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APPALACHIAN ECO 2030 - Elasticity of Supply

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ECO2030 1nd Edition Lecture 12Outline of Last Lecture I. ElasticityOutline of Current Lecture II. Elasticity of Supply III. Examples of price elasticity of supplyCurrent LectureQuiz next monday, exam friday. Elasticity in the real world chart:Revenue = Price x Quantity▪ Continuing our scenario from the previous lecture, if you raise your price of websites from $200 to $250, would your revenue rise or fall?Revenue = P x Q● a price increase can have two effects on revenue○ a higher price means more revenue on each website you sell ○ but you will sell less because of the law of demand● However, which effect is greater depends on the price elasticity of demand of your product.Recall that if price is elastic, price elasticity of demand will be >1% change in Q > % change in P● because the fall in revenue from the lower demand (Q) is greater than the increase in revenue from the higher price(P), overall there is a fall inrevenue. steeper demand curve = moreinelastic, less steep = more elasticElastic Demand (elasticity = 1.8)If P = $200 and Q = 12 then,Revenue = P x Q = (200)(12) = $2400If P = $250 and Q = 8 thenRevenue = P x Q = (200)(8) = $2000When D is elastic a price increase causesrevenue to fall!If P is raised by $50 again but demand(Q) only falls to 10 instead of 8 it isbecause the demand curve is steeper andtherefore, If P = $200 and Q = 12, Revenue =$2400(just like before), However, if P = $250and Q = 10, then Revenue = $2500This is $100 more because when thedemand curve is steeper gains in P canoutweigh losses in Q. (Remember this isbecause the demand curve is steeper) Conclusion: when D is inelastic, a price increase causes revenue to rise!Example Questions (likely on the exam!). when you see a question like this you need to determine if the demand is elastic!A. Pharmacies raise the price of insulin by 10%. Does total expenditure on insulin rise or fall?a. Recall that insulin is a necessity and therefore, demand is inelastic. Since the demand will not fall much for necessities, a 10% increase in price will not decrease demand as much as 10%, so the revenue/expenditure risesB. As a result of a price war, the price of luxury cruise falls 20%. does the total revenuefor luxury cruises rise or fall?a. although the fall in P reduces revenue the demand increase outweighs it. This is because demand is elastic, meaning Q will increase more than 20%, so total revenue will rise.Example:A. Does drug interdiction increase ordecrease drug related crime.a. a side effect of drug use iscrime in order to pay for theaddictionb. For simplicity we say that drug related crime is equal to the money spent on drugs (dollar value). c. Also since demand for drugs is similar to insulin (because addiction is similar to anecessity) the demand curve is inelastic.Interdiction reduces the supply of drugs. However, since demand for drugs is inelastic, P rises more than Q falls. Remember that we assume that drug related crime is equal to the money spent on drugs, therefore if the price of drugs goes up more than the demand falls, there is an increase in spending on drugs and therefore an increase in spending on drug related crime!The other alternative: EducationEducation reduces the demand for drugs,therefore both P and Q fall. The resultsounds good because this effectivelyreduces the price of drugs which reducesdrug related crime expenditures.The problem is that cheap drugs are anincentive to try them, so in reality lawofficials use both methods shown here. When a demand is inelastic, a price increase causes revenue to riseWhen a demand is elastic, a price increase causes revenue to fallPrice elasticity of Supply: (very similar to demand)Measures price elasticity of supply, how much Q responds to change in PRemember that when price increases so doesquantity (the Law of Supply). Price elasticity of Supply = Percent change in Q /Percent change in PSo, P elasticity of Supply = 16%/8% = 2(steeper = more inelastic, less steep = more elastic)One thing that differs from the elasticity of demand and the elasticity of supply is that when priceincreases do does quantity!Perfectly inelastic supplyQ/P = 0%/10% = 0 S curve is steep! (vertical)No Price sensitivityInelasticQ/P = <10%/10% = <1The S curve is relatively steep - the Pricesensitivity is relatively lowUnit ElasticityQ/P = 10%/10% = 1Just like elasticity of demandElastic (flatter, stretchier!)P rises 10% and Q rises >10%so, Elasticity = >10%/10% = >1Relatively flat curve, price sensitivity relatively highPerfectly Elasticsomething that is not dependent on resources, e.g.copying software. Determinants of supply elasticity▪ The more easily sellers can change the quantity they produce, the greater the price elasticityof supply. ▪ Example: Supply of beachfront property is harder to vary and thus less elastic than supply of new cars. ▪ For many goods, price elasticity of supply is greater in the long run than in the short run, because firms can build new factories, or new firms may be able to enter the


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