Chapter 5 Elasticity Elasticity is a unit free measure of responsiveness of quantity demanded or supplied to price Explains how total spending on a good revenue changes with a price change Can be helpful in understanding the effectiveness of certain government policies Although we will be doing some math in this chapter don t get bogged down in the calculations Focus on the concept and the intuition You can always look up the formula 2 McDonald s to Coca Cola Why are CEOs suddenly obsessed with elastic ity 3 Q Elasticity of demand P Note Units cancel Elasticity is a unit free number 4 Problem When percent change is calculated the traditional way elasticity computed for a price increase is different from that calculated for a price decrease Solution Mid point formula Ed Q P Q Q P P where Q Q1 Q2 2 P P1 P2 2 5 P 5 4 P Q A Try out the mid point formula Same answer A to B or B to A A to B Ed 120 100 110 4 5 4 5 B to A Ed 100 120 110 5 4 4 5 B Ed 0 818 100 120 D Q 6 Elasticity is related to slope but not the same Ed P Q slope A Slope is constant from A to B to C B But elasticity is changing because P Q is changing P P1 P2 P3 C D Q 7 Q1 Q2 Q3 A Geometric Note If you start from the same P and Q then the steeper curve is less elastic i e it has a smaller value of Ed The flatter curve is more elastic bigger Ed Ed P Q slope P1 D More elastic D Less elastic 8 Q1 Footnote Price elasticity of demand Ed is always negative If P increases Q decreases and vice versa Don t forget to keep track of that in calculations 9 Unit free measure of responsiveness of Q demanded to changes in P Chicken 1 2 Ball bearings 0 01 Gasoline 0 4 Which is most responsive Which is least responsive 10 Unit free measure of responsiveness of Q demanded to changes in P Chicken 1 2 Ball bearings 0 01 Gasoline 0 4 If the price of chicken goes down by 10 percent what is the percent change in quantity demanded E Q P 1 2 x 10 x 12 percent If the price of ball bearings goes up by five percent what is the percent change in quantity demanded of ball bearings E Q P 0 01 x 5 x 0 05 percent iClicker Time 11 If the price elasticity of demand for gasoline is 0 4 and the price of gasoline increases by 50 by what percentage does the quantity demanded change Determinants of the Elasticity of Demand A Preview 1 Availability of Substitutes 2 Time Horizon 3 Category of Product specific or broad 4 Necessities vs Luxuries 5 Purchase Size This is the fundamental determinant 13 Determinants of the Elasticity of Demand 1 The availability of substitutes is very important Fewer substitutes makes it harder for consumers to adjust Q when P changes so demand is less elastic Many substitutes Switching brands when prices change is EASY so demand is more elastic 14 Determinants of Elasticity of Demand 2 The time horizon matters Less time to adjust means lower elasticity Over time consumers can adjust their behavior by finding substitutes making demand more elastic 15 Determinants of Elasticity of Demand 3 The classification of the good matters The less specific the classification the fewer substitutes there are making demand less elastic And vice versa E g the elasticity of demand is higher for lettuce than for food vs 16 Determinants of Elasticity of Demand 4 The nature of the good to the consumer can also affect the elasticity of demand For necessities we do not change Q much when P changes For luxuries we are more sensitive to P changes 17 Determinants of Elasticity of Demand 5 The size of the purchase relative to our budget matters We are less sensitive to price changes when the good is cheap relative to our budgets We are more sensitive to price changes when the good is expensive relative to our budgets 18 Determinants of Elasticity of Demand Summary of Determinants of Elasticity of Demand Less Elastic Fewer Substitutes Short Run less time Broad Classification Necessities Small Part of Budget More Elastic More Substitutes Long Run more time Specific Classification Luxuries Large Part of Budget iClicker Time 19 Which of the following statements would NOT support the argument that demand for BMW automobiles is quite elastic A There are many other high end car brands Mercedes Audi Lexus etc B BMWs are made in Germany C The car payments on a BMW are likely to make up a large proportion of one s income D Owning a BMW is more of a luxury than a necessity SEE THE INVISIBLE HAND SEE THE INVISIBLE HAND A Kentucky governor proposed a 70 cent pack cigarette tax increase Estimated effects Average cost of a pack would go from 3 97 to 4 55 Youth smoking would be cut by an estimated 16 6 percent Adult smoking would decrease by an estimated 4 percent Ed 1 Demand is Elastic e g Ed 2 0 Ed 1 Demand is Inelastic e g Ed 0 2 Ed 1 Demand is Unit Elastic Why 1 Why not 2 or 4 or 3 1416 22 Answer Ed 1 or 1 tells us about the change in total spending Revenue in response to a price change Revenue Rule of Elasticity Revenue R P x Q R P Q P 1 Ed So if Ed 2 and P 0 then R 0 In English If you lower price and demand is elastic then revenues rise 23 R P Q P 1 Ed But if Ed 0 5 and P 0 then R 0 In English If you lower price and demand is inelastic then revenues fall 24 Applying the Revenue Rule Why good weather can be bad for farmers 25 P P0 P1 R0 R1 S Market for Corn S R0 P0 x Q0 R1 P1 x Q1 R1 R 0 Farmer D Q0 Q1 Q 26 Applications of Elasticity of Demand Why the War on Drugs is Hard to Win Because demand for most illegal drugs is inelastic drug dealers earn greater revenue and gain more power as the drug war becomes more effective 27 Elasticity of Demand and Total Revenue Summary of Relationship between Elasticity of Demand and Revenue Absolute Value of Elasticity Name Inelastic Elastic Unit Elastic Price and Revenue P and R Move Together P and R Move Opposite P Moves but R Stays the Same Understanding these rules is important in making pricing decisions iClicker Time 28 Suppose that the University of Missouri increases its tuition As a result the amount of revenue brought in through course enrollment increases This suggests that A the demand for Mizzou classes is inelastic B the demand for Mizzou classes is elastic C the supply of Mizzou classes is elastic D the supply of Mizzou classes is …