Elasticity

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Elasticity

• Claudia Garcia-Szekely

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150
120
A movement Along
100
50
30
D
0
20
10
0
6
24
30
3
Consumers barely notice
Consumers Overreact
110
110
Small change in Q
100
100
100
130
100
105
4
Consumers barely notice
Consumers Overreact
110
110
Small change in Q
100
100
100
130
100
105
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The Price Elasticity of Demand

• Measures the response of the quantity demanded to
  a change in price.
• How responsive to price changes is the quantity
  demanded of prescription drugs? and the quantity
  demanded of strawberries?

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The Midpoint Formula
Change in Quantity Average Quantity
epd
Change in Price Average Price
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Elasticity Between two points
Elasticity between B and C measures the response
to a 0.50 change in the price.
Note that a point is a pair (p, q)
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Midpoint Formula

• Compute the difference between the two
  quantities 22-19 3

• Compute the average of the two quantities (22
  19)/2 41/2 20.5

• Divide the answer you got in (1) by the answer in
  (2). This is the percentage change in the
  quantity demanded 3/20.5 0.146

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The Midpoint Formula

• Compute the difference between the two prices
  (1-0.5) 0.5

• Compute the average of the two prices (10.5)/2
  0.75

• Divide the answer in (4) by the answer in (5).
  This is the percentage change in the price
  0.5/0.75 0.667.

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The Midpoint Formula

• Divide the percentage change in the quantity
  demanded the answer you got in (3), by the
  percentage change in the price the answer you
  got in (6).
• The answer is the Price Elasticity of Demand
  between B and C.
• 0.146 / 0.667 0.21

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Price Elasticity of Demand

• Measures the responsiveness of the quantity
  demanded to a change in price.
• There is a negative relationship between the
  price and the quantity demanded.
• The price elasticity of demand is
  ALWAYS NEGATIVE.

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Price elasticity of demand is ALWAYS NEGATIVE
Always write a negative sign in front!
epd
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Elasticity of Demand Between Points A and E
Midpoint formula gives you the elasticity at the
Midpoint
10
A
7
6
E
5
18
30
24
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Elasticity of Demand at Point A
Make A the Midpoint
10
8
A
7
6
Use a point above A and a point below A
12
18
24
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Change in Quantity
Elasticity
Change in Price
lt 1
1
gt 1
lt
gt
The steeper Demand is, the more Inelastic The
flatter Demand is, the more Elastic
Change in Quantity

Change in Quantity
Change in Quantity
Change in Price
Change in Price
Change in Price
Consumers Under-react Demand is Inelastic
Demand is UNIT Elastic
Consumers Over-react Demand is Elastic
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Example
Elasticity has no units!

• It has been observed that a 20 decrease in the
  price of good X, caused a 5 increase in the
  quantity demanded of X.

epd 5 / -20 - 0.25
Elasticity of Demand is less than one Inelastic
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Example

• It has been observed that a 5 increase in the
  price, caused a 10 reduction in the quantity
  demanded.

epd -10 / 5 - 2
Elasticity of Demand is greater than one Elastic
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• If the price elasticity of demand for good X is
  0.5. In order to induce a 10 reduction in
  consumption of this good, the government would
  need to tax this good until the price rises by
  how much?

edp D Q / D P
0.5 10/ D P
10 /0.5 D P
20 D P
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Calculate price elasticity
e -1
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Price Elasticity of Demand
e - 0.75
If we want to increase quantity demanded by 10
what is the necessary change in price? Price must
_________________ by _______ (Increase/decrease)
If we increase the price by 10 how would the
quantity demanded change? Quantity
demanded_______________ by _______
(Increase/decrease)
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Calculate price elasticity
e -1.2
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The Elasticity Changes Along the Demand Curve
For high prices (at the top of the demand curve)
demand is relatively elastic

• As you move along a demand curve -as price
  changes- the elasticity changes in absolute value.

