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Elasticity: Measuring Responsiveness

MICROECONOMICS
PROF. RUSHEN CHAHAL

Prof. Rushen Chahal

2/12/2012

Chapter 5
y y y y y y y

Elasticity

Midpoint formula

Demand elasticity Demand elasticity and total revenue Extremes of demand elasticity Income elasticity Cross-elasticity of demand Supply elasticity

Prof. Rushen Chahal

2/12/2012

Learning Objectives

y y

Discuss how elasticity is used to measure the responsiveness of quantity changes to price. Compute the elasticity of demand. Describe the conditions under which a price change would increase, decrease, or not change a firms total revenue. Discuss the significance of the income elasticity of demand, the cross elasticity of demand, and the elasticity of supply.
2/12/2012

Prof. Rushen Chahal

Elasticity

y If you increase the amount of time you study by

25%, what percentage will your grades increase? y If I spend 10% more time in front of the mirror in the mornings, how much better looking will I be? y If I increase the amount I exercise by 50%, what percentage of my body weight will I lose? y All of these questions are asking questions about elasticity
Prof. Rushen Chahal

2/12/2012

Elasticity

y Elasticity measures the responsiveness of one

thing (Y) to another (X), specifically, the percentage change in Y divided by the percentage change in X.

Elasticity = Percentage change in one variable (Y)


Percentage change in another variable (X)
y In other words:  What percent will one variable will change when another variable changes?
Prof. Rushen Chahal

2/12/2012

Elasticity
y How do we calculate this percentage change in a

variable? y If I am 100lbs and gain weight until Im 150lbs, Ive gained 50% of my bodyweight y If Im 150lbs and lose weight until Im 100lbs, Ive lost 33.3% of my bodyweight y Clearly, comparing the change to the original value isnt going to work y So instead were going to use the midpoint formula
Prof. Rushen Chahal

2/12/2012

Midpoint Formula
y The measure of percentage changes is provided by

the midpoint formula.




The formula computes a percentage change as the change in the variable divided by an amount halfway between the starting and ending amount.

Percentage change in Y= change in Y/Y midpoint Divided by Percentage change in X= change in X/X midpoint

Prof. Rushen Chahal

2/12/2012

Midpoint Formula
y Say I increase my studying time from 2 hours to

three hours y As a result my test grade increases from 75 to 95 y Whats my elasticity of test grade with respect to study time? y Lets use the midpoint formula to calculate it

Prof. Rushen Chahal

2/12/2012

Midpoint Formula
y Whats the change in my study time?  1 hour y Whats the midpoint of my study time?  (2+3)/2 = 2.5 y Whats the change in my grade?  20 points y Whats the midpoint of my grades?  (75+95)/2 = 85

Prof. Rushen Chahal

2/12/2012

Midpoint Formula
y Change in study time = 1 y Midpoint of study time = 2.5 y Change in grades = 20 y Midpoint of grades = 85

20 85 ______ _1_ 2.5


Prof. Rushen Chahal

0.588

This means that every one percentage point increase of study time results in a 0.588 percentage increase in my grades
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Midpoint Formula
y Again, the midpoint formula to calculate the

percentage change in Y caused by a 1 percentage change of X is:

_________________

Change in Y Y midpoint

1 0 ______________

(Y

Y )

0 1 __________________ 1 0 ______________

0.5 (Y + Y ) (X X )

Change in X X midpoint
Prof. Rushen Chahal

0.5 (X0 + X1)


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Midpoint Formula
y Im a farmer y When I use 40 pounds of fertilizer, I can grow 100

bushels of tomatoes y When I use 50 pounds of fertilizer I can grow 130 bushels of tomatoes y Calculate the elasticity of bushels of tomatoes with respect to fertilizer used

Prof. Rushen Chahal

2/12/2012

Midpoint Formula

y Change in tomato crop: 130100=30 y Tomato crop midpoint: (130+100)/2=115 y Change in fertilizer: 50-40=10 y Fertilizer midpoint: (50+40)/2=45 y Elasticity=

30 115 ______ _10_ 45 Prof. Rushen Chahal

1.17

This means that a one percent change in the amount of fertilizer used results in a 1.17 percent increase in the 2/12/2012 tomatoes I can grow

Elasticity
y Elasticity has a broad range of applications.

