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Economics Combined Version Edwin G. Dolan Best Value Textbooks 4th edition Chapter Supply, Demand, and Elasticity Dolan, Microeconomics 4e, Ch. 3 Elasticity Elasticity: A way to measure responsiveness How responsive is a dependant variable to a change in the independent variable? or How much “bounce” do you get in your Quantity Demanded for a change in your price? Economics uses several different types of elasticity Price Elasticity of Demand Definitions of Price Elasticity of Demand: The percentage change in the quantity demanded of a product divided by the percentage change in the price of the product. The percentage change in the quantity demanded caused by a one percent change in the price. Price Elasticity of Demand - - Simplified How sensitive is the quantity demanded to changes in price? … How responsive are consumers to price changes? A producer wants to know: How many sales will I lose if I increase my price? What if I lower my price? What effect will that have on my revenue? Price Elasticity: Mathematical Definition – the easy one The price elasticity of demand, ed, is: Example: If the quantity of movie tickets sold falls by 3% when the price is raised by 1%, then the price elasticity of demand is -3/1 = -3. Calculating Percentage Change (The simple, standard way) Calculating Percentage Change (the Midpoint Method) Percent Change stays constant whether moving up or moving down. Elasticity: The all-out mathematical version Sign of Price Elasticity According to the law of demand, whenever the price rises, the quantity demanded falls. Thus the price elasticity of demand is always negative. Because it is always negative, economists usually state the value without the sign. Defining elasticities When price elasticity is between zero and -1 we say demand is inelastic. When demand is inelastic, revenue rises when price rises When price elasticity is between -1 and - infinity, we say demand is elastic. When demand is elastic, revenue falls when price rises When price elasticity is -1, we say demand is unit elastic. When demand is unit elastic, revenue is maximized and will decline if price rises or falls Demand Curve Shapes and Elasticity Perfectly Elastic Demand Curve The demand curve is horizontal, any change in price can and will cause consumers to change their consumption completely. An increase of $0.01 leads to a 100% decrease in sales Perfectly Inelastic Demand Curve The demand curve is vertical, the quantity demanded is totally unresponsive to the price. Changes in price have no effect on consumer demand. Even a large change in price will not effect the sales In between the two extreme shapes of demand curves are the demand curves for most products. Demand Curve Shapes and Elasticity Price Elasticity Along a Straight Line Demand Curve The price elasticity of demand changes as we move up or down a straight-line demand curve. The price elasticity becomes more inelastic as we move down the curve. If an entire demand curve (D2) is more elastic than another (D1) it means that at every single price, D2 is more elastic than on D1. Elastic and Inelastic All downward-sloping straight-line demand curves are divided into three parts: Inelastic region: where ed < 1. (bottom half of curve) Unit elastic point: where ed = 1. (center of curve) Elastic region: where ed > 1. (top half of curve) All elasticies are percentages of change. The Price Elasticity of Demand Along a Straight-line Demand Curve Determinants of the Price Elasticity of Demand The degree to which the price elasticity of demand is inelastic or elastic depends on: How many substitutes there are More substitutes make for greater elasticity How well a substitute can replace the good or service under consideration Closer substitutes make for greater elasticity The importance of the product in the consumer’s total budget Larger parts of the budget create greater price elasticity The time period under consideration The longer the time, the greater the elasticity Using the Price Elasticity of Demand Price Elasticity of Demand is crucially important to any firm manager: It tells a manager in a firm whether to raise or lower prices if they want to increase revenue. Total Revenue (TR) equals the price times the quantity sold: TR = P x Q. Total Revenue and Price Elasticity of Demand Total Revenue (TR) equals the price (P) of a product multiplied by the quantity sold (Q): TR = P x Q Total revenue increases as price is increased if demand is inelastic, decreases as price is increased if demand is elastic, and does not change as price is increased if demand is unit-elastic. Using the Price Elasticity of Demand The law of demand tells us that: Q decreases when P rises. What is the optimal price to