McTaggart Micro Ch04 - Charles Sturt...

McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia

Chapter 4:

Elasticity

4-2McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia

Objectives

After studying this chapter, you will be able to:§ Define, calculate, and explain the factors that influence the

price elasticity of demand

§ Define, calculate, and explain the factors that influence the cross elasticity of demand and the income elasticity of demand

§ Define, calculate, and explain the factors that influence the elasticity of supply


Squeezing Out Revenue

§ To predict the quantitative effects of changes in demand and supply on prices, quantities and total revenue, we need to know how responsive demand and supply are to price and other influences on buying plans and selling plans.

§ This chapter explains how we measure the response of demand and supply to price and other influences on buying plans and selling plans using the concept of elasticity.

§ It explains how we calculate, interpret, and use elasticity.


Price Elasticity of Demand

When supply increases, the equilibrium price falls and the equilibrium quantity increases§ But does the price fall by a larger amount and the quantity

increase by a little? (Figure 4.1(a))

§ Or does the price barely fall and the quantity increase by a large amount? (Figure 4.1 (b))

§ The answer depends on the responsiveness of the quantity demanded to a change in price.


Impact of a Change in Supply

Quantity (smoothies per hour)Quantity (smoothies per hour)

Pric

e (d

olla

rs p

er s

moo

thie

)Pr

ice

(dol

lars

per

sm

ooth

ie)

1.001.00

2.002.00

3.003.00

4.004.00

DDAA

00 252555 1010 1515 2020

SS00… a largefall in price...

SS11

An increasein supply brings ...

… and a smallincrease in quantity

Figure 4.1 (a)


Impact of a Change in Supply

Quantity (smoothies per hour)Quantity (smoothies per hour)

Pric

e (d

olla

rs p

er s

moo

thie

)Pr

ice

(dol

lars

per

sm

ooth

ie)

1.001.00

2.002.00

3.003.00

4.004.00

DDAA

00 252555 1010 1515 2020

SS00… a smallfall in price...

SS11

An increasein supply brings ...

… and a largeincrease in quantity

Figure 4.1 (b)



§ The price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price, when all other influences on buyers’ plans remain the same.

§ Calculating Elasticity§ The price elasticity of demand is calculated by using the

formula:

Percentage change in quantity demandedPercentage change in price



To calculate the price elasticity of demand:

§ We express the change in price as a percentage of the average price—the average of the initial and new price,

§ and we express the change in the quantity demanded as a percentage of the average quantity demanded—the average of the initial and new quantity.


Newpoint

Quantity (millions of smoothies per hour)

Pric

e (d

olla

rs p

er s

moo

thie

)

9 10 11

2.90

3.00

3.10

D

Originalpoint

Pave = $3.00

= $0.20P∆Qave = 10

= 2Q∆

Elasticity = 3

Calculating the Elasticity of Demand

Figure 4.2



§ By using the average price and average quantity, we get the same elasticity value regardless of whether the price rises or falls.

§ The ratio of two proportionate changes is the same as the ratio of two percentage changes.

§ The measure is units free because it is a ratio of two percentage changes and the percentages cancel out.

§ Changing the units of measurement of price or quantity leaves the elasticity value the same.



§ The formula yields a negative value because price and quantity move in opposite directions.

§ But it is the magnitude, or absolute value, of the measure that reveals how responsive the quantity change has been to a price change.



§ Inelastic and elastic demand§ Demand can be inelastic, unit elastic, or elastic, and can

range from zero to infinity.

§ If the quantity demanded doesn’t change when the price changes, the price elasticity of demand is zero and the good has a perfectly inelastic demand.



§ Between the two previous cases, the percentage change in the quantity demanded is smaller than the percentage change in price, so the price elasticity of demand is less than 1 and the good has inelastic demand.

§ If the percentage change in the quantity demanded is infinitely large when the price barely changes, the price elasticity of demand is infinite and the good has perfectly elastic demand.