Price elasticity of demand Price elasticity of supply Cross price elasticity Income Elasticity

Prof. Rushen Chahal

2/12/2012

Price Elasticity of Demand


y We have seen that demand is downwards

sloping y This means that an increase in price will lead to a decrease of quantity demanded y But how much will an increase in price decrease quantity demanded? y This idea is called the price elasticity of demand y Because price and quantity demanded are inversely related, the value will be negative y For simplicity we always make elasticity of demand positive (absolute value) Prof. Rushen Chahal 2/12/2012

Price Elasticity of Demand


y How do we calculate elasticity of demand?

%( Quantity Ep ! %( Price

Change in Y Y midpoint

1 0 ______________

(Q

Q )

0.5 (Q0 + Q1)

_________________

________________ ______________

Change in X X midpoint

( P1

P0 )

0.5 (P0 + P1)

Prof. Rushen Chahal

Again, we will be using the midpoint formula to calculate the percentage change in quantity and price

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The Elasticity of Demand


y Note: The slope of the demand curve is NOT the

elasticity of demand y Slope measures change in price related to change in quantity demanded in absolute terms y Elasticity measures change in price related to change in quantity demanded as a percentage y Slope makes no calculation for percentage changes

Prof. Rushen Chahal

2/12/2012

Price elasticity of demand: example


y Lets calculate my elasticity of demand for t-shirts y At $10 a t-shirt, I will buy 12 t-shirts a year y At 8$ a t-shirt I will buy 18 t-shirts a year y Whats my elasticity of demand for t-shirts?

Prof. Rushen Chahal

2/12/2012

Price elasticity of demand: example


y Whats the change in t-shirts demanded?  18-12=6 t-shirts y Whats the midpoint of t-shirts?  (18+12)/2=15 t-shirts y Whats the percentage change in t-shirts?  6/15

Prof. Rushen Chahal

2/12/2012

Price elasticity of demand: example


y Whats the change in price?  $10-$8 = $2 y Whats the midpoint price?  ($10+$8)/2 = $9 y Whats the percentage change of price?  2/9

Prof. Rushen Chahal

2/12/2012

Price elasticity of demand: example


y What percentage has quantity demanded changed as

a result of a price change? y Percentage change Q Percentage change Y

6/15

2/9

= 1.8

This means a 1% change in price will result in a 1.8% change in quantity demanded
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Prof. Rushen Chahal

The Price Elasticity of Demand

y Categories of Demand Elasticity  Inelastic demand: 0 < EP < 1


A

1% change in price will result in a less than 1% change in quantity demanded 1% change in price will result in exactly 1% change in quantity demanded

Unit elasticity of demand: EP = 1


A

Elastic demand: EP > 1


A

1% change in price will result in a larger than 1% change in quantity demanded

Prof. Rushen Chahal

2/12/2012

The Price Elasticity of Demand


y Factors affecting demand elasticity  Ease of substitution
The greater

availability of substitutes, the greater will be the

elasticity.


Proportion of total expenditures


The larger

the proportion of a consumers income is used for the product, the greater its elasticity. longer period of time you can find more alternatives. necessities is inelastic; demand for luxuries is

Length of time
Over a

Necessity or Luxury?
Demand for

elastic.
Prof. Rushen Chahal

2/12/2012

The Range of the Elasticity of Demand


Unit Elastic This value can range from zero to infinity (in absolute value)

Inelastic

Elastic

1
Elasticity of Demand

Prof. Rushen Chahal

2/12/2012

Estimates of Demand Elasticities


Product
Beef Fish Public Transit Peak use business electricity Physician services Poultry Fruit Peak use residential electricity Restaurant meals Kellogg s Fruit Loops Cheerios Coke
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Elasticity of Demand
0.35 0.39 0.40 .47 0.60 0.64 0.71 1.5 2.3 2.3 3.6 3.8 4.4 4.6

