity: 1 = P2 P falls by 10% D Q1 Q2 Q Q rises by 10% 3 5/6/2023 “Elastic demand” Price elasticity = of demand % change in Q % change in P > 10% 10% >1 P D curve: relatively flat P1 Consumers’ price sensitivity: relatively high Elasticity: >1 = P2 D P falls by 10% Q1 Q2 Q Q rises more than 10% “Perfectly elastic demand” (the other extreme) Price elasticity = of demand % change in Q % change in P Elasticity: infinity any % 0% = infinity P D curve: horizontal Consumers’ price sensitivity: extreme = D P2 = P1 P changes by 0% Q2 Q1 Q Q changes by any % The Variety of Demand Curves • The price elasticity of demand is closely related to the slope of the demand curve. • Rule of thumb: The flatter the curve, the greater the elasticity. The steeper the curve, the smaller the elasticity. 4 5/6/2023 The Variety of Demand Curves 5 classifications of D curve: • |Ed| = 0: Perfectly Inelastic; • |Ed| <1: Inelastic; • |Ed| = 1: Unit elastic; • |Ed| > 1: Elastic; • |Ed| = ∞ : Perfectly elastic. Edp and Total Revenue Total revenue - TR: the amount paid by buyers and received by sellers of a good. TR = P x Q Edp and Total Revenue Ex: P = 4$, Qd = 100 units TR = 4 x 100 = 400 5 5/6/2023 Edp and Total Revenue |Ed| < 1: P rises TR rises At At Edp and Total Revenue |Ed| > 1: P falls TR falls 1.2. Cross elasticity of demand Cross-price elasticity of demand: measures the response of demand for one good to changes in the price of another good Cross-price elast. = of demand % change in Qd for good 1 % change in price of good 2 Ex: Edx,y = 1,5 PY changes by 1%, QdX changes by1,5% 6 5/6/2023 1.2. Cross elasticity of demand For substitutes, cross-price elasticity > 0 (e.g., an increase in price of beef causes an increase in demand for chicken) For complements, cross-price elasticity < 0 (e.g., an increase in price of computers causes decrease in demand for software) 1.3. Income elasticity of demand Income elasticity of demand: measures the response of Qd to a change in consumer income. Income elasticity of demand = Percent change in Qd Percent change in income For normal goods, income elasticity > 0. For inferior goods, income elasticity < 0. 2. Elasticity of supply • Price elasticity of supply measures how much Qs responds to a change in P. • The percentage change in quantity supplied resulting from 1% change in price. • Loosely speaking, it measures sellers’ pricesensitivity. 7 5/6/2023 Standard method % change in Q % change in Es = Midpoint method in Q Es = %%change change in % change = (end value – start value/midpoint) x 100% Note: Es > 0 The Variety of Supply Curves Five classifications of S curve: • Es = 0: Perfectly Inelastic; • Es <1: Inelastic; • Es = 1: Unit elastic; • Es > 1: Elastic; • Es = ∞ : Perfectly elastic. “Perfectly inelastic” (one extreme) Price elasticity = of supply % change in Q % change in P P S curve: vertical 10% =0 S P2 Sellers’ price sensitivity: none Elasticity: 0 0% = P1 P rises by 10% © 2015 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. Q1 Q Q changes by 0% 24 8 5/6/2023 “Inelastic” Price elasticity = of supply % change in Q % change in P < 10% 10% P S curve: relatively steep <1 S P2 Sellers’ price sensitivity: relatively low Elasticity: <1 = P1 P rises by 10% Q Q1 Q2 Q rises less than 10% 25 © 2015 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. “Unit elastic” Price elasticity = of supply % change in Q % change in P 10% 10% =1 P S curve: intermediate slope S P2 Sellers’ price sensitivity: intermediate Elasticity: =1 = P1 P rises by 10% Q1 Q Q2 Q rises by 10% 26 © 2015 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. “Elastic” Price elasticity = of supply % change in Q % change in P > 10% 10% >1 P S curve: relatively flat S P2 Sellers’ price sensitivity: relatively high Elasticity: >1 = P1 P rises by 10% © 2015 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. Q1 Q2 Q Q rises more than 10% 27 9 5/6/2023 “Perfectly elastic” (the other extreme) Price elasticity = of supply % change in Q % change in P Elasticity: infinity any % 0% = infinity P S curve: horizontal Sellers’ price sensitivity: extreme = P2 = P1 P changes by 0% S Q1 Q2 Q Q changes by any % © 2015 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. 28 The Variety of Supply Curves The slope of the supply curve is closely related to price elasticity of supply. Rule of thumb: The flatter the curve, the greater the elasticity. The steeper the curve, the smaller the elasticity. © 2015 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. 29 The Determinants of Supply Elasticity • How easy the sellers can change the quantity they produce • The time horizon—elasticity is higher in the long run than the short run © 2015 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. 30 10 5/6/2023 3. Applications Elasticity and tax incidence If the government imposes a tax on the supplier, which group will bear most of the burden? © 2015 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. Elasticity and tax incidence Who bill bear most of the burden? Short explanation and Illustrating by graphs (Work in groups) The buyer’s pricesensitivity is higher then the seller’s A B The buyer’s price-sensitivity is lower than the seller’s C D The buyer is perfectly sensitive with the change in price The buyer is not sensitive with the change in price © 2015 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. Elasticity and tax incidence A. The buyer’s price-sensitivity is higher then the seller’s Tax drops on: Buyer (td) = Seller (ts) = ……………bears the most © 2015 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. 11 5/6/2023 Elasticity and tax incidence B. The buyer’s price-sensitivity is lower than the seller’s Tax drops on: Buyer (td)= P2 – P1 Seller (ts) = t – td …………….bears the most © 2015 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. Elasticity and tax incidence C. The buyer is perfectly sensitive with the change in price The equilibrium price………….. after tax © 2015 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. Elasticity and tax incidence D. The buyer is not sensitive with the change in price The change in equilibrium price = ………………………….. © 2015 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. 12