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MICROECONOMICS
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
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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.
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Elasticity
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
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Elasticity
thing (Y) to another (X), specifically, the percentage change in Y divided by the percentage change in X.
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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
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Midpoint Formula
y The measure of percentage changes is provided by
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
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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
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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
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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
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
_________________
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
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
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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=
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
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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
%( Quantity Ep ! %( Price
Change in Y Y midpoint
1 0 ______________
(Q
Q )
_________________
________________ ______________
Change in X X midpoint
( P1
P0 )
Again, we will be using the midpoint formula to calculate the percentage change in quantity and price
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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
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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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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
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elasticity.
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.
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Inelastic
Elastic
1
Elasticity of Demand
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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
Fresh Tomatoes
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:
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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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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.
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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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Q2
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
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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?
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Elasticity and Total Revenue Total Revenue = Price v Quantity TRo TR constant TRq Depending upon the elasticity
Prof. Rushen Chahal
When Po Po
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Total Revenue
$
Total revenue = price x quantity which is the area of the shaded rectangle.
Price
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
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P
P1 P2
Q2
Q
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P
P1 P2
Q2
Q
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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.
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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
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demand for the newspaper, as the price decrease was not accompanied by as large of a quantity demanded increase
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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
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Demand elasticity
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)
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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
Quantity
Elasticity = % change in quantity % change in price Prof. Rushen Chahal Low price (big % change, high quantity (small % change)
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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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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
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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
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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
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6 3 1
Demand Demand
Demand
Quantity
Quantity
12
Quantity
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
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Income Elasticity
demand responds to income; computed as the percentage change in quantity demanded divided by the percentage change in income. y Y means Income
%(Q EY ! %(Y
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Income Elasticity
y Normal goods
0
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
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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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?
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demand.
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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).
%(QA EX ! %(PB
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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
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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
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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
Prof. Rushen Chahal
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
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Elasticity of Supply
responsiveness of quantity supplied to price; computed as the percentage change in quantity supplied divided by the percentage change in price.
negative.
Prof. Rushen Chahal
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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.
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Supply Supply
Quantity
Quantity
Quantity
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.