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Economics
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ECN 104
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Lecture

Description

Chapter 5
Elasticity and Its Application
Copyright © 2011 Nelson Education Limited In this chapter,
look for the answers to these questions:
What is elasticity? What kinds of issues can
elasticity help us understand?
What is the price elasticity of demand?
How is it related to the demand curve?
How is it related to revenue & expenditure?
What is the price elasticity of supply?
How is it related to the supply curve?
What are the income and cross-price elasticities of
demand?
Copyright © 2011 Nelson Education Limited A scenario…
You design websites for local businesses.
You charge $200 per website,
and currently sell 12 websites per month.
Your costs are rising
(including the opportunity cost of your time),
so you consider raising the price to $250.
The law of demand says that you won’t sell as
many websites if you raise your price.
How many fewer websites? How much will your
revenue fall, or might it increase?
Copyright © 2011 Nelson Education Limite3 Elasticity
Basic idea:
Elasticity measures how much one variable
responds to changes in another variable.
• One type of elasticity measures how much
demand for your websites will fall if you raise
your price.
Definition:
Elasticity is a numerical measure of the
responsiveness of Q or Q to one of its
determinants.
Copyright © 2011 Nelson Education Limited Price Elasticity of Demand
Percentage change in Q d
Price elasticity =
of demand Percentage change in P
Price elasticity of demand measures how
d
much Q responds to a change in P.
Loosely speaking, it measures the price-
sensitivity of buyers’ demand.
Copyright © 2011 Nelson Education Limited Price Elasticity of Demand
d
Price elasticity Percentage change in Q
=
of demand Percentage change in P
P
Example:
P rises
Price elasticity by 10% P 2
of demand
P 1
equals D
15% Q
= 1.5 Q 2 Q1
10% Q falls
by 15%
Copyright © 2011 Nelson Education Limited Price Elasticity of Demand
d
Price elasticity Percentage change in Q
=
of demand Percentage change in P
P
Along a D curve, P and Q
move in opposite directions,
P2
which would make price
elasticity negative. P1
D
We will drop the minus sign
and report all price Q
elasticities as Q 2 Q 1
positive numbers.
Copyright © 2011 Nelson Education Limited Calculating Percentage Changes
Standard method
of computing the
Demand for percentage (%) change:
your websites end value – start value
P x 100%
start value
$250 B
Going from A to B,
$200 A
the % change in P equals
D ($250–$200)/$200 = 25%
8 12 Q Going from B to A,
($200-$250)/$250 =-20%
Copyright © 2011 Nelson Education Limited Calculating Percentage Changes
Problem:
The standard method gives
Demand for different answers depending
your websites on where you start.
P From A to B,
$250 B P rises 25%, Q falls 33%,
elasticity = 33/25 = 1.33
$200 A
From B to A,
D
P falls 20%, Q rises 50%,
8 12 Q elasticity = 50/20 = 2.50
Copyright © 2011 Nelson Education Limited Calculating Percentage Changes
So, we instead use the midpoint method:
end value – start value
midpoint x 100%
The midpoint is the number halfway between
the start & end values, the average of those
values.
It doesn’t matter which value you use as the
“start” and which as the “end” – you get the
same answer either way!
Copyright © 2011 Nelson Education Limited Calculating Percentage Changes
Using the midpoint method, the % change
in P equals
$250 – $200
$225 x 100% = 22.2%
The % change in Q equals
12 – 8 x 100% = 40.0%
10
The price elasticity of demand equals
40/22.2 = 1.8
Copyright © 2011 Nelson Education Limited A C T I V E L E A R N I N G 1
Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:
if P = $70, Q = 5000
if P = $90, Q = 3000
Copyright © 2011 Nelson Education Limited A C T I V E L E A R N I N G 1
Answers
Use midpoint method to calculate
% change in Q d
(5000 – 3000)/4000 = 50%
% change in P
($90 – $70)/$80 = 25%
The price elasticity of demand equals
50%
25% = 2.0
Copyright © 2011 Nelson Education Limited What determines price elasticity?
To learn the determinants of price elasticity,
we look at a series of examples.
Each compares two common goods.
In each example:
Suppose the prices of both goods rise by 20%.
d
The good for which Q falls the most (in percent)
has the highest price elasticity of demand.
Which good is it? Why?
What lesson does the example teach us about the
determinants of the price elasticity of demand?
Copyright © 2011 Nelson Education Limited EXAMPLE 1:
Breakfast cereal vs. Sunscreen
The prices of both of these goods rise by 20%.
d
For which good does Q drop the most? Why?
Breakfast cereal has close substitutes
(e.g., pancakes, Eggo waffles, leftover pizza),
