Elasticity

Chapter 4 Elasticity

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Example 4.1
 Will the China’s trade balance (export – import) deteriorate if RMB appreciates (say, from 1USD=8.1RMB to 1USD=7.8RMB)? 1. China’s imports become less expensive. Quantity demanded for import may increase. 2. China’s Exports become more expensive. Quantity demanded for export may decrease.  The impact of RMB appreciation on the trade balance depends on the responsiveness of import demand and export demand to the appreciation.
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Price Elasticity of Demand
 The Price Elasticity of Demand is a measure of the responsiveness of the quantity demanded of a good to a change in the price of that good.  Formally, it is the percentage change in the quantity demanded that results from a 1 percent change in its price. Percentage change in quantity demanded Percentage change in price
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Elasticity
 Generally, elasticity is a measure of the responsiveness of the quantity demanded of a good to a change in the price of that good

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2  The price of pork falls by 2% and the quantity demanded increases by 6%  Then the price elasticity of demand for pork is 6% -2% = -3 Percentage change in quantity demanded Percentage change in price 5 .Example 4.

 If a 1 percent rise in the price of shelter caused a 2 percent reduction in the quantity of shelter demanded.3.Example 4. the price elasticity of demand for shelter would be -2% 1% = -2 6 .

an inverse relationship between price and quantity).  For convenience sometimes we drop the negative sign. 7 .e.Price Elasticity of Demand  Measuring Price Elasticity of Demand Percentage change in quantity demanded Percentage change in price  Observations  Price elasticity of demand will always be negative (i..

Price Elasticity of Demand Percentage Change in Quantity Demanded Percentage Change in Price Unit elastic Elastic inelastic -3 -2 -1 Price elasticity 0 of demand 8 .

4.Example 4.7/piece  Quantity demanded = 404 pieces/day.400)/400 (9.7 . then (404 . What is the elasticity of demand for sushi?  Originally  Price = $10/piece  Quantity demanded = 400 pieces/day  New  Price = $9.10)/10 1% -3% = = -1 3 Inelastic! 9 .

then (12000 .Example 4.10000)/10000 (1520 .1600)/1600 = 20% -5% = -4 Elastic! 10 .000 passes/year  New  Price = $1520  Quantity demanded = 12. What is the elasticity of Hong Kong Disney passes?  Originally  Price = $1600  Quantity demanded = 10.5.000 passes/year.

2. 11 . Availability of substitutes . So quantity will not respond much in the short run. Proportion of income used to buy the good . the higher is elasticity.the response of quantity demanded that day will be much greater than the response to quantity when prices are expected to decrease permanently. individuals will take some time to find other substitutes and make suitable changes. Suppose there is a one-day sale . Temporary versus permanent change in price . 3. 4.Determinants of Price Elasticity of Demand 1.elasticity increases over time. Short run versus long run .if the price change is temporary people react more to it. the more responsive people are to price changes.the higher the fraction of income spent on a good. If there is a sudden price increase.the higher the number of substitutes. Elasticity increases with availability of substitutes.

Example 4.20 -1. opera Price elasticity -2.25 -0.70 -0.87 -0.77 -0.35 -1.63 -1. Price Elasticity Estimates for Selected Products Good or service Green peas Restaurant meals Automobiles Electricity Beer Movies Air travel (foreign) Shoes Coffee Theater.19 -0.6.18 Why is the price elasticity of demand more than 14 times larger for green peas than for theater and opera performances? 12 .80 -1.

13 .A Graphical Interpretation of Price Elasticity  For small changes in price ΔQ Q Price elasticity = ∈ = = ( ΔQ / ΔP )( P / Q) ΔP P Where Q is the original quantity and P is the original price.

A Graphical Interpretation of Price Elasticity  For small changes in price Price elasticity =∈= ΔQ Q ΔP P P A P  P  1   Pr ice elasticity at A =   Q  slope     Price P- P Q D Q Q+ Q 14 Quantity .

7.Example 4. Calculating Price Elasticity of Demand slope = D 20 16 12 vertical intercept − 20 = = −4 horizontal intercept 5 Price 8 −1 8 2 ∈ = x =− =− A 3 4 12 3 A 8 4 Question: What is the price elasticity of demand when P = $8? 1 2 3 Quantity 15 4 5 .

8.Example 4. 12 16 Price 4 6 Quantity . the steeper curve must be less elastic with respect to price at that point. Price Elasticity and the Steepness of the Demand Curve What is the price elasticity of Demand for D1 & D2 when P = $4? 12 D1   1  4  1  ∈D1 =   − =−  12  2 4 6     4  1  ∈D2 =   − = −2  6  4  12  D2 6 4 Observation If two demand curves have a point in common.

