Professional Documents
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Princ Ch05 Presentation7e
Princ Ch05 Presentation7e
Principles of
Economics
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Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
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Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Example:
P rises
Price elasticity P2
by 10%
P1
of demand D
equals
15% Q
= 1.5 Q2 Q1
10%
Q falls
by 15%
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Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Along a D curve, P and Q
move in opposite directions, P2
which would make price
elasticity negative. P1
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Calculating Percentage Changes
Standard method
of computing the
Demand for percentage (%) change:
your websites
P end value – start value
x 100%
start value
B
$250
A Going from A to B,
$200
the % change in P equals
D
($250–$200)/$200 = 25%
Q
8 12
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Calculating Percentage Changes
Problem:
The standard method gives
Demand for different answers depending
your websites on where you start.
P
From A to B,
B P rises 25%, Q falls 33%,
$250
A elasticity = 33/25 = 1.33
$200
From B to A,
D
P falls 20%, Q rises 50%,
Q elasticity = 50/20 = 2.50
8 12
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Calculating Percentage Changes
So, we instead use the midpoint method:
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Calculating Percentage Changes
Using the midpoint method, the % change
in P equals
$250 – $200
x 100% = 22.2%
$225
The % change in Q equals
12 – 8
x 100% = 40.0%
10
The price elasticity of demand equals
40/22.2 = 1.8
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ACTIVE LEARNING 1
Calculate an elasticity
if P = $165, Qd = 7400
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ACTIVE LEARNING 1
Applying the principles
15%
= 0.75
20%
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What determines price elasticity?
To learn the determinants of price elasticity,
we look at a series of examples.
Each compares two common goods.
In each example:
Suppose the prices of both goods rise by 20%.
The good for which Qd falls the most (in percent)
has the highest price elasticity of demand.
Which good is it? Why?
What lesson does the example teach us about the
determinants of the price elasticity of demand?
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EXAMPLE 1
Breakfast Cereal vs. Sunscreen
The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
Breakfast cereal has close substitutes
(e.g., pancakes, Eggo waffles, leftover pizza),
so buyers can easily switch if the price rises.
Sunscreen has no close substitutes,
so a price increase would not affect demand
very much.
Lesson: Price elasticity is higher when close
substitutes are available.
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EXAMPLE 2
“Blue Jeans” vs. “Clothing”
The prices of both goods rise by 20%.
For which good does Qd drop the most? Why?
For a narrowly defined good such as
blue jeans, there are many substitutes
(khakis, shorts, Speedos).
There are fewer substitutes available for
broadly defined goods.
(Are there any substitutes for clothing?)
Lesson: Price elasticity is higher for narrowly
defined goods than for broadly defined ones.
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EXAMPLE 3
Insulin vs. Caribbean Cruises
The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or no
decrease in demand.
A cruise is a luxury. If the price rises,
some people will forego it.
Lesson: Price elasticity is higher for luxuries
than for necessities.
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EXAMPLE 4
Gasoline in the Short Run vs.
Gasoline in the Long Run
The price of gasoline rises 20%. Does Qd drop
more in the short run or the long run? Why?
There’s not much people can do in the
short run, other than ride the bus or carpool.
In the long run, people can buy smaller cars
or live closer to work.
Lesson: Price elasticity is higher in the
long run than the short run.
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The Determinants of Price Elasticity:
A Summary
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The Variety of Demand Curves
The price elasticity of demand is closely related
to the slope of the demand curve.
Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
Five different classifications of D curves.…
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“Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Q 0%
= = =0
% change in P 10%
of demand
D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
none
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
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“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
% change in P 10%
of demand
D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls Q
Elasticity: by 10% Q 1 Q2
<1
Q rises less
than 10%
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“Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
% change in P 10%
of demand
D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
D
intermediate
P falls Q
Elasticity: by 10% Q1 Q2
1
Q rises by 10%
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“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
% change in P 10%
of demand
D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
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“Perfectly elastic demand” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
% change in P 0%
of demand
D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
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A few elasticities from the real world
Eggs 0.1
Healthcare 0.2
Rice 0.5
Housing 0.7
Beef 1.6
Restaurant meals 2.3
Mountain Dew 4.4
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Elasticity of a Linear Demand Curve
P The slope
200% of a linear
$30 E = = 5.0
40% demand
67% curve is
20 E = = 1.0 constant,
67%
but its
40% elasticity
10 E = = 0.2
200% is not.
$0 Q
0 20 40 60
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Price Elasticity and Total Revenue
Continuing our scenario, if you raise your price
from $200 to $250, would your revenue rise or fall?
Revenue = P x Q
A price increase has two effects on revenue:
Higher P means more revenue on each unit
you sell.