maximize total revenue? Answer: the price at the unit-elastic point. At any higher price – or any lower price – total revenue is decreased! Total Revenue and Price Elasticity Price Quantity Revenue $1000 200 $200,000 $900 400 $360,000 $800 600 $480,000 $700 800 $560,000 $600 1000 $600,000 $500 1200 $600,000 $400 1400 $560,000 $300 1600 $480,000 $200 1800 $360,000 $100 2000 $200,000 Price Discrimination Price discrimination is charging different customers different prices for the same product. Why do firms want to do this? When different groups of customers have different price elasticities of demand for the same product, total revenue can be increased by charging each of the groups a different price. The groups must be easily identifiable, and there must be little possibility of people from different groups trading with each other. Dumping Dumping: A form of price discrimination wherein an identical good is sold to foreign buyers for a lower price than to domestic buyers. Predatory Dumping: dumping intended to drive rival firms out of business. Usually charges of “dumping” against foreign firms really are charges of “predatory dumping”. Other Demand Elasticities Demand may respond to changes in other variables. The measures of such responses are also elasticities. j %ΔQ k %ΔP Cross-Price Elasticity of Demand: The percentage change in the quantity demand for one good, divided by the percentage change in price of another good. Measures the degree to which goods are substitutes or complements. If the cross-price elasticity is positive, then the goods are substitutes. If the cross price elasticity is negative, then the goods are complements. Other Demand Elasticities Income Elasticity of Demand: the percentage change in the quantity demanded divided by the percentage change in income. %ΔQ %ΔY Normal goods: goods for which the income elasticity of demand is positive. Inferior goods: Goods for which the income elasticity of demand is negative. Necessities and Luxuries Goods with lower income elasticities are often called necessities, since the quantities demanded don’t vary much with income. Typical income elasticities are 0.4 or 0.5. Goods with higher income elasticities are often called luxuries, since people give them up readily when their incomes fall. Typical elasticities are 1.5 to 2.0. The Price Elasticity of Supply The price elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in price. Price Elasticity of Supply and Shape of Supply Curve The price elasticity of supply is either zero or a positive number. A zero price elasticity of supply means that the quantity supplied will not vary as the price varies. A positive price elasticity of supply means that as the price of an item rises, the quantity supplied rises. Supply Curve Shapes and Elasticity Supply Elasticities in the Long and Short Runs The shape of the supply curve depends heavily on the length of time being considered. In the short run, at least one of the resources used in production cannot be changed. In the long run, the firm has long enough to change any aspect of production, and therefore can more fully respond. Interaction of Price Elasticities of Demand and Supply Together, both the price elasticity of demand and the price elasticity of supply determine the full effect of a price change. If the price elasticity of supply of an item is large and the demand for it is price inelastic, then the firm can raise the price without losing revenue. Conversely, if the price elasticity of supply is small and the price elasticity of demand is large, then the firm is unable to raise the price because the consumer will switch to another firm or product. Incidence and Taxes Incidence is the measure of who actually pays for a cost increase or a tax. In general, the more elastic the demand and the less elastic the supply the more the incidence of a tax falls on businesses and the less it falls on consumers. Tax Incidence and Revenue A tax imposed on a good that has an inelastic demand will generate more tax revenue than a tax on a good with elastic demand, assuming similar supply conditions. The diagrams below compare the effects of a $1.00 tax on the markets for milk (inelastic demand) and pork (elastic demand). Dolan, Economics Combined Version 4e, Ch. 3 Effect of Prohibition on Market for Cocaine Suppose the demand for Supply and Demand for Cocaine cocaine is inelastic Sale of cocaine is prohibited, but the prohibition is not completely effective, shifting Prohibition the supply curve from S1 to S2 As a result of prohibition, the total revenue from cocaine increases (PXQ at E2 compared with PXQ at E1) Legal supply Some of the revenue is profit for drug dealers, some the extra cost of selling an illegal good. Dolan, Economics Combined Version 4e, Ch. 3