1 Chapter 4 Elasticity McGraw-Hill/IrwinCopyright © 2015 by McGraw-Hill Education (Asia). All rights reserved.

2 The Basics Markets Increasing Opportunity Costs Cost – BenefitSupply and Demand Scarcity Cost – Benefit Incentive Comparative Advantage Increasing Opportunity Costs Efficiency Equilibrium

3 Learning Objectives Define price elasticity of demand and explain what determines whether demand is elastic or inelastic Calculate the price elasticity of demand using information from the demand curve Understand how changes in the price of a good affect total revenue and total expenditure depending on the price elasticity of demand for the good Explain the cross-price elasticity of demand and income elasticity of demand Discuss the price elasticity of supply, explain what determines whether supply is elastic or inelastic, and calculate the price elasticity of supply using information from a supply curve

4 Drug Enforcement and Local TheftHypothesis Drug users steal to buy drugs Increasing drug enforcement will decrease theft Analysis Increased enforcement reduces supply of drugs Price of drugs increases Quantity demanded decreases Theft goes down ONLY IF total expenditure on drugs decreases How responsive is quantity demanded to price?

5 Price Elasticity of DemandPrice elasticity of demand is defined as the percentage change in quantity demanded from a 1% change in price Measure of responsiveness of quantity demanded to changes in price Example: Price of beef decreases 1% Quantity of beef demanded increases 2% Price elasticity of demand is – 2 P Q

6 Calculate Price ElasticitySymbol for elasticity is ε Lower case Greek letter epsilon For small percentage changes in price ε = Percentage change in quantity demanded Percentage change in price Price elasticity of demand is always negative Ignore the sign

7 Price Elasticity of DemandElastic Demand If price elasticity is greater than 1, demand is elastic Percentage change in quantity is greater than percentage change in price Demand is responsive to price 3 Price Elasticity of Demand Inelastic Unit elastic Elastic 2 1

8 Price Elasticity of DemandInelastic Demand If price elasticity is less than 1, demand is inelastic Percentage change in quantity is less than percentage change in price Quantity demanded is not very responsive to price 3 Price Elasticity of Demand Inelastic Unit elastic Elastic 2 1

9 Price Elasticity of DemandUnit Elastic Demand If price elasticity is 1, demand is unit elastic Price and quantity change by the same percentage 3 Price Elasticity of Demand Inelastic Unit elastic Elastic 2 1

10 Example: Demand for PizzaOld New % Change Price $1.00 $0.97 3% Quantity 400 404 1% ε = Percentage change in quantity demanded Percentage change in price ε = 1% 3% = 0.33 Demand is inelastic

11 Determinants of Price Elasticity of DemandSubstitution Options More options, more elastic White sugar Brown sugar Budget Share Large share, more elastic New car Salt Time Long time to adjust, more elastic Air conditioner Gasoline

12 Examples of ElasticitiesGreen peas 2.80 Restaurant meals 1.63 Beer 1.19 Coffee 0.25 Automobiles 1.35 Foreign air travel 0.77 Movies 0.87 Theater, opera 0.18

13 Taxes And Teen Smoking Hypothesis: Analysis:Teens’ demand for cigarettes is inelastic Demand is driven by peers But, teens also lack income Analysis: Cigarette taxes increase the price of cigarettes Some teens will smoke less or quit altogether These teens will influence others to quit Higher taxes are likely to reduce teen smoking

14 Unintended Effects of the Yacht Tax in the U.S.Hypothesis Luxury tax on yachts over $100,000 will yield $31 million in tax revenue Analysis Price elasticity of demand is high Actual tax revenue $16.6 million People bought yachts outside US to avoid tax 7,600 jobs in US boating industry lost Outcome: tax repealed after 2 years

15 Price Elasticity NotationΔQ is the change in quantity ΔQ / Q is percentage change in quantity ΔP is change in price ΔP / P is percentage change in price ε = Percentage change in quantity demanded Percentage change in price ε = ΔQ / Q ΔP / P

16 Price Elasticity: Graphical Viewε = ΔQ / Q ΔP / P P – Δ P Price P D A Q Q + Δ Q Δ Q Δ P Quantity ε = ΔQ Q P ΔP x ε = P Q ΔQ ΔP x ε = P Q 1 slope x

17 Price Elasticity: Graphical ViewAt point A P = 8 Q = 3 Slope = 20 / 5 = 4 P – Δ P Price P D A Q Q + Δ Q Δ Q Δ P Quantity P 1 ε = x Q slope ε = 8 3 1 4 x = 0.67

18 Price Elasticity and SlopeWhen two demand curves cross P / Q is same for both curves (1 / slope) is smaller for the steeper curve At the common point demand is less price elastic for the steeper curve D1 D2 12 4 6 Quantity Price Less Elastic More Elastic

19 Price Elasticity on a Straight-Line Demand CurvePrice elasticity is different at each point Slope is the same for the demand curve P/Q decreases as price goes down and quantity goes up ε = P Q 1 slope x

20 Price Elasticity PatternPrice elasticity changes systematically as price goes down At high P and low Q, P / Q is large Demand is elastic At the midpoint, demand is unit elastic At low P and high Q, P / Q is small Demand is inelastic Price b/2 a/2 a b Quantity

21 Two Special Cases Perfectly Elastic Perfectly Inelastic Demand DemandInfinite price elasticity of demand Perfectly Inelastic Demand Zero price elasticity of demand Price Price D D Quantity Quantity