At the midpoint, e 1
As Price Increases
Elasticity Increases
For low prices (at the bottom of the demand
curve) demand is relatively inelastic
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The Elasticity Changes Along the Demand Curve
e 1
0
100
0
1000
Midpoint
100/2 50
1000/2 500
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• Without calculating the elasticity
• Is the elasticity at A gt B? A lt B? AB?
• Is the elasticity at F gt 1? F lt 1? F1?
• Is the elasticity at E 1?

F
E
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Demand is Perfectly Elastic
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Demand is Perfectly Inelastic
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Demand is UNIT Elastic Everywhere
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The demand curve with the smallest elasticity is
_______
The demand curve with the largest elasticity is
_______
Demand curve _______ is perfectly elastic
Demand curve _______ is perfectly inelastic
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Elasticity and Price Controls

• When supply and demand are both elastic, a price
  floor will cause a larger surplus than when
  supply and demand are inelastic
• When supply and demand are both elastic, a price
  ceiling will cause a a larger shortage than when
  supply and demand are inelastic.      

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What Determines the Elasticity?

• The number of substitutes available.
• The Definition of the market.
• The length of time consumers have to react to a
  price change.
• Necessities tend to have inelastic demands,
  whereas luxuries have elastic demands.
• Example Doctor visits, sailboats.

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The number of Substitutes Available.
The more substitutes exist for a given good, the
easier it would be for consumers to switch.
The more sensitive (elastic) demand would be to
price changes
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Definition of the market.
Common mistake The more specific the more
inelastic because only Ben and Jerrys chocolate
ice cream will do
The more specific the more alternatives available
and thus the more elastic
Narrowly defined markets have more elastic
demands.
Ben and Jerrys Chocolate Ice Cream
epd gt 1
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The Definition of the market.
Common mistake The larger the set the more
elastic because there are lots of choices
Broadly defined markets have less elastic demands
Food
Ice Cream
HDz
BJ
Cookies
Beverages
epd lt 1
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2. Which product has more substitutes?
2. Which product will be more elastic? Why?

• All frozen desserts
• Ice cream
• Chocolate ice cream
• Ben and Jerrys chocolate ice cream

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The Amount of Time to React

• The longer the time allowed, the easier it is for
  consumers to find an alternative or modify their
  behavior.
• Goods have more elastic demands over longer time
  horizons.
• Example Gasoline.

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Two ways to increase revenue

• Increase price, in order to make more per unit
• Decrease price, in order to sell more units.

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Inelastic Demand

• Increase Price

• Decrease Price

• Quantity sold drops
• Decrease in Q is SMALLER than increase in price
• Total Revenue increase.

• Quantity sold increase
• Increase in Q is SMALLER than decrease in price
• Total Revenue decrease

If demand is Inelastic, increase price to
increase TR
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Elastic Demand

• Increase Price

• Decrease Price

• Quantity sold drops
• Decrease in Q is LARGER than increase in price
• Total Revenue decrease.

• Quantity sold increase
• Increase in Q is LARGER than decrease in price
• Total Revenue increase

If demand is Elastic, decrease price to increase
TR
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The Price Elasticity of Demand and Revenues

• Total Revenues Price x Quantity
• An increase in price will increase TR only if the
  quantity demanded does not fall too much.
• If the increase in price is larger than the drop
  in quantities, TR will increase.
• This is precisely what happens if demand is
  _____________

Inelastic
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When Demand is Inelastic TR follow the change in P
If the drop in quantities is smaller than the
increase in price, total revenues will increase.
epd DQ / DP

• TR P x Q

epd small/ Large
epd lt 1
This is the case when e lt 1.
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When Demand is Elastic TR follow the change in Q
If the drop in quantities sold is larger than the
increase in price, total revenues will fall after
a price increase.
epd DQ / DP

• TR P x Q

epd Large/ small
epd gt 1
This is the case when e gt 1
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Elasticity and Total Revenues
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Demand is Inelastic
If total Revenues increase as price increase
If total Revenues decrease as price increase
Demand is elastic
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If a company increases prices and as a result

• Total Revenues Decrease.
• Then the effect of higher prices, was completely
  offset by the drop in quantities sold.

