ECON 202: Principles of MicroeconomicsChapter 6Elasticity: The Responsiveness of Demand and Supply

Elasticity: The Responsiveness of Demand and Supply 2ECON 202: Princ. of Microeconomics

Elasticity: The Responsiveness of Demand and Supply1. Price elasticity of demand.2. Determinants of the price elasticity of demand.3. Price elasticity of demand and total revenue.4. Other demand elasticities.5. Price elasticity of supply.

Elasticity: The Responsiveness of Demand and Supply 3ECON 202: Princ. of Microeconomics

Whats elasticity?

A measure of how much one economic variable responds to changes in another economic variable.

Price elasticity of demand. How much quantity demanded varies when price changes.

It is an important tool for economic analysis. Valuable information for producers. How quantity demanded reacts to changes in own prices,

competitors prices or income. Useful to explain magnitudes of changes in price and quantity

after a shift in demand or supply curve.

Elasticity: The Responsiveness of Demand and Supply 4ECON 202: Princ. of Microeconomics

1. Price Elasticity of Demand

From law of demand: Price falls, quantity demanded increases. But, how much?

To avoid problems of comparability between different goods (tons vs. gallons), we use percentages:

Elasticity: The Responsiveness of Demand and Supply 5ECON 202: Princ. of Microeconomics

Case A: Price is 10, quantity 50. Price goes up to 12, quantity goes down to 45. Price elasticity of demand: -10% / 20% = - 0.5

Case B: Price is 20, quantity 100. Price goes down to 18, quantity goes up to 85. Price elasticity of demand: 15% / -10% = - 1.5

But, what happens if we start from the end point? 11.1% / -16.6% = - 0.66 17.6% / 11.1% = - 1.58

1. Price Elasticity of Demand

Elasticity: The Responsiveness of Demand and Supply 6ECON 202: Princ. of Microeconomics

1. Price Elasticity of Demand

Midpoint formula

Case A: ( -5 / 47.5 ) / ( 2 / 11 ) = - 0.58 Case B: ( 15 / 92.5 ) / ( -2 / 19 ) = - 1.54

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demandedquantity in change Perc.dmd. elast. Price

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Elasticity: The Responsiveness of Demand and Supply 7ECON 202: Princ. of Microeconomics

1. Price Elasticity of Demand If elasticity is between 0 and -1:

Change in price causes a change less than proportional in quantity demanded.

Demand is inelastic. If elasticity is smaller than -1:

Change in price causes a change more than proportional in quantity demanded.

Demand is elastic. If elasticity is equal to -1:

Change in price cause a change proportional in quantity demanded.

Demand is unit-elastic.

Elasticity: The Responsiveness of Demand and Supply 8ECON 202: Princ. of Microeconomics

1. Price Elasticity of Demand

Price elast. of demand 1:(40/60)/(-10/30) = -2

Price elast. of demand 2:(10/45)/(-10/30) = -.67

The bigger the elasticity in absolute value, the more elastic the demand.

The flatter the curve, the more elastic the demand.

Elasticity: The Responsiveness of Demand and Supply 9ECON 202: Princ. of Microeconomics

1. Price Elasticity of DemandPolar cases: Perfectly inelastic demand.

Quantity demanded is completely unresponsive to price.

Price elasticity of demand equals zero.

Perfectly elastic demand. Quantity demanded is

infinitely responsive to price Price elasticity of demand

equals infinity.

Elasticity: The Responsiveness of Demand and Supply 10ECON 202: Princ. of Microeconomics

2. Determinants of the Price Elasticity of Demand Availability of close substitutes.

When more substitutes available, more elastic demand. Movie theaters in CS and movie theaters in Houston.

Passage of time. Reaction to price changes can take some time. The more time passes, the more elastic the demand for a

product becomes. Change of vehicle before a rise in gasoline price.

