Chapter 5 Elasticity PDF

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The lecture notes for the elasticity chapter of microeconomics...

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Elasticity: Measure of Responsiveness (Chapter 5) So we know that we price changes, it creates a movement along the demand curve, but this chapters want to measure the degree of the change. To do that we need to calculate the price of Elasticity: Price of Elasticity: E (d): Measures responsiveness of the quantity demanded to change in price. To compute price elasticity of demand, we divide the percentage change in the quantity demanded by the percentage change in price, and then we can take the absolute value of ratio: Ed= Percentage change in quantity demanded / Percentage change in Price (absolute ratio). The law of demand tells us that the price and quantity demanded move in opposite directions. So the percentage change in quantity will always have the opposite sign of the percentage change in price. For example: -15%/10% = 1.50 The ratio of the percentage changes is -1.50 and take the absolute ratio, the elasticity is 1.50. Since this number is a positive number we can interpret that if the elasticity number is large, it means that the demand for the product is very elastic or very responsive to changes in price. A small number indicates that the demand for a product is very inelastic. Remember that we use the absolute value since we ignore the negative sign. There are two ways to compute the elasticity of demand: A) Depending that you know the direction: Point elasticity of Demand (we will assume we will use this one: Initial Value Method For example: We can compute a percentage change, we can see if a price increases from $20 to $22, then quantity decrease from 10 units to 8 units. Formula used: Quantity (new) – Quantity (old) / Quantity (old) Price (new) - Price (old) / Price (old) P(1) = $20 Q (1) = 10

(absolute value)

P(2) = $ 22 Q (2) = 8

= 8 -10 / 10 = -0.2 = |-2| = 2 22 – 20 / 20 0.1 So we can determine how sensitive the demand for a product is to a price change. The higher the price elasticity, the more sensitive consumers are to price changes. A very high price elasticity suggest that when the price of a good goes up consumers will buy a great deal less of it and when the price of that good goes up, consumers will buy a great deal less of it. A very low price elasticity implies the opposite, that changes in price have little influence on demand. Different types of Elasticity of Demand: If Ed = 0, the Demand is Perfectly Inelastic (Demand is unresponsive to price changes) If Ed < 1 & >0, then Demand is Price Inelastic (Demand is not sensitive to price changes) If Ed = 1 then Demand is Unit Elastic If Ed > 1 then Demand is Price Elastic (Demand is sensitive to price changes) If Ed = infinity, then Demand is Perfectly Elastic (Demand is extremely responsive to price changes)

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Now let’s graph each one:

At the extremes, a perfectly elastic curve will be horizontal, and a perfectly inelastic curve will be vertical. An Inelastic curve is more vertical, like the letter I. An Elastic curve is flatter, like the horizontal lines in the letter E.

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From price of $20 to $21, we see a change from 100 to 95. Quantity change: 95-100/100 = -0.05 Price change: 21-20/20 = 0.05 =-0.050.05 = |1|

From price of $0.75 to $100, we see a change from Quantity of 9 to 3. Quantity change: 3-9/9 = -0.666 Price change: 1.00-0.75/ 0.75 = 0.333 =-2 = |2|. The flatter the demand curve the more elastic the good.

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From price of $0.50 to $1.50, we see a change from Quantity of 5 to 3. Quantity change: 3-5/5 = -0.4 Price change: 1.50-0.50/ 0.50 = 2 =-0.2 = |0.2|. The stepper the curve the more inelastic the demand curve.