9. Price Elasticity Regions along a Straight-Line Demand Curve 12 When P = $4 When P = $1    4  1  ∈D =   − = −2  6  4  12    1  1  1  ∈D =   − =− 5  10  6   12  6 Price 4 D 1 4 6 Quantity 10 Observation Price elasticity varies at every point along a straight-line demand curve 12 17 .Example 4.

Price Elasticity Regions along a Straight-Line Demand Curve Observation Price elasticity varies at every point along a straightline demand curve a ε < −1 ε = −1 Price a/2 ε > −1 b/2 Quantity b 18 .

∞) Price Quantity If the price increases a little. If the price drops a little. 19 . the quantity demanded will increase a lot. the quantity demanded will drop to zero.Perfectly Elastic Demand Curve Perfectly elastic demand (elasticity = .

20 .Perfectly Inelastic Demand Curve Perfectly inelastic demand (elasticity = 0) Price Quantity The quantity demanded is not responsive to any change in price.

Elasticity and Total Expenditure  Total Expenditure = P x Q  Market demand measures the quantity (Q) at each price (P)  Total Expenditure = Total Revenue 21 .

The Demand Curve for Movie Tickets Price ($/ticket) 12 10 Total expenditure ($/day) 0 1000 1600 1800 1600 1000 0 Price ($/ticket) 8 6 4 2 0 1 2 3 4 12 10 8 6 4 2 0 5 6 Quantity (100s of tickets/day) 22 .Example 4.10.

800 1.600 Price ($/ticket) 8 6 4 2 0 1 2 3 4 5 6 Total expenditure ($/day) 1.Total Expenditure as a Function of Price Total revenue is at a maximum at the midpoint on a straight-line demand curve. 12 10 1.000 0 2 4 6 8 10 12 Quantity (100s of tickets/day) Price ($/ticket) 23 .

Quantity (sq yds/wk) 24 .  What happens to total expenditure on shelter when the price is reduced from $12/sq yd to $10/sq yd? When price goes 16 14 12 E 10 8 6 4 F 2 0 2 Reduction in expenditure from sale at a lower price Increase in expenditure from additional sales G 4 6 8 10 12 16 14 Price ($/sq yd) down.11. total expenditure will rise [fall] if the gain from sale of additional units is larger [smaller] than the loss from the sale of existing units at the lower price.Example 4.

Maximizing total revenue is the same as maximizing total profit.000/week  If P is lowered 10%.000.  Total revenue = $20 x 5.500 = $177.500 = $77.Example 4.000/week Note: Cost does not change with Q.000/week  If P is increased 10%. Elasticity and Total Expenditure  Should a rock band raise or lower its price to increase total revenue?  Assume P=$20. Q=5.  Q will decrease 30%  Total revenue = $22 x 3. and ε =-3.12.  Q will increase 30%  Total revenue = $18 x 6.000 = $100. 25 .

.. A price increase will.Elasticity and Total Expenditure If demand is.. increase total expenditure elastic (ε > 1) P x Q = P Q P x Q = P Q increase total expenditure reduce total expenditure inelastic (ε < 1) P x Q = P Q P x Q = P Q 26 ... reduce total expenditure A price reduction will..

A demand curve with constant elasticity P Unitary elastic: PxQ=k Q 27 .

So answer a is correct. a fare increase will increase total revenue. d.  A director of a big bus company said. ∆ Q/Q = -0.13. demand is price elastic. we lose 0.2." We can conclude that: a. A fare increase will increase total revenue.2 percent of our riders. c. e.2%.  We are told that when ∆ P/P = 1%. 28 . demand for bus service will go up as fares increase.Example 4. (inelastic)  Elasticity = (∆ Q/Q)/(∆ P/P) = -0. "For each 1 percent fare hike. a 10 percent fare hike will produce a 20 percent reduction in riders. b. the price elasticity is -5.

Cross-Price Elasticity of Demand  The percentage by which quantity demanded of the first good changes in response to a 1 percent change in the price of the second good  Substitute Goods When the cross-price elasticity of demand is positive  Complement Goods When the cross-price elasticity of demand is negative 29 .

Income Elasticity of Demand  The percentage by which quantity demanded changes in response to a 1 percent change in income  Normal Goods Income elasticity is positive  Inferior Goods Income elasticity is negative 30 .

The Price Elasticity of Supply  Price Elasticity of Supply  The percentage change in the quantity supplied that occurs in response to a 1 percent change in price ∆Q Q Price elasticity of supply = ∆P P  P  1 Price elasticity of supply =     Q  slope     31 .

