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6>>?2009WorthPublishersElasticityWhatisthedefinitionofelasticity?Whatisthemeaningandimportanceof:priceelasticityofdemand?incomeelasticityofdemand?priceelasticityofsupply?Whatfactorsinfluencethesizeofthesevariouselasticities?Howthecross-priceelasticityofdemandmeasurestheresponsivenessofdemandforonegoodtochangesinthepriceofanothergoodDefiningandMeasuringElasticityThepriceelasticityofdemandistheratioofthepercentchangeinthequantitydemandedtothepercentchangeinthepriceaswemovealongthedemandcurve(droppingtheminussign).ThePriceElasticityofDemandDemandforVaccinationsWhenpricerisesto$21perbarrel,worlddemandfallsto9.9millionbarrelsperday(pointB).D10.09.9$2120Priceofvaccination0Quantityofvaccinations(millions)BACalculatingthePriceElasticityofDemand

UsingtheMidpointMethodThemidpointmethodisatechniqueforcalculatingthepercentchange.Inthisapproach,wecalculatechangesinavariablecomparedwiththeaverage,ormidpoint,ofthestartingandfinalvalues.UsingtheMidpointMethodUsingtheMidpointMethodSomeEstimatedPriceElasticitiesofDemandGood

PriceelasticityInelasticdemandEggs 0.1Beef 0.4Stationery 0.5Gasoline 0.5ElasticdemandHousing 1.2Restaurantmeals 2.3Airlinetravel 2.4Foreigntravel 4.1Priceelasticityofdemand<1Priceelasticityofdemand>1InterpretingthePriceElasticityofDemandTwoExtremeCasesofPriceElasticityofDemand:Demandisperfectlyinelasticwhenthequantitydemandeddoesnotrespondatalltochangesintheprice.Whendemandisperfectlyinelastic,thedemandcurveisaverticalline.Demandisperfectlyelasticwhenanypriceincreasewillcausethequantitydemandedtodroptozero.Whendemandisperfectlyelastic,thedemandcurveisahorizontalline.TwoExtremeCasesofPriceElasticityofDemandD1…leavesthequantitydemandedunchanged.Anincreaseinprice…10Quantityofshoelaces(billionsofpairsperyear)(a)PerfectlyInelasticDemand:PriceElasticityofDemand=0$3$2Priceofshoelaces(perpair)TwoExtremeCasesofPriceElasticityofDemandAtanypriceabove$5,quantitydemandediszeroAtexactly$5,consumerswillbuyanyquantityAtanypricebelow$5,quantitydemandedisinfiniteD2(b)0PriceElasticDemand:PriceElasticityofDemand=∞$5Priceofpinktennisballs(perdozen)Quantityoftennisballs(dozensperyear)InterpretingthePriceElasticityofDemandDemandiselasticifthepriceelasticityofdemandisgreaterthan1.Demandisinelasticifthepriceelasticityofdemandislessthan1.Demandisunit-elasticifthepriceelasticityofdemandisexactly1.UnitElasticityofDemandA20%increaseintheprice...D1...generatesa20%decreaseinthequantityofcrossingsdemanded.(a)Unit-ElasticDemand:PriceElasticityofDemand=19001,1000$1.100.90PriceofcrossingQuantityofcrossings(perday)ABInelasticDemandD2...generatesa10%decreaseinthequantityofcrossingsdemanded.(b)InelasticDemand:PriceElasticityofDemand=0.59501,0500$1.100.90PriceofcrossingQuantityofcrossings(perday)A20%increaseintheprice...ABElasticDemand…generatesa40%decreaseinthequantityofcrossingsdemanded.D3(c)ElasticDemand:PriceElasticityofDemand=28001,2000$1.100.90Quantityofcrossings(perday)PriceofcrossingA20%increaseintheprice...BAWhyDoesItMatterWhetherDemandisUnit-Elastic,Inelastic,orElastic?Becausethisclassificationpredictshowchangesinthepriceofagoodwillaffectthetotalrevenueearnedbyproducersfromthesaleofthatgood.Thetotalrevenueisdefinedasthetotalvalueofsalesofagoodorservice,i.e.TotalRevenue=Price×QuantitySoldTotalRevenuebyAreaDTotalrevenue=pricexquantity=$9901,1000$0.90PriceofcrossingQuantityofcrossings(perday)ElasticityandTotalRevenueWhenasellerraisesthepriceofagood,therearetwocountervailingeffectsinaction(exceptintherarecaseofagoodwithperfectlyelasticorperfectlyinelasticdemand):Apriceeffect:Afterapriceincrease,eachunitsoldsellsatahigherprice,whichtendstoraiserevenue.Aquantityeffect:Afterapriceincrease,fewerunitsaresold,whichtendstolowerrevenue.EffectofaPriceIncreaseonTotalRevenuePriceeffectofpriceincrease:higherpriceforeachunitsoldDQuantityeffectofpriceincrease:fewerunitssoldBCA9001,1000$1.100.90Quantityofcrossings(perday)PriceofcrossingElasticityandTotalRevenueIfdemandforagoodiselastic