Determinants of Elasticity of Price (Demand): a) Elasticity is generally greater for goods that take a relatively part of a consumer’s budget (necessities). Goods that represent a small part of the budget of the typical consumer, demand is relatively inelastic. For example: suppose price of pencils is 20 cents, and then increases by 10%, or 2 cents. Since the price change is tiny compared to the income of the typical consumer, we would expect a relatively small decrease in the quantity of pencils demanded. On the other hand, if the price of a car is $20,000 and then increases by 10% ($2,000) we would expect a bigger response because the change in price is large relatively to the income of the typical consumer. (Usually food is more price elasticity when the good is a large part of consumer’s budget). b) Another factor to determine the elasticity of demand is whether the product is a necessarily or luxury good, since the demand for luxury like restaurant meals, foreign travel, and motorboats is relatively elastic. c) Another factor is the availability of substitute products (close substitutes). For example: imagine if there are no close substitutes for insulin, so diabetics are not very responsive to change in price. When the price of insulin increases, they cannot switch to another medicine, so the demand for insulin is inelastic. In contrast, there are many substitutes for cornflakes, including different types of corn cereals, as well as cereals made from wheat, rice and oats. Faced with an increase in the price of cornflakes, consumers can easily switch to substitute goods, so the demand for cornflakes is relatively elastic. Another example is the price elasticity of demand for water which is 0.2, meaning that a 10% increase in price decreases quantity demanded by 2%, so the elasticity is inelastic as there are not close substitutes. The demand for coffee is inelastic is 0.30, because 4

although there are alternative beverages and caffeine-delivery systems (tea, soft drinks, sports drinks and pills) since coffee provides a unique combination of taste and caffeine. E1 Show Elasticity & Availability of Substitutes d) Market vs brand, market for general goods are inelastic, market for specific product, elastics e) Passage of time, as time goes by the demand is relatively elastic, when a short time period passes the demand is inelastic. Example For example: when we look at the demand for gasoline, its more elastic in the LR, when consumer have more opportunity to respond to change in prices. So when these prices increase, the short run response is a low change in quantity demanded as its not easy to adjust. However, the long run response is that people drive fewer miles so there are fewer cars on the road and they switch to more fuel efficient cars. So the elasticity is elastic in the LR. Other examples of Elasticty of Demand: Inelastic Demand Gasoline The demand for gasoline generally is fairly inelastic, especially in the short run. Car travel requires gasoline. The substitutes for car travel offer less convenience and control. Much car travel is necessary for people to move between activities and can’t be reduced to save money. In the long run, though, more options are available, such as purchasing a more fuel-efficient car or choosing a job that is closer to where you work.

Elastic Demand Gas from a Particular Station The demand for gasoline from any single gas station, or chain of gas stations, is highly elastic. Buyers can choose between comparable products based on price. There are often many stations in a small geographic area that are equally convenient.

Traditional Textbooks Generally an instructor assigns a textbook to the student, and the student who wants access to the learning materials must buy it, regardless of the price level. Because the student can’t easily identify another textbook or resource that will ensure the same content and grade for the class, he has no substitutes and must buy the book at any price (or opt not to buy it at all).

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New Textbook Distribution Channels Increasingly, students have new options to buy the same textbooks from different distribution channels at different price points. The introduction of new distribution channels is increasing options for buyers and having an impact on the price elasticity for publishers.

Inelastic Demand

Elastic Demand

Specialty Coffee Drinks

Black Coffee

Many coffee shops have developed branded drinks and specialized experiences in order to reduce substitutes and build customer loyalty. While black coffee is available almost universally, there are few substitutes for a Starbucks Java Chip Frappuccino. Demand for such products is more inelastic.

Coffee is generally widely available at a level of quality that meets the needs of most buyers. The combination of a low price, relative to the buyer’s spending power, and the fact that the product is sold by many different suppliers in a competitive market, make the demand highly elastic.

Concert Tickets

Airline Tickets

Only Taylor Swift can offer a Taylor Swift Airline tickets are sold in a fiercely concert. She holds a monopoly on the creation competitive market. Buyers can easily and delivery of that experience. There is no compare prices, and buyers experience the substitute, and loyal fans are willing to pay for the services provided by competitors as being experience. Because it is a scarce resource and the very similar. Buyers can often choose not to delivery is tightly controlled by a single provider, travel if the cost is too high or substitute access to concerts has inelastic demand. travel by car or train. Soft Drinks Medical Procedures Essential medical procedures have inelastic demand. The patient will pay what she can or what she must. In general, products that significantly affect health and well-being have inelastic demand.

Soft drinks and many other nonessential items have highly elastic demand. There is competition among every brand and type of soda, and there are many substitutes for the entire category of soft drinks.