Mountain Dew

Prof. Rushen Chahal

Fresh Tomatoes

The Effect of Elasticity on Price and Quantity


y Why do we care about price elasticity of demand? y A response to change in supply is largely determined

by price elasticity. y Both price and quantity will be affected, but by how much depends in part on elasticity. y Lets look at an example:

Prof. Rushen Chahal

2/12/2012

The Effect of Elasticity of Demand on Price and Quantity


Here we have a demand curve P that is relatively elastic. 10 Equilibrium is at P = 4 and 9 Q=29. 8 Now there is a decrease in supply. You can see that price only increases by a small amount ($0.50) but quantity decreases by a large amount, about 9.
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S2

S1

7 6

P2 P1

5 4 3 2 1 10

D1 Q2
20

Q1
30 40 50
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The Effect of Elasticity of Demand on Price and Quantity


y Elastic demand curve


if supply decreases, prince increases a little and quantity decreases a lot. If supply increases, price decreases a little and quantity increases a lot. Small changes in price and large changes in quantity.

y Example: luxury goods

Prof. Rushen Chahal

2/12/2012

The Effect of Elasticity of Demand on Price and Quantity

Lets look at a demand curve with that is more inelastic. Now we shift supply in by the exact same amount. P2 With this curve price rises by much more ($2) but quantity only decreases by P1 about 3

10 9 8 7 6 5 4 3 2 1 10 20

S2

S1

D2 Q1 30
40 50
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Prof. Rushen Chahal

Q2

The Effect of Elasticity of Demand on Price and Quantity


y Inelastic demand curve


if supply decreases, prince increases a lot and quantity decreases a little. If supply increases, price decreases a lot and quantity increases a little. Large changes in price and small changes in quantity.

y Example: necessities

Prof. Rushen Chahal

2/12/2012

Demand Elasticity and Revenue


y Another more important aspect of demand elasticity

is its effect on revenue - Price x Quantity, or P x Q y A decrease in price will also be accompanied by an increase in quantity demanded y Will this cause revenue to increase or decrease?

Prof. Rushen Chahal

2/12/2012

Elasticity and Total Revenue Total Revenue = Price v Quantity TRo TR constant TRq Depending upon the elasticity
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When Po Po

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Total Revenue
$
Total revenue = price x quantity which is the area of the shaded rectangle.

Price

Demand Quantity demanded


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Quantity
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If we raise the price and: Demand is inelastic, we will see an increase in total revenue Demand is elastic, we will see a decrease in total revenue Demand is unit elastic, revenue remains constant

Demand Elasticity and Total Revenue

Prof. Rushen Chahal

2/12/2012

Demand Elasticity and Revenue


If we decrease the price and: Demand is inelastic we will see a decrease in total revenue Demand is elastic we will see an increase in total revenue Demand is unit elastic, revenue remains constant

Prof. Rushen Chahal

2/12/2012

Demand Elasticity and Revenue


Here we are at a point on the demand curve that is relatively inelastic. Revenue is represented by P x Q, or the shaded area. Now price falls, and quantity rises. Total revenue falls. When demand is inelastic, a decrease in price decreases total revenue.
Q1
Prof. Rushen Chahal

P
P1 P2

Q2

Q
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Demand Elasticity and Revenue


Here we are at a point on the demand curve that is relatively elastic. Revenue is represented by P x Q, or the shaded area. Now price falls, and quantity rises. Total revenue rises. When demand is elastic, a decrease in price increases total revenue.
Q1
Prof. Rushen Chahal

P
P1 P2

Q2

Q
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The Effect of a Change in Total Revenue


Change in Price
Higher Price

Effect on Total Revenue


If demand is inelastic, total revenue rises. If demand is unit elastic, total revenue remains constant. If demand is elastic, total revenue falls.

Lower price

If demand is inelastic, total revenue falls. If demand is unit elastic, total revenue remains constant. If demand is elastic, total revenue rises.