so buyers can easily switch if the price rises.
Sunscreen has no close substitutes,
so consumers would probably not
buy much less if its price rises.
Lesson: Price elasticity is higher when close
substitutes are available.
Copyright © 2011 Nelson Education Limited EXAMPLE 2:
“Blue Jeans” vs. “Clothing”
The prices of both goods rise by 20%.
For which good does Q drop the most? Why?
For a narrowly defined good such as
blue jeans, there are many substitutes
(khakis, shorts, Speedos).
There are fewer substitutes available for
broadly defined goods.
Lesson: Price elasticity is higher for narrowly
defined goods than broadly defined ones.
Copyright © 2011 Nelson Education Limited EXAMPLE 3:
Insulin vs. Caribbean Cruises
The prices of both of these goods rise by 20%.
For which good does Q drop the most? Why?
To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or no
decrease in demand.
A cruise is a luxury. If the price rises,
some people will forego it.
Lesson: Price elasticity is higher for luxuries
than for necessities.
Copyright © 2011 Nelson Education Limited EXAMPLE 4:
Gasoline in the Short Run vs. Gasoline
in the Long Run
The price of gasoline rises 20%. Does Q drop
more in the short run or the long run? Why?
There’s not much people can do in the
short run, other than ride the bus or carpool.
In the long run, people can buy smaller cars
or live closer to where they work.
Lesson: Price elasticity is higher in the
long run than the short run.
Copyright © 2011 Nelson Education Limited The Determinants of Price Elasticity:
A Summary
The price elasticity of demand depends on:
the extent to which close substitutes are
available
whether the good is a necessity or a luxury
how broadly or narrowly the good is defined
the time horizon – elasticity is higher in the
long run than the short run
Copyright © 2011 Nelson Education Limited The Variety of Demand Curves
The price elasticity of demand is closely related
to the slope of the demand curve.
Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
Five different classifications of D curves.…
Copyright © 2011 Nelson Education Limited “Perfectly inelastic demand” (one extreme case)
Price elasticity% change in Q 0%
= = = 0
of demand % change in P 10%
D curve: P
D
vertical
P
Consumers’ 1
price sensitivity:
P2
none
P falls Q
Elasticity: by 10% Q1
0
Q changes
by 0%
Copyright © 2011 Nelson Education Limited “Inelastic demand”
Price elasticity % change in Q < 10%
= = < 1
of demand % change in P 10%
D curve: P
relatively steep
P
Consumers’ 1
price sensitivity:
P 2
relatively low D
P falls Q
Elasticity: by 10% Q1Q 2
< 1
Q rises less
than 10%
Copyright © 2011 Nelson Education Limited “Unit elastic demand”
Price elasticity% change in Q 10%
= = = 1
of demand % change in P 10%
D curve: P
intermediate slope
P
Consumers’ 1
price sensitivity:
P2 D
intermediate
P falls Q
Elasticity: by 10% Q1 Q 2
1
Q rises by 10%
Copyright © 2011 Nelson Education Limited “Elastic demand”
Price elasticity% change in Q > 10%
= = > 1
of demand % change in P 10%
D curve: P
relatively flat
P
Consumers’ 1
price sensitivity:
P2 D
relatively high
P falls Q
Elasticity: by 10% Q 1 Q2
> 1
Q rises more
than 10%
Copyright © 2011 Nelson Education Limited “Perfectly elastic demand” (the other extreme)
Price elasticity% change in Q any %
= = = infinity
of demand % change in P 0%
D curve: P
horizontal
P = P D
Consumers’ 2 1
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q 1 Q 2
infinity
Q changes
by any %
Copyright © 2011 Nelson Education Limited Elasticity of a Linear Demand Curve
P The slope
200% of a linear
$30 E = 40% = 5.0 demand
67% curve is
20 E = = 1.0 constant,
67%
40% but its
10 E = = 0.2 elasticity
200% is not.
$0 Q
0 20 40 60
Copyright © 2011 Nelson Education Limited Price Elasticity and Total Revenue
Continuing our scenario, if you raise your price
from $200 to $250, would your revenue rise or fall?
Revenue = P x Q
A price increase has two effects on revenue:
• Higher P means more revenue on each unit
you sell.
• But you sell fewer units (lower Q),
due to Law of Demand.
• Which of these two effects is bigger?
It depends on the price elasticity of demand.
Copyright © 2011 Nelson Education Limited Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P
Revenue = P x Q
If demand is elastic, then
price elast. of demand > 1
% change in Q > % change in P
The fall in revenue from lower Q is greater
than the increase in revenue from higher P,
so revenue falls.
Copyright © 2011 Nelson Education Limited Price Elasticity and Total Revenue
Elastic demand
increDemand for
(elasticity = 1.8) P reveyour websiteslost
to higher P revenue
If P = $200,
Q = 12 and due to
$250 lower Q
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
Copyright © 2011 Nel

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