Price Elasticity

Report
Mr. Barnett
University High
AP Economics
2012-2013

We already know that if the price of a good rises,
consumers will buy less
 But….how much less?
 Economists measure the change through elasticity

Elasticity: a measure of the responsiveness of
quantity demanded or quantity supplied to a
change in one of its determinants
 Basically, a measure of how much buyers and sellers
respond to change in market conditions

Remember the Law of demand….
 A fall in the price of a good will raise the
quantity demanded

Price Elasticity – measures how much
the quantity demanded responds to a
change in price

Demand is:
 Elastic – if quantity demanded responds
substantially to a change in price
 Inelastic – if quantity demanded responds
only slightly to a change in price

Availability of close substitutes
 Goods with close substitutes tend to have more
elastic demand because it is easier for consumer to
switch from that good to another
 Example
▪ Butter goes up $0.15 in price
▪ Price of margarine stays the same
▪ Result: large drop in quantity of butter sold

Necessities versus luxuries
 Necessities have _________ demands
 Luxuries have ___________demands

Example:
 When the price of a dentist visit
increases, people will not drastically
reduce the # of visits
 When the price of video games rise, the
quantity demanded of video games falls
substantially

Note: Whether a good is a necessity
or a luxury depends on personal
preference

Definition of the market
 Elasticity of demand in a market depends on its
definition (how we qualify it)
 Narrowly defined markets tend to have more elastic
demand than broadly defined markets
▪ Because easier to find substitutes if more narrowly defined
 Food -> inelastic
 Ice Cream -> elastic
 Vanilla Ice Cream -> very elastic

Time Horizon
 Goods have more elastic
demand in the long term

Example
 When the price of gasoline
increases, the quantity of
gasoline only falls slightly in
the short term
 Long term, people will set up
carpools, buy more fuel
efficient cars, electric cars,
ride buses, move closer to
work

Inexpensive vs expensive
 Expensive items tend to
have elastic demand curve
 Inexpensive items tend to
have inelastic demand
curve
 A screw doubles in price
from $0.05 to $0.10
 A civic doubles in price
from $20,000 to $40,000
Total Revenue = Price x Quantity
TR = P x Q
Price (P)
Quantity (Q) TR
Price (P)
Quantity (Q) TR
Price INC, Total Revenue INC
Price INC, Total Revenue DEC
Price DEC, Total Revenue DEC
Price DEC, Total Revenue INC

The Elasticity Coefficient equals the percentage
change in quantity demanded divided by the
percentage change in price
▪
▪
▪
▪
Butter goes from $1.00 to $1.20
Causes 40% drop in amount bought
40 percent/20 percent = 2.0
Elasticity coefficient = 2
▪ Note: Use absolute values so all elasticities are positive numbers
▪ A larger price elasticity implies a greater responsiveness of quantity
demanded to change in price
Make sure to use positive numbers
Make sure to start with original numbers
Figure out the elasticity of demand of both graphs above using the TR test
Figure out the elasticity of demand of both graphs above by figuring out the of
elasticity coefficient
Elasticity Coefficient
Test
Inelastic
Elastic
Ed < 1
Ed > 1

So 5 tests of Elasticity
Tests
Inelastic
Elastic
Substitutes
Few Substitutes
Many Substitutes
Necessity v Luxury
Necessity
Luxury
Cost
Inexpensive
Expensive
Total Revenue
P Inc, TR Inc
P Dec, TR Dec
P Inc, TR Dec
P Dec, TR Inc
Elasticity Coefficient
Test
Ed < 1
Ed > 1

When the price elasticity of demand is greater than one,
demand is defined to be elastic
 Percentage change in quantity demanded will be greater than
the percentage change in price

When the price elasticity of demand is less than one,
demand is defined to be inelastic
 Percentage change in price will be greater than the percentage
change in quantity demanded

When the price elasticity of demand is equal to one , the
demand is said to have unit elasticity
 Percentage change in price will be equal to the percentage
change in quantity demanded

Most demand curves that have a downward
slope have an elastic, inelastic and unit elastic
portion

There are some drawbacks to using the coefficient of price
elasticity of demand test
 As we have seen, the PED can vary at different points along a
demand curve, due to its percentage nature
 Also, percentage changes are not symmetric; rather, the
percentage change between any two values depends on which
one is chosen as the starting value and which one as the ending
value
 What if a company just wants to compare the results of two
different possible pricings, instead of “starting” at one price and
moving to another?
▪ If quantity demanded increases from 10 to 15 units, the percentage
change is 50%...... (15-10)/10
▪ If quantity demanded decreases from 15 to 10 units, the percentage
change is 33.3%....(10-15)/10
Thus, we can use the midpoint method to avoid those problems. Also
known as Arc Elasticity
 Involves calculating the percentage change in either P or Qd by
dividing the change in the variable by the midpoint between the
initial and final levels rather than by the initial value itself