2/12/2012

Prof. Rushen Chahal

Demand Elasticity for Newspapers


y A French newspaper Le Quotidien, wanted to gain a

competitive edge y They therefore lowered the price of a paper from FF6 to FF4 y Circulation increased from 30,000 to 40,000 y But total revenues decreased from FF180,000 to FF160,000

Prof. Rushen Chahal

2/12/2012

Demand Elasticity for Newspapers


y In this example, was demand for this newspaper

relatively elastic or inelastic?


y It seems that they miscalculated the elasticity of

demand for the newspaper, as the price decrease was not accompanied by as large of a quantity demanded increase

Prof. Rushen Chahal

2/12/2012

Demand Elasticity
y Demand elasticity will be different on different

parts of the demand curve y With downward sloping straight line demand curves:
  

Demand is unit elastic at the midpoint Demand is elastic above the midpoint Demand is inelastic below the midpoint

Prof. Rushen Chahal

2/12/2012

Demand elasticity

y Why? y At high prices and low quantities, a small

percentage change in price causes a larger percentage change in quantity (elasticity) y At low prices and high quantities, a large percentage change in price causes a small percentage change in quantity (inelasticity)

Prof. Rushen Chahal

2/12/2012

Price ($s)

Example: The price is 100 RMB. A change in price of 2 RMB is a large or small percentage? Small The price is 10 RMB. A change in price of 2 RMB is a large or small percentage? Large

Example: The quantity is 100. A change in quantity of 4 is a large or small percentage? Small The quantity is 10. A change in quantity of 4 is a large or small percentage? Large = big small

Elastic

Midpoint: Unit Elastic Inelastic


= small big

High price (small % change), Low quantity (big % change)

Quantity
Elasticity = % change in quantity % change in price Prof. Rushen Chahal Low price (big % change, high quantity (small % change)
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Demand, Elasticity, Total Revenue


Total revenue is maximized when demand is unit elastic.

Elastic

Dollars

Total Revenue

Unit Elastic Inelastic Each firm produces in the elastic range of its Prof. Rushen Chahal demand curve.

Demand
Quantity
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Extremes of Demand Elasticity


y Sometimes quantity demanded isnt affected by price

at all y No matter what the price is, the quantity demanded will always be the same y This would be called perfectly inelastic y E.g. medicine needed to keep people alive: insulin for diabetics

Prof. Rushen Chahal

2/12/2012

Extremes of Demand Elasticity


y Sometimes its going to be impossible to raise prices y If you raise prices even just a little bit, nobody will

buy your product y This is called perfectly elastic y For example you are one firm in an industry with 1000 firms, all selling at the same price

Prof. Rushen Chahal

2/12/2012

Extremes of Demand Elasticity


y Sometimes total revenue will be the exact same, no

matter what price you charge y This is called unit elastic y This may be the case where consumers have a fixed budget to spend on a good, no matter what the price

Prof. Rushen Chahal

2/12/2012

6 3 1

Demand Demand

Demand

Quantity

Quantity

12

Quantity

1. Perfectly Inelastic Elasticity = 0


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2. Unit Elastic Elasticity =1

3. Perfectly Elastic Elasticity = g


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Income Elasticity
y If your income rises, youre going to buy more of

(almost) everything y If your income rises by 10%, how many more DVDs will you buy? y If your income rises by 10%, how much more electricity will you consume? y This is determined by income elasticity

Prof. Rushen Chahal

2/12/2012

Income Elasticity

y Income Elasticity of Demand measures how

demand responds to income; computed as the percentage change in quantity demanded divided by the percentage change in income. y Y means Income

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%(Q EY ! %(Y

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Income Elasticity
y Normal goods
0

< EY Income elasticity is POSITIVE Demand INCREASES as income increases

y Inferior goods
EY

<0 Income elasticity is NEGATIVE Demand decreases as income increases if you have more money, you buys less of this inferior good.
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Prof. Rushen Chahal

Income Elasticity of Demand

Change in Income Change in Demand Income Elasticity Type of Good Increase Increases Positive Normal Increase Decreases Negative Inferior Decrease Increases Negative Inferior Decrease Decreases Positive Normal
Prof. Rushen Chahal

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The Cross-Elasticity of Demand

y So far we have been looking at how changes in

price affects changes in quantity demanded of one product y What would happen to the demand for Cocacola if the price of Pepsi-cola rose? y What would happen to the demand for bicycle locks if the price of bicycles rose?

