ECON 202: Principles of Microeconomics
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ECON 202: Principles of Microeconomics Chapter 6 Elasticity: The Responsiveness of Demand and Supply Elasticity: The Responsiveness of Demand and Supply 1. 2. 3. 4. 5. Price elasticity of demand. Determinants of the price elasticity of demand. Price elasticity of demand and total revenue. Other demand elasticities. Price elasticity of supply. ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 2 What’s elasticity? A measure of how much one economic variable responds to changes in another economic variable. Price elasticity of demand. How much quantity demanded varies when price changes. It is an important tool for economic analysis. Valuable information for producers. How quantity demanded reacts to changes in own prices, competitors prices or income. Useful to explain magnitudes of changes in price and quantity after a shift in demand or supply curve. ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 3 1. Price Elasticity of Demand From law of demand: Price falls, quantity demanded increases. But, how much? To avoid problems of comparability between different goods (tons vs. gallons), we use percentages: ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 4 1. Price Elasticity of Demand Case A: Price is 10, quantity 50. Price goes up to 12, quantity goes down to 45. Price elasticity of demand: -10% / 20% = - 0.5 Case B: Price is 20, quantity 100. Price goes down to 18, quantity goes up to 85. Price elasticity of demand: 15% / -10% = - 1.5 But, what happens if we start from the end point? 11.1% / -16.6% = - 0.66 17.6% / 11.1% = - 1.58 ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 5 1. Price Elasticity of Demand Midpoint formula Case A: ( -5 / 47.5 ) / ( 2 / 11 ) = - 0.58 Case B: ( 15 / 92.5 ) / ( -2 / 19 ) = - 1.54 Q2 − Q1 ⎛ Q1 + Q2 ⎞ ⎜ ⎟ Perc. change in quantity demanded ⎝ 2 ⎠ Price elast. dmd. = = P2 − P1 Perc. change in price ⎛ P1 + P2 ⎞ ⎜ ⎟ 2 ⎠ ⎝ ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 6 1. Price Elasticity of Demand If elasticity is between 0 and -1: Change in price causes a change less than proportional in quantity demanded. Demand is inelastic. If elasticity is smaller than -1: Change in price causes a change more than proportional in quantity demanded. Demand is elastic. If elasticity is equal to -1: Change in price cause a change proportional in quantity demanded. Demand is unit-elastic. ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 7 1. Price Elasticity of Demand Price elast. of demand 1: (40/60)/(-10/30) = -2 Price elast. of demand 2: (10/45)/(-10/30) = -.67 ECON 202: Princ. of Microeconomics The bigger the elasticity in absolute value, the more elastic the demand. The flatter the curve, the more elastic the demand. Elasticity: The Responsiveness of Demand and Supply 8 1. Price Elasticity of Demand Polar cases: Perfectly inelastic demand. Quantity demanded is completely unresponsive to price. Price elasticity of demand equals zero. Perfectly elastic demand. Quantity demanded is infinitely responsive to price Price elasticity of demand equals infinity. ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 9 2. Determinants of the Price Elasticity of Demand Availability of close substitutes. When more substitutes available, more elastic demand. Movie theaters in CS and movie theaters in Houston. Passage of time. Reaction to price changes can take some time. The more time passes, the more elastic the demand for a product becomes. Change of vehicle before a rise in gasoline price. Luxuries vs. Necessities. Demand curve for a luxury is more elastic than the demand curve for a necessity. Demand for necessities (food, clothes, gasoline) does not depend much on price. ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 10 2. Determinants of the Price Elasticity of Demand Definition of the market. The more narrowly defined a market, the more substitutes available, and the more elastic the demand. Apple Cinnamon Cheerios vs. breakfast cereal. Share of a good in a consumer’s budget. The bigger the share in the consumer’s budget, the more elastic the good. Increases in price affect considerably purchasing power, then reaction to this change can be significant. Houses, cars. ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 11 Goods or services with Elastic Demand Metals Electrical engineering products Mechanical engineering products Furniture Motor vehicles Instrument engineering products Professional services Transportation services ECON 202: Princ. of Microeconomics 1.52 1.39 1.30 1.26 1.14 1.10 1.09 1.03 Elasticity: The Responsiveness of Demand and Supply 12 Goods or services with Inelastic Demand Gas, electricity, and water Drinks (all types) Clothing Tobacco Banking and insurance services Agricultural and fish products Books, magazines and newspapers Food Oil ECON 202: Princ. of Microeconomics 0.92 0.78 0.64 0.61 0.56 0.42 0.34 0.12 0.05 Elasticity: The Responsiveness of Demand and Supply 13 3. Price Elasticity of Demand and Total Revenue Total revenue: price x units sold ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 14 3. Price Elasticity of Demand and Total Revenue When demand inelastic: A cut in price increases quantity demanded less than proportionally. Total revenue decreases. When demand elastic: A cut in price increase quantity demanded more than proportionally. Total revenue increases. When demand unit-elastic: A cut in price increase quantity demanded proportionally. Total revenue does not change. ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 15 3. Price Elasticity of Demand and Total Revenue Price elasticity is not constant along a linear demand Price elast. of demand at: p = 7 : (2/3)/(-1/6.5) = - 4.3 p = 2 : (2/13)/(-1/1.5) = - 0.23 p = 4 : (2/8)/(1/4) = -1 ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 16 3. Price Elasticity of Demand and Total Revenue ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 17 4. Other Demand Elasticities Cross-Price Elasticity of Demand If products are substitutes: Cross-price elasticity of demand is positive. Summer vacation destinations: Cancun vs. Puerto Vallarta. If products are complements Cross-price elasticity of demand is negative. Airline tickets and hotel rooms. If products are unrelated Cross-price elasticity of demand is zero. ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 18 4. Other Demand Elasticities Income Elasticity of Demand If the income elasticity is positive and smaller than 1: Good is normal and necessity. Food expenses. If the income elasticity is positive and greater than 1: Good is normal and luxury. Designer clothing. If the income elasticity is negative Good is inferior. Inter-city bus service. ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 19 4. Other Demand Elasticities The level of income has a important effect on income elasticities of demand. Income elasticity of demand for food. ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 20 4. Other Demand Elasticities Goods or services Income Elastic: Airline travel Movies Foreign travel Electricity Restaurant meals Local buses and trains Haircuts Cars ECON 202: Princ. of Microeconomics 5.82 3.41 3.08 1.94 1.61 1.38 1.36 1.07 Elasticity: The Responsiveness of Demand and Supply 21 4. Other Demand Elasticities Goods or services Income Inelastic: Tobacco Alcoholic beverages Furniture Clothing Newspapers Telephone Food ECON 202: Princ. of Microeconomics 0.86 0.62 0.53 0.51 0.38 0.32 0.14 Elasticity: The Responsiveness of Demand and Supply 22 4. Other Demand Elasticities Elasticities in the Market for Alcoholic Beverages Price elasticity of demand for beer -0.23 Cross-price elasticity of demand between beer and wine 0.31 Cross-price elasticity of demand between beer and spirits 0.15 Income elasticity of demand for beer -0.09 Income elasticity of demand for wine 5.03 Income elasticity of demand for spirits 1.21 ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 23 4. Price Elasticity of Supply In an analogous way to demand Because supply curves are upward sloping, Price Elasticity of Supply is positive. If smaller than 1: inelastic. If greater than 1: elastic. If equal to 1 : ? ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 24 4. Price Elasticity of Supply Price elasticity of supply depends on the availability of inputs and capital to increase production. In a short period of time, supply will be inelastic. After some time has passed, supply will become more elastic, as more resources can be dedicated to production. If a necessary input is not available, supply can be inelastic. ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 25 Using Price Elasticity of Supply to Predict Changes in Price Effect on market price of a shift in demand depends on elasticity of the supply curve. ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 26 Using Price Elasticity of Supply to Predict Changes in Price In the last 30 years prices of oil have fluctuated considerably. From $11 per barrel to $75 per barrel. Supply of oil is relatively inelastic, since exploring, drill and start exploiting new reserves is a lengthy process. Demand of oil derivatives (gasoline) is inelastic. Shifts in supply were common because of the coordination of oil producers countries. (OPEC) ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 27 Using Price Elasticity of Supply to Predict Changes in Price With more elastic supply curves, changes in prices are more moderate. ECON 202: Princ. of Microeconomics Elasticity: The Responsiveness of Demand and Supply 28 ECON 202: Principles of Microeconomics Chapter 6 Elasticity: The Responsiveness of Demand and Supply
