Unformatted text preview: 4/7/2011 Economics 1B UC Davis UC D i Professor Siegler Spring 2011 I. Introduction to Elasticity
Elasticity is a unit free measure of the Elasticity is a unitfree measure of the responsiveness of one variable to a change in another variable, holding all else equal. Elasticity can be applied to anything:
How much do polling numbers respond to negative political ads? How much does unemployment respond when interest rates rise? Today we will be discussing elasticity within the context of the supply and demand model.
2 1 4/7/2011 II. Price Elasticity of Demand The Law of Demand says that buyers will buy more The Law of Demand says that buyers will buy more if prices fall and buy less as prices increase, holding all else equal. The Law of Demand says nothing about how much more or less is purchased as prices change. To measure the responsiveness of buyers, we need to introduce the concept of the price elasticity of demand, which is also sometimes called "elasticity of demand," "demand elasticity," or even just "elasticity" if the context is clear.
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Defining the Price Elasticity of Demand: Defining the Price Elasticity of Demand: 4 2 4/7/2011 II. Price Elasticity of Demand
Terminology for Price Elasticity of Demand T i l f P i El ti it f D d
Perfectly Inelastic Inelastic Elastic Unit Elastic Perfectly Elastic Value of Price Elasticity of Demand
0 (vertical demand curve) Less than 1 Greater than 1 Greater than 1 Elasticity equal to 1 Infinity (horizontal demand curve)
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P D1 Perfectly Inelastic Demand D0 Perfectly Elastic Demand Q 6 3 4/7/2011 II. Price Elasticity of Demand
Percentage changes are asymmetric in terms of Percentage changes are asymmetric in terms of increases and decreases.
Suppose the price of a good increases from $5 to $10, then this is a 100 percent increase: Suppose instead that the price of a good decreases from $10 to $5, then this is a 50 percent decrease. 7 II. Price Elasticity of Demand
One solution to the asymmetry of percentage One solution to the asymmetry of percentage changes is to use an average of, the midpoint between, the two values. That way, you'll get the same answer whether you are moving up or down a given demand curve. 8 4 4/7/2011 II. Price Elasticity of Demand
The Midpoint Formula for computing elasticity is: The Midpoint Formula for computing elasticity is: 9 II. Price Elasticity of Demand
Always use the midpoint formula in this class. Always use the midpoint formula in this class. The Midpoint Formula for computing elasticity can be simplified to: 10 5 4/7/2011 II. Price Elasticity of Demand
Numerical Example Numerical Example
Consider two points on a demand curve. At Point 1, the price is $4 and the quantity demanded is 120. At Point 2, the price is $6 and the quantity demanded is 80. Calculate the price elasticity of demand using the midpoint formula: 11 II. Price Elasticity of Demand
Key Determinants of Price Elasticity of Demand: Key Determinants of Price Elasticity of Demand:
Availability of Close Substitutes
The more close substitutes there are for a good or service, the larger the elasticity of demand. Share of the Good or Service in Consumers' Budgets
The larger the share of the good or service in consumers' budgets, the larger the elasticity of demand. budgets the larger the elasticity of demand Passage of Time
The longer the time period, the larger the elasticity of demand.
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Key Determinants of Price Elasticity of Demand (cont.): ( )
Luxuries vs. Necessities
The price elasticity of demand is generally larger for luxuries and smaller for necessities. Temporary vs. Permanent Price Changes
The price elasticity of demand is larger for temporary price changes. Differences in Consumer Preferences
When there is not perfect competition, firms try to price discriminate (charge different consumers different prices) based on differences in price elasticities of demand across individuals or groups. Why are airline tickets cheaper with a Saturday night stay over?
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Relationship Between Price Elasticity of Demand p y and Total Revenue (TR)
Total revenue is calculated by multiplying the price per unit by the number of units sold. That is, TR=PQ. If ed<1, then an increase in price causes total revenue to increase because the decrease in quantity demanded is proportionally smaller than the increase in price. If ed>1, then an increase in price causes total revenue to decrease because the decrease in quantity demanded is proportionally larger than the increase in price. Elasticity is not the same thing as slope!
