Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank,...

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and JenningsSlides prepared by Nahid Khan

4-1

Chapter 4

Elasticity


4-2

Elasticity

• What do you think?– Could reducing the supply of illegal drugs cause an increase

in drug-related burglaries?– How would reducing the supply of illegal drugs change total

spending?


4-3

The effect of extra border patrols on the market for illicit drugs

Q(1000s of ounces/day)

P($

/ou

nce

)

50

50

S

D

80

40

S’

Total expenditure = P x QS $250 = $50 x 50S’ $320 = $80 x 40


4-4

Price elasticity of demand

• Elasticity– A measure of the extent to which quantity demanded and

quantity supplied respond to variations in price, income and other factors.

– An important determinant for various policy issues.


4-5


• Defined– Generally

A measure of the responsiveness of the quantity demanded of a good to a change in the price of that good.

– Formally The percentage change in the quantity demanded that results

from a 1 per cent change in its price.


4-6


• Measuring price elasticity of demand

Price in Change Percentage

DemandedQuantity in Change Percentage


4-7


• Assume – The price of pork falls by 2% and the quantity demanded

increases by 6%. Then the price elasticity of demand for pork is

32

6


4-8



• Observations • Price elasticity of demand will always be negative

(i.e. an inverse relationship between price and quantity).

• For convenience we drop the negative sign.




4-9



When is

> 1: elastic

< 1: inelastic

= 1: unit elastic




4-10

Elastic and inelastic demand

3

Price elasticityof demand

Inelastic

Unit elastic

Elastic

210


4-11


• What is the elasticity of demand for sushi?– Originally

Price = $2/piece Quantity demanded = 400 pieces/day

– New Price = $1.94/piece Quantity demanded = 404 pieces/day, then

Inelastic :3

1

Price in Change %

Quantity in Change %


4-12


• What is the elasticity of season ski passes?– Originally

Price = $1000 Quantity demanded = 10 000 passes/year

– New Price = $950 Quantity demanded = 12 000 passes/year, then

Elastic :5

20

Price in Change %

Quantity in Change %


4-13


• Determinants of price elasticity of demand– Substitution possibilities

Elasticity of table salt and snake antivenom

– Budget share Elasticity of key rings and hot tub

– Time Elasticity of postage stamps today and tomorrow


4-14

Price elasticity estimates for selected products

Good or service Price elasticity

Green peas 2.80

Restaurant meals 1.63

Automobiles 1.35

Electricity 1.20

Beer 1.19

Movies 0.87

Air travel (foreign) 0.77

Shoes 0.70

Coffee 0.25

Theatre, opera 0.18


4-15


• What do you think?– Why is the price elasticity of demand more than 14 times

larger for green peas than for theatre and opera performances?

– Is it budget share or substitution possibilities?


4-16


• Economic naturalist– How effective will a ‘fat tax’ be in solving the growing

problem of obesity?– Will higher taxes on cigarettes curb teenage smoking?– Why was the luxury tax on yachts such a disaster?


4-17

A graphical interpretation of price elasticity

• For small changes in price

PΔP

QΔQ elasticity Price

Where Q is the original quantity and P is the original price.


4-18

A graphical interpretation of price elasticity• Example

– Originally Price (P) = $100 Quantity (Q) = 20

– New Price (P) = $105 Quantity (Q) = 15

Elastic:55

25

1005

205


4-19

A graphical interpretation of price elasticity of demand

Quantity

Pri

ce

P

D

A

Q

P - P

Q + Q

Q

P

slopeQ

P A

1 at elasticity icePr


4-20

Calculating price elasticity of demand

20

Quantity

Pri

ce

1

D

A

2 3 4 5

16

12

8

4

45

20

intercept horizontal

intercept verticalslope

3

2

12

8

4

1x

3

8A


4-21

Calculating price elasticity of demand

20

Quantity

Pri

ce

1 2 3 4 5

16

12

8

4

D

A

Question:What is the price elasticityof demand when P = $4?


4-22

D1

D2

12

4 6 12

6

4

Price elasticity and the steepness of the demand curve

Quantity

Pri

ce

What is the price elasticity ofdemand when P = $4?

2

1

612

1

4

41D

2

126

1

4

42D


4-23

12

D1

D2

4 6 10 12

6

4

1

For D2 when P = $1


Quantity

Pri

ce

5

1

1261

10

12

D


4-24


12

Quantity

Pri

ce

D1

D2

4 6 10 12

6

4

1

ObservationIf two demand curves have a point in common, the steeper curve must be less elastic with respect to price at that point.


4-25

Price elasticity regions along a straight-line demand curve

Quantity

Pri

ce

b/2

a/2

a

b

1

1

1

ObservationPrice elasticity varies at every point along a straight-line demand curve.


4-26

Perfectly elastic demand curve

Quantity

Pri

ce

) y (elasticit demand

elastic Perfectly


4-27

Perfectly inelastic demand curve

Quantity

Pri

ce

)0 y (elasticit demand

inelasticPerfectly


4-28

4

4

6

A

B3

P

Q

1 then 6 and 3 Q P If

2 then 4 and 4 If Q P6

12

Example: The price elasticity of demand at two different points on a demand curve

Two points on a demand curve

Quantity

Pri

ce

0


4-29

A graphical interpretation of price elasticity

• The midpoint formula

2PPP

2QQQ

BA

BA

/

/

BA

BA

PPP

QQQ

and


4-30

Two points on a demand curve

Then the price elasticity ofdemand between A and B:

Quantity

Pri

ce

40

6

12

4

6

A

B3

P

Q

41

341/

642/ .


