Professional Documents
Culture Documents
A scenario
You
You design
design websites
websites for
for local
local businesses.
businesses.
You
You charge
charge $200
$200 per
per website,
website,
and
and currently
currently sell
sell 12
12 websites
websites per
per month.
month.
Your
Your costs
costs are
are rising
rising
(including
(including the
the opportunity
opportunity cost
cost of
of your
your
time),
time),
so
so you
you consider
consider raising
raising the
the price
price to
to $250.
$250.
The
The law
law of
of demand
demand says
says that
that you
you wont
wont sell
sell
as
as many
many websites
websites ifif you
you raise
raise your
your price.
price.
How
How many
many fewer
fewer websites?
websites? How
How much
much will
will
your
your revenue
revenue fall,
fall, or
or might
might itit increase?
increase?
3
Elasticity
Basic idea:
Elasticity measures how much one
variable responds to changes in
another variable.
One type of elasticity measures how
much demand for your websites will fall
if you raise your price.
Definition:
Elasticity is a numerical measure of
the responsiveness of Qd or Qs to
one of its determinants.
ELASTICITY AND ITS
APPLICATION
Percentage change in
Qd
Percentage change in
P
Percentage change in
Qd
Percentage change in
P
P
Example:
Price
elasticity
of demand
equals
15%
= 1.5
10%
ELASTICITY AND ITS
APPLICATION
P
rises
by
10%
P2
P1
D
Q2
Q falls
by
15%
Q
1
Demand for
your
websites
B
$25
0
$20
0
A
D
8
1
2
Standard method
of computing the
percentage (%)
change:
end value start
x
value
start
100%
value
Going from A to B,
the % change in P
equals
($250$200)/$200 =
25%
Problem:
The standard method
gives different answers
depending on where you
start.
From A to B,
Demand for
your
websites
B
$25
0
$20
0
A
D
8
1
2
Q From B to A,
$250
= 22.2%
x
$200
$22
100%
5
The % change in Q equals
12 8
=
x
10
100% 40.0%
The price elasticity of demand equals
40/22.2 =
1.8
ELASTICITY AND ITS
APPLICATION
10
ACTIVE LEARNING 1
Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:
if P = $70, Qd =
5000
if P = $90, Qd =
3000
11
ACTIVE LEARNING 1
Answers
Use midpoint method to calculate
% change in Qd
(5000 3000)/4000 = 50%
% change in P
($90 $70)/$80 = 25%
The price elasticity of demand equals
50
%
25
%
=
2.0
12
13
0%
% change in
Price
=
=
Q
elasticity
10%
% change in
of demand
P
P
D
D
curve:
vertical
P1
Consumers
price sensitivity:
P2
none
Elasticit
y:0
ELASTICITY AND ITS
APPLICATION
P
falls
by
10%
14
=
0
Q1
Q
changes
by 0%
Inelastic demand
<
% change in
Price
= 10% <
=
Q
elasticity
10% 1
% change in
of demand
P
P
D
curve:
relatively steep
P1
Consumers
price sensitivity:
P2
relatively low
D
Elasticit
y:< 1
ELASTICITY AND ITS
APPLICATION
P
falls
by
10%
15
Q1 Q
2
Q rises
less than
10%
Elasticit
y:1
ELASTICITY AND ITS
APPLICATION
P
falls
by
10%
16
Q1
Q
2
=
1
D
Q
Q rises by
10%
Elastic demand
>
% change in
Price
= 10%
=
Q
elasticity
10%
% change in
of demand
P
P
D
curve:
relatively flat
P1
Consumers
price sensitivity:
P2
relatively high
Elasticit
y:> 1
ELASTICITY AND ITS
APPLICATION
P
falls
by
10%
17
Q1
>
1
Q
2
Q rises
more than
10%
any %
% change in
Price
=
=
=
Q
elasticity
0% infinity
% change in
of demand
P
P
D
curve:
horizontal
D
P2 P1
Consumers
=
price sensitivity:
extreme
Elasticit
y:infinity
ELASTICITY AND ITS
APPLICATION
P
changes
by 0%
18
Q1
Q2
Q
changes
by any %
200
E
= 5.0
%
= 40%
67%
E
= 1.0
67%
=
$3
0
20
10
$0
20
40
60
40%
E
= 0.2
= 200
%
Q
19
The slope
of a
linear
demand
curve is
constant,
but its
elasticity
is not.
20
EXAMPLE 1:
Price of Goods
Elastic demand with
substitutes: Cereals
22
EXAMPLE 2:
23
24
EXAMPLE 3:
ELASTICITY: Necessities VS
Luxuries
Insulin (Per thousand
perscriptions)
26
EXAMPLE 4:
Price of Gasoline
Elastic demand in the
long run
28
The
The price
price elasticity
elasticity of
of demand
demand
depends
depends on:
on:
the
the extent
extent to
to which
which close
close substitutes
substitutes
are
are available
available
whether
whether the
the good
good is
is aa necessity
necessity or
or aa
luxury
luxury
how
how broadly
broadly or
or narrowly
narrowly the
the good
good is
is
defined
defined
the
the time
time horizon
horizon elasticity
elasticity is
is higher
higher
ELASTICITY
ITS
in
long
29 the
inANDthe
the
long run
run than
than
the short
short run
run
APPLICATION
30
32
If P = $200,
Q = 12 and
$25
revenue =
0
$20
$2400.
If P = $250,
0
Q = 8 and
revenue =
When D is elastic,
$2000.
a price increase
causes revenue to
fall.