• Total Revenues Increase.
• Then the quantity sold did not drop enough to
  offset the increase in price.

Demand is Elastic
Demand is Inelastic
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3. Is this demand elastic or inelastic?
Demand is Inelastic
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The Elasticity Changes Along the Demand Curve
Decrease Price to Increase TR
e 1
An increase/decrease in price would leave TR
unchanged
Increase Price to Increase TR
Midpoint
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When Demand is Inelastic
S1
S0
P1
gt
Gain
Gain
Loss
P0
Loss
TR increase
D0
Q1
Q0
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When Demand is Inelastic
S0
S1
P0
gt
Loss
Loss
Gain
P1
Gain
D0
Q1
Q0
TR decrease
50
When Demand is Elastic
Gain
S0
gt
S1
Loss
P0
P1
Loss
Gain
D0
TR Increase
Q1
Q0
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When Demand is Elastic
S1
S0
Loss
gt
Gain
P1
Gain
P0
Loss
D0
TR Decrease
Q1
Q0
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Questions to prepare for the Quiz

• Assume that currently, a book publisher charges
  one price for a novel by author B.
• An economist determines that the price elasticity
  of demand for die hard fans of this author is
  0.4 and that the price elasticity of demand for
  regular buyers is 3.
• The advertising department comes up with the idea
  of publishing the same book in a hard cover
  version to be published first, and a soft cover
  version to be released two months after the
  release of the hard cover version. This would
  allow the publisher to charge different prices to
  these two groups.
• How would you advise them to set prices in order
  to increase total revenues?

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• Assume that currently, all customers pay the same
  price for a packet of cigarettes Generic brand
  D.
• An economist determines that the price elasticity
  of demand by adults is 0.4 and that the price
  elasticity of demand by teenagers is 3.
• The advertising department comes up with the idea
  of packaging cigarettes differently to target
  different groups Target teenagers with Cool
  brand A and adults with less tar brand B.
• How would you adjust prices in order to increase
  your total revenues?
• You must provide a clear explanation for your
  answer.

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• Determine whether demand is elastic, inelastic,
  unit elastic or cant tell
• Chapped Hands Community Colleges tuition
  increased from 20 per unit to 25 per unit.
  Enrollment dropped from 8,000 to 7,200 students.
• Washington apple growers sell a 10 larger crop
  than last years , but the revenue they earned is
  unchanged.
• Honda offers a 100 rebate on its largest rider
  lawn mowers, and their sales rise 5.
• The price of doctor services falls and your
  familys total expenditures are less on doctor
  services and more on other things.
• The price of carnations rises by 15. Florists
  substitute daisies and ferns ant the quantity
  used of carnations drop by 25.
• The price of coffee drops by 25 cents per pound,
  but you continue to drink the same amount as
  before.

• Inelastic 0.47
• Unit elastic
• Cant tell
• Inelastic
• Elastic 1.67
• Perfectly Inelastic E0

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• The price of coffee drops by 25 cents per pound,
  but total revenue remains the same.
• The price of natural gas falls and as a result,
  revenues drop.
• The price of strawberries fall, and as a result,
  revenues for strawberry farmers rise.
• The price of Tylenol rise and as a result,
  revenues rise.
• The price of Pert shampoo rises and as a result,
  revenues drop.

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Is Demand elastic? Inelastic?

• Reducing soda intake by a 100 calories a day
  results in a half a pound of weight loss after 18
  months.
• A tax which increases the price of soda, sports
  drinks and juice cocktails by 10 would prompt
  consumers to reduce consumption by 8.