4-31

Elasticity and total expenditure

• Total expenditure = P x Q– Market demand measures the quantity (Q) at each price (P).

• Total expenditure = Total revenue


4-32

D

A

Total expenditure = $1000/day

The demand curve for movie tickets

12

Quantity (100s of tickets/day)

Pri

ce (

$/ti

cket

)

1 3 4 5 6

10

8

6

4

2

0 2


4-33

D

B



12


Pri

ce (

$/ti

cket

)

1 3 4 5 6

10

8

6

4

2

0 2


4-34


• What do you think?– Will increasing the market price always increase total

revenue?


4-35

DTotal expenditure = $1600/day


12


Pri

ce (

$/ti

cket

)

1 3 4 5 6

10

8

6

4

2

0 2


4-36

D



12


Pri

ce (

$/ti

cket

)

1 3 4 5 6

10

8

6

4

2

0 2


4-37


• General rule– A price increase will increase total revenue when the %

change in P is greater than the % change in Q.


4-38


12


Pri

ce (

$/ti

cket

)

1 3 4 5 6

10

8

6

4

2

0 2


4-39

Total expenditure as a function of price

Price ($/ticket) Total expenditure ($/day)

12 0

10 1000

8 1600

6 1800

4 1600

2 1000

0 0


4-40

Total expenditure as a function of price

1800

Price ($/ticket)

To

tal

ex

pe

nd

itu

re (

$/d

ay

)

2 6 8 10 12

1600

1000

0 4

12


Pri

ce

($

/tic

ke

t)

1 3 4 5 6

10

8

6

4

2

0 2

Total revenue is at a maximum at themidpoint on a straight-line demand curve.


4-41


• What do you think?– Should a rock band raise or lower its price to increase total

revenue?

• Assume

3

5000

20$

Q

P


4-42


• What do you think?– Should a rock band raise or lower its price to increase total

revenue?

• Then– Total revenue = $20 x 5000 =

$100 000/week– If P is increased 10%, Q will decrease 30%

Total revenue = $22 x 3500 = $77 000/week

– If P is lowered 10%, Q will increase 30% Total revenue = $18 x 6500 = $177 000/week


4-43


• Rule– When price elasticity is greater than 1, changes in price and

changes in total expenditures always move in opposite directions.

– When price elasticity is less than 1, changes in price and changes in total expenditures always move in the same direction.


4-44


• Measuring changes in quantity demanded for sausage rolls due to a change in – price of pies– price of sausage meat– income– income when sausage roll is a normal good– income when sausage roll is an inferior good.


4-45


• Cross-price elasticity of demand– The percentage by which quantity demanded of the first

good changes in response to a 1 per cent change in the price of the second good.

• Substitute goods When the cross-price elasticity of demand is positive.

– Complement goods When the cross-price elasticity of demand is negative.


4-46


• Income elasticity of demand– The percentage by which quantity demanded changes in

response to a 1 per cent change in income.– Normal goods

Income elasticity is positive.

– Inferior goods Income elasticity is negative.


4-47

The price elasticity of supply

• Price elasticity of supply– The percentage change in the quantity supplied that occurs

in response to a 1 per cent change in price.

PP

QQ supply of elasticity Price

slope

1

Q

P supply of elasticity Price


4-48

15

5B

P

Q

1515155 B

S

12

4A

1412124 A

Calculating the price elasticity of supply graphically

Quantity

Pri

ce

0


4-49

2

4

2

A

2224 A

3

5B

3

5135 B

A supply curve for which price elasticity declines as quantity rises

Quantity

Pri

ce

0

S


4-50

A perfectly inelastic supply curve

Quantity of land in New Zealand

(1000s of hectares)

Pri

ce (

$/h

ecta

re)

0

S

Elasticity = 0 at everypoint along a verticalsupply curve

What is the price elasticity of supply of lakefront land in Taupo, New Zealand?


4-51

Quantity of lemonade

(cups/day)

Pri

ce (

cen

ts/c

up

)

0

14 S

If MC is constant, then theprice elasticity of supply at every pointalong a horizontal supply curve is infinite

What is the price elasticity of supply of lemonade?

A perfectly elastic supply curve


4-52


• Determinants of supply elasticity– Flexibility of inputs– Mobility of inputs– Ability to produce substitute inputs– Time


4-53


• Thinking as an economist– Why are petrol prices so much more volatile than car prices?

Differences in markets• Demand for petrol is more inelastic.• Petrol market has larger and more frequent supply shifts.


4-54

Greater volatility in petrol prices than in car prices

Quantity(millions of litres/day)

Pri

ce (

$/lit

re)

0 6

1.69

S’

D

1.02

7.2

S

Petrol


4-55

Greater volatility in petrol prices than in car prices

Pri

ce (

$100

0s/c

ar)

D

17

S’

11Quantity

(1000s of cars/day)Cars

16.4

12

S

Cars


4-56


• What do you think?– How would elasticity of supply and fluctuating demand

impact price volatility?


4-57


• Unique and essential inputs: The ultimate supply bottleneck– Why does Guus Hiddink get paid more than $20 million over

a four-year contract?

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