Report

Elasticity Elasticity of Demand • Elasticity: measures the responsiveness of demand or supply to one of its determinants – Own price – Income – Price of related goods Price Elasticity • Own Price Elasticity of Demand : measures how responsive the quantity demanded is to its price • Defined as the percentage change in quantity demanded divided by the percentage change in price • Tells us how willing consumers are to buy more if the price goes down, or buy less if the price goes up • Elastic Demand – Quantity demanded relatively responsive to price changes • Inelastic Demand – Quantity demanded relatively unresponsive to price changes Determinants of Elasticity • Availability of Close Substitutes – If there are many close substitutes then will tend to be very elastic • Necessity vs Luxury – If it is a necessary good it will be inelastic – If it is a luxury good it will be elastic • Definition of Market – Narrow definition of good would be more elastic • Time Horizon – Longer time horizon makes it more elastic Calculating Elasticity • Elasticity is not constant over the demand curve – changes at every point • %change in Q/%change in P (absolute value) • %Q Q / Q Q P = 1/slope x (P/Q) %P P / P P Q (slope = P ) Q Or: Midpoint method (why) – Two points (Q1,P1) and (Q2,P2) – Own price elasticity = (Q1 Q2 ) /[(Q1 Q2 ) / 2] ( P1 P2 ) /[(P1 P2 ) / 2] • • • • • • Elasticity > 1 : elastic Elasticity < 1 : inelastic Elasticity = 1 : unit elasticity Elasticity = 0 : perfectly inelastic (vertical DC) Elasticity = ∞ : perfectly elastic (horizontal DC) Linear Demand curves (except perfectly elastic or inelastic) will be half elastic, half inelastic and midpoint where it is unit elastic • At any given point (Q,P) the flatter the curve the more elastic Perfectly Inelastic Demand Perfectly Elastic Demand P P Demand Curve Demand is zero above 7 8 Demand Curve 7 6 Demand is infinite below 7 Will buy any quantity at 7 Change in price has no effect on quantity demanded 50 Q Q Slope of Demand is 1 (remember all in absolute values) 12 Elastic : 1/Slope*(p/q) = 1*(p/q >1) >1 10 Unit Elastic : 1/Slope*(p/q) = 1*(p/q =1) =1 Price 8 Inelastic : 1/Slope*(p/q) = 1*(p/q <1) <1 6 4 2 0 1 2 3 4 5 6 Quantity 7 8 9 10 |Slope of Demand Curve| = 3 30 Elastic : 1/Slope*(p/q) = 1/3*(p/q >3) >1 25 Unit Elastic : 1/Slope*(p/q) = 1/3*(p/q =3) =1 Price 20 15 Inelastic : 1/Slope*(p/q) = 1/3*(p/q <3) <1 10 5 0 1 2 3 4 5 6 Quantity 7 8 9 10 Midpoint Method P To get elasticity at this (any) point would have to take derivative (calculus required) (Q1,P1) = (3,11) ; (Q2,P2) = (9,5) 11 (Q1 Q2 ) /[(Q1 Q2 ) / 2] (3 9) /[(3 9) / 2] 4 100% ( P1 P2 ) /[(P1 P2 ) / 2] (11 5) /[(11 5) / 2] 3 75% Remember absolute value 5 3 9 Q Revenue of Seller and Elasticity • Total Revenue – Total Amount Given by buyers – Total Amount received by sellers – TR = P x Q (market price, and market quantity) P Demand TR = P x Q = 10 x 8 = $80 10 TR 8 Q • If at market price/quantity demand is elastic – Raising price reduces revenue – Lowering price raises revenue – Why • If at market price/quantity demand is inelastic – Raising price raises revenue – Lowering price lowers revenue – Why Inelastic Demand Slope = 1/10 ; At original pt Elasticity = 10 * 4/100 = 2/5 < 1 P P Raising Price Raises Revenue Lowering Price Lowers Revenue TR = 480 6 TR = 330 4 3 TR = 400 100 Q 80 110 Q Elastic Demand Slope = 1/50 ; At original pt Elasticity = 50 * 4/100 = 2> 1 P P Raising Price Lowers Revenue Lowering Price Raises Revenue TR = 250 5 TR = 450 4 3 TR = 400 100 Q 50 150 Q Income Elasticity of Demand • Measures how responsive quantity demanded is to changes in ones income • % change in Q/% change in Income – No absolute value here, because two types of goods distinguished by sign of elasticity (+/-) – Normal Good : positive elasticity • Necessary Good : small elasticity • Luxury Good : large elasticity – Inferior Good : negative elasticity Cross Price Elasticity of Demand • Measures how responsive quantity demanded is to changes in the price of a related good • % change in Q(of good one)/% change in P (of good two) – Again here no absolute value because we distinguish two types of related goods – Substitute: positive cross price elasticity • Price of sub goes up, then demand goes up – Compliment: negative cross price elasticity • Price of comp goes up, then demand goes down • For both income elasticity of demand, and cross price elasticity of demand – Use midpoint method – Cross Price: – Income: (Q Q ) /[(Q Q ) / 2] ( P P ) /[(P P ) / 2] 1 1 2 1 1 2 2 2 1 1 2 1 1 2 2 2 (Q1 Q2 ) /[(Q1 Q2 ) / 2] ( I1 I 2 ) /[(I1 I 2 ) / 2] Elasticity of Supply • Measures how responsive the quantity supplied is to changes in that goods price • % change in Q/% change in price • Again if linear we can use 1/slope * P/Q • If not use midpoint method • Main determinant is technology/time – How quick can they respond and does the technology they use allow more/less production All the Same as Elasticity of Demand • • • • Elastic: very responsive to price >1 Inelastic: not responsive <1 Unit elastic = 1 Perfectly elastic : infinite elasticity – Horizontal supply curve • Perfectly inelastic: zero elasticity – Vertical supply curve Application • Say new crop technology comes out which increases corn yields per acre (GM foods) • This shifts the supply curve out (to the right) • But demand is fairly inelastic • So we get a lower price, and slightly higher quantity • But farm revenues fall P 3 Technology Shifts supply curve 2 Original Revenue = 3*200 = 600 New Revenue = 2*220 = 440 200 220 Q Public Policy Implications Application to Illegal Drugs • Focus on reducing supply (raids etc) or focus on reducing demand (education, rehab etc)? • Note: demand for drug inelastic – Assumption: addiction • Reducing supply increases price/reduce quantity, but – Increases revenue, more incentive to sellers • Reducing demand decreases price/reduces quantity, and – Decreases revenue