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ECONOMICS. What Does It Mean To Me?. Part VI: Elasticity of Demand Elasticity of Supply Supply, Demand, and Taxation. READ Krugman Section 9, Modules 46, 47, 48 Mankiw Ch 5 DO Morton Unit 2. Module. The Income Effect, Substitution Effect, and Elasticity. 10. Micro: Econ:. - PowerPoint PPT PresentationTRANSCRIPT
ECONOMICSWhat Does It Mean To Me?
Part VI:Part VI:
Elasticity of DemandElasticity of Demand
Elasticity of SupplyElasticity of Supply
Supply, Demand, and Supply, Demand, and TaxationTaxation
READ Krugman Section 9, Modules 46, 47, 48
Mankiw Ch 5DO Morton Unit 2
•KRUGMAN'S•MICROECONOMICS for AP*
The Income Effect, Substitution Effect, and Elasticity
Margaret Ray and David Anderson
46
10Micro:
Econ:
Module
What you will learn
in this Module:• How the income and substitution effects
explain the law of demand
• The definition of elasticity, a measure of responsiveness to changes in prices or incomes
• The importance of the price elasticity of demand, which measures the responsiveness of the quantity demanded to changes in price
• How to calculate the price elasticity of demand
The Law of Demand• The substitution effect
• The income effectI
“The elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price.”
--Alfred Marshall, Principles of Economics
The law of demand tells us that consumers will respond to a decline in a product’s price by buying more of that
product.
But how much more of it will they But how much more of it will they purchase?purchase?
That amount can vary considerably by product and over different price ranges
for the same product.
The responsiveness, or sensitivity, of quantity demanded to a change in the price of a product is measured by the
concept of
PRICE ELASTICITY OF PRICE ELASTICITY OF DEMAND.DEMAND.
Demand for some products is such that consumers are highly responsive to price
changes; modest price changes lead to modest price changes lead to very large changes in the quantity very large changes in the quantity
purchasedpurchased, for example: restaurant meals, steak, cars.
The demand for such products is said to be
relatively elastic, or simply ELASTICELASTIC.
For other products, consumers are quite unresponsive to price changes;
substantial price changes result in substantial price changes result in only small changes in the amount only small changes in the amount purchasedpurchased, for example: salt, milk,
soap.
For such products, demand is relatively
inelastic or simply INELASTICINELASTIC.
Economist measure the degree of price elasticity or inelasticity of demand with the coefficient Ed defined as:
percentage change in quantity
demanded of product X
Ed = percentage change in price of
product X(Ed = Elasticity of demand)
These percentage changes are calculated by dividing the change in price by the original
price and the consequent change in quantity demanded by the original quantity
demanded. Thus, our definition can be restated as follows:
change in quantity demanded of X change in price
of X Ed
original quantity original price of X
demanded of X
:
Another way to state the equation would be using the Greek letter delta, ,
meaning change in…….
% Qd
(Q1 + Q2)/2
% P
(P1 + P2)/2
Ed =
Calculating Elasticity
• Calculating elasticity
– Elasticity is the % change in the dependent variable divided by the % change in the independent variable
– In symbols, elasticity is %∆dep/%∆ind
– Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in the price.
– In symbols: Ed = %ΔQd/ΔP note: we drop the negative sign for Ed only.
Why use percentages?Why use percentages?
Economists give two reasons:
1) Choice of Units
2) Comparing products
1) Choice of UnitsChoice of Units
If we use absolute changes, our impression of buyer responsiveness will be arbitrarily
affected by the choice of units. Using percentages avoids this problem. A particular price decline is 33 percent
whether measured in terms of dollars ($1/$3) or pennies (100 cents/300 cents).
2) Comparing productsComparing products
By using percentages, we can correctly compare consumer responsiveness to
changes in the prices of different products. It makes little sense to compare the effects on quantity demanded of (1) a $1 increase in the price of a $10,000 auto with (2) a $1 increase in the price of a $1 can of cola. Here, the price of an auto is rising by .01 percent while the price of
cola is up by 100 percent.
