Elasticity and Straight Line Demand Curves Price Since equal dollar increases vertical arrows are smaller and smaller percentage increases 3 2 and since equal quantity decreases horizontal arrows are larger and larger percentage decreases 1 demand becomes more and more elastic as we move leftward and upward along a straight line demand curve D Quantity Categorizing Goods by Elasticity Price elasticity of demand Between 0 and 1 Demand Equal to 0 Perfectly Inelastic Absolute Value 1 Elastic Equals 1 Unitary Elastic Approaches minus infinity Perfectly infinitely Elastic Inelastic Categorizing Goods by Elasticity Inelastic Demand Inelastic Demand Change in Quantity Demanded 1 0 Change in Price Change in Quantity Demanded Change in Price Elastic Demand Price elasticity of demand with absolute value 1 Change in Quantity Demanded Elastic Demand 1 Change in Price Extreme Cases of Demand a Price per Unit b Price per Unit D 4 3 2 4 Perfectly Inelastic Demand 1 3 Perfectly Elastic Demand 2 D 1 20 40 60 80 100 Quantity 20 40 60 80 100 Quantity Elasticity and Total Revenue Total revenue TR of all firms in the market is defined as TR P x Q When two numbers are both changing percentage change in their product is approximately the sum of their individual percentage changes Applying this to total revenue Change in TR Change in Price Change in Quantity Demanded Assume demand is unitary elastic and Q rises by 10 Change in TR 10 10 0 Elasticity and Total Revenue If demand is inelastic a 10 rise in price will cause quantity demanded to fall by less than 10 change in TR 10 something less negative than 10 0 If demand is elastic so that Q falls by more than 10 TR will fall Change in TR 10 something more negative than 10 0 Elasticity and Total Revenue Where demand is inelastic total revenue moves in same direction as price Where demand is elastic total revenue moves in opposite direction from price Where demand is unitary elastic total revenue remains the same as price changes At any point on a demand curve sellers total revenue buyers total expenditure is the area of a rectangle Width equal to quantity demanded Height equal to price Figure 6 Elasticity and Total Expenditure Price per Laptop 3 500 3 000 2 500 2 000 1 500 1 000 2 At point B revenue is 750 million 1 At point A where price is 1 000 and 600 000 laptops are demanded revenue is 600 million 3 Moving from A to B expenditure increases so demand must be inelastic over that range B A D 500 100 000 200 000 300 000 400 000 500 000 600 000 Quantity of Laptops What affects Elasticity Availability of Substitutes Demand is more elastic If close substitutes are easy to find and buyers can cut back on purchases of the good in question Demand is less elastic If close substitutes are difficult to find and buyers can not cut back on purchases of the good in question Narrowness of Market More narrowly we define a good easier it is to find substitutes More elastic is demand for the good More broadly we define a good Harder it is to find substitutes and the less elastic is demand for the good Different things are assumed constant when we use a narrow definition compared with a broader definition Necessities vs Luxuries The more necessary we regard an item the harder it is to find a substitute Expect it to be less price elastic The less necessary luxurious we regard an item the easier it is to find a substitute Expect it to be more price elastic Time Horizon Short run elasticity Measured a short time after a price change Long run elasticity Measured a year or more after a price change Usually easier to find substitutes for an item in the long run than in the short run Therefore demand tends to be more elastic in the long run than in the short run Importance in the Buyer s Budget The more of their total budgets that households spend on an item The more elastic is demand for that item The less of their total budgets that households spend on an item The less elastic is demand for that item Using Price Elasticity of Demand The War on Drugs Every year U S Government spends about 20 billion on efforts to restrict the supply of drugs Figure A Market for heroin without government intervention Figure B Result of government efforts to restrict supply current policy Figure C Results of an effective policy of reducing demand Figure A The War on Drugs a Price per Unit S1 P1 A D1 Q1 Quantity Figure B The War on Drugs b Price per Unit S2 B S1 P2 P1 A D1 Q2 Q1 Quantity Figure C The War on Drugs c Price per Unit S1 A P1 P3 C D1 D2 Q3 Q1 Quantity Using Price Elasticity of Demand Mass Transit Elasticity studies show that long run demand for mass transit is inelastic Therefore a rise in fare would increase revenues However most cities do not raise transit fares due to Desire to provide low income households with affordable transportation Desire to manage traffic congestion Desire to limit air pollution in the city An increase in fares would increase revenue Would also decrease ridership and require the city to sacrifice these other goals Using Price Elasticity of Demand An Oil Crisis For the past five decades Middle East has been a geopolitical hot spot Both military and economic government agencies ask What if questions If an event in the Middle East were to disrupt oil supplies what would happen to the price of oil on world markets Flipping the elasticity equation like so 1 Change in Price ED Change in Quantity Demanded Tells us percentage rise in price that would bring about a 1 percent decrease in quantity demanded Enables us to make reasonable forecasts about the impact of various events on oil prices Once we have established our forecasted oil prices we can then use that data to examine effect that higher oil prices would have on many broader issues Effect on U S inflation rate Effect on number of flights offered by U S airlines Income Elasticity of Demand Percentage change in quantity demanded divided by the percentage change in income With all other influences on demand including the price of the good remaining constant EY change in Quantity Demanded Change in Income Interpret this number as percentage increase in quantity demanded for each 1 rise in income Income Elasticity of Demand Income elasticities vs price elasticities of demand Price elasticity of demand Measures effect of change in price of good Assumes that other influences on demand including income remain unchanged Income elasticity Measures effect on demand we would observe if income changed and all other
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