Luxuries vs. Necessities. Demand curve for a luxury is more elastic than the demand

curve for a necessity. Demand for necessities (food, clothes, gasoline) does not

depend much on price.

Elasticity: The Responsiveness of Demand and Supply 11ECON 202: Princ. of Microeconomics

2. Determinants of the Price Elasticity of Demand Definition of the market.

The more narrowly defined a market, the more substitutes available, and the more elastic the demand.

Apple Cinnamon Cheerios vs. breakfast cereal. Share of a good in a consumers budget.

The bigger the share in the consumers budget, the more elastic the good.

Increases in price affect considerably purchasing power, then reaction to this change can be significant.

Houses, cars.

Elasticity: The Responsiveness of Demand and Supply 12ECON 202: Princ. of Microeconomics

Goods or services with Elastic Demand

Metals 1.52 Electrical engineering products 1.39 Mechanical engineering products 1.30 Furniture 1.26 Motor vehicles 1.14 Instrument engineering products 1.10 Professional services 1.09 Transportation services 1.03

Elasticity: The Responsiveness of Demand and Supply 13ECON 202: Princ. of Microeconomics

Goods or services with Inelastic Demand

Gas, electricity, and water 0.92 Drinks (all types) 0.78 Clothing 0.64 Tobacco 0.61 Banking and insurance services 0.56 Agricultural and fish products 0.42 Books, magazines and newspapers 0.34 Food 0.12 Oil 0.05

Elasticity: The Responsiveness of Demand and Supply 14ECON 202: Princ. of Microeconomics

3. Price Elasticity of Demand and Total Revenue Total revenue: price x units sold

Elasticity: The Responsiveness of Demand and Supply 15ECON 202: Princ. of Microeconomics

3. Price Elasticity of Demand and Total RevenueWhen demand inelastic: A cut in price increases quantity demanded less than

proportionally. Total revenue decreases.

When demand elastic: A cut in price increase quantity demanded more than

proportionally. Total revenue increases.

When demand unit-elastic: A cut in price increase quantity demanded proportionally.

Total revenue does not change.

Elasticity: The Responsiveness of Demand and Supply 16ECON 202: Princ. of Microeconomics

3. Price Elasticity of Demand and Total Revenue Price elasticity is not constant along a linear demand

Price elast. of demand at:p = 7 : (2/3)/(-1/6.5) = - 4.3p = 2 : (2/13)/(-1/1.5) = - 0.23p = 4 : (2/8)/(1/4) = -1

Elasticity: The Responsiveness of Demand and Supply 17ECON 202: Princ. of Microeconomics

3. Price Elasticity of Demand and Total Revenue

Elasticity: The Responsiveness of Demand and Supply 18ECON 202: Princ. of Microeconomics

4. Other Demand ElasticitiesCross-Price Elasticity of Demand

If products are substitutes: Cross-price elasticity of demand is positive. Summer vacation destinations: Cancun vs. Puerto Vallarta.

If products are complements Cross-price elasticity of demand is negative. Airline tickets and hotel rooms.

If products are unrelated Cross-price elasticity of demand is zero.

Elasticity: The Responsiveness of Demand and Supply 19ECON 202: Princ. of Microeconomics

4. Other Demand ElasticitiesIncome Elasticity of Demand

If the income elasticity is positive and smaller than 1: Good is normal and necessity. Food expenses.

If the income elasticity is positive and greater than 1: Good is normal and luxury. Designer clothing.

If the income elasticity is negative Good is inferior. Inter-city bus service.

Elasticity: The Responsiveness of Demand and Supply 20ECON 202: Princ. of Microeconomics

4. Other Demand Elasticities The level of income has a important effect on income

elasticities of demand. Income elasticity of demand for food.

