Elasticity The Midterm

… We just got grade sheets last night (in giant pdf

… Lecture 10 outline: Read Chapter 7 and the reading files). We’ll get them to your TAs late today. They’ll
for today. have them at your section this week.
† Announcements: homework, exam, others † For those who did well, keep pushing. Students
Definition of elasticity typically find the material gets more difficult.
¾ price elasticity of demand † For those who did poorly, you can drop the low
¾ income elasticity of demand and midterm. But you need to figure out what is keeping
¾ price elasticity of supply you from learning the material.
Factors that influence the size of elasticities … Provisional curve
How elasticity affects the incidence of a tax, and who † 91-100 A; 83-90 A/B; 77-82 B; 68-76 B/C; 59-67
bears its burden? C; 40-58 D; 0-39 F

Defining and Measuring an Elasticity Elasticity: Simple Examples

3 4

… Price elasticity of demand

… Elasticities are always defined as a “percentage
… Calculate a percentage %ΔQ=((75-125)/(125+75)/2)*100 = -50
change in this” over a “percentage change in that.” change.
P
%ΔP=((30-20)/(30+20)/2)*100=40
… The p
price elasticityy of demand,, therefore,, is the † My GPA rose to 3.4
34 30
percentage change in the quantity demanded over the from 3.0 because of my
20
εp = -50/40 = -1.25

percentage change in the price, moving along the good work in Economics.
demand curve. … Your percentage change
in GPA is
† ((3.4- D
3.0)/((3.4+3.0)/2))*100
or 12.5 percent. 75 125 Q
Since demand curve slope downward, price elasticities are always negative. We
take the absolute value, so εp = 1.25

1
 We Will Use the “Midpoint Method” to
Calculating an Elasticity: The
Calculate Elasticities
5 6 World Demand for Oil
… % change in price is
† ($1/$20.5)*100=4.878
… % change in Q is
† -(0 1/9 95)*100=-1
-(0.1/9.95) 100=-1.005
005
… The elasticity is
† -1.005/4.878 = -0.206
… Price elasticity of demand is
always a negative number –
again, we typically drop the
negative, taking the absolute
value.

What Determines the Magnitude of Some Estimated Price

7
Elasticities? 8
Elasticities of Demand
… Good Price elasticity
… The availability of close substitutes.
… Inelastic demand
† The price elasticity of demand will tend to be large if there
are close substitutes. … Eggs 0.1 Price elasticity of
… Whether the good is a necessity or a luxury. … Beef 0.4 demand < 1
… Stationery 0.5
† The price
Th i elasticity
l ti it off d
demand
d ttends
d tto b
be llow if th
the good
d iis … G li
Gasoline 05
0.5
a necessity.
… Elastic demand
… Time
† The “long-run” price elasticity of demand is often higher … Housing 1.2 Price elasticity of
than the “short-run” elasticity. … Restaurant meals 2.3 demand > 1
… Airline travel 2.4
… Elasticities have the very useful “unit-free” property, … Foreign travel 4.1
by making use of percentage changes.

2
 Three Demand Curves with Constant Conventions with Describing the Price
9
Elasticity… 10
Elasticity of Demand
P P P … Demand is elastic if the price elasticity of demand is
D greater than 1: εp>1
… Demand is inelastic if the price elasticity of demand
is less than 1: εp<1
D … Demand is unit elastic if the price elasticity of
demand is exactly 1: εp=1
D

Q Q Q

Εp=0; shoelaces? Εp=1; product with

Εp=∞; pink tennis balls?
unit-elastic demand.

Why Am I Paying So Much Attention to

Two Examples
11 12
Price Elasticities?
… Inelastic demand … Elastic demand … It affects total revenue (TR = P*Q)
† If demand is elastic, a 1 percent price cut increases the
P P quantity sold by more than 1 percent, and total revenue
increases.
A 20% increase in price… A 20% increase in price…
† If demand is inelastic, a 1 percent price cut increases the
… generates a 10% quantity sold by less than 1 percent
percent, and total revenue
1.10 decrease in the quantity 1.10 decreases.
demanded, so εp=0.5 † If demand is unit elastic, total revenues are unaffected by
0.90 0.90 price changes.
D … Dairy farmers (generally), for example, oppose
… generates a 40% adoption of Bovine Growth Hormone (BGH). Milk
D
decrease in the quantity demand is inelastic.
demanded, so εp=2.0
Q Q
950 1,050 800 1,200

