Slide 1Slide 2OVERVIEWPrice Elasticity of Demand and SupplyPossible Values for ED and ESInterpreting Elasticity: Elastic DemandInterpreting Elasticity: Inelastic DemandInterpreting Elasticity: Unit Elastic DemandElasticity of Demand: Basic IdeaPRICE ELASTICITY OF DEMANDElasticity Factors: Necessities vs. LuxuriesElasticity Factors: Availability of SubstitutesElasticity Factors: Portion of Your BudgetElasticity Factors: Short Run vs. Long RunCALCULATING ELASTICITYArc Method: The Midpoint FormulaPractice: The Midpoint FormulaWhy use the Midpoint formula?Why use the Midpoint formula?How did this happen?APPLICATION OF EDFinding %ΔQDFinding %ΔQdPredicting Changes in Total RevenueFinding Changes in Total RevenueFinding changes in TR (cont)Finding TR GraphicallyFinding TR Graphically (cont)Ed and Total RevenueBIG IDEA IN ECONOMICSSummary of ED and Total RevenueEd along a Linear Demand CurveED along a Linear Demand CurveKEY CONCEPTS AND TERMSSlide 35PRACTICEFalling Prices of CigarettesSlide 38SUPPLY, DEMAND, MARKETS AND APPLICATIONSUnderstanding How Markets Work1Markets I: Supply and DemandMarkets II: We Love Markets!Markets III: Sometimes we Don’t!Markets IV: Elasticity & ApplicationsDEMAND ELASTICITYIf gas rose to $5/gallon, how much would you cut back, really?2OVERVIEWElasticity is used to measure the strength of a relationship between any two variables•Elasticity measures the…•responsiveness of one variable in response to changes in a related variable•sensitivity of one variable in response to changes in a related variable•Specifically, it measures the 3Price Elasticity of Demand and SupplyPrice Elasticity of Demand•Measures the responsiveness of QD to changes in•We know that when price falls consumers tend to buy more, but how much more?Measures the % change (∆) in QD when P changes by 1%Price Elasticity of Supply•Measures the responsiveness of QS to changes in•We know that when price falls firms tend to produce less, but how much less?Measures the % change (∆) in QS when P changes by 1%4Possible Values for ED and ES•0 < E < 1: Inelastic• Qd (or Qs) is not responsive/sensitive to changes in price•E = 1: Unit Elastic•Qd (or Qs) change by the same percentage as price•1 < E: Elastic•Qd (or Qs) is responsive/sensitive to changes in price0 1 25Interpreting Elasticity: Elastic DemandIf Ed > 1, then we say “demand for good X is elastic”•For Ed > 1, it must mean that •QUANTITY DEMANDED CHANGES BY •Ed of 2 means that QD will change by twice as much as P•If P rises by 8%, QD will 6ED = %∆QD%∆PInterpreting Elasticity: Inelastic DemandIf Ed < 1, then we say “demand for good X is inelastic”•For Ed < 1, it must mean that•QUANTITY DEMANDED CHANGES BY•Ed of 0.25 means that QD will change by a fourth as much as P•If P rises by 8%, QD will7ED = %∆QD%∆PInterpreting Elasticity: Unit Elastic DemandIf Ed = 1, then we say “demand for good X is unit elastic”•For Ed = 1, it must mean that•QUANTITY DEMANDED CHANGES BY•Ed = 1 means that QD will change by the same % as P•If P rises by 8%, QD will8ED = %∆QD%∆PElasticity of Demand: Basic Idea9DPQDPQTwo very different demand curves…PRICE ELASTICITY OF DEMANDElasticity FactorsElastic: you change the amount you buy a lot when the price changesInelastic: you change the amount you buy only a little when the price changes•Why are some goods elastic and others inelastic?•Why is it that for some goods, people change their spending habits a lot when the price changes, while for other goods people don’t change their spending habits much at all?10Elasticity Factors: Necessities vs. LuxuriesNecessities•Examples?• •What happens when the price of these change?•Necessities TEND to be Ed (physician services): Luxuries•Examples?• •What happens when the price of these change?•Luxuries TEND to be Ed (foreign travel): 11Elasticity Factors: Availability of SubstitutesGoods with no close substitutes•Examples?• •What happens when the price of these change?•These TEND to be Ed (coffee) = Ed (soda) = Goods with many close substitutes•Examples?•What happens when the price of these change?•These TEND to be Ed (French vanilla coffee) = Ed (Coke) = 12Elasticity Factors: Portion of Your BudgetInexpensive Goods•Examples?• •What happens when the price of these change?•These TEND to be ED (toothpicks): Expensive Goods•Examples?• •What happens when the price of these change?•These TEND to be Ed 13Elasticity Factors: Short Run vs. Long RunShort RunIn the short run, buyers don’t have time to change their habits/wants or find suitable substitutes•What happens when the price of these change?•These TEND to be ED (Gasoline, SR): ED (Airline Travel, SR): Long RunIn the long run, buyers have more time to adjust to changes in price and find substitutes•What happens when the price of these change?•These TEND to be ED (Gasoline, LR): ED (Airline Travel, LR): 14CALCULATING ELASTICITYPoint Method: measures the elasticity at a certain point on the demand curveArc Method: measures the elasticity between 2 points on the demand curve; measures the elasticity over a DPDPQQ15Arc Method: The Midpoint Formula16ED = %∆QD%∆PWe have a special way of breaking down the equation using the midpoint formulaPractice: The Midpoint Formula17What is the elasticity along this range of the demand curve for milk?31084PQ (gallons of milk/month)DIs it elastic or inelastic?Therefore,%∆QD =%∆P =ED = = Demand is along that portion of the demand curve18Why use the Midpoint formula?D31084PQ (gallons of milk/month)where…%∆QD =∆QDinitial QDx 100%∆P =∆Pinitial Px 100ED = %∆QD%∆PUse the “normal” percentage change formula to find elasticity of demand along this range of the demand curve19Why use the Midpoint formula?Therefore,%∆QD =28x 100 =%∆P =14x 100 =ED = = Therefore,%∆QD =210x 100 =%∆P =13x 100 =ED = = If price falls from $4 to $3… If price rises from $3 to $4…Going up the demand curve, Qd changed by 2 gallons, starting from 10 gallons, which is a 20% changeGoing down the demand curve, Qd changed by 2 gallons, starting from 8 gallons, which is a 25% changeGoing up the demand curve, P changed by $1, starting from $3, which is a 33.33% changeGoing down the demand curve, P changed by $1, starting from $4, which is a 25% change  The answer depends on your starting point!!20How did this happen?APPLICATION OF EDPredicting changes in