Chapter 5: Elasticity and Taxation

Prepared for MICROECONOMICS, Ms BonfigNotes Adapted from Krugman, Wells and Graddy “Essentials of Economics” Third Edition,

2013 and notes from Dr. Julie Mueller

Elasticity – How do we respond to price?

Elasticity is a measure of “price responsiveness” If demand is elastic, the price elasticity of

demand is > 1 , or demand is responsive to change.

If demand is inelastic, the price elasticity of demand is < 1 , or demand is less responsive to price changes.

If demand is unitary elastic, the price elasticity of demand = 1 , or the change in demand is equal to the change in price.

Inelastic Unitary Elastic 1

Defining and Measuring Elasticity The Price Elasticity of demand is

Where the % change in quantity demanded = X 100

And the % change in price = X 100

Interpreting Elasticity…if P.E.D = 1.

Demand is…..

A. Unitary ElasticB. ElasticC. Inelastic

Interpreting Elasticity…if P.E.D = 0.5

Demand is…..

A. Unitary ElasticB. ElasticC. Inelastic

Interpreting Elasticity …if P.E.D = 2 .

Demand is…..

A. Unitary ElasticB. ElasticC. Inelastic

Understanding “Perfectly Elastic” and “Perfectly Inelastic” Demand

What Factors Influence Price Elasticity of Demand?

1. Availability of substitutes More substitutes = more elastic ; less substitutes = more inelastic

2. Whether the good is a necessity or a luxury

Luxury good = elastic ; necessity good = more inelastic

3. Share of income spent on the good Lower price = elastic ; higher price = inelastic

4. Time elapsed since the price change More time = elastic ; less time = inelastic

Total Revenue and Elasticity

Total Revenue is the total value of sales of a good or service. TR = Price X Quantity Sold

When a seller raises a price, two things happen A price effect—each unit sells at a higher price, ⇒ revenue increases A quantity effect—fewer units are sold, ⇒ revenue decreases

Which impact dominates? Elastic demand: QUANTITY effect dominates, and an increase in price results in a decrease in revenue

Inelastic demand: PRICE effect dominates, and an increase in price result in an increase in revenue

Unitary elastic: The effects perfectly balance, and an increase in price has no change in revenue

Total Revenue and Elasticity continued

Demand Elasticity Practice Problem

1.Find the % change in the consumption of gasoline in the short run.

2.Find the % change in the consumption of gasoline in the long run.

3.Find the relevant numerical quantities for the horizontal axis by finding the amount demanded at $4.00 per gallon

4.Draw and label the demand curve.

Gasoline prices increased from about $3.00 per gallon in 2010 to about $4.00 per gallon in 2012. Economists have measured the short run elasticity of demand for gasoline to be about 0.25, and the long run elasticity of demand to be about 0.75. • What is the predicted change in

consumption of gasoline in the short run? • What is the predicted change in

consumption of gasoline in the long run? • Draw and label a demand curve that

reflects the long run elasticity, assuming that at $3.00 per gallon, motorists in the US consume 10 million barrels of gasoline per day.

Demand Elasticity Practice Problem Answer

1. Find the % change in the consumption of gasoline in the short run. percent change in price = X 100 = $1/$3 = 33% = elasticity, so elasticity X % change in price = % change in quantity demanded % change in quantity demanded = 0.25 x 33% = 8.33%

2. Find the % change in the consumption of gasoline in the long run.

0.75 * 33% = 25%

3. Find the relevant numerical quantities for the horizontal axis by finding the amount demanded at $4.00 per gallon.

percent change in quantity demanded = X 100

Rearranging the formula, we see change in quantity demanded = % change in quantity demanded * initial /100= 25 * 10 /100 = 2.5 million barrels

So the new quantity demanded equals 10-2.5 = 7.5 million barrels at a price of $4.

Demand Elasticity Practice Problem Answer

4. Draw and label the demand curve.

Price Elasticity of Supply

The Price Elasticity of Supply is

Measures the responsiveness of quantity supplied to changes in price

Perfectly elastic supply: When even the smallest price changes will lead to drastic changes in the quantity supplied.

Perfectly inelastic supply: When the price elasticity is zero, such that changes in the price have no effect on the quantity supplied.

VS

Interpreting the Price Elasticity of Supply

To be continued when we discusses taxes…