ELASTICITY AND ITS
APPLICATION
increased
Demand for
revenue
your
lost
due to
revenu
websites
higher P
e due
to
lower Q
D
33
1
2
APPLICATION
Q = 12 and
$25
revenue =
0
$2400.
$20
If P = $250,
0
Q = 10 and
revenue =
When D is inelastic,
$2500.
a price increase
causes revenue to
ELASTICITY AND ITS
rise.
APPLICATION
lost
revenu
e due
to
lower Q
D
10
35
1
2
ACTIVE LEARNING 2
B. As
ACTIVE LEARNING 2
Answers
A. Pharmacies raise the price of insulin by
37
ACTIVE LEARNING 2
Answers
B. As a result of a fare war, the price of a
38
Elasticity
ELASTICITY (price elasticity of supply)
What is it
How do we compute it
What affects it
5 different graphs
How it is related to revenue
39
Percentage change in
Qs
Percentage change in
P
40
Percentage change in
Qs
Percentage change in
P
P
Example:
Price
elasticity
of supply
equals
P
P2
rises
by 8% P1
Q1
16%
= 2.0
8%
ELASTICITY AND ITS
APPLICATION
41
Q
rises
by
Q
2
42
S
curve:
vertical
0%
% change in
=
=
Q
10%
% change in
P
P
S
P2
Sellers
price sensitivity:
none
Elasticit
y:0
ELASTICITY AND ITS
APPLICATION
=
0
P1
P
rises
by
10%
43
Q1
Q
changes
by 0%
Inelastic
<
% change in
= 10%
=
Q
10%
% change in
P
P
S
S
curve:
relatively steep
P2
Sellers
price sensitivity:
P1
relatively low
Price
elasticity
of supply
Elasticit
y:< 1
ELASTICITY AND ITS
APPLICATION
P
rises
by
10%
44
<
1
Q1 Q
2
Q rises less
than 10%
Unit elastic
Price
elasticity
of supply
10%
% change in
=
=
Q
10%
% change in
P
P
S
curve:
intermediate
slope
Sellers
price sensitivity:
intermediate
Elasticit
y:= 1
ELASTICITY AND ITS
APPLICATION
=
1
S
P2
P1
P
rises
by
10%
45
Q1
Q
2
Q rises
by 10%
Elastic
Price
elasticity
of supply
S
curve:
relatively flat
>
% change in
= 10%
=
Q
10%
% change in
P
P
S
P2
Sellers
price sensitivity:
relatively high
Elasticit
y:> 1
ELASTICITY AND ITS
APPLICATION
>
1
P1
P
rises
by
10%
46
Q1
Q
2
Q rises
more than
10%
Price
elasticity
of supply
S
curve:
horizontal
any %
% change in
=
=
=
Q
0% infinity
% change in
P
P
Sellers
price sensitivity:
extreme
Elasticit
y:infinity
ELASTICITY AND ITS
APPLICATION
P2 P1
=
P
changes
by 0%
47
Q1
Q2
Q
changes
by any %
48
ACTIVE LEARNING 3
ACTIVE LEARNING 3
Answers
When supply
is inelastic,
an increase
in demand
has a bigger
impact on
price than on
quantity.
Beachfront
property (inelastic
supply):
S
D1 D2
P2
P1
A
Q1 Q2
Q
50
ACTIVE LEARNING 3
Answers
When supply
is elastic,
an increase
in demand
has a bigger
impact on
quantity than
on price.
New cars
(elastic supply):
P
D1 D2
S
P2
P1
B
A
Q1
Q2
Q
51
elasticit
y<1
Supply
Supply
often
often
becomes
becomes
less
less elastic
elastic
as
as Q
Q rises,
rises,
due
due to
to
capacity
capacity
limits.
limits.
elasticit
y>1
$3
10
0
ELASTICITY AND ITS
APPLICATION
20
0
Q
50
0
52
5
52
Other Elasticities
53
Other Elasticities
54
Other
Elasticities
Cross-price
elasticity of demand:
measures the response of demand for one
good to changes in the price of another good
d
%
change
in
Q
for
Cross-price
=
good 1
elast.
% change in price of
of demand
good 2
For substitutes, cross-price elasticity > 0
(e.g., an increase in price of beef causes an
increase in demand for chicken)
56
Policy 1: Interdiction
Interdictio
n reduces
Price of
the
Drugs
supply of
drugs.
P2
Since
demand for
drugs is
P1
inelastic,
P rises
proportionally more
Result: an increase in
than Q falls.
total spending on
drugs, and in drugrelated
crime
ELASTICITY
AND ITS
APPLICATION
new value of
drug-related
S2
crime D
1
Q2 Q
1
57
S1
initial
value of
drugrelated
crime
Quantit
y
of Drugs
Policy 2: Education
Price of
Education
Drugs
reduces
the
demand
for drugs.
P and Q fall.
Result:
A decrease in
total
spending on
drugs, and in
drug-related
crime.
ELASTICITY AND ITS
APPLICATION
new value of
drug-related
crime
D2
D1
S
P1
P2
Q2 Q
1
58
initial
value of
drugrelated
crime
Quantit
y
of Drugs
CHAPTER SUMMARY
CHAPTER SUMMARY
Demand is less elastic in the short run,
for necessities, for broadly defined goods,
or for goods with few close substitutes.
Price elasticity of supply equals percentage
change in Qs divided by percentage change
in P.
When its less than one, supply is inelastic.
When greater than one, supply is elastic.
Price elasticity of supply is greater in the
long run than in the short run.
60
CHAPTER SUMMARY