Elimination of Minus SignElimination of Minus Sign
We know from the downsloping demand curve that price and quantity are inversely related.
Thus, the price elasticity coefficient of demand Ed will always be a negativenegative number.
As an example, if price declines, then quantity demanded will increase. This means that the numerator
in our formula will be positive and the denominator negative, yielding a negative Ed . For an increase in
price, the numerator will be negative but the denominator positive, again yielding a negative Ed .
Economists usually ignore the minus sign and present the absolute value of the elasticity
coefficient to avoid ambiguity.
Interpretations of Ed
We can interpret the coefficient of price elasticity of demand as follows:
1) elastic demand
2) inelastic demand
3) unit elasticity
Elastic DemandElastic Demand
Demand is said to be elastic if a specific a specific percentage change in price results in a larger percentage change in price results in a larger
percentage change in quantity demandedpercentage change in quantity demanded. Then Ed > 1.
Example: If a 2 percent decline in a price results in a 4 percent increase in quantity
demanded, then demand is elasticelastic and
.04
Ed = .02 = 2
PRICE
QUANTITY
DD22
Relatively elastic demand
A small percentage change in price leads to a larger percentage change in quantity demanded.
P0
P1P
0 Q0Q1
Qd
Ed > 1
When we say demand is “elastic,” we do not mean that consumers are completely
responsive to a price change. In that extreme situation, where a small price reduction
would cause buyers to increase their purchases from zero to all they could obtain, economists say demand is perfectly elasticperfectly elastic.
You will see in later chapters that such a demand applies to a firm, for instance, a blueberry grower, selling its product in a
purely competitive market.
PRICE
QUANTITY
DD22
Perfectly elastic demand
A small percentage change in price will change quantity demanded by an infinite amount.
P0
P1P
0 Q0Q1
Qd Ed =
Inelastic DemandInelastic Demand
If a specific percentage change in price is accompanied by a smaller percentage change in quantity demanded, demand is said to be
inelastic. Then Ed < 1.
Example: If a 3 percent decline in price leads to only a 1 percent increase in quantity
demanded, demand is inelasticinelastic and
.01
Ed = .03 = .33
PRICE
QUANTITY
DD11
Relatively inelastic demand
P0
P1
P
0 Q0Q1
Qd
A change in price leads to a smaller percentage change in quantity demanded.
Ed < 1
When we say demand is “inelastic,” we do not mean that consumers are completely unresponsive to a price change. In that extreme situtation, where a price change results in no change whatsoever in the quantity demanded, economist say that
demand is perfectly inelasticperfectly inelastic.
Examples include an acute diabetic’s demand for insulin or and addict’s
demand for heroin.
PRICE
QUANTITY
DD11
Perfectly inelastic demand
P0
P1
P
0 Q0 = Q1
The quantity demanded does not change regardless of the percentage change in price.
Ed = 0
Elastic or Inelastic demand?
Unit ElasticityUnit Elasticity
The case separating elastic and inelastic demands occurs where a change in price and
the accompanying percentage change in quantity demanded are equal.
Example: A 1 percent drop in price causes a 1 percent increase in quantity demanded. This special case is termed unit elasticityunit elasticity because
Ed = 1, or unity. In this example:
.01
Ed = .01 = 1
PRICE
QUANTITY
DD11
Unit elastic demand
P0
P1
P
0 Q0Q1
Qd
The percentage change in quantity demanded is the same as the percentage change in price that caused it.
Ed = 1
PRICE
QUANTITY
DD11
P0
P1
0 Q0Q1
DD00
Q2
Relatively Relatively inelasticinelastic
Relatively Relatively elasticelastic
When a demand curve is relatively steep, such as D0 in this graph, its price
elasticity is relatively inelastic.When a demand curve is
relatively flat, such as D1, its price elasticity is relatively
elastic.
A more accurate way to calculate elasticity is
THE MIDPOINT FORMULA
The Midpoint Formula
• The problem with calculating percentage changes
• The solution: Use the Midpoint formula!
