Elasticity-CH6

Chapter 6: Elasticity and its Application

Introduction to Elasticity

• Elasticity: A concept that measures responsiveness.

• Key Insights:

  • Measures how strongly people respond to changes in prices and income.

  • Answers questions like:

    • Impact on museum attendance after a price increase.

    • Demand changes for products due to price variations.

    • Effects on demand when competitive product prices change.

Importance for Public Policy

• Elasticity in Policy Making: Helps answer crucial economic questions.

• Examples of applications:

  • Effects of increasing taxes on labor supply.

  • Implications of reducing fuel taxes on gasoline demand.

  • Impact of luxury taxes on item demand (yachts).

• Forecasting: Accurate elasticity measurements are vital for predictions.

Case Study: Tennis Court Permits

• Incident: Permit prices doubled from $100 to $200.

• Outcome: Almost a 50% drop in sales from 2010 to 2012.

• Economic Findings:

  • Expected revenue was $6.3 million; actual was only $1.1 million.

  • Higher fees led to decreased income suggesting elastic demand.

Practical Scenario in Business

• Website Design: Changing the price from $200 to $250 per website.

• Current sales: 12 websites per month.

• Questions:

  • How many fewer will be sold?

  • Will overall revenue fall or potentially rise?

Understanding Elasticity

• Definition: Elasticity measures the degree of response of quantity demanded (Qd) or supplied (Qs) to changes in determining factors.

Price Elasticity of Demand

• Formula: Price elasticity of demand = Percentage change in Qd / Percentage change in P.

• Significance: Measures price sensitivity of buyers.

Calculation Examples

• Basic Example: If P rises by 10% and Q falls by 15%, then:

  • Price elasticity of demand = 15% / 10% = 1.5

• Elasticity Sign: Generally presented as positive even though demand typically falls as price rises.

Percent Change Calculations

• Standard Method:

  • Formula: (End Value - Start Value) / Start Value x 100%

• Illustration: Price change from A ($200) to B ($250).

Conundrum in Elasticity Calculations

• Issue: Elasticity values differ based on starting points.

• Resolution: Use the midpoint formula for consistent results in calculations.

Using the Midpoint Method

• Formula: (End Value - Start Value) / Midpoint x 100%

• Example Calculation from A to B:

  • Price change: ($200 - $250) / $225 = -22.2%

  • Quantity change: (12 - 8) / 10 = 40.0%

  • Elasticity = 40 / -22.2 = 1.8

Determinants of Price Elasticity

• Factors affecting price elasticity:

  • Availability of substitutes.

  • Whether the good is a necessity or luxury.

  • Broadness or narrowness of the good's definition.

  • Time horizon for consumer adjustment.

Examples of Goods

• Rice Krispies vs Sunscreen: Close substitutes lead to higher elasticity for Rice Krispies.

• Blue Jeans vs Clothing: Narrowly defined goods like blue jeans have higher elasticity.

• Insulin vs Cruises: Necessities (insulin) have lower elasticity compared to luxuries (cruises).

• Gasoline: Price elasticity affects short-term vs long-term consumer behavior.

Summary of Factors Influencing Elasticity

• Price elasticity of demand varies based on:

  1. Availability of substitutes

  2. Necessity versus luxury classification

  3. Definition breadth

  4. Time consideration (long-run vs short-run)

Demand Curve Elasticity

• Classification: Economists categorize demand curves by elasticity based on slope.

• Elasticity Guidelines:

  • Flatter curves indicate greater elasticity.

  • Steeper curves indicate lower elasticity.

Types of Demand Elasticity

• Perfectly Inelastic: Elasticity = 0 (no change in quantity demanded regardless of price).

• Inelastic Demand: Elasticity < 1 (quantity changes less than price).

• Unit Elastic Demand: Elasticity = 1 (proportional changes in quantity and price).

• Elastic Demand: Elasticity > 1 (quantity changes more than price).

• Perfectly Elastic Demand: Elasticity = ∞ (any price change results in infinity quantity change).

Price Elasticity and Total Revenue

• Total Revenue = P x Q

• Relationship between price increase and revenue depends on demand elasticity:

  • Elastic Demand: Price increase → Revenue decrease.

  • Inelastic Demand: Price increase → Revenue increase.

Summary of Price Elasticity Effects on Revenue

• Elastic Demand: Higher price leads to significantly lower quantity sold, thus decreasing revenue.

• Inelastic Demand: Higher price leads to minor decrease in quantity sold, thus increasing revenue.

Elasticity and Expenditure Revenue Examples

• Insulin Price Increase: Total expenditure likely rises.

• Cruise Price Decrease: Total revenue for cruise companies likely falls due to high elasticity.

Estimated Price Elasticities of Demand (Table 6-1)

• Inelastic Demand Examples:

  • Gasoline (short-run): 0.09

• Elastic Demand Examples:

  • College (out-of-state tuition): 1.5

Price Elasticity of Supply

• Definition: Measures how Qs changes with price changes.

• Formula: Price elasticity of supply = Percentage change in Qs / Percentage change in P.

Characteristics of Supply Curves

• Classified based on elasticity similarly to demand curves:

  • Flatter = more elastic, steeper = less elastic.

Types of Supply Elasticity

• Classification includes Perfectly Inelastic, Inelastic, Unit Elastic, Elastic, and Perfectly Elastic.

Determinants of Supply Elasticity

• Availability of production inputs.

• Time considerations impact supplier responsiveness.

Other Elasticities

• Income Elasticity of Demand: Measures Qd change due to income change, varies for normal and inferior goods.

• Cross-Price Elasticity of Demand: Measures demand change for one good in response to another good's price change, indicating substitution or complementary relationships.