1
ElasticityElasticity
2
““Demand Shifters” [TIMER]Demand Shifters” [TIMER]1.1. TTaste [aste [directdirect]]2.2. IIncomencome [normal-[normal-directdirect] [inferior-] [inferior-iinnvveerrssee]]3.3. MMarketarket Size [number ofSize [number of consumers-consumers-directdirect]]4.4. EExpectationsxpectations [of consumers about future[of consumers about future *price*price--directdirect, , about futureabout future availability-availability-iinnvveerrssee,, or about futureor about future income–income–directdirect..5.5. RRelatedelated GoodGood *Prices*Prices [substitutes-[substitutes-directdirect]] [complements-[complements-iinnvveerrssee]]
Changes in “D” [curve]Changes in “D” [curve]1. Non price change [“TIMER”]2. Whole “D” curve shifts[There is a change in “QD” but it isnot caused by a change in “price.”[QD-”single price”QD-”single price”; D-”all prices”D-”all prices”]
ComplementComplement[[iinnvveerrssee]]
SubstituteSubstitute
[[DirectDirect]]ButterButter BreadBread BagelsBagels
PP
DD33 DD11 DD33
QDQD33 QDQD11 QDQD22
DD11 DD22
PPPP11
QDQD11 QDQD22
PP22
DD11
DD22
DD
PP
3
What is Elasticity?What is Elasticity?What is Elasticity?What is Elasticity?
A term economists use to describe sensitivity of quantity
demanded or supplied to a change in price.
4
The percentage change in quantity demandedquantity demanded
divided by the percentage change in priceprice
How do we measure the Price How do we measure the Price Elasticity of Demand?Elasticity of Demand?
5
Price Elasticity of Price Elasticity of DemandDemand
Price Elasticity of Price Elasticity of DemandDemand
Ed = % change in Qd
% change in P
Ed = % in Qd
% in P
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Notes on ENotes on EddNotes on ENotes on Edd
• Ed negative, but ignore negative
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Classifying EClassifying EddClassifying EClassifying Edd
• Ed = 1 Unitary elasticity• Ed > 1 Elastic demand• Ed < 1 Inelastic demand
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Extreme elasticitiesExtreme elasticitiesExtreme elasticitiesExtreme elasticities
• Ed = 0 Perfectly inelastic (vertical demand curve)
• Ed = Perfectly elastic (horizontal demand curve)
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DP
Q
Perfectly inelastic Perfectly inelastic demanddemand
P
Q
D
Perfectly elastic Perfectly elastic demanddemand
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When consumers are When consumers are very very sensitivesensitive to a price change to a price change
what does the demand curve what does the demand curve look like?look like?
Very horizontal
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When consumers are less When consumers are less sensitive to a price change sensitive to a price change
what does the demand curve what does the demand curve look like?look like?
Very vertical
1212
135
64
90
75
220
70
4030
NewNew
.2-inelastic50%10%15050
2-elastic10%20%80200
0.33-inelastic75%25%12040
3-elastic.6/.2
20%5/25
60%60/100
10025
InitialInitial
Price Elasticity of
Demand
% change in
P
% change in Qd
QuantityPrice
Ed = % in Qd
% in P
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Estimating the Elasticity of DemandEstimating the Elasticity of Demand3 Key Questions:3 Key Questions:
1. Subs? 2. Necessity? 3. Expensive?1. Subs? 2. Necessity? 3. Expensive?
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What factors influence Demand What factors influence Demand Sensitivity (elasticity)?Sensitivity (elasticity)?
What factors influence Demand What factors influence Demand Sensitivity (elasticity)?Sensitivity (elasticity)?
• Number and closeness of Substitute goods
• % of income a good makes up
• Basic goods or “needs”
• Time to adjust
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What do substitutes have to What do substitutes have to do with sensitivity?do with sensitivity?
The more substitutes a good has, the more sensitive consumers are to a price change
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P
Q0
P
Q0
A B
D D
Which demand curve is for spark plugs and which for Coca-Cola?
