5 CHAPTER D YNAMIC P OWER P OINT ™ S LIDES BY S OLINA L INDAHL 1 Elasticity and its Applications C...

55CHAPTE

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DYNAMIC POWERPOINT™ SLIDES BY SOLINA LINDAHL

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Elasticity and its Elasticity and its ApplicationsApplications

COPYRIGHT 2012 WORTH PUBLISHERS

Some good blogs and other sites to get the juices flowing:

Food for Food for Thought….Thought….

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SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND

SEE THE SEE THE INVISIBLEINVISIBLE HANDHANDA hard question:

Does slave redemption create more slavery? How will slave traders respond to an increase in demand for slaves?

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Harvard Sophomore Jay Williams redeems slaves in the Sudan

CHAPTER OUTLINE

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The Elasticity of Demand

The Elasticity of Supply

Using Elasticities for Quick Predictions (Optional)

Appendix 1: Using Excel to Calculate Elasticities (see book)

Appendix 2: Other Types of ElasticitiesFor applications, click hereTo Try it! To Try it!

questionquestionss

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Elasticity of Demand

We know there is an inverse relationship between price and quantity demanded.

But how much does quantity demanded change when price changes?

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A demand curve is elastic when an increase in price reduces the quantity demanded a lot (and vice versa).

When the same increase in price reduces quantity demanded just a little, then the demand curve is

inelastic.

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… Causes a Small Decrease in Quantity Demanded if Demand is Inelastic

$50

The Same Price Increase

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Elastic Demand

Inelastic Demand

$40

80

Price

Quantity

… Causes a Big Decrease in Quantity Demanded if Demand is Elastic

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The More Responsive Quantity Demanded is to a Change in Price, the More Elastic is the Demand Curve

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Elasticity Rule

Elasticity slope BUT:If two linear demand (or supply) curves run through a common point,

then at any given quantity the curve that is FLATTER is MORE ELASTIC

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Determinants of the Elasticity of Demand: a preview

1.Availability of Substitutes ***2.Time Horizon3.Category of product (specific

or broad)4.Necessities vs. Luxuries5.Purchase Size

*** this is the fundamental determinant

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Determinants of the Elasticity of Demand

1. The availability of substitutes is very important.fewer substitutes makes it harder for consumers to adjust Q when P changes… so demand is inelastic.many substitutes? Switching brands when prices change is EASY, so demand is elastic.

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Try it!Try it!

When the patent expires on a brand-name drug and 5 generic drugs come on the market, what happens to elasticity of demand?a) It risesb) It falls

To next To next Try it! Try it!

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Determinants of Elasticity of Demand

2. The time horizon matters.Less time to adjust means lower elasticityOver time consumers can adjust their behavior by finding substitutes (making demand more elastic).

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3. The classification of the good matters.The less specific the classification, the fewer substitutes there are (making demand inelastic).And vice versa…E.g. the elasticity of demand is higher for “lettuce” than for “food.”

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vs.

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4. The nature of the good to the consumer can also affect the elasticity of demand.For necessities, we do not change Q much when P changes For luxuries, we are more sensitive to P changes

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vs.

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5. The size of the purchase (relative to our budget) matters.We are less sensitive to price changes when the good feels cheap We are more sensitive to price changes when the good feels expensive

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Mathematics of Demand Elasticity

Elasticity of demand = the percentage change in quantity demanded divided by the percentage change in price.

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Ed = the percentage change in quantity demandedpercentage change in price

Or,

Where is the mathematical symbol for “change in”

rice

demandedD P

QE

%

%

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Less Elastic More Elastic

Fewer Substitutes More Substitutes

Short Run (less time) Long Run (more time)

Necessities Luxuries

Small Part of Budget Large Part of Budget

Summary of Determinants of Elasticity of Demand

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Example:If the price of oil increases by 10% and over a period of several years, the quantity demanded falls by 5%, then the long run elasticity of demand for oil is:

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terms)absolute (in 0.5or

0.510%

5%


SEE THE SEE THE INVISIBLEINVISIBLE HANDHANDA Kentucky governor

proposed a 70 cent/pack cigarette tax increase.

Estimated effects:Average cost of a pack would go from $3.67 to $4.55. Youth smoking would be cut by an estimated 16.6 percent. Adult smoking would decrease by an estimated 4 percent.

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Using the Midpoint Formula for Elasticity

To erase the natural bias associated with choice of base point, we calculate the elasticity of demand using the Midpoint Formula given by:

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.

2)(

2)(

beforeafter

beforeafter

beforeafter

beforeafter

D

PPPP

QQQQ

E or,

d dQ /averageQElasticity of Demand

P/averageP

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Elasticity of demand is always negative, so we typically drop the negative sign and use absolute value instead.