– %ΔQd = 100*(New Quantity – Old Quantity)/Average Quantity
– %ΔP = 100*(New Price – Old Price)/Average Price
– Ed = %ΔQd/ΔP
• Example
Using the midpoint formula, calculate the following:
Price Qdemanded
Apples A .90 1,100
Apples B 1.50 900
(1100-900) 200(1100+900)/2 1000
(1.50 - .90) .60(1.50 + .90)/2 1.20
=
= x
x 100
100
=
=
20
50
.4
Using the midpoint formula, calculate the following:
Price Qdemanded
Apples A .90 1,500
Apples B 1.10 900
(1500-900) 600(1500+900)/2 1000
(1.10 - .90) .20(1.10 + .90)/2 1.00
=
= x
x 100
100
=
=
60
20
3
•Available substitutes
•Proportion of income
•Luxuries vs necessities
•Time
What influences the price elasticity of demand?
Available SubstitutesAvailable Substitutes
The largerlarger the number of close substitutes, the greater the elasticitygreater the elasticity. If the price increases, consumers may
select a relatively lower-priced substitute instead.
Examples may include:
•Butter => Margarine
•Pepsi => Coca Cola
•Texaco gasoline => Hess gasoline
Proportion of Income Spent on the GoodProportion of Income Spent on the Good
The smallersmaller the proportion of income spent on a good, the lower its elasticity of lower its elasticity of
demanddemand. If the amount spent on a good relative to income is small, then the change in price on one’s income will also be small.
Example:
•100% increase in price of salt vs. 100% increase in price of an automobile.
•50% increase in price of private education vs. 50% increase in cost of textbooks.
Luxuries vs NecessitiesLuxuries vs Necessities
The demand for “necessities” tends to be price-inelastic; that for “luxuries” price-elastic. A price
increase will not significantly the amount of a necessity consumed. If the price of a luxury rises, an individual need not buy them and will suffer no great
hardship without them.
Examples (necessities):
•Bread
•Electricity
•Appendectomy
Examples (Luxuries):
•Caribbean cruise
•Emerald ring
•Lexus
The Amount of Time Since the Price The Amount of Time Since the Price ChangeChange
The moremore time that people have to adapt to a new price change, the greater its greater its
elasticity of demandelasticity of demand. Immediately after a price change, consumers may be unable to locate good alternatives or easily change
their consumption patterns.
Total-Revenue TestTotal-Revenue Test
Total revenue (TR) is the total amount the seller receives from the sale of a product; it is calculated by
multiplying the product price (P) by the quantity demanded and sold (Q). In equation form:
TR = P x Q
Total revenue and the price elasticity are related. Indeed, perhaps the easiest way to infer whether
demand is elastic or inelastic is to employ the total-revenue test, where we observe what
happens to total revenue when product price changes.
Elastic DemandElastic Demand
If demand is elastic, a decreasedecrease in price will increaseincrease total revenue. Even though
a lesser price is received per unit, enough additional units are sold to more
than make up for the lower price.
TR = P x Q
TR = P x Q
Elastic Demand and Total Revenue
P
Q
$10
$5
0 20 40 60 80 100
B
A
cb
a
At point A, total revenue is $400 ($10 x 40), or area a + b.
At point B, the total revenue is $500 ($5 x 100), or area b + c.
Total revenue has increased by $100.
We can also see in the graph that total revenue
has increased because the area b + c is greater than
area a + b, or c > a.Delastic
Inelastic DemandInelastic Demand
If demand is inelastic, a price decreasedecrease will reducereduce total revenue. The modest
increase in sales will not offset the decline in revenue per unit, and the net
result is that total revenue declines.
TR = P x Q
TR = P x Q
Inelastic Demand and Total Revenue
P
Q
$10
$5
0 10 20 30 40
B
A
cb
a
At point A, total revenue is $300 ($10 x 30), or area a + b.
At point B, the total revenue is $200 ($5 x 40), or area b + c.
Total revenue has decreased by $100.
