principles of microeconomics & principles of macroeconomics: ch. 5 second canadian edition...

Principles of Microeconomics & Principles of Macroeconomics: Ch. 5 Second Canadian Edition

Chapter 5

Elasticity and Its Applications

© 2002 by Nelson, a division of Thomson Canada Limited


Overview

ElasticityElasticity of DemandElasticity of SupplyApplications of Elasticity


Elasticity . . .

… is a measure of how much buyers

and sellers respond to changes in

market conditions. . .

… allows us to analyze supply and

demand with greater precision.


Elasticity: A General Definition:

The percentage (%) change in

something . . .

. . . given a one percent (1%) change

in something else.


Three Types of Elasticities. . .

Price Elasticity of Demand

Income ElasticityPrice Elasticity of

Supply

Price

Quantity


Overview



Price Elasticity of Demand

The percentage change in the quantity

demanded given. . .

. . . a one percent change in the price.

A

B

DemandP

Q


Ranges of Elasticity . . .

Perfectly Inelastic Consumers are

“completely unresponsive” to price changes.

Perfectly Elastic Consumers are “infinitely

responsive” to price changes.

Unit Elastic Consumer’s response is “equal

to” change in price.


Elasticity of Demand Illustrated

Perfectly Inelastic

P2

P1

Even if priceincreases a lot quantity demanded stays the same.


Elasticity of Demand Illustrated

Perfectly Elastic

P1

A small increasein price will causedemand to drop offcompletely.


Determinants of Price Elasticity of Demand

Demand tends to be more elastic:– if the good is a luxury;

– the longer the time period;

– the greater the number of close substitutes; and

– the more narrowly defined the market.


Determinants of Price Elasticity of Demand

Demand tends to be more inelastic:– if the good is a necessity;

– the shorter the adjustment time;

– if there are few good substitutes; and

– the more broadly defined the market.


Computing Elasticity Coefficient

Computed as the percentage change in the quantity demanded divided by the percentage change in price.

Price Elasticityof Demand

=

Percentage Change in Quantity Demanded

Percentage Change in Price



Demand forIce Cream

2.20

2.00

108

ED

($2.20 - $2.00) / $2.00

(8 - 10) / 10

=



Demand forIce Cream

2.20

2.00

108

ED

(10%)

(20%)

=



Demand forIce Cream

2.20

2.00

108

ED= 2



Demand forIce Cream

2.20

2.00

108

ED= 2

Demand is Elastic


Elasticity and Total Revenue

Over the Elastic Range of

prices and quantity

the relationship between price and total revenue is

INDIRECT or OPPOSITE



ED > 1 then

P Q TRand



Over the Inelastic Range of prices and quantity

the relationship between price and total revenue is

DIRECT or THE SAME



ED < 1 then

P Q TRand


Income Elasticity of Demand

The percentage change in the quantity demanded

given a one percent change in income.


Computing Income Elasticity

Computed as the percentage change in demand divided by the percentage change in Income.

Income Elasticityof Demand

=

Percentage Change in Demand

Percentage Change in Income


Income Elasticity... Types

YD > 0 Normal Goods

YD < 0 Inferior Goods

YD = 0 Income-neutral Goods



Goods consumers regard as “necessities” tend to be income inelastic...– Examples include: food, fuel, clothing,

utilities, & medical services.



Goods consumers regard as “luxuries” tend to be income elastic...– Examples include: Sports cars, furs, and

expensive foods.


Quick Quiz!

Define the price elasticity of demand.

Explain the relationship between total revenue and elasticity of demand


Overview



Price Elasticity of Supply

The percentage change in

quantity supplied

resulting from a one (1) percent change in price.

Price

Quantity

A

B


Ranges of Elasticity

Perfectly Elastic infinite Relatively Elastic >1 Unitary or Unit =1 Relatively Inelastic <1 Perfectly Inelastic = 0


Elasticity of Supply Illustrated

Perfectly Inelastic

Perfectly Elastic

P

Q


Determinants of Elasticity of Supply

Flexibility or ability of sellers to change the amount of the good they produce.– Beachfront land vs. books, cars,

manufactured goods, etc.

– More elastic in the long run.



Computed as the percentage change in the quantity supplied divided by the percentage change in price.

Elasticityof Supply

=

Percentage Change in Quantity Supplied

Percentage Change in Price


Quick Quiz!

Define the elasticity of supply.

Explain why the price elasticity of supply might be different in the long run than in the short run.


Overview



Applications of Elasticity

“Can Good News for Farming Be Bad News For Farmers?”

What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties?


Apply Comparative Statics

Examine whether the supply or demand curve shifts.

Consider the direction the curve shifts.

Use supply-and-demand diagrams to see how the market equilibrium changes. Consider the state of elasticity.



SA

DA

Price

Quantity

$4.00

2000


Consider which direction the curve shifts.

SA

DA

Price

Quantity

$4.00

2000

SB

Technologycauses an increasein supply.


Use Supply-and-Demand diagram to see how the market changes.

SA

DA

Price

Quantity

$4.00

2000

SB

2400

$2.60


Compute Elasticity

ED =(2400 - 2000) / (2000)

($2.60 - $4.00) / ($4.00)

ED = 0.57 (Inelastic)


Observe the Change in Total Revenue

SA

DA

Price

Quantity

$4.00

2000

SB

2400

$2.60

TRSA = $8,000

TRSB = $5,760!



“Does a War on Drug Dealers Reduce Drug-Related Crime?”

What happens to drug-related crime such as theft and violent behaviour when police and custom officers impose higher penalties and stricter enforcement on drug dealers?



Going after drug dealers affects the supply of drugs such as heroin.

This policy reduces supply.The price of illegal drugs will increase.

Since the demand for addictive drugs is inelastic, drug users will need to spend more in total dollars on drugs.Drug-related crime will increase!


Drug Education Policy?Educating the public with regard to the bad

effects of drug use will affect the demand for illegal drugs.

This policy reduces demand.The price of illegal drugs will decrease.

Since the demand for addictive drugs is inelastic, drug users spend less in total dollars on drugs.Drug-related crime will decrease!



“Why did OPEC fail to keep the price of oil high in the long run?”

While the OPEC cartel has been successful in achieving short run bursts in oil prices, over the long run these high oil prices have not been maintained.



OPEC’s cartel policy consists of restricting the supply of oil.

The supply for oil will decrease.The price of oil will increase.In the short run, the demand for oil is

inelastic. A higher price for oil will increase the total revenue of OPEC.


Apply Comparative StaticsIn the long run, the demand for oil and the

supply of oil becomes more elastic. This will tend to dampen oil prices.

Why is oil inelastic in the short run?– oil is a necessity item– adding to the supply of oil is difficult

Over time elasticity increases due to conservation, alternate energy sources...


Conclusion

Elasticity is defined as. . .Price Elasticity of demand is. . .Income Elasticity of demand is. . .Price Elasticity of supply is. . .What are the relationships between

elasticity and total revenue or total consumer expenses?


Overview


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