If the |Ed| < 1, the demand curve is inelastic.If the |Ed| > 1, the demand curve is elastic.If the |Ed| = 1, the demand curve is unit elastic.

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Example: At the initial price of $10, the quantity demanded is 100. When the price rises to $20, the quantity demanded is 90.

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%5.10100

29010010090

x :Qd in Change Percentage

%6.66100

x2

201010-20

Price in Change Percentage

15.0%6.66%5.10

DE



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What is the elasticity of demand for Google searches? The summary: Google ran an experiment and observed the following:

Using “time waiting” as the price, calculate Elasticity of Demand for Google searches.Answer: -20% / ((0.5/0.65)x100) = -0.26

THE PAGE WITH 10 RESULTS TOOK .4 SECONDS TO GENERATE. THE PAGE WITH 30 RESULTS TOOK .9 SECONDS.HALF A SECOND DELAY CAUSED A 20% DROP IN TRAFFIC. HALF A SECOND DELAY KILLED USER SATISFACTION.

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Elasticity of Demand and Total Revenue

A firm’s revenues are equal to price per unit times quantity sold.

Revenue = Price x Quantity

The elasticity of demand directly influences revenues when the price of the good changes.

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Revenues Rise as Price Rises if Demand is Inelastic

Q

P

D

$10

100

R=$10x100 =$1,000

$20

90

R=$20x90 =$1,800

R=$10x100 =$1,000

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Revenues Fall as Price Rises with Elastic Demand Curves

Q

P

D

$10

250

R=$10x250 =$2,500

$20

50

R=$20x50 =$1,000

R=$10x250 =$2,500

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Summary of Relationship between Elasticity of Demand and Revenues

Absolute Value of Elasticity

Name Price and Revenue

Inelastic P and R Move Together

Elastic P and R Move Opposite

Unit Elastic P Moves but R Stays the Same

1DE

1DE

1DE

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Applications of Elasticity of Demand

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How the American Farmer has Worked Himself Out of a Job:

•Increased agricultural productivity has the supply of food BUT the supply of farmers….

•And their revenues because the demand for most agricultural products is inelastic.

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Applications of Elasticity of Demand

Why the War on Drugs is Hard to Win:• Because demand for most illegal drugs is inelastic, drug dealers earn greater revenue and gain more power as the drug war becomes more effective.

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Try it!Try it!

The elasticity of demand for eggs has been estimated to be 0.1. If egg producers raised their prices by 10 percent, what will happen to their total revenue?a) It will increaseb) It will decreasec) It won’t change


Try it!Try it!

If a fashionable clothing store raised its prices by 25 percent, what does that tell you about the store’s estimate of the elasticity of demand for its products?a) They think it’s elasticb) They think it’s inelastic


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Elasticity of Supply

The law of supply indicates a direct direct relationship between price and relationship between price and quantity supplied.quantity supplied.

But how strong is that relationship?

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A supply curve is elastic if a rise in price increases the quantity supplied a lot (and vice versa).

it’s inelastic if sellers change quantity just a little.

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Quantity

Price per Unit

Elasticity of Supply Captures the Sensitivity of Quantity Supplied to Changes in Price

Inelastic Supply

Elastic Supply

$40

80…Causes a Small Increase in Quantity Supplied if Supply is Inelastic

$50The Same Price Increase

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…Causes a Big Increase in Quantity Supplied if Supply is Elastic

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Determinants of Elasticity of Supply

1.Change in Per-Unit Costs with Increased Production

2.Time Horizon3.Share of Market for Inputs4.Geographic Scope

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1.How quickly do per-unit costs increase when more is produced?If increased production is very expensive, then the supply curve will be inelastic.If production can increase with little extra cost, then the supply curve will be elastic.

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Ivory: increasing collection costs, inelastic supply

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2.The time horizon matters.Immediately following a price increase, producers can expand output only using their current capacity (making supply inelastic).Over time, however, producers can expand their capacity (making supply elastic).

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3.The share of the market for the inputs used in production matters.Supply is elastic when the industry can be expanded without causing a big increase in the demand (and price) for the industry’s inputs.Supply is inelastic when industry expansion causes a significant increase in the demand/price for inputs.

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4.The geographic scope of the market matters.The wider the scope of the market of a good, the less elastic its supply.The narrower the scope of the market of a good, the more elastic its supply.

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Summary of Determinants of Elasticity of Supply

Less Elastic More Elastic

Difficult to Increase Production at Constant

Unit Cost

Easy to Increase Production at Constant

Unit Cost

Raw Materials Manufactured Goods

Short Run Long Run

Large Share of Market for Inputs

Small Share of Market for Inputs

Global Supply Local Supply

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Mathematics of Supply Elasticity

Elasticity of supply = the percentage change in quantity supplied divided by the percentage change in price (use the midpoint formula here too!)