We can also see in the graph that total revenue has decreased because the area a + b is greater than area b + c, or a > c.Dinelastic
APPLICATIONS OF APPLICATIONS OF PRICE ELASTICITY PRICE ELASTICITY
OF DEMANDOF DEMAND
1) Bumper Crops1) Bumper Crops
Increases in the output of most Increases in the output of most farm products arising from a farm products arising from a
good growing season or good growing season or increase in productivity will increase in productivity will
cause to decrease both the farm cause to decrease both the farm products and the total revenues products and the total revenues
(or incomes) of farmers.(or incomes) of farmers.
2) Automation2) Automation
The impact of technological advances on The impact of technological advances on employment depends in part on the elasticity of employment depends in part on the elasticity of
demand for the product or service that is involved. demand for the product or service that is involved. If a firm installs technology that replaces 1000 If a firm installs technology that replaces 1000
workers, who are then laid off, the savings from workers, who are then laid off, the savings from the cost reduction could be passed on to the cost reduction could be passed on to
consumers. The effect of the price reduction on consumers. The effect of the price reduction on sales will depend on the elasticity of the product. sales will depend on the elasticity of the product. An elastic demand could increase sales to a point An elastic demand could increase sales to a point where some of the workers might be rehired. An where some of the workers might be rehired. An
inelastic demand will result in only minimal inelastic demand will result in only minimal increase in sales.increase in sales.
3) Airline Deregulation3) Airline Deregulation
In the 1970s, deregulating the airlines caused In the 1970s, deregulating the airlines caused increased profits for the carriers in the short increased profits for the carriers in the short term, because it increased price competition term, because it increased price competition
among the airlines, thus lowering airfares. Lower among the airlines, thus lowering airfares. Lower fares, and an elastic demand for air travel, fares, and an elastic demand for air travel,
increased revenues. Filling the airplanes to increased revenues. Filling the airplanes to capacity increased revenues more than the costs capacity increased revenues more than the costs
and increased profits.and increased profits.
Profits did not last, however, because of rising Profits did not last, however, because of rising fuel prices, persistent fare wars, and the entry of fuel prices, persistent fare wars, and the entry of
competitors on profitable routes.competitors on profitable routes.
4) Excise Taxes4) Excise Taxes
The government selects certain goods and The government selects certain goods and services with which to levy excise taxes by services with which to levy excise taxes by
paying attention to elasticity of demand. If a $1 paying attention to elasticity of demand. If a $1 tax is levied on a product and 10,000 units are tax is levied on a product and 10,000 units are
sold, tax revenue will be $10,000. If sold, tax revenue will be $10,000. If government then raises the tax to $1.50 and the government then raises the tax to $1.50 and the consequent higher price reduces sales to 5000, consequent higher price reduces sales to 5000, tax revenue will tax revenue will declinedecline to $7500. A higher tax to $7500. A higher tax
on a product with an elastic demand will on a product with an elastic demand will reduce revenue, therefore, governments seek reduce revenue, therefore, governments seek
products with inelastic demands, such as products with inelastic demands, such as liquor, gasoline and cigarettes.liquor, gasoline and cigarettes.
5) Drugs and Street Crime5) Drugs and Street CrimeIs an addict’s demand for crack cocaine and heroin highly elastic? This belief is typically used by law enforcement to reduce supply by intercepting drug
shipments. If this is true, then the street price to addicts will rise sharply while amounts purchased will decrease slightly. This will result in greater revenues for drug dealers. Because the income of the addict
comes from crime, it may be true that restricting supply of drugs actually causes crime.
Proponents of drug legalization contend that drugs should be treated like alcohol because the war on drugs has been unsuccessful and the associated costs are too
great.
Clip
Price of Drugs
Price of Drugs
Quantity of Drugs
Quantity of Drugs
D
S1
S2
Q1Q2
P1
P2
If the demand for drugs is inelastic then drug “busts” reduce the supply of drugs,which raises the price,and reduces quantity supplied.
Price of Drugs
Price of Drugs
Quantity of Drugs
Quantity of Drugs
D
S1
S2
Q1Q2
P1
P2
Another option is drug education, which reduces demand, which lowers the price,and reduces quantity supplied.