Elasticity: The Responsiveness of Demand and Supply 21ECON 202: Princ. of Microeconomics

4. Other Demand Elasticities

Goods or services Income Elastic: Airline travel 5.82 Movies 3.41 Foreign travel 3.08 Electricity 1.94 Restaurant meals 1.61 Local buses and trains 1.38 Haircuts 1.36 Cars 1.07

Elasticity: The Responsiveness of Demand and Supply 22ECON 202: Princ. of Microeconomics

4. Other Demand Elasticities

Goods or services Income Inelastic: Tobacco 0.86 Alcoholic beverages 0.62 Furniture 0.53 Clothing 0.51 Newspapers 0.38 Telephone 0.32 Food 0.14

Elasticity: The Responsiveness of Demand and Supply 23ECON 202: Princ. of Microeconomics

4. Other Demand Elasticities

Price elasticity of demand for beer -0.23

Cross-price elasticity of demand between beer and wine 0.31

Cross-price elasticity of demand between beer and spirits 0.15

Income elasticity of demand for beer -0.09

Income elasticity of demand for wine 5.03

Income elasticity of demand for spirits 1.21

Elasticities in the Market for Alcoholic Beverages

Elasticity: The Responsiveness of Demand and Supply 24ECON 202: Princ. of Microeconomics

4. Price Elasticity of Supply

In an analogous way to demand

Because supply curves are upward sloping, Price Elasticity of Supply is positive.

If smaller than 1: inelastic. If greater than 1: elastic. If equal to 1 : ?

Elasticity: The Responsiveness of Demand and Supply 25ECON 202: Princ. of Microeconomics

4. Price Elasticity of Supply

Price elasticity of supply depends on the availability of inputs and capital to increase production.

In a short period of time, supply will be inelastic. After some time has passed, supply will become more

elastic, as more resources can be dedicated to production.

If a necessary input is not available, supply can be inelastic.

Elasticity: The Responsiveness of Demand and Supply 26ECON 202: Princ. of Microeconomics

Using Price Elasticity of Supply to Predict Changes in Price Effect on market price of a shift in demand depends on

elasticity of the supply curve.

Elasticity: The Responsiveness of Demand and Supply 27ECON 202: Princ. of Microeconomics

Using Price Elasticity of Supply to Predict Changes in Price In the last 30 years prices of oil have fluctuated

considerably. From $11 per barrel to $75 per barrel.

Supply of oil is relatively inelastic, since exploring, drill and start exploiting new reserves is a lengthy process.

Demand of oil derivatives (gasoline) is inelastic. Shifts in supply were common because of the

coordination of oil producers countries. (OPEC)

Elasticity: The Responsiveness of Demand and Supply 28ECON 202: Princ. of Microeconomics

Using Price Elasticity of Supply to Predict Changes in Price

With more elastic supply curves, changes in prices are more moderate.

ECON 202: Principles of MicroeconomicsChapter 6Elasticity: The Responsiveness of Demand and Supply

ECON 202: Principles of MicroeconomicsElasticity: The Responsiveness of Demand and SupplyWhats elasticity?1. Price Elasticity of Demand1. Price Elasticity of Demand1. Price Elasticity of Demand1. Price Elasticity of Demand1. Price Elasticity of Demand1. Price Elasticity of Demand2. Determinants of the Price Elasticity of Demand2. Determinants of the Price Elasticity of DemandGoods or services with Elastic DemandGoods or services with Inelastic Demand3. Price Elasticity of Demand and Total Revenue3. Price Elasticity of Demand and Total Revenue3. Price Elasticity of Demand and Total Revenue3. Price Elasticity of Demand and Total Revenue4. Other Demand Elasticities4. Other Demand Elasticities4. Other Demand Elasticities4. Other Demand Elasticities4. Other Demand Elasticities4. Other Demand Elasticities4. Price Elasticity of Supply4. Price Elasticity of SupplyUsing Price Elasticity of Supply to Predict Changes in PriceUsing Price Elasticity of Supply to Predict Changes in PriceUsing Price Elasticity of Supply to Predict Changes in PriceECON 202: Principles of Microeconomics