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• It has been estimated that the price elasticity
  for cigarettes is -0.3.
• In order to reduce cigarette purchases by 5,
  the government would need to tax cigarettes
  enough to increase the price by _______

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Calculate the change in quantity demanded after
a 5 increase in the price of movie tickets if
the price elasticity of demand was
-0.6.         What would a 5 increase in the
price of movie tickets mean for the revenue of a
movie theater if the price elasticity of demand
was -0.6?       Calculate the change in quantity
demanded after a 5 increase in the price of
movie tickets if the price elasticity of demand
was -3.       What would a 5 increase in the
price of movie tickets mean for the revenue of a
movie theater if the price elasticity of demand
was -3?  
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Supply X
Demand X
Demand Substitute
Demand Complement

• Use the table above to answer the following
  questions
• Calculate the elasticity of demand and the
  elasticity of supply at point B
• Should this producer increase, decrease or leave
  the price the same? Why?

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Use a supply and demand diagram to explain why

• Oil producing countries enjoy increases in their
  total revenues when they restrict supply.
• Farmers suffer declines in their total revenues
  when they become more productive as a group.
• Fresh tomato farmers enjoy increases in their
  total revenues when they become more productive
  as a group.
• Oil producing countries would see their total
  revenues decrease if they were to increase oil
  production.
• Restaurant owners see an increase in total
  revenues as competition from new restaurants
  increases.

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Types of Elasticity

• Price elasticity of demand.
• Price elasticity of supply.
• Income elasticity of demand.
• Cross Price elasticity of demand.

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The Price Elasticity of Supply

• Measures the sensitivity of the quantity supplied
  to changes in the price.
• Since there is a direct relationship between the
  price and the quantity supplied
• The price elasticity of supply is always positive.

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Price Elasticity of Supply eps
Change in Quantity Average Quantity
epd
Change in Price Average Price
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Calculating the Price Elasticity of Supply

• To calculate the price elasticity of supply,
  follow the same steps as for the price elasticity
  of demand.
• The only difference is that the price elasticity
  of supply is always POSITIVE.

All positive Numbers!
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Extreme Cases
D1
D0
P
Perfectly Elastic Supply suppliers can easily
increase or decrease production to match demand,
Po
S
Q1
Q0
S
Perfectly Inelastic Supply suppliers cannot
increase production to match demand. Supply is
fixed.
P
eps 0
D1
D0
Fixed Quantity
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Perfectly Inelastic Supply

• The quantity supplied of DaVinci paintings
  doesn't change regardless of what the price is.
• The number of seats in a stadium/theater does not
  change regardless of price

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Elasticity changes along a Supply Curve
Note these three supply curves have the same
SLOPE yet Elasticity is different!
P
S
eps infinity
S
e 1
S
e gt 1 elastic
e lt 1 inelastic
Cut Vertical Axis elastic
eps 0
Cut Horizontal Axis inelastic
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Without calculating the elasticity, you know the
elasticity at point B is lt 1 gt 1 1? How do
you know?
Calculate the Elasticity at point B.
Calculate the Elasticity Between A and C.
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When price rises by 20, quantity supplied rises
by 20. Which curve best demonstrates the
elasticity of supply in this example?
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When price rises by 20, quantity supplied
remains the same. Which curve best demonstrates
the elasticity of supply in this example?
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Refer to the graph above. When price rises by
20, quantity supplied increases by 5. Which
curve best demonstrates the elasticity of supply
in this example?
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• Without calculating the elasticity
• Is the elasticity at AgtB? AltB? AB?
• Is the demand elasticity at Fgt1? Flt1? F1?
• Is the demand elasticity at B gt0? lt0? 0?
• Is the supply elasticity at Fgt1? Flt1? F1?
• Is the supply elasticity at C gt0? lt0? 0?
• Is the elasticity at CgtD? CltD? CD?
• Is the elasticity at Egt1? Elt1? E1?
• Is the elasticity at Cgt1? Clt1? C 1?

