5Elasticity and Its ApplicationsElasticity . . . allows us to analyze supply and demand with greater precision. is a measure of how much buyers and sellers respond to changes in market conditions THE ELASTICITY OF DEMANDPrice elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price. The Price Elasticity of Demand and Its DeterminantsAvailability of Close SubstitutesNecessities versus LuxuriesDefinition of the MarketTime HorizonThe Price Elasticity of Demand and Its DeterminantsDemand tends to be more elastic :lthe larger the number of close substitutes.lif the good is a luxury.lthe more narrowly defined the market (why?).lthe longer the time period.Computing the Price Elasticity of DemandThe price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as:Computing the Price Elasticity of DemandIf changes from opposite direction: if the price of an ice cream cone decreases from $2.20 to $2.00 and the amount you buy increases from 8 to 10 cones, then your elasticity of demand would be calculated as:Computing the Price Elasticity of DemandThe Midpoint Method: A Better Way to Calculate Percentage Changes and ElasticitiesThe midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.The Midpoint Method: A Better Way to Calculate Percentage Changes and ElasticitiesExample: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:A Shortcut for Calculating ElasticitiesThe elasticity of a straight line at a point is given by the ratio of the length of the line segment below the point to the length of the line segment above the point. Homework for this chapter: Prove the above Proposition with mathematical method.The Variety of Demand CurvesInelastic DemandlQuantity demanded does not respond strongly to price changes.lPrice elasticity of demand is less than one.Elastic DemandlQuantity demanded responds strongly to changes in price.lPrice elasticity of demand is greater than one.Computing the Price Elasticity of Demand54DemandQuantity100050Price$740ABCThe Variety of Demand CurvesPerfectly InelasticlQuantity demanded does not respond to price changes.lPrice elasticity of demand is equal to zero.Perfectly ElasticlQuantity demanded changes infinitely with any change in price.lPrice elasticity of demand is infinity.Unit ElasticlQuantity demanded changes by the same percentage as the price.lPrice elasticity of demand is equal to one.The Variety of Demand CurvesBecause the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve, but not the same as the slope.Figure 1 The Price Elasticity of Demand(a) Perfectly Inelastic Demand: Elasticity Equals 0$54QuantityDemand10001. Anincreasein price . . .2. . . . leaves the quantity demanded unchanged.PriceFigure 1 The Price Elasticity of Demand(b) Inelastic Demand: Elasticity Is Less Than 1Quantity0$590Demand1. A 22%increasein price . . .Price2. . . . leads to an 11% decrease in quantity demanded.4100Figure 1 The Price Elasticity of Demand2. . . . leads to a 22% decrease in quantity demanded.(c) Unit Elastic Demand: Elasticity Equals 1Quantity41000Price$5801. A 22%increasein price . . .DemandFigure 1 The Price Elasticity of Demand(d) Elastic Demand: Elasticity Is Greater Than 1DemandQuantity41000Price$5501. A 22%increasein price . . .2. . . . leads to a 67% decrease in quantity demanded.Figure 1 The Price Elasticity of Demand(e) Perfectly Elastic Demand: Elasticity Equals InfinityQuantity0Price$4Demand2. At exactly $4,consumers willbuy any quantity.1. At any priceabove $4, quantitydemanded is zero.3. At a price below $4,quantity demanded is infinite.Total Revenue and the Price Elasticity of DemandTotal revenue is the amount paid by buyers and received by sellers of a good.Computed as the price of the good times the quantity sold.TR = P QFigure 2 Total RevenueDemandQuantityQP0Price P Q = $400(revenue)$4100Elasticity and Total Revenue along a Linear Demand CurveWith an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases. Figure 3 How Total Revenue Changes When Price Changes: Inelastic DemandDemandQuantity0PriceRevenue = $100 Quantity0PriceRevenue = $240 Demand$1100$380An Increase in price from $1 to $3 leads to an Increase in total revenue from $100 to $240Elasticity and Total Revenue along a Linear Demand CurveWith an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases. Question: With an elastic demand curve, what should be done in order to increase total revenue?Figure 4 How Total Revenue Changes When Price Changes: Elastic DemandDemandQuantity0PriceRevenue = $200 $450DemandQuantity0PriceRevenue = $100 $520An Increase in price from $4 to $5 leads to an decrease in total revenue from $200 to $100Elasticity of a Linear Demand CurveIncome Elasticity of DemandIncome elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income. Computing Income ElasticityIncome ElasticityTypes of GoodslNormal GoodslInferior GoodsHigher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. Income ElasticityGoods consumers regard as necessities tend to be income inelasticlExamples include food, fuel, clothing, utilities, and medical services.Goods consumers regard as luxuries tend to be income elastic.lExamples include sports cars, furs, and expensive foods.THE ELASTICITY OF SUPPLYPrice 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.Figure 6 The Price Elasticity of Supply(a) Perfectly Inelastic Supply: Elasticity Equals 0$54SupplyQuantity10001. Anincreasein price . . .2. . . . leaves the quantity supplied unchanged.PriceFigure 6 The Price Elasticity of Supply(b) Inelastic Supply: Elasticity Is Less Than 1110$51004Quantity01. A 22%increasein price . . .Price2. . . . leads to a 10% increase in quantity supplied.SupplyFigure 6 The Price Elasticity of Supply(c) Unit Elastic Supply: Elasticity Equals 1125$51004Quantity0Price2. . . . leads to a 22% increase in quantity supplied.1. A 22%increasein price . . .SupplyFigure 6 The Price Elasticity of Supply(d) Elastic Supply: Elasticity Is Greater Than 1Quantity0Price1. A 22%increasein price . . .2. . . . leads to a 67% increase in quantity supplied.4100$5200SupplyFigure 6 The Price Elasticity of Supply(e) Perfectly Elastic Supply: Elasticity Equals InfinityQuantity0Price$4Supply3. At a price below $4,quantity supplied is zero.2. At exactly $4,producers willsupply any quantity.1. At any priceabove $4, quantitysupplied is infinite.Determinants of Elasticity of SupplyAbility of sellers to change the amount of the good they produce.lBeach-front land is inelastic.lBooks, cars, or manufactured goods are elastic.Time period. lSupply is more elastic in the long run.Computing the Price Elasticity of SupplyThe price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price.Compute the Price Elasticity of SupplySupply is inelasticTHREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITYCan 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?THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITYExamine 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.Figure 8 An Increase in Supply in the Market for WheatQuantity ofWheat0Price ofWheat3. . . . and a proportionately smallerincrease in quantity sold. As a result,revenue falls from $300 to $220. DemandS1S22. . . . leadsto a large fallin price . . . 1. When demand is inelastic,an increase in supply . . .2110$3100Why did OPEC fail to keep the price of oil high?In the short run: Left-hand side of figure9 ,P107In the long run: Right-hand side of figure9 ,P107THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITYTHREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITYDoes drug interdiction increase or decrease drug-related crime?To compare the two policies: Policy of trying to move the supply curve v.s. that of demand curve.When analyzing the effects of economic policy, it is important to keep in mind that what is good for some people of society is not necessarily good for society as a whole.SummaryPrice elasticity of demand measures how much the quantity demanded responds to changes in the price. Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price.If a demand curve is elastic, total revenue falls when the price rises. If it is inelastic, total revenue rises as the price rises. SummaryThe income elasticity of demand measures how much the quantity demanded responds to changes in consumers income.The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good.The price elasticity of supply measures how much the quantity supplied responds to changes in the price. . SummaryIn most markets, supply is more elastic in the long run than in the short run. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price.The tools of supply and demand can be applied in many different types of markets.