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The lower the % of ones budget a good is, the less sensitive consumers are to a price change
What does % of income a good makes What does % of income a good makes up have to do with sensitivity?up have to do with sensitivity?
SALT!
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The greater the need a good has to the consumer, the less sensitive the consumer is to a price change
What do basic goods have What do basic goods have to do with sensitivity?to do with sensitivity?
WATER!
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The more time to adjust, the more sensitive consumers are to a price change
What does time have to What does time have to do with sensitivity?do with sensitivity?
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If demand is elasticelastic - revenue goes down
If demand is inelasticinelastic - revenue goes up
If a college raises tuition, If a college raises tuition, what happens to revenue?what happens to revenue?
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Elasticity and Total Elasticity and Total Revenue (TR)Revenue (TR)
Elasticity and Total Elasticity and Total Revenue (TR)Revenue (TR)
TR = PQ (price times quantity)
Ed = % change in Qd
% change in P
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Q
P
D
When prices are low,
TR
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUEPRICE ELASTICITY & TOTAL REVENUE
So is total revenue
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Q
P
D
Total revenue rises with price to a point...
TR
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUEPRICE ELASTICITY & TOTAL REVENUE
24
Q
P
D
Total revenue riseswith price to a
point...
then declines
TR
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUEPRICE ELASTICITY & TOTAL REVENUE
25
Q
P
D
Total revenue riseswith price to a
point...
then declines
TR
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUEPRICE ELASTICITY & TOTAL REVENUE
26
Q
P
D
Total revenue riseswith price to a
point...
then declines
TR
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUEPRICE ELASTICITY & TOTAL REVENUE
Total Revenue TestTotal Revenue Test
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Q
P
D
Total revenue riseswith price to a
point...
then declines
InelasticInelasticDemandDemand
InelasticInelasticDemandDemand
TR
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUEPRICE ELASTICITY & TOTAL REVENUE
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Q
P
D
Total revenue riseswith price to a
point...
then declines
ElasticElasticDemandDemand
ElasticDemand
InelasticInelasticDemandDemand
TR
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUEPRICE ELASTICITY & TOTAL REVENUE
InelasticInelasticDemandDemand
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Q
P
D
Total revenue riseswith price to a
point...
then declines
ElasticElasticDemandDemand
ElasticElasticDemandDemand
InelasticInelasticDemandDemand
TR
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUEPRICE ELASTICITY & TOTAL REVENUE
InelasticInelasticDemandDemand
UnitElastic
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Summary, elasticity, price changes, Summary, elasticity, price changes, and total revenueand total revenue
Summary, elasticity, price changes, Summary, elasticity, price changes, and total revenueand total revenue
Total revenue falls
Total revenue rises
Ed < 1
Total revenue rises
Total revenue falls
Ed > 1
Total revenue same
Total revenue same
Ed = 1
Price increase
Price Decrease
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The percentage change in the quantity demanded of one commodity resulting from a 1 percent change in price of another commodity
What is Cross Elasticity What is Cross Elasticity of Demand?of Demand?
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E E cc = = % % Quantity of X Quantity of X
%% Price of Y Price of Y
E E cc = = % % Quantity of X Quantity of X
%% Price of Y Price of Y
Cross Elasticity of DemandCross Elasticity of Demand
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If E E cc negative - complements (steak
& steak sauce)
If E E cc positive - substitutes (butter &
margarine)
Unrelated goods should have a E E cc close to zero
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The ratio of the percentage change in quantity
demanded to the percentage change in income
What is Income What is Income Elasticity of Demand?Elasticity of Demand?
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E E ii = = % % Quantity Quantity % % Income Income
E E ii = = % % Quantity Quantity % % Income Income
• E i > 0 Normal goods• E i < 0 Inferior goods• E i > 1 Luxury goods• 0 < E i < 1 Necessities
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When does a good face When does a good face an income elastic an income elastic demand curve?demand curve?