Using Price Elasticity If we know the Ped, we can quantify the LoD and predict the change in quantity resulting from a change in price. So we can use an estimate of the Ped to predict how a change in price affect’s a firms TR So for example: Ped= % change in Q(d) / % change in P Rearrange: % change in Q(d) = % change in P * Ped Example: if you run a campus film series and you have decided to increase your admission price by 15%, if you know the Ped for your movies, you can use it to predict how many fewer tickets you will sell at a higher price. If Ped =2.0, and you increase prices by 15%, so we can: 6

=2 * 15% = 30% Example for beer prices and highway deaths. If we know that Ed for beer: 1.3 If state imposes a beer tax that increase price of beer by 10%, we expect the beer consumption to decrease by 13%. There is a connection of beer consumption to number of death that is very proportional, so the number of deaths decreased by 13%. Example for antidrug policies and property crime Let’s look at the government use of various policies to restrict the supply of illegal drugs and the decrease in supply increase the equilibrium price. Since the demand for illegal drugs is inelastic, the increase in price will increase total spending on illegal drugs. If you are into drugs and to keep your habit, you will commit more property crimes to pay for the drugs. However as the policy increases drug prices, it will reduce consumption in one way or another, however it will also increase crimes committed by those users who will continue to abuse drugs.

Elasticity of Price Demand and Total Revenue. What happens to total revenue? Ped is inelastic and a firm raises its price.

Total revenue increases

Ped is elastic and a firm lowers its price.

Total revenue increases

Ped is elastic and a firm raises price.

Total revenue decreases

Change in the market What happens to total revenue? Ped is inelastic (1) and a firm lowers its price. Total revenue increases Ped is elastic (>1) and a firm raises price Total revenue decreases Ped is unit elastic (=1) and a firm raises price Total revenue remains the same Ped is -1.5 (elastic) and the firm raises price by 4%Total revenue decreases We can sum all of these up in the following graph : E2: Elasticity and TR relationship To sum up again: Do not need to go over it again -So when the price elasticity of demand for a good is perfectly inelastic(ED =0), changes in the price do not affect quantity demanded, raising price will cause total revenue to increase.

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-When the price elasticity of demand for a good i s relatively inelastic (- 1 < Ed < 0), the percentage change in quantity demanded is smaller than that in price. Hence, when the price is raised, the total revenue rises. -When the price elasticity of demand for a good is unit (or unitary) elastic (Ed = -1), the percentage change in quantity is equal to that in price, so a change in price will not affect total revenue. -When the price elasticity of demand for a good is relatively elastic (- ∞ < Ed < - 1), the percentage change in quantity demanded is greater than that in price. Hence, when the price is raised, the total revenue falls, and vice versa. -When the price elasticity of demand for a good is perfectly elastic (Ed is = ∞), any increase in the price, no matter how small, will cause demand for the good to drop to zero. Hence, when the price is raised, the total revenue falls to zero.

Elasticity of Income Demand The demand for a particular product depends in part on the consumer’s income. It measure the responsiveness of demand to changes in income, indicating how much more or less of a particular product is purchased as income changes. The income elasticity of demand is defined as the percentage change in Quantity demanded divided by the percentage change in income. E(i) = Percentage change in Q(d) / Percentage change in Income. For example: If a 10% increase in income increases the quantity of books demanded by 15%, the income elasticity of demand for books is 1.50 (15% / 10%) If income elasticity is positive, it indicates a positive relationship between income and demand, so we can say that we consider the goods as normal goods. If income elasticity is negative, it indicates a negative relationship between income and demand, so we can say that the good is an inferior good. For example: inferior goods are bus intercity bus travel, used clothing, and used cars. Cross-Price Elasticity of Demand This measures the responsiveness of demand to changes in the prices of other goods, indicating how much more or less of a particular good is purchased as other prices changes. Basically this defines the percentage change in the quantity demanded of one good (X) divided over the percentage change in the price of another good (Y). E(XY) = percentage change in Quantity X demanded / percentage change in Price of Good Y Two goods are considered substitutes if there is a positive relationship between the quantity demanded of one good and the price of another good. For example: an increase in the price of bananas increases the demand for apples as consumers substitute apples for the now relatively expenses bananas. For substitute goods, the cross-price elasticity is positive.