(thepriceelasticityofdemandisgreaterthan1),anincreaseinpricereducestotalrevenue.Inthiscase,thequantityeffectisstrongerthanthepriceeffect.Ifdemandforagoodis

inelastic

(thepriceelasticityofdemandislessthan1),ahigherpriceincreasestotalrevenue. Inthiscase,thepriceeffectisstrongerthanthequantityeffect.Ifdemandforagoodis

unit-elastic

(thepriceelasticityofdemandis1),anincreaseinpricedoesnotchangetotalrevenue.Inthiscase,thesaleseffectandthepriceeffectexactlyoffseteachother.PriceElasticityofDemandandTotalRevenueDemandScheduleandTotalRevenueDDemandiselastic:ahigherreducestotalrevenueElasticInelasticUnit-elasticDemandisinelastic:ahigherpriceincreasetotalrevenue0012345671098$252421169QuantityTotalrevenue012345671098$10987654321QuantityPrice$012345678910$091621242524211690109876543210TotalRevenueQuantitydemanded

DemandScheduleandTotalRevenueforaLinearDemandCurvePriceThepriceelasticityofdemandchangesalongthedemandcurveWhatFactorsDeterminethePriceElasticityofDemand?PriceElasticityofDemandisdeterminedby:WhetherCloseSubstitutesAreAvailableWhethertheGoodIsaNecessityoraLuxuryShareofIncomeSpentontheGoodTimeHowMad?RespondingtoyourtuitionbillTuitionhasbeenrisingfasterthantheoverallcostoflivingforyears.Butdoesrisingtuitionkeeppeoplefromgoingtocollege?A1988studyfoundthata3%increaseintuitionledtoanapproximately2%fallinthenumberofstudentsenrolledatfour-yearinstitutions,givingapriceelasticityofdemandof0.67(2%/3%)and0.9fortwo-yearinstitutions.Enrollmentdecisionforstudentsattwo-yearcollegeswassignificantlymoreresponsivetopricethanforstudentsatfour-yearcolleges.Theresult:studentsattwo-yearcollegesaremorelikelytoforgogettingadegreebecauseoftuitioncoststhanstudentsatfouryearcolleges.A1999studyconfirmedthispattern.OtherDemandElasticities:Cross-PriceElasticityThecross-priceelasticityofdemandbetweentwogoodsmeasurestheeffectofthechangeinonegood’spriceonthequantitydemandedoftheothergood.Itisequaltothepercentchangeinthequantitydemandedofonegooddividedbythepercentchangeintheothergood’sprice.TheCross-PriceElasticityofDemandbetweenGoodsAandBCross-PriceElasticityGoodsaresubstituteswhenthecross-priceelasticityofdemandispositive.Goodsarecomplementswhenthecross-priceelasticityofdemandisnegative.TheIncomeElasticityofDemandTheincomeelasticityofdemandisthepercentchangeinthequantityofagooddemandedwhenaconsumer’sincomechangesdividedbythepercentchangeintheconsumer’sincome.NormalGoodsandInferiorGoodsWhentheincomeelasticityofdemandispositive,thegoodisanormalgood-thatis,thequantitydemandedatanygivenpriceincreasesasincomeincreases.Whentheincomeelasticityofdemandisnegative,thegoodisaninferiorgood-thatis,thequantitydemandedatanygivenpricedecreasesasincomeincreases.WhereHaveAlltheFarmersGone?WhydosofewpeoplenowliveandworkonfarmsintheUnitedStates?1)Theincomeelasticityofdemandforfoodismuchlessthan1—itisincomeinelastic.Asconsumersgrowricher,otherthingsequal,spendingonfoodriseslessthanincomeastheU.S.economyhasgrown,theshareofincomeitspendsonfood—andthereforetheshareoftotalU.S.incomeearnedbyfarmers—hasfallen.2)Agriculturehasbeenatechnologicallyprogressivesectorforapproximately150yearsintheU.S.,withsteadilyincreasingyieldsovertime.Competitionamongfarmersmeansthattechnologicalprogressleadstolowerfoodprices.Meanwhile,thedemandforfoodisprice-inelastic,sofallingpricesofagriculturalgoods,otherthingsequal,reducethetotalrevenueoffarmersprogressinfarminghasbeengoodforconsumersbutbadforfarmers.Food’sBiteinWorldBudgets2004060100%Income(%ofU.S.incomepercapital)8080%604020Spendingonfood(%ofincome)SriLankaMexicoIsraelUnitedStatesMeasuringthePriceElasticityofSupplyThepriceelasticityofsupplyisameasureoftheresponsivenessofthequantityofagoodsuppliedtothepriceofthatgood.Itistheratioofthepercentchangeinthequantitysuppliedtothepercentchangeinthepriceaswemovealongthesupplycurve.TwoExtremeCasesofPriceElasticityofSupply(b)PerfectlyElasticSupply:PriceElasticityofSupply=∞0Quantityofpizzas$12PriceofpizzaS1(a)PerfectlyInelasticSupply:PriceElasticityofSupply=01000Quantityofcellphonefrequencies$3,0002,000Priceofcellphonefrequency…leavesthequantitysuppliedunchangedS2Atanypriceabove$12,quantitysuppliedisinfinite.Atexactly$12,producerswillproduceanyquantityAtanypricebelow$12,quantitysuppliediszero.Anincreaseinprice…TwoExtremeCasesofPriceElasticityofSupplyThereisperfectlyinelasticsupplywhenthepriceelasticityofsupplyiszero,sothatchangesinthepriceofthegoodhavenoeffectonthequantitysupplied.Aperfectlyinelasticsupplycurveisaverticalline.Thereisperfectlyelasticsupplywhenevenatinyincreaseorreductioninthepricewillleadtoverylargechangesinthequantitysupplied,sothatthepriceelasticityofsupplyisinfinite.Aperfectlyelasticsupplycurveisahorizontalline.WhatFactorsDeterminethePriceElasticityofSupply?TheAvailabilityofInputs:Thepriceelasticityofsupplytendstobelargewheninputsarereadilyavailableandcanbeshiftedintoandoutofproductionatarelativelylowcost.Ittendstobesmallwheninputsaredifficulttoobtain.Time:Thepriceelasticityofsupplytendstogrowlargerasproducershavemoretimetorespondtoapricechange.Thismeansthatthelong-runpriceelasticityofsupplyisoftenhigherthantheshort-runelasticity.EuropeanFarmSurplusesImpositionofapricefloorstosupporttheincomesoffarmershascreated“buttermountains”and“winelakes”inEurope.WereEuropeanpoliticiansunawarethattheirpricefloorswouldcreatehugesurpluses?Theyprobablyknewthatsurpluseswouldarise,butunderestimatedthepriceelasticityofagriculturalsupplyduetoavailabilityofinputs.TheythoughtbigincreasesinproductionwereunlikelysincetherewaslittlenewlandavailableinEuropeforcultivation.However,farmproductioncouldexpandbyaddingotherresources,especiallyfertilizerandpesticides.Soalthoughfarmacreagedidn’tincreasemuch,farmproductiondid!AnElasticityMenagerieAnElasticityMenagerieElasticityisageneralmeasureofresponsivenessthatcanbeusedtoanswersuchquestions.Thepriceelasticityofdemand—thepercentchangeinthequantitydemandeddividedbythepercentchangeintheprice(droppingtheminussign)—isameasureoftheresponsivenessofthequantitydemandedtochangesintheprice.Theresponsivenessofthequantitydemandedtopricecanrangefromperfectlyinelasticdemand,wherethequantitydemandedisunaffectedbytheprice,toperfectlyelasticdemand,wherethereisauniquepriceatwhichconsumerswillbuyasmuchoraslittleastheyareoffered.Whendemandisperfectlyinelastic,thedemandcurveisaverticalline;whenitisperfectlyelastic,thedemandcurveisahorizontalline.Thepriceelasticityofdemandisclassifiedaccordingtowhetheritismoreorlessthan1.Ifitisgreaterthan1,demandiselastic;ifitislessthan1,demandisinelastic;ifitisexactly1,demandisunit-elastic.Thisclassificationdetermineshowtotalrevenue,thetotalvalueofsales,changeswhenthe