E
F
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Calculating the resulting change in price
P1
D Price DDemand/(Ed Es)
P0
Q0
Q1
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Suppose demand shifts out to the right by 10
percent, the elasticity of demand is 1.5 and the
elasticity of supply is 0.5. By how much will
price change?
P1
D Price DDemand/(Ed Es)
D Price 10/(1.5 0.5)
P0
D Price 10/2
D Price 5
Price increase by 5
Q0
Q1
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Calculating the resulting change in price
P0
D Price DSupply/(Ed Es)
P1
Q0
Q1
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If supply increases by 4 percent, the elasticity
of demand is 0.5, and elasticity of supply is
1.5, then the price will
P0
D Price DSupply/(Ed Es)
P1
D Price 4/(0.5 1.5)
D Price 4/(2)
D Price 2
Q0
Q1
Price decrease by 2
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A significant price decline with virtually no
change in quantity would most likely be caused by
       a. a highly elastic demand and a shift
in supply to the right.       b. a highly
inelastic supply and a shift in demand to the
right.       c. a highly inelastic demand and a
shift in supply to the right.       d. a highly
elastic supply and a shift in demand to the left.
a
b
d
c
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The Income Elasticity of Demand

• Measures the sensitivity of Demand to changes in
  INCOME.
• The relationship between Demand and INCOME
  depends on whether the good is normal or
  inferior.

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The Income Elasticity Formula
Change in Quantity / Average Quantity
epd
Change in Income / Average Income
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Normal Goods

• The Demand for normal goods INCREASES when income
  INCREASES.
• There is a positive relationship between income
  and demand for normal goods.
• The sign of the income elasticity for normal
  goods is positive.

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Calculating the Income Elasticity (Normal
Goods)

• Find the Percentage change in quantity demanded
  100 / 350 0.286

• Find the percentage change in income 1000/1500
  0.667

• The Income Elasticity 0.286/0.667 0.429

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Inferior Goods

• Demand for inferior goods DECREASES when income
  INCRESES.
• There is a negative relationship between income
  and demand for inferior goods.
• The sign of the income elasticity for inferior
  goods is negative.

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Inferior Good Income Elasticity
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The Cross Price Elasticity

• Measures the sensitivity of the quantity demanded
  of one good to changes in the price of ANOTHER
  GOOD.
• Goods can be either Complements or Substitutes.

How much would demand for headphones increase
when the price of Ipod rises?
How much would demand for Coke increase when the
price of Pepsi rises?
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Cross Price Elasticity Formula
Coke
Pepsi
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Cross Price Elasticity for Complements

• The quantity demanded of a good decreases when
  the price of a complement increases,
• Example When the price of PRINTERS increases,
  the quantity demanded of INK decreases.
• The price of one good and the Demand of the other
  good move in opposite directions.
• The cross price elasticity between complements is
  NEGATIVE.

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Cross Price Elasticity Complements ( Negative)
All Negative!
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Cross Price Elasticity for Substitutes

• When the price of a substitute INCREASES, the
  quantity demanded of the good INCREASES.
• Example When the price of movie tickets
  increases, the quantity demanded of video tapes
  increases too.
• The price of one good and the Demand of the other
  move in the SAME direction.
• The cross price elasticity between substitutes is
  POSITIVE.

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Cross Price Elasticity Substitutes (Positive)
All Positive!
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Is the elasticity positive or negative?
Is the good Normal or Inferior?
Calculate the Income Elasticity for an increase
in income from 3,000 to 4,000.
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• Use the information in table 1 above to
  calculate
• Price elasticity of demand for good X between
  points B and D.
• Price elasticity of demand for good X at C.
• Price elasticity of supply between A and B.
• Cross Price elasticity between X and N between
  points E and F. Are X and N substitutes? Or
  complements?
• Cross Price elasticity between X and R between
  points E and F. Are X and R substitutes? Or
  complements?
• Your answer must have a value AND A SIGN!

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Solutions
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Solutions
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Solutions
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Solutions
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