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Es = the percentage change in quantity supplied

percentage change in price

Or, rice

supplieds P

QE

%

%

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Using the Midpoint Formula for Elasticity

Again we use the Midpoint Formula given by:

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.

2)(

2)(

afterbefore

beforeafter

afterbefore

beforeafter

s

PPPP

QQQQ

E or,

s sQ /averageQElasticity of Supply

P/averageP

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Example:If the price of cocoa rises by 10% and the quantity supplied increases by 3%, then the elasticity of supply for cocoa is:

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0.310%3%

ES

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If the Es < 1, the supply curve is inelastic.If the Es > 1, the supply curve is elastic.If the Es = 1, the supply curve is unit elastic.

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Example: At the initial price of $10, the quantity supplied is 100. When the price rises to $20, the quantity supplied is 110.

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%5.9100

2110100100110

x :Supplied Quantity in Change Percentage

%6.66100

x

2201010-20

Price in Change Percentage

14.0%6.66

%5.9SE

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Slave Redemption and ElasticitySlave Redemption Works Best When the Supply Curve for Slaves is Perfectly Inelastic

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If the Supply Curve for Slaves is Elastic, Slave Redemption is less helpful

In this moving yet pragmatic talk, Kevin Bales explains the business of modern slavery, a multibillion-dollar economy that underpins some of the worst industries on earth. He shares stats and personal stories from his on-the-ground research -- and names the price of freeing every slave on earth right now. (18:01 minutes)

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http://www.ted.com/talks/lang/eng/kevin_bales_how_to_combat_modern_slavery.html

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Gun Buybacks and Elasticity

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The supply of guns to a local region is very elastic, so local buybacks don’t affect the number of guns on the street (nor affect their price.)

Try it!Try it!

A computer manufacturer makes an experimental computer chip that critics praise, leading to a huge increase in the demand for the chip. How elastic is supply in the short run? What about the long run? Graph both.


Try it!Try it!

Will the same increase in the demand for housing increase prices more in Manhattan or in Des Moines, Iowa? Graph both. To next To next

Try it! Try it!

Try it!Try it!

If the price of a sushi roll drops from $8 to $4, and sales rise from 20 to 40 units, what is the (absolute value) of the price elasticity of demand?

a) 0.5b) 0.66c) 1d) 2


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If price falls from $60 to $40, total revenue changes by _______, so demand is _______.a) $240; inelasticb) $480; elasticc) $360; inelasticd) $120; elastic


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Which supply curve is the most elastic?a) S1b) S2c) S3d) S4

Price

Quantity

S1S2

S3

S4


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Elasticity and Quick Predictions

Two simple formulas allow for quick predictions of price changes (using elasticities):

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SEDE

Demand in Change Percent Demand in Shift a fromPrice in Change Percent

SEDE

Supply in Change Percent- Supply in Shift a fromPrice in Change Percent

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Cross-Price Elasticity of Demand

The Cross-Price Elasticity of Demand measures how sensitive the quantity demanded of good A is to the price of good B.Cross-Price Elasticity of Demand =

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or

B Good of Price in Change Percentage

A Good of Demanded Quantity in Change Percentage

B rice,

A demanded,

P %

Q %

Δ

Δ

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Cross-Price Elasticity of Demand

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For substitutes, Cross-Price Elasticity of Demand is positive.

An increase in the price of one brand of milk will increase the demand for other brands.

For complements, Cross-Price Elasticity of Demand is negative.

An increase in the price of milk causes a decrease in demand for Oreos.

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Income Elasticity of Demand

The Income Elasticity of Demand measures how sensitive the quantity demanded of a good is to changes in income.Income Elasticity of Demand =

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or

Income in Change Percentage

Demanded Quantity in Change Percentage

Income %Q % demanded

Δ

Δ

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Income Elasticity of Demand

The income elasticity of demand can be used to distinguish normal from inferior goods.

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• For normal goods, Income Elasticity is positive.

• For luxury goods, Income Elasticity is greater than one.

• For inferior goods, Income Elasticity is negative.

Try it!Try it!

Tonya consumes 10 boxes of Ramen Noodles a year when her yearly income is $40,000. After her income falls to $30,000 a year, she consumes 40 boxes of Ramen Noodles a year. Calculate her income elasticity of demand for Ramen Noodles. a) 4.2b) –4.2c) –2.25d) 2.25


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The price of Good B increases by 4%, causing the quantity demanded of Good A to decrease by 6%. The cross-price elasticity of demand is _____, and the goods are ______. a) 1.5; substitutesb) –1.5; complementsc) 0.67; complementsd) –2.4; substitutes

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5 CHAPTER D YNAMIC P OWER P OINT ™ S LIDES BY S OLINA L INDAHL 1 Elasticity and its Applications C...

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