3
 Elasticity and Total Revenue Price Changes and Total Revenue
13 14

… After increasing price there is a “price effect…”

† Each unit sold sells at a higher price, which tends to raise P
total revenue.
Price effect of the price
… But there is also a “quantity effect…” increase: higher price
† After a price
Aft i iincrease, ffewer units
it are sold,
ld which
hi h ttends
d tto f each
for h unit
it sold
ld
lower total revenue.
… The overall effect of a price change on total revenue,
as noted earlier, depends on the elasticity of Sales effect of a price
increase: fewer units are
demand. sold
P’

TR=(P’)*(Q’) D

Q’ Q
Net effect in this example: Total revenue increases (demand must have been inelastic)

The Price Elasticity of Demand Changes Along15the

Demand Curve The Elasticity Changes Along a Linear
Demand Curve!
16

ΔQ
(Q + Q 2 ) / 2 ΔQ ( P1 + P 2 )
1
1 ( P1 + P 2 )
εp ≡ = * 1 = * 1
ΔP ΔP (Q + Q ) Slope (Q + Q 2 )
2

(P + P ) / 2
1 2

Since the slope is constant along a

linear demand curve, the elasticity
must change as the price and quantity
change along the demand curve.

4
 Other Elasticities Other Elasticities, continued
17 18

… Remember the elasticity definition … Remember the elasticity definition

† Percentage change in this over the percentage † Percentage change in this over the percentage change in
change in that. that.
… C
Cross price
i elasticity
l i i off d
demand
d … Income elasticity of demand
%ΔQA %ΔQD
ε AB = εY =
%ΔPB % ΔY
† If εAB>0, the goods are substitutes † If εY>0, the good is a normal good
† If εAB<0, the goods are complements † If εY<0, the good is an inferior good
„ If εY>1, the good is sometimes called a “luxury good”

Two Extreme Cases of the Price

Other Elasticities, part 3
19 20
Elasticity of Supply

… Remember the elasticity definition … Perfectly inelastic, εS=0 … Perfectly elastic, εS=∞
† Percentage change in this over the percentage P S
P
At exactly $12,
change in that. producers will
produce any
… Price elasticity of supply quantity. S
† The price elasticity of supply is a measure of the $12
…leaves the
responsiveness of the quantity of a good supplied to A price quantity
increase… Below $12
supplied of
the price of that good. beachfront
none is
supplied…
property
unchanged.
%ΔQS
εS = Q Q of pizza
% ΔP

5
 Factors that Influence the Price Elasticities and Tax Incidence: Excise Taxes
Elasticity of Supply Get Shifted to the Inelastic Factor
21 22

… The availability of inputs

S
† When inputs are easily available, εS (the price elasticity of Because supply is so inelastic,
supply) will tend to be large (meaning supply is elastic). producers bear almost the full
New price consumers pay
burden of the excise tax. In
When the inputs are difficult to obtain, εS will tend to be other words, the incidence of
small.
small th ttax ffalls
the ll on producers.
d

… Time No tax P
tax
† εS tend to be larger the longer the period of time that Tax
producers have to respond to a price change. New price
producers receive D
„ Long-run price elasticities are generally larger than short-run
elasticities.
D’
Q
Q

Deadweight Loss is Affected by the

Elasticities and Tax Incidence, Part 2
23 24
Elasticity of Demand…
S’ S’
New price
consumers P P
S
pay S S
tax

Because demand is so inelastic,

N ttax P
No
consumers bear almost the full
burden of the excise tax. In D DWL
New price
producers other words, the incidence of
receive the tax falls on consumers. DWL
Tax

D D
D’
Q Q
Q
Q
The DWL is clearly larger when demand is more elastic

6
 Deadweight Loss is Affected by the
25
Elasticity of Supply
S
P P
Tax
S’

DWL
Tax S
DWL

D D

Q Q

The DWL is clearly larger when supply (and/or demand) is more elastic