Formula:
Note: Use averages for quantities and prices. Avoids having to deal
with beg and ending values

Example:
 Price of hamburgers rise from $4 to $6
 Quantity demanded falls from 120 to 80
▪ % change in quantity demanded = (120-80)/100 = 40%
▪ % change in price = (6-4)/5 x 100% = 40%
▪ Price elasticity of demand = 40/40 = 1
(a) Perfectly Inelastic Demand: Elasticity Equals 0
Price
Demand
$5
4
1. An
increase
in price . . .
0
100
Quantity
2. . . . leaves the quantity demanded unchanged.
Copyright©2003 Southwestern/Thomson Learning
(b) Inelastic Demand: Elasticity Is Less Than 1
Price
$5
4
1. A 22%
increase
in price . . .
Demand
0
90
100
Quantity
2. . . . leads to an 11% decrease in quantity demanded.
Figure 1 The Price Elasticity of Demand
(c) Unit Elastic Demand: Elasticity Equals 1
Price
$5
4
Demand
1. A 22%
increase
in price . . .
0
80
100
Quantity
2. . . . leads to a 22% decrease in quantity demanded.
Copyright©2003 Southwestern/Thomson Learning
Figure 1 The Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Price
$5
4
Demand
1. A 22%
increase
in price . . .
0
50
100
Quantity
2. . . . leads to a 67% decrease in quantity demanded.
Copyright © 2004 South-Western/Thomson Learning
Figure 1 The Price Elasticity of Demand
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Price
1. At any price
above $4, quantity
demanded is zero.
$4
Demand
2. At exactly $4,
consumers will
buy any quantity.
0
3. At a price below $4,
quantity demanded is infinite.
Quantity
Copyright © 2004 South-Western/Thomson Learning
Total Revenue = Amount paid by buyers and received by sellers of a good
= price of the good times the quantity sold

Even though slope is
constant, elasticity is not
 Slope is the ratio of changes
in the 2 variables
 Elasticity is the ratio of
percentage changes in the
two variables


At points with a high price
and low quantity, the
demand curve is ____
At points with a low price
and high quantity, the
demand curve is ____

When the price is $1, demand is inelastic
 An increase in price to $2 will increase total revenue

When the price is $5, demand is elastic,
 A price increase to $6 will reduce total revenue

At $3.50, demand is unit elastic, and consumers will buy
any quantity
Price
Price
… leads to an Increase in
total revenue from $100 to
$240
An Increase in price from $1
to $3 …
$3
Revenue = $240
$1
Demand
Revenue = $100
0
100
Quantity
Demand
0
80
Quantity
Price
Price
… leads to an decrease in
total revenue from $200 to
$100
An Increase in price from $4
to $5 …
$5
$4
Demand
Demand
Revenue = $200
0
50
Revenue = $100
Quantity
0
20
Quantity
(Q 2  Q1 ) / [(Q 2  Q1 ) / 2]
Price elasticity of demand =
(P2  P1 ) / [(P2  P1 ) / 2]

Example: If the price of Hello Kitty pencil
toppers increases from $2.00 to $2.20 and the
amount you buy falls from 10 to 8 toppers,
then your elasticity of demand, using the
midpoint formula, would be calculated as…
(10  8)
22%
(10  8) / 2

 2.32
(2.20  2.00)
9.5%
(2.00  2.20) / 2
Income elasticity of demand
measures how much the quantity
demanded of a good responds to a
change in consumers’ income
Percentage change
in quantity demanded
Income elasticity of demand =
Percentage change
in income


Normal goods have ______income elasticities
Inferior goods have ______income elasticities

Higher income raises the quantity demanded
for normal goods but lowers the quantity
demanded for inferior goods

Necessities tend to have _____income
elasticities, whereas luxuries tend to have
______income elasticities

We use the absolute value when figuring out
price elasticity of demand because the value
is always negative (because when price
changes in one direction, quantity
demanded always changes in the other).

But this isn't true for income. When income
changes, people might want to buy more or
less of the good.