When does a good face When does a good face an income elastic an income elastic demand curve?demand curve?
A 1% change in income generates a greater than 1% change quantity demanded
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When does a good face When does a good face an income inelastic an income inelastic
demand curve?demand curve?
When does a good face When does a good face an income inelastic an income inelastic
demand curve?demand curve?A 1% change in income
generates a less than 1% change quantity demanded
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What is Price Elasticity What is Price Elasticity of Supply?of Supply?
What is Price Elasticity What is Price Elasticity of Supply?of Supply?
The ratio of the percentage change in quantity supplied to the percentage change in price
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E E ss = = % % Q supplied Q supplied % % Price Price
E E ss = = % % Q supplied Q supplied % % Price Price
• E s = 1 Unitary• E s > 1 Elastic• E s < 1 Inelastic
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Extreme cases of E Extreme cases of E ss Extreme cases of E Extreme cases of E ss • E s = 0, perfectly inelastic
(vertical supply curve
• E s = , perfectly elastic (horizontal supply curve)
SP
Q
SP
Q
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Does time effect Supply Does time effect Supply Elasticities?Elasticities?
Does time effect Supply Does time effect Supply Elasticities?Elasticities?
Yes! The more time, the more elastic the supply curve
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Which type of good Which type of good would be best to tax to would be best to tax to raise the most revenue?raise the most revenue?
Which type of good Which type of good would be best to tax to would be best to tax to raise the most revenue?raise the most revenue?
Goods that face a price inelastic demand curve will generate the most revenue
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TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
01
010
Units consumed per meal
Units consumed per meal
30
20
10
To
tal
Uti
lity
(u
tils
)M
arg
ina
l U
tili
ty (
uti
ls)
10 8 6 4 2 0 -2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
44
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
01
010 10
Units consumed per meal
Units consumed per meal
30
20
10
To
tal
Uti
lity
(u
tils
)M
arg
ina
l U
tili
ty (
uti
ls)
10 8 6 4 2 0 -2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
45
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
012
01018
10 8
Units consumed per meal
Units consumed per meal
30
20
10
To
tal
Uti
lity
(u
tils
)M
arg
ina
l U
tili
ty (
uti
ls)
10 8 6 4 2 0 -2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
46
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
0123
0101824
10 8 6
0 1 2 3 4 5 6 7
Units consumed per meal
Units consumed per meal
30
20
10
To
tal
Uti
lity
(u
tils
)M
arg
ina
l U
tili
ty (
uti
ls)
10 8 6 4 2 0 -2
1 2 3 4 5 6 7
47
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
01234
010182428
10 8 6 4 Units consumed per meal
Units consumed per meal
30
20
10
To
tal
Uti
lity
(u
tils
)M
arg
ina
l U
tili
ty (
uti
ls)
10 8 6 4 2 0 -2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
48
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
012345
01018242830
10 8 6 4 2
Units consumed per meal
Units consumed per meal
30
20
10
To
tal
Uti
lity
(u
tils
)M
arg
ina
l U
tili
ty (
uti
ls)
10 8 6 4 2 0 -2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
49
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
0123456
0101824283030
10 8 6 4 2 0
Units consumed per meal
Units consumed per meal
30
20
10
To
tal
Uti
lity
(u
tils
)M
arg
ina
l U
tili
ty (
uti
ls)
10 8 6 4 2 0 -2
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
50
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
01234567
010182428303028
10 8 6 4 2 0 -2
Units consumed per meal
Units consumed per meal
30
20
10
To
tal
Uti
lity
(u
tils
)M
arg
ina
l U
tili
ty (
uti
ls)
10 8 6 4 2 0 -2
TU
MU
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
51
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
01234567
010182428303028
10 8 6 4 2 0 -2
Units consumed per meal
Units consumed per meal
30
20
10
To
tal
Uti
lity
(u
tils
)M
arg
ina
l U
tili
ty (
uti
ls)
10 8 6 4 2 0 -2
TU
MU
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
ObserveDiminishing
MarginalUtility