But you sell fewer units (lower Q),
due to law of demand.
Which of these two effects is bigger?
It depends on the price elasticity of demand.
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Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P
Revenue = P x Q
If demand is elastic, then
price elast. of demand > 1
% change in Q > % change in P
The fall in revenue from lower Q is greater
than the increase in revenue from higher P,
so revenue falls.
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Price Elasticity and Total Revenue
Demand for
Elastic demand increased your websites
(elasticity = 1.8) P revenue due
lost
to higher P
revenue
If P = $200,
due to
Q = 12 and $250 lower Q
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
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Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P
Revenue = P x Q
If demand is inelastic, then
price elast. of demand < 1
% change in Q < % change in P
The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
In our example, suppose that Q only falls to 10
(instead of 8) when you raise your price to $250.
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Price Elasticity and Total Revenue
Now, demand is Demand for
increased your websites
inelastic:
revenue due
elasticity = 0.82 P to higher P lost
If P = $200, revenue
due to
Q = 12 and
$250 lower Q
revenue = $2400.
$200
If P = $250,
Q = 10 and D
revenue = $2500.
When D is inelastic,
Q
a price increase 10 12
causes revenue to rise.
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ACTIVE LEARNING 2
Elasticity and expenditure/revenue
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ACTIVE LEARNING 1
Answers
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ACTIVE LEARNING 2
Answers
P and Q fall.
P1 initial value
Result: of drug-
A decrease in P2 related
total spending crime
on drugs, and
in drug-related Q2 Q 1 Quantity
crime. of Drugs
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Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P
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Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P
P
Example: S
P rises
Price P2
by 8%
elasticity P1
of supply
equals
Q
16% Q1 Q2
= 2.0
8% Q rises
by 16%
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The Variety of Supply Curves
The slope of the supply curve is closely related
to price elasticity of supply.
Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
Five different classifications…
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“Perfectly inelastic” (one extreme)
Price elasticity % change in Q 0%
= = =0
% change in P 10%
of supply
S curve: P
S
vertical
P2
Sellers’
price sensitivity: P1
none
P rises Q
Elasticity: by 10% Q1
0
Q changes
by 0%
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“Inelastic”
Price elasticity % change in Q < 10%
= = <1
% change in P 10%
of supply
S curve: P
S
relatively steep
P2
Sellers’
price sensitivity: P1
relatively low
P rises Q
Elasticity: by 10% Q 1 Q2
<1
Q rises less
than 10%
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“Unit elastic”
Price elasticity % change in Q 10%
= = =1
% change in P 10%
of supply
S curve: P
intermediate slope S
P2
Sellers’
price sensitivity: P1
intermediate
P rises Q
Elasticity: by 10% Q1 Q2
=1
Q rises
by 10%
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“Elastic”
Price elasticity % change in Q > 10%
= = >1
% change in P 10%
of supply
S curve: P
relatively flat S
P2
Sellers’
price sensitivity: P1
relatively high
P rises Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
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“Perfectly elastic” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
% change in P 0%
of supply
S curve: P
horizontal
P2 = P1 S
Sellers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
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The Determinants of Supply Elasticity
The more easily sellers can change the quantity
they produce, the greater the price elasticity of
supply.
Example: Supply of beachfront property is
harder to vary and thus less elastic than
supply of new cars.
For many goods, price elasticity of supply
is greater in the long run than in the short run,
because firms can build new factories,
or new firms may be able to enter the market.
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ACTIVE LEARNING 3
Elasticity and changes in equilibrium
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ACTIVE LEARNING 3
Answers
Beachfront property
When supply (inelastic supply):
is inelastic, P
an increase in
demand has a D1 D2 S
bigger impact
on price than P2 B
on quantity.
P1 A
Q
Q1 Q2
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ACTIVE LEARNING 3
Answers
New cars
When supply (elastic supply):
is elastic, P
an increase in
demand has a D1 D2
bigger impact S
on quantity
than on price. B
P2
A
P1
Q
Q1 Q2
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How the Price Elasticity of Supply Can Vary
P Supply often
S
elasticity becomes
$15 <1 less elastic
as Q rises,
12 due to
capacity
elasticity
>1 limits.
4
$3
Q
100 200
500 525
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Other Elasticities
Income elasticity of demand: measures the
response of Qd to a change in consumer income
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Other Elasticities
Cross-price elasticity of demand:
measures the response of demand for one good to
changes in the price of another good
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Summary
• Demand is less elastic in the short run,
for necessities, for broadly defined goods,
and for goods with few close substitutes.
• Price elasticity of supply equals percentage
change in Qs divided by percentage change in P.
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