Prof. Rushen Chahal

2/12/2012

The Cross Elasticity of Demand


y How much is demand for a product changed when a

there is a price change in a substitute or complement (related products)?


y To answer this we must look at the cross-elasticity of

demand.

Prof. Rushen Chahal

2/12/2012

The Cross-Elasticity of Demand

y Cross-elasticity of demand measures how the

demand for one good responds to changes in the price of another good; computes as the percentage change in the quantity demanded of one good (A) divided by the percentage change in the price of another good (B).

Prof. Rushen Chahal

%(QA EX ! %(PB

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The Cross-Elasticity of Demand

y The sign of cross-elasticity for substitutes is

positive.
In

other words: if the cross elasticity of two goods is positive, then those two goods are substitutes.

Example: if

the price of Coca cola rises (positive change), then the quantity demanded of Pepsi cola increases (positive change).
(+ number) (+ number) = + number

Prof. Rushen Chahal

2/12/2012

The Cross-Elasticity of Demand


y The sign of cross-elasticity for complements is

negative.
In

other words: if the cross elasticity of two goods is negative, then those two goods are complements. Example: if the price of bicycles rises (positive change), then the quantity demanded of bicycle locks falls (negative change).
(+ number) (- number) = - number

Prof. Rushen Chahal

2/12/2012

Cross Elasticity of Demand

Change in the Cross Elasticity Price of Change in Demand Between Another Good for the First Good the Goods Increase Increases Positive Increase Decreases Negative Decrease Increases Negative Decrease Decreases Positive
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Relationship Between the Goods Substitutes Complements Complements Substitutes


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Elasticity of Supply
y Demand is not the only thing affected by price y We have seen that supply is also affected by price y An increase in price will result in an increase of

quantity supplied y But by how much? y This is determined by elasticity of supply

Prof. Rushen Chahal

2/12/2012

Elasticity of Supply

y Price Elasticity of Supply measures the

responsiveness of quantity supplied to price; computed as the percentage change in quantity supplied divided by the percentage change in price.

% ( Quantity Supplied ES ! % ( Price


y Elasticity of supply is 0 or POSITIVE. It is never

negative.
Prof. Rushen Chahal

2/12/2012

Elasticity of Supply
y When the supply curve is more elastic, a change in

demand will cause a small change in price and a large change in quantity demanded. y When the supply curve is less elastic, a change in demand will cause a large change in price and a small change in quantity demanded.

Prof. Rushen Chahal

2/12/2012

The Extremes of Supply Elasticity


Supply

Supply Supply

Quantity

Quantity

Quantity

1. Perfectly Inelastic Elasticity = 0


Prof. Rushen Chahal

2. Unit Elastic Elasticity =1 (only if the line is at a 45 degree angle)

3. Perfectly Elastic Elasticity = g


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THE ELASTICITY OF SUPPLY


T H E E L A S T I C I T Y O F S U P P L Y M E A S U R E S T H E

RESPONSIVENESS OF QUANTITY SUPPLIED TO PRICE.

ELASTICITY OF SUPPLY CAN FALL WITHIN THE FOLLOWING THREE RANGES:

INELASTIC SUPPLY: ELASTICITY OF SUPPLY LIES BETWEEN 0 AND 1.  UNIT ELASTIC SUPPLY: ELASTICITY OF SUPPLY = 1.  ELASTIC SUPPLY: ELASTICITY OF SUPPLY IS Prof. Rushen Chahal 2/12/2012 GREATER THAN 1.


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