Inelastic and Elastic Demand

6

12

Pric

e

Quantity

D1

Elasticity = 0

Perfectly Inelastic

Figure 4.3(a)



6

12

Pric

e

Quantity

D2

1 2 3

Elasticity = 1

Unit Elasticity

Figure 4.3(b)



6

12

Pric

e

Quantity

D3

Elasticity = ∞

Perfectly Elastic

Figure 4.3(c)



§ Elasticity along a linear demand curve§ Figure 4.4 shows how demand becomes less elastic as the

price falls along a linear demand curve.

§ At prices above the mid-point of the demand curve, demand is elastic.

§ At prices below the mid-point of the demand curve, demand is inelastic



§ For example, if the price falls from $5 to $3, the quantity demanded increases from 0 to 10 smoothies an hour.

§ The average price is $4 and the average quantity is 5.

§ The price elasticity of demand is (10/5)/(2/4), which equals 4.


Elastic

Inelastic

Elasticity Along a Linear Demand Curve

Elasticity = 1

0 5 10 12.5 15 20 25

2.50

1.00

2.00

3.00

4.00

5.00

Pric

e (d

olla

rs p

er s

moo

thie

)

Quantity (smoothies per hour)

Elasticity 1/4

Elasticity =4 Figure 4.4



§ Total revenue and elasticity§ The total revenue from the sale of a good or service equals

the price of the good multiplied by the quantity sold.§ When the price changes, total revenue also changes.§ But a rise in price doesn’t always increase total revenue.



§ The change in total revenue due to a change in price depends on the elasticity of demand:§ If demand is elastic, a 1 percent price cut increases the

quantity sold by more than 1 percent, and total revenueincreases.

§ If demand is inelastic, a 1 percent price cut decreases the quantity sold by more than 1 percent, and total revenues decreases.

§ If demand is unit elastic, a 1 percent price cut increases the quantity sold by 1 percent, and total revenue remains unchanged.



§ The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue that results from a price change (when all other influences on the quantity sold remain the same).

§ If a price cut increases total revenue, demand is elastic.

§ If a price cut decreases total revenue, demand is inelastic.

§ If a price cut leaves total revenue unchanged, demand is unit elastic.

When demandis inelastic, aprice cut decreasestotal revenue

Inelastic demand

When demandis elastic, aprice cut increasestotal revenue

Elastic demand

31.250 6 12

1.00

2.00

3.00

4.00

5.00

Pric

e (d

olla

rs p

er s

moo

thie

)

0 12.5 25

Tot

al R

even

ue (d

olla

rs)

Quantity (smoothies per hour)

Unitelastic

Maximum total revenue

2.50

Copyright © 2007 Pearson Education Australia Pty Limited

Elasticity and Total Revenue

Figure 4.5

23



§ Your expenditure and your elasticity§ If your demand is elastic, a 1 percent price cut increases the

quantity you buy by more than 1 percent, and your expenditure on the item increases.

§ If your demand is inelastic, a 1 percent price cut increases thequantity you buy by less than 1 percent, and your expenditure on the item decreases.

§ If your demand is unit elastic, a 1 percent price cut increases the quantity you buy by 1 percent, and your expenditure on the item does not change.



§ The factors that influence the elasticity of demand

§ The elasticity of demand for a good depends on:§ The closeness of substitutes

§ The proportion of income spent on the good

§ The time elapsed since a price change



§ The closeness of substitutes§ The closer the substitutes for a good or service, the more

elastic is the demand for it.

§ Necessities, such as food or housing, generally have inelastic demand.

§ Luxuries, such as exotic vacations, generally have elastic demand.

§ The proportion of income spent on the good§ The greater the proportion of income consumers spent on a

good, the larger is its elasticity of demand.



§ The time elapsed since a price change§ The more time consumers have to adjust to a price

change, or the longer that a good can be stored without losing its value, the more elastic is the demand for that good.