S
D1D2
P1
P2
Q1Q2
6) Minimum Wage6) Minimum WageCritics say that a minimum wage, if it is above the
equilibrium market wage, moves employers upward along their downsloping labor demand curves toward lower
quantities of labor demanded, thus causing unemployment--especially among teenage workers.
Conversely, workers who remain employed received higher incomes with a minimum wage than otherwise.
Research suggests that the demand for teenage labor is inelastic, with Ed possibly as low as 0.15 or 0.25. If
correct, this means income gains associated with the minimum wage exceed income losses. The argument
would be stronger if the demand for teenage workers were elastic.
$5
$4
$3
$2
$1
Labor0 1 2 3 4 5 6 7 8 9 10
S
D
E
When the government mandates a the minimum price When the government mandates a the minimum price of something, it is called a of something, it is called a PRICE FLOORPRICE FLOOR and it keeps and it keeps the market from reaching equilibrium.the market from reaching equilibrium.
The demand for labor diminisheswhile the supply of labor increasescausing a surplus.
Elasticity of Supply
The PRICE ELASTICITY OF SUPPLY measures how
much the quantity supplied responds to changes in
price.
PRICE
QUANTITY
SS22
Relatively elastic supply
A small percentage change in price leads to a larger percentage change in quantity supplied.
P0
P1
P
0 Q0Q1
Qd
Ed > 1
Supply is said to be elastic if the quantity supplied responds substantially to changes in price.
PRICE
QUANTITY
SS22
Relatively inelastic supply
A small percentage change in price leads to a
smaller percentage change in quantity
supplied.P0
P1
P
0 Q0Q1
Qd
Ed < 1
Supply is said to be inelastic if the quantity supplied responds slightly to changes in price.
Elasticity of Supply is dependant upon the Elasticity of Supply is dependant upon the sellers’ flexibility in changing the amount they sellers’ flexibility in changing the amount they
produce.produce.
For example: Beachfront property in Florida has an inelasticinelastic supply because we
cannot produce more of it.
Manufactured goods such as microwave ovens, televisions, and cars are elasticelastic
because the producers can easily adjust production of a good more or less.
How do government
policies (taxes) affect
market outcomes?
When a tax on tea is levied on consumers, the sellers will share part of the tax burden.
PRICE
QUANTITY
SS
P0
P1
0 Q0Q1
P2
E w/o tax
D0
D1
P0 is the equilibrium price WITHOUT the tax.
P1 is the price sellers will receive.
P2 is the price consumers will pay.
($2.50)
($2.20)
($2.00)
($.50)
($.50)
$5
$4
$3
$2
$1
Qlabor0 1 2 3 4 5 6 7 8 9 10
Slabo
r
Dlabor
E
Plabor
A payroll tax puts a wedge between the price that workers receive and the amount producers pay.
$5
$4
$3
$2
$1
Q0 1 2 3 4 5 6 7 8 9 10
S
D
E
P
When supply is more elastic than demand, the burden of the tax falls primarily on consumers.
Pw/o tax
Pconsumers pay
Pproducers receive
In the late 1980s, Governor Martinez of Florida placed a tax on
luxury items in the State of Florida. Why was this tax repealed a few
years later??
$5
$4
$3
$2
$1
Q0 1 2 3 4 5 6 7 8 9 10
S
DE
P
When demand is more elastic than supply, the burden of the tax falls primarily on producers.
Pw/o tax
Pconsumers pay
Pproducers receive
Project by:Project by:
Virginia H. MeachumVirginia H. Meachum
Coral Springs High SchoolCoral Springs High School
Sources:Sources:
Principles, Problems, and PoliciesPrinciples, Problems, and Policies, by Campbell McConnell & , by Campbell McConnell & Stanley BrueStanley Brue
Principles of EconomicsPrinciples of Economics, by N. Gregory Mankiw, by N. Gregory Mankiw
Economics For AP, by Paul Krugman, Robin Wells, David Anderson, Margaret Ray
Notes by Florida Council on Economic Education and FAU Notes by Florida Council on Economic Education and FAU Center for Economic EducationCenter for Economic Education
Notes by Foundation for Teaching EconomicsNotes by Foundation for Teaching Economics