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In contrast, two goods are considered complements if there is a negative relationship between the quantity demanded of one good and the price of another. For example: an increase in the price of ice-cream increases the cost of apple pie with ice-cream, causing consumers to demand fewer apples. For complementary goods, the cross-price elasticity is negative. So looking at the last two elasticity of Demand: Income elasticity is + for Normal Goods and – for Inferior Goods Cross-price elasticity is + for Substitute Goods and – for Complementary Goods Lets look at US Department of Agriculture for Cross Price elasticities, remember: positive number is substitute and negative means complementary goods https://data.ers.usda.gov/reports.aspx?ID=17825

Country: USA Commodity: example: apple juice Cross Commodity. Submit Price Elasticity of Supply: A measure of the responsiveness of the quantity supplies to changes in price; equal to the percentage change in quantity supplies divided by the percentage change in price. E(S) = percentage change in Quantity Supplied / Percentage change in Price Example: Price of milk increases from $1.00 to $1.20, the Quantity supplied increase from $100 million gallons (point a) to $102 million gallons (point b). The percentage change in E(S) = 102- 100 /100 / 1.20 – 1.00 /1.00 = 0.02/0.2= 0.10. So the elasticity of supply is inelastic. The steeper the curve the less elastic the supply curve. Now let’s look at another example: Price of milk increases from $1.00 to $1.20, the Quantity supplied increase from $100 million gallons (point a) to $150 million gallons (point b). The percentage change in E(S) = 150- 100 /100 / 1.20 – 1.00 /1.00 = 0.5/0.2= 2.5. So the elasticity of supply is elastic. The flatter the curve the more elastic the supply curve.

Different types of Elasticity of Supply: If PEoS = 0, the Supply is Perfectly Inelastic (Supply is unresponsive to price changes) If PEoS < 1 & >0, then Supply is Price Inelastic (Supply is not sensitive to price changes) If PEoS = 1 then Supply is Unit Elastic If PEoS > 1 then Supply is Price Elastic (Supply is sensitive to price changes) If PEoS = infinity, then Supply is Perfectly Elastic (Supply is extremely responsive to price changes) 9

Determinants of Price of Elasticity of Supply: Short-run vs. Long-run: -Short-run, a higher price encourages existing firms to increase their output by purchasing more materials and hiring more workers. Remember that in the short-run, the fixed input is the firm’s production facility. Although a higher price will induce firms to produce more, the response is limited by the fixed capacity of the firm’s production facilities. So the short-run supply curve is relatively steep and the short-run supply elasticity is relatively small.

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-Long-run, new firms enter the market and existing firms expand their production facilities to produce more output. The long-run supply response to an increase in price is not limited by diminishing returns because production facilities are not fixed. Over time, new firms enter the market with new production facilities and old firms build new facilities. As a result, a given increase in price generates a larger increase in quantity supplied. The long-run supply curve will be relatively flat and the elasticity of supply will be relatively large. For example: let’s look at the milt industry. The steeper curve is a short-run supply, which shows the relationship between price and quantity supplied over a one-year period. The price elasticity of supply over a one-year period is about 0.10. If the price of milk increases by 20% and stays there for a year, the quantity of milk supplied will be rise by only 2%. In the short-run dairy farmers can squeeze just a little more output from their existing production facilities.

In the long-run, the relationship between price and Q(s) over a 20 year period, a dairy farmer can expand existing facilities and build new ones, so farms are more responsive to a higher price, the supply is flatter and the supply elasticity is larger. The price elasticity of supply is 2.5, so the same 20% rise in price increases the quantity supplied by 50%.

-number of producers, the more producers there are, and the easier it should be for the industry to increase output in response to a price increase. Supply then will be more elastic. -existence of small capacity, the more capacity there is in the industry; the easier it should be to increase output if price goes up. Supply then will be more elastic. -time period, over time the firm can invest in training and more equipment and more firms can join the industry, so supply should be more flexible, more elastic. -length of production period, the quicker a good is to produce, the easier it will to respond to a change in price, example: supply in manufacturing is usually more price elastic than agriculture. -availability of materials -ability to store products, more products, more elastics, less products to ...