Some Real-world Price Elasticities of Demand


Price Elasticity in 10 Countries

Figure 4.6


More Elasticities of Demand

§ Cross elasticity of demand§ The cross elasticity of demand is a measure of the

responsiveness of demand for a good to a change in the price of a substitute or a compliment, other things remaining the same.

§ The formula for calculating the cross elasticity is:

Percentage change in quantity demandedPercentage change in price of substitute or complement



§ The cross elasticity of demand for a substitute is positive.

§ The cross elasticity of demand for a complement is negative.


Cross Elasticity of DemandPr

ice

of s

moo

thie

s

Quantity of smoothies

D0Price of a soft drink,a substitute, falls,Positive cross elasticity

D1

D2

Price of a sandwich, a complement, falls.Negative cross elasticity

Figure 4.7



§ Income Elasticity of Demand§ The income elasticity of demand measures how the quantity

demanded of a good responds to a change in income, other things equal.

§ The formula for calculating the income elasticity of demand is:

Percentage change in quantity demandedPercentage change in income



§ If the income elasticity of demand is greater than 1, demand is income elastic and the good is a normal good.

§ If the income elasticity of demand is greater than zero but lessthan 1, demand is income inelastic and the good is a normal good.

§ If the income elasticity of demand is less than zero (negative) the good is an inferior good.



Figure 4.8


Elasticity of Supply

§ The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain the same.

§ Calculating the Elasticity of Supply§ The elasticity of supply is calculated by using the formula:

Percentage change in quantity suppliedPercentage change in price


How a Change in Demand Changes Price and Quantity

Quantity (pizzas per hour)Quantity (pizzas per hour)

Pric

e (d

olla

rs p

er p

izza

)Pr

ice

(dol

lars

per

piz

za)

1.001.00

5.005.00

DD0000 252555 1010 1515 2020

SSaa

Large price change and small quantity change

…… a largeprice rise......2.002.00

3.003.00

DD11

An increasein demandbrings ...

…… and a smallquantity increase

4.004.00

6.006.00

Figure 4.9 (a)


How a Change in Demand Changes Price and Quantity

Quantity (pizzas per hour)Quantity (pizzas per hour)

Pric

e (d

olla

rs p

er p

izza

)Pr

ice

(dol

lars

per

piz

za)

1.001.00

5.005.00

DD0000 252555 1010 1515 2020

SSAA

Small price change and large quantity change

…… a smallprice rise......

2.002.00

3.003.00

…… and a largequantity increase

4.004.00

6.006.00

DD11

An increasein demandbrings ...

3.203.20

Figure 4.9 (b)



§ The factors that influence the elasticity of supply§ Resource substitution possibilities§ The easier it is to substitute among the resources used to

produce a good or service, the greater is its elasticity of supply.

§ The time frame for supply decisions§ The more time that passes after a price change, the

greater is the elasticity of supply.



§ Supply is perfectly inelastic if the supply curve is vertical and the elasticity of supply is 0.

§ Supply is unit elastic if the supply curve is linear and passes through the origin. (Note that slope is irrelevant.)

§ Supply is perfectly elastic if the supply curve is horizontal and the elasticity of supply is infinite.


Perfectly Inelastic Supply

Pric

ePr

ice

QuantityQuantity

SS11

Elasticity of Elasticity of supply = 0supply = 0

00

Figure 4.10 (a)


Unit Elastic Supply

Pric

ePr

ice

QuantityQuantity

SS22AA

00

SS22BB

Elasticity of Elasticity of supply = 1 supply = 1

Figure 4.10 (b)


Perfectly Elastic Supply

Pric

ePr

ice

QuantityQuantity

SS33

00

Elasticity of Elasticity of supply = supply = ∞

Figure 4.10 (c)



§ The time frame for supply decisions§ The more time that passes after a price change, the greater

is the elasticity of supply.§ Momentary supply is perfectly inelastic. The quantity

supplied immediately following a price change is constant.§ Short-run supply is somewhat elastic.§ Long-run supply is the most elastic.§ Table 4.3 (p 99) provides a glossary of all the elasticity

measures.


ENDCHAPTER 4

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