22 Elasticity and Total ExpenditureWhen price increases, total expenditure can increase, decrease or remain the same The change in expenditure depends on elasticity Terminology: total expenditure = total revenue Calculate as P x Q Graphing idea: total expenditure is the area of a rectangle with height P and width Q Example: P = 2 and Q = 4 Price Quantity D 2 4 Expenditure = 8

23 Price Elasticity and Total ExpenditureMovie ticket price increases from $2 to $4 A and B are both below the midpoint of the curve Inelastic portion of the demand curve Total revenue increases when price increases Quantity (00s of tickets/day) D A Expenditure = $1,000/day 12 Price ($/ticket) 5 6 2 4 B Expenditure = $1,600/day

24 Price Elasticity and Total ExpenditureMovie ticket price increases from $8 to $10 Prices are both above the midpoint of the curve Elastic portion of the demand curve Total revenue decreases D Expenditure = $1,600/day 12 Quantity (00s of tickets/day) Price ($/ticket) 2 6 8 Y Z Expenditure = $1,000/day 1 10

25 The Effect of a Price Change on Total Expenditure$12 $10 $8 $6 $4 $2 $0 Quantity 1,000 2,000 3,000 4,000 5,000 6,000 Expenditure $1,000 $1,600 $1,800 1,800 Price ($/ticket) Total expenditure ($/day) 2 6 10 1,600 1,000 12 Quantity (00s of tickets/day) 1 3 4 5 8

26 Elasticity, Price Change, and Expenditure

27 Cross-Price Elasticity of DemandSubstitutes and complements affect demand Cross-price elasticity of demand is defined as the percentage change in quantity demanded of good A from a 1 percent change in the price of good B Sign of cross-price elasticity shows relationship between the goods Complements have negative cross-price elasticity Substitutes have positive cross-price elasticity

28 Income Elasticity of DemandIncome elasticity of demand is defined as the percentage change in quantity demanded from a 1 percent change in income Income elasticity of demand can be positive or negative Positive income elasticity is a normal good Negative income elasticity is an inferior good

29 Price Elasticity of SupplyPercentage change in quantity supplied from a 1 percent change in price Price elasticity of supply = ΔQ / Q ΔP / P Price elasticity of supply = P Q 1 slope x

30 Price Elasticity of SupplyIf supply curve has a positive intercept Price elasticity of supply decreases as Q increases Graph shows Slope = 2 At A, P = 8 and Q = 2 Price elasticity of supply = (8 / 2) (1 / 2) = 2.00 At B, P = 10 and Q = 3 Price elasticity of supply = (10 / 3) (1 / 2) = 1.67 2 8 A 3 10 B Quantity Price 4 S

31 Price Elasticity of SupplyIf supply curve has a zero intercept Price elasticity of supply is 1.00 Graph shows Slope = 1 / 3 At A, P = 4 and Q = 12 Price elasticity of supply = (4 / 12) (3) = 1.00 At B, P = 5 and Q = 15 Price elasticity of supply = (5 / 15) (3) = 1.00 15 5 B ΔP Δ Q S 12 4 A Quantity Price

32 Perfectly Inelastic SupplyZero price elasticity of supply No response to change in price Example: land in Tokyo Supply is completely fixed Any one-of-a-kind item has perfectly inelastic supply Work of art (Mona Lisa) Hope Diamond Price Quantity S

33 Perfectly Elastic SupplyInfinite price elasticity of supply Sell all you can at a fixed price Inputs purchased at a constant price No volume discounts Constant proportions of production Lemonade example Cost of production is 14¢ at all levels of Q Marginal cost P = 14¢ Price Quantity S

34 Determinants of Price Elasticity of SupplyInput Flexibility Uses adaptable inputs, more elastic Mobility of Inputs Resources move where needed, more elastic Produce Substitute Inputs Alternative inputs easy to find, more elastic Time Long run, more elastic

35 Gas Prices and Car PricesGasoline Prices Short-run elasticity of demand is smaller Difficult to adjust quickly to changes in price Supply fluctuates more often and by larger amounts Some oil-producing countries are unstable Speculation about instability Car Prices Short-run elasticity of demand is greater Timing of purchase can be adjusted to price changes Supply of cars is relatively stable Inputs are readily available Production lines yield predictable, steady output levels

36 Supply Bottleneck: Unique InputsOver time, most producers develop alternative production methods and a variety of input choices The more flexible the production process, the more elastic supply When production relies on a single input, supply is highly inelastic No alternatives to singular talent Sports stars Actors and musicians Bill Gates, Warren Buffet, Li Ka Shing, Jerry Yang

37 The Midpoint Formula for Demand ElasticityChapter 4 Appendix The Midpoint Formula for Demand Elasticity

38 The Midpoint Formula for Elasticity of DemandElasticity is different at each point on the demand curve Compare 2 points and get 2 answers Depends on which point is the starting point Start at A and elasticity is 2 Start at B and elasticity is 1 A more stable solution is needed Use the midpoint formula P Q ΔP Δ Q 4 3 6

39 The Midpoint Formula for Elasticity of DemandUse average quantity in the numerator Use average price in the denominator Elasticity using midpoint formula is 1.40 ΔQ / [(QA + QB)/2] Δ P / [(PA + PB)/2] ε = P Q ΔP Δ Q 4 3 6 Δ Q / (QA + QB) Δ P / (PA + PB) ε =