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Lecture

Chapter 5_Slides.ppt

56 Pages
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Department
Economics
Course Code
ECN 104
Professor
Tsogbadral Galaabaatar

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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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