A Supply Curve for Which Price Elasticity Declines as Quantity Rises A = ( 8 2)(1 2 ) = 2 10 8 8 Price A B S 5 B = (10 3)(1 2 ) = 3 4 Observations: 1.Example 4. Elasticity >1 for linear supply curve that has a positive Yintercept. Elasticity >0 2. 3. 2 2 3 Quantity 32 0 .14. Elasticity decreases as quantity increases.

0 12 Quantity 15 33 . A Supply Curve for Which Price Elasticity is unity A = ( 4 / 12 )(12 / 4 ) = 1 B = ( 5 15 )(15 5) = 1 5 4 Price A Q B P S The price elasticity of supply will always equal 1 at any point along a straight-line supply curve that passes through the origin.15.Example 4.

34 .A challenge  Construct an example of supply curve so that price elasticity increases as quantity rises.

A Perfectly Inelastic Supply Curve What is the price elasticity of supply of land within Central? S Price ($/acre) Elasticity = 0 at every point along a vertical supply curve 0 Quantity of land in Central (1.000s of acres) 35 .

then the price elasticity of supply at every point along a horizontal supply curve is infinite 14 S 0 Quantity of lemonade (cups/day) 36 .A Perfectly Elastic Supply Curve Price (cents/cup) If MC is constant.

Flexibility of inputs Mobility of inputs Ability to produce substitute inputs Time 37 . 3.Determinants of Supply Elasticity 1. 4. 2.

Example 4:16. Why are gasoline prices so much more volatile than car prices?  Differences in markets  Demand for gasoline is more inelastic  Gasoline market has larger and more frequent supply shifts 38 .

69 1.2 Quantity (millions of gallons/day) 39 .02 D 0 6 7.Greater Volatility in Gasoline Prices than in Car Prices S’ Gasoline S Price ($/gallon) 1.

000s of cars/day) Cars 40 .Greater Volatility in Gasoline Prices than in Car Prices Cars S’ Price ($1.000s/car) S 17 16.4 D 11 12 Quantity (1.

an example of ultimate supply bottleneck.Example 4. 41 .17.5 million? YAO Ming is a unique and essential inputs. Earnings of YAO Ming  Why does YAO Ming earn an annual basketball salary of some US$4.

42 . head of HSBC's private banking in Asia. the plaintiff? Mimi Monica Wong.Other examples of unique and essential inputs  Dr. Joseph YAM?  Mr Mirko Saccani? “The fee was agreed to be $120 million for eight years' of unlimited [Latini]dance lessons and competitions. CITY3) Who was she.” (SCMP 2006-06-14. and Mr Saccani would be her dancing partner and instructor by such agreements.

a student different? of Robert Frank. the fare is a lot lower than if you start the same trip in Honolulu and fly to Kansas City round-trip. Passengers travel on same planes. 43 .Example 4. and so on. consuming the same fuel. So why are the fares so By Karen Hittle. So why are the fares so different? If you start in Kansas City and you fly to Honolulu roundtrip.18. the same in-flight amenities.

Example 4. you either have business or family reasons for traveling.18. Given economies of scale inherent in larger aircraft. to Barbados. 44 . You could go to Florida.  But if you are starting in Honolulu on a trip to Kansas City. Because vacationers have many destinations to choose from. you are probably going on vacation. carriers have a strong incentive to fill additional seats by targeting lower prices to the people who are more sensitive to price – vacationers. So you are probably not shopping for a destination if you are going to Kansas City. More likely. You could go lots of different places. to Cancun. airlines must compete fiercely for their business. you are probably not a vacationer.  That is why the fares are so different. So why are the fares so different?  If you are starting in Kansas City and going to Honolulu.

the own price elasticity of demand for rental homes is price inelastic. rented homes and owned homes are complements. the own price elasticity of demand for rental homes is price elastic. B. the own price elasticity of demand for rental homes has unitary price elasticity. 45 . D.19. rented homes and owned homes are substitutes.Example 4. Other things being equal. C. E. the increase in rents that occur after rent control are abolished is smaller when A.

 Excess demand (i.Example 4.. P D S Trading Loci Pe Price Ceiling Q 46 .e.19.  Rent control is a form of PRICE CEILING. shortage) results.  Price Ceiling is set at a price LOWER than the market equilibrium price.

the market equilibrium quantity and price should be restored eventually.19.Example 4.  And when the Price Ceiling is lifted.  Price (rent) should increase. ↑P → ↑ TR Price Ceiling Q 47 . P D S Because supply is upward sloping.

48 . Relative inelastic P D S Pe Price Ceiling Relative elastic Q Hence.19. the increase in rents that occur AFTER abolishing rent control is smaller when (B) The own price elasticity of demand is elastic.Example 4.

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