After irrevocably destroying
symbols borrowed from the
American West, PSY’s income rises
from $100,000 to 1,000,000. The
quantity of hamburger he buys each
week rises from two pounds to four
pounds.
 What is PSY’s income elasticity?
 What kind of good is hamburger for
PSY?

Cross-Price Elasticity of demand: A measure of
how much the quantity demanded of one good
responds to a change in the price of another
good

Cross-Price Elasticity =
% change in quantity demanded of good 1
___________________________________
% change in price of good 2

Substitutes have ______ cross price
elasticities, whereas complements have
________cross-price elasticities

The sign matters for cross-price elasticity.

When the price of one good changes, people
might want to buy more of the other good, or
less.

The price of Kris-Kross cassette
tapes rise from $8 to $10. As a
result, the quantity of Kris-Kross
trading cards demanded falls from
8,000 per week to 9,500.
 What is the cross-price elasticity?
 What is the relationship between the
two goods?


Price elasticity of supply is a measure of how
much the quantity supplied of a good
responds to a change in the price of that
good.
Price elasticity of supply is the percentage
change in quantity supplied resulting from a
percent change in price
Percentage change
in quantity supplied
Price elasticity of supply =
Percentage change in price
(a) Perfectly Inelastic Supply: Elasticity Equals 0
Price
Supply
$5
4
1. An
increase
in price . . .
0
100
Quantity
2. . . . leaves the quantity supplied unchanged.
Copyright©2003 Southwestern/Thomson Learning
(b) Inelastic Supply: Elasticity Is Less Than 1
Price
Supply
$5
4
1. A 22%
increase
in price . . .
0
100
110
Quantity
2. . . . leads to a 10% increase in quantity supplied.
Copyright©2003 Southwestern/Thomson Learning
(c) Unit Elastic Supply: Elasticity Equals 1
Price
Supply
$5
4
1. A 22%
increase
in price . . .
0
100
125
Quantity
2. . . . leads to a 22% increase in quantity supplied.
Copyright©2003 Southwestern/Thomson Learning
(d) Elastic Supply: Elasticity Is Greater Than 1
Price
Supply
$5
4
1. A 22%
increase
in price . . .
0
100
200
Quantity
2. . . . leads to a 67% increase in quantity supplied.
Copyright©2003 Southwestern/Thomson Learning
(e) Perfectly Elastic Supply: Elasticity Equals Infinity
Price
1. At any price
above $4, quantity
supplied is infinite.
$4
Supply
2. At exactly $4,
producers will
supply any quantity.
0
3. At a price below $4,
quantity supplied is zero.
Quantity
Copyright©2003 Southwestern/Thomson Learning

Flexibility of Sellers
 Goods that are somewhat fixed in supply have
inelastic supplies
 Goods that are not (books, cars, tamagotchi pets)
have elastic supplies

Time Period
 Supply is usually more inelastic in the short run
 Supply is usually more elastic in the long run

The price of chocolate milk increases from
$2.85 per gallon to $3.15 per gallon and the
quantity supplied rises from 9,000 to 11,000
gallons per month

Price elasticity of supply is ?


Can good news for farming be bad news for
farmers?
What happens to wheat farmers and the
market for wheat when university
agronomists discover a new wheat hybrid
that is more productive than existing
varieties?



Examine whether the supply or demand
curve shifts.
Determine the direction of the shift of the
curve.
Use the supply-and-demand diagram to see
how the market equilibrium changes.
Price of
Wheat
2. . . . leads
to a large fall
in price . . .
1. When demand is inelastic,
an increase in supply . . .
S1
S2
$3
2
Demand
0
100
110
Quantity of
Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
Copyright©2003 Southwestern/Thomson Learning
100  110
(100  110) / 2
ED 
3.00  2.00
(3.00  2.00) / 2
0.095

 0.24
0.4
Supply is inelastic
Supply _____, price _____, quantity demanded
______
 If demand is ineastic, the fall in price is greater than
the increase in quantity demanded and total revenue
______
 Demand for basic foodstuffs is usually inelastic

 Less revenue for farmers
 Because farmers are price takers they still have incentive
to adopt new hybrid so they can produce and sell more
wheat
 Explains why number of farms has declined so much over
the past 200 years
 Also explains why some gov policies encourage farmers to
decrease the amuont of crops planted

In the 1970s and 1980s, OPEC reduced the
amount of oil it was willing to supply to world
markets. The decrease in supply led to an
increase in the price of oil and a decrease in
quantity demanded. The increase in price was
much larger in the short run than the long
run. Why?

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