5 ELASTICITY AND ITS APPLICATION 10 02 2012 The concepts of demand and supply are two of the most useful in economics These concepts can be used to both explain and predict This chapter will develop some of the concepts required to make economic behavior predictions o Begins with discussion of sensitivity to price changes o Deals first with how sensitive or insensitive changes or quantity demanded are to changes in price Sensitivity to price changes demand o Different products can have very different price sensitivities o For many purposes economists want to be precise about how sensitive or insensitive changes or quantity demanded are to changes in price o We want to have a measure of this sensitivity Price Elasticity of Demand the percent change in quantity demanded divided by the percent change in price o change in quantity demanded change in price elasticity one measure of sensitivity of demand to price o Let Q1 P1 be the initial point and Q2 P2 the new point Percent change in quantity change in quantity intl quantity 100 Percent change in price change in price intl price 100 o Q2 Q1 Q1 100 P2 P1 P1 100 The Initial Value Method paul samuelson o Always there is a slight ambiguity about percentage changes o Ex buys bread for 15 cents sells for 25 is that 66 66 percent markup relating to the lower base 15 Or is it the 0 percent change that comes from relating 10 to the higher base 25 No answer can be right or wrong When it comes to small changes it doesn t really matter which of the two you choose because the difference is very small BUT with large changes no single answer can be declared as right o A good rule is not to relate the price to either higher or lower but instead relate change to their average Midpoint method Q2 Q1 Q1 Q2 Q1 2 P2 P1 P1 THE LARGER the price elasticity of demand the more senstitive quantity demanded is to given changes in price SMALLER values indicate that demand is less sensitive to price P2 P1 2 changes DETERMINANTS OF THE ELASTICITY OF DEMAND 1 Price elasticity is higher when close substitutes are available o Breakfast cereal vs Sun Screen Cereal has close substitutes pancakes waffles pop tarts so buyers can easily switch if the price rises Sunscreen has no close substitutes so consumers would not buy much less if price rises 2 Price elasticity is higher for narrowly defined goods than broadly defined ones o Blue Jeans VS Clothing o For narrowly defined good such as blue jeans there are many substitutes Khakis corduroy pants shorts o For broadly defined goods there may be few or no reasonable substitutes available 3 Elasticities for necessities are low and high for luxury goods o Basic Food VS Caribbean Cruises o Basic food is a necessity A rise in its price causes little or no decrease in demand o A Caribbean cruise is a luxury If price rises some people will forego it o Short Run VS Long Run o In the short run we assume that the value for some variable cannot be changed o In the long run the values for all variables can be changed Gas Short Run VS Gas Long Run There s not much people can do in the short run other than ride bus or carpool In long run people can buy smaller cars or live closer to where they work More of a response in long run OCT 4 Elastic Demand Price elasticity of demand change in Q change in P o D curve relatively flat o Consumers price sensitivity relatively high A demand curve is price elastic when the elasticity is greater than 1 A demand curve is price inelastic when the elasticity is less than 1 A demand curve is unit elastic when the elasticity is equal to one Consumer s Price Relatively High Extreme change in Q change in P Elasticity D Curve sensitivity change in Q change in P Elasticity D Curve Consumer s Price sensitivity 10 10 1 Flat 10 10 1 Steep Low Any 0 Undefined Horizontal 0 10 Vertical none change in Q change in P Elasticity D Curve Consumer s Price sensitivity 10 10 1 Intermediate slope intermediate A firm gets revenue money that comes in from selling its output Let R denote a firm s revenue Let P denote the price of the firm s output Let Q denote the quantity of output sold by the firm Using this notation o R PQ Price Elasticity and Revenues If P rises and Q falls what happens to R Revenue Price x Quantity Which effect dominates The answer depends on the price elasticity of demand The RELATION between a firm s revenue and the price elasticity of demand hinges on a comparison of the absolute value of the Lost revenue due to Lower Q When D is elastic a price increase causes revenue to fall Increased revenue to do higher P In our example suppose that Q only falls to 10 instead of 8 when the price elasticity with 1 Example P1 200 Q1 12 P2 250 Q2 8 Revenue 2000 Elasticity 1 8 Rev 2400 is raised to 250 P1 200 Q1 12 P2 250 Q2 10 Revenue 2500 Elasticity 1 8 Rev 2400 Lost revenue do to lower Q When D is inelastic a price increase causes revenue to rise When the price rises the quantity demanded will fall What happens to the Increased revenue do to higher P revenue If e 1 elastic demand then the increase in price will result in a relatively large decrease in quantity demanded So revenue falls If e 1 inelastic demand then the increase in price will result in a relatively small decrease in quantity demanded So revenue rises If e 1 unit elastic demand then the two effects offset one another So revenue is constant Elasticity and Slope The slope of a demand curve o Recall that when we draw a demand curve we put price on the vertical axis and quantity on the horizontal axis o P change in Price o Q change in quantity o Slope p q The slope of the linear demand curve is a constant Elasticity of a Linear Demand Curve If initially the price is low quantity is high then the elasticity is low If initially the price is high quantity is low then the elasticity is high elasticity Supply curves usually have positive slopes o But their sensitivity to price changes may vary o numerical measure of the responsiveness of quantity o demanded or quantity supplied to one of its determinants Price Elasticity of Supply Q P We can use price elasticity of supply to predict the effect of price If initially the price is low quantity is low then the elasticity of If initially the price is high quantity is high then the elasticity of changes on supply supply is high supply is low Price Elasticity of Supply Elasticity Description 0 1 Between 0 and 1 Greater than 1 Undefined Perfectly Inelastic vertical supply Curve Inelastic Unitary Elastic Elastic
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