14 7 4/7/2011 Elasticity and TR Are Not Constant Along a Linear Demand Curve D dC Question 4.1
J Jenna runs a small boutique in Capitola. She tells one of q p her suppliers that she is willing to pay $6 for a pair of wool hand warmers and not a dime more. On the basis of this information, what can you conclude about her price elasticity of demand for wool hand warmers? A) It is elastic. B) It is perfectly elastic. B) It is perfectly elastic C) It is perfectly inelastic. D) The price elasticity coefficient is 0. Correct answer: B
16 8 4/7/2011 Question 4.2
Which of the following statements is true about the price g p elasticity of demand along a downward sloping linear demand curve? A) It is inelastic at high prices and elastic at low prices. B) It is unitelastic throughout the demand curve. C) It is elastic at high prices and inelastic at low prices. i D) It is perfectly elastic at very high prices and perfectly inelastic at very low prices. Correct answer: C
17 Question 4.3
The demand for all carbonated beverages is likely to The demand for all carbonated beverages is likely to be ________ the demand for Dr. Pepper. A) more elastic than B) perfectly elastic compared to C) less elastic than D) perfectly inelastic compared to D) perfectly inelastic compared to Correct answer: C. 18 9 4/7/2011 III. Other Demand Elasticities
Cross Price Elasticity of Demand CrossPrice Elasticity of Demand 19 III. Other Demand Elasticities
Summary of CrossPrice Elasticities y
Types of Products Substitutes Value of Cross Price Elasticity Positive Examples Two types of "smart" phones (Android and iPhone) Apps and iPhones iPhones and peanut butter Complements Unrelated Negative Zero 20 10 4/7/2011 III. Other Demand Elasticities
Income Elasticity of Demand Income Elasticity of Demand 21 III. Other Demand Elasticities
Summary of Income Elasticities y
Types of Products Normal and a necessity Normal and a luxury y Inferior Value of Income Elasticity Positive but less than 1 Examples Bread Positive and greater Caviar than 1 Negative Beer, Big Macs 22 11 4/7/2011 IV. Price Elasticity of Supply
Since supply curves are upward sloping, there s no Since supply curves are upward sloping, there's no need to use absolute value in the case of the price elasticity of supply. 23 IV. Price Elasticity of Supply
P S1 Perfectly Inelastic Supply S0 Perfectly Elastic Supply Q 24 12 4/7/2011 V. Applications Using Elasticity
Why is the Price of Gasoline So Volatile? y
Price elasticity of demand and supply for gasoline is low (inelastic), so changes in supply and demand lead to larger changes in prices compared to changes in quantities. Apple introduced the firstgeneration iPhone in 2007 for $599, but quickly dropped the price to $399, why?
The price elasticity of demand for iPhones in 2007 was more elastic than Apple thought. more elastic than Apple thought Using Elasticity to Analyze the Disappearing Family Farm (see next slide)
In 1950, 17 percent of the labor force was employed in agriculture. Today, it's less than 2 percent. Why?
25 Using Elasticity to Analyze the Disappearing Family Farm In 1950, U.S. farmers produced 1.0 billion bushels of wheat at a price of $17.65 per bushel. Over the next 60 years, rapid increases in farm productivity caused a large shift to the right in the supply curve for wheat. The income elasticity of demand for wheat is low, so the demand for wheat increased little over this period. Because the demand for wheat is also price inelastic, the large shift in the supply curve and the small shift in the demand curve resulted in a sharp decline in the price of wheat, from $17.65 per bushel in 1950 to $5.33 per bushel in 2009. Note that the total revenue decreased from 1950 to 2009, resulting in a decrease in the number of family farms. 13 4/7/2011 Question 4.4
If a household increases its consumption of a good If a household increases its consumption of a good by 10 percent when its income increases by 5 percent, then the good is A) an inferior good. B) a luxury. ) y C) a necessity. D) both an inferior good and a necessity. Correct answer: B. 27 Question 4.5
If the cross price elasticity of demand between two If the crossprice elasticity of demand between two goods is positive, then it is most likely that the two goods are A) both inferior goods. B) both luxury goods. ) p C) complements. D) substitutes. E) necessities. Correct answer: D.
28 14 4/7/2011 VI. Conclusions
In making real world business and public policy In making realworld business and public policy decisions, the concept of elasticity is key. You often need to know the responsiveness of one variable to a change in another variable. If you are given actual numbers, all of the elasticities (price elasticity of demand, crossprice elasticity of demand, income elasticity of demand, and elasticity d d i l ti it f d d d l ti it of supply) can be computed using the midpoint formula. 29 15 ...
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