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Imagine!
■ Wheat Farmer
■ Higher harvest = higher income
■ A major discovery
■ A new form of hybrid wheat
2
To use or not to use?
■ The yield will increase by 20% per hectare of land
■ Should you use it?
■ Is it a good alternative?
■ Will it cost more?
■ Will demand increase?
3
Basic rule of Supply and Demand
■ The quantity of a product supplied and demanded reacts to changes in price
■ Can you measure this reaction?
■ Elasticity
4
What is Elasticity?
■ A measure of how much buyers and sellers respond to changes in markets conditions.
■ Determining the direction of effect
■ The quantitative value of the effect
5
Price Elasticity of Demand
■ Percentage change in quantity demanded divided by the percentage change in price
■ Suppose price decreases by 25%
■ Demand increases by 100%
■ Elasticity = 100/25 = 4
6
Price
Quantity
4
3
50 100
Price Elasticity of Demand
■ Now if price increases
■ % increase in price is 33.33%
■ Demand decreases by 50%
■ Elasticity = 50/33.33 = 1.5
■ So value of E changes according to price increase of decrease
7
Price
Quantity
4
3
50 100
Solution
■ The Midpoint Method:
■ Divide the change in value by the median price.
■ Price on average = (4-3)/3.5 = 28.57%
■ Quantity on average = (100-50)/75 = 66.67%
■ PE = 66.67/28.57 = 2.33
8
Price
Quantity
4
3
50 100
3.5
75
9
■Inelastic Demand
■ Quantity demanded does not respond strongly to price changes.
■ Price elasticity of demand is less than one.
■Elastic Demand
■ Quantity demanded responds strongly to changes in price.
■ Price elasticity of demand is greater than one.
The Variety of Demand Curves
The Variety of Demand Curves11
■Because 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.
slope = (y1-y2)/(x1-x2)
The Variety of Demand Curves12
■Perfectly Inelastic
■ Quantity demanded stays the same regardless the price.
■Perfectly Elastic
■ Quantity demanded changes infinitely with any change in price.
■Unit Elastic
■ Quantity demanded changes by the same percentage as the price.
■
In extreme cases...
The Variety of Demand Curves13
■ The price elasticity of demand determines whether the demand curve is steep or flat. Note that all percentage changes are calculated using the midpoint method.
18
Total Revenue and the Price Elasticity of Demand
■ Total Revenue = P * QThe amount paid by buyers and received by sellers of the
good
Total Revenue and Price Elasticity of Demand 19
■ Inelastic Demand
■ An increase in the price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increase.
Total Revenue and Price Elasticity of Demand 20
■ Elastic Demand
■ An increase in the price leads to a decrease in quantity that is proportionately larger. Thus, total revenue decreases.
Total Revenue and Price Elasticity of Demand 21
■ Inelastic Demand
■ Price and total revenue move in the same direction
■ Elastic Demand
■ Price and total revenue move in opposite direction
■ Unit Elastic Demand
■ Total revenue remains constant when the price changes
22
Elasticity and Total Revenue along a linear Demand Curve
Price ( USD)
Quantity Total Revenue ( USD)
Percent change in price
Percent change in quantity
Price elasticity Quantity description
7 0 0
6 2 12 15 200 13 Elastic
5 4 20 18 67 3.7 Elastic
4 6 24 22 40 1.8 Elastic
3 8 24 29 29 1.0 Unit elastic
2 10 20 40 22 0.6 inelastic
1 12 10 67 18 0.3 inelastic
0 14 0 200 15 0.1 inelastic
Income Elasticity of Demand
■ Income 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.
23
Other Elasticities
24
Income Elasticity of Demand
Income elasticty of demand =
Percentage change in quantity demanded
Percentage change in income
Other Elasticities
25
Income Elasticity of Demand
■ Types of Goods
■ Normal Goods
■ Inferior Goods
■ Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.
Other Elasticities
27
Income Elasticity of Demand
■ Goods consumers regard as necessities tend to be income inelastic
■ Goods consumers regard as luxuries tend to be income elastic.
Other Elasticities
28The Cross-Price Elasticity of Demand
Cross-price elasticity of demand =
Percentage change in quantity demanded of good 1
Percentage change in the price of good 2
Other Elasticities
■ The Cross-Price elasticity of Demand measures the response of demand for one good to changes in the price of another good
29The Cross-Price Elasticity of Demand
Other Elasticities
■ For substitutes, cross-price elasticity > 0 (e.g., an increase in price of beef causes an increase in demand for chicken)
■ For complements, cross-price elasticity < 0 (e.g., an increase in price of computers causes decrease in demand for software)
30The Elasticity of Supply
■ Price 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.
31The Elasticity of Supply
Percentage change in quantity supplied
Percentage change in pricePrice elasticity of supply =
32The Elasticity of Supply
Q2
Price elasticity of supply equals
P
Q
S
P2
Q1
P1
P rises
by 8%
Q rises by
16%
16%8%
= 2.0
Example:
How the Price Elasticity of Supply Can Vary 38
ELASTICITY AND ITS APPLICATION 38
SP
Q
Supply often becomes less elastic as Q rises, due to capacity limits.
$15
525
12
500
$3
100
4
200
elasticity > 1
elasticity < 1