Elasticity. Krzysztof Kołodziejczyk, PhD

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1 Elasticity Krzysztof Kołodziejczyk, PhD

2

3 Agenda 1. Price elasticity of demand 2. Extreme cases of elasticity 3. Elasticity and pricing 4. Elasticity in the long-term and short-term 5. Elasticity in areas other than price

4 Elasticity keywords price elasticity of demand income elasticity of demand cross-price elasticity of demand elastic inelastic unitary pricing passing costs on to consumers normal good inferior good short run / long run

5 Elasticity todays questions What is price elasticity? How to calculate and interpret price elasticity of demand What are the extreme cases of elasticity of demand? What is the link between elasticity of demand and pricing? What are the differences between price elasticity in the short term and long term? What about elasticities caused by other determinants than price?

6 What is price elasticity of demand? micro in theory Simple example for standard demand Price (gallon) Quantity demanded (millions of gallons) $ $ $ $ $ $ $ What is going on if the price changes? We already know that the law of demand is working. But is the buyer's response to the change in price always the same?

7 What is price elasticity of demand? micro in theory Simple example for standard demand Price (gallon) Quantity demanded (millions of gallons) Ep $ ? $ ? $ ? $ ? $ ? $ ? $ ? We compute Ep as a relative change in demand divided by the relative price change

8 What is price elasticity of demand? micro in theory Simple example Price (gallon) Quantity demanded (millions of gallons) Ep $ ,6 $ $ $ $ $ $ Please measure elasticities for other indicated prices.

9 What is price elasticity of demand? micro in theory Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It is computed as the percentage change in quantity demanded or supplied divided by the percentage change in price. We will focus on the price elasticity of demand Elasticity can be described as elastic very responsive unit elastic, or inelastic not very responsive. o Elastic demand curve indicate that the quantity demanded responds to price changes in a greater than proportional manner. o An inelastic demand curve is one where a given percentage change in price will cause a smaller percentage change in quantity demanded. o Unitary elasticity means that a given percentage change in price leads to an equal percentage change in quantity demanded.

10 Calculating price elasticity of demand micro in theory If % change in quantity % change in price % change in quantity % change in price > 1 = 1 it means elastic demand unitary elasticity % change in quantity % change in price < 1 inelastic demand

11 Extreme cases micro in theory Perfect elasticity (or infinite elasticity) - the extreme case where either the quantity demanded or supplied changes by an infinite amount in response to any change in price. Image credit: Figure 1 in "Polar Cases of Elasticity and Constant Elasticity" by OpenStaxCollege, CC BY 4.0

12 Extreme cases micro in theory Perfect elasticity (or infinite elasticity)

13 Extreme cases micro in theory Perfect elasticity (or infinite elasticity)

14 Extreme cases micro in theory Perfect inelasticity (or zero elasticity) - the extreme case where a percentage change in price - no matter how large - results in zero change in quantity. Image credit: Figure 2 in "Polar Cases of Elasticity and Constant Elasticity" by OpenStaxCollege, CC BY 4.0

15 Extreme cases micro in theory Perfect inelasticity (or zero elasticity)

16 Extreme cases micro in practice Think about other examples from the real markets. Justify your choice.

17 Elasticity and pricing micro in theory Price (gallon) Quantity demanded (millions of gallons) Ep Revenues (P x Qd) $ ,6 800 $ $ $ $ $ $

18 Elasticity and pricing micro in theory The price elasticity of demand is the key concept when thinking about how to collect the most revenue. Because total revenue is price times the quantity of tickets sold. Three scenarios: o if demand is elastic, then total revenue goews up thanks to lower price; o If demand is inelastic, then total revenue goes up thanks to higher price; o If demand is unitary, then total revenue remains unchanged when price changes.

19 Elasticity and pricing micro in practice Group 1 Think about which producers can afford a pricing policy that involves price increases. Justify the answer. Group 2 Think about which producers should look for opportunities to reduce prices. Justify the answer.

20 Elasticity and pricing micro in practice Goods and services Housing 0.12 Transatlantic air travel, economy class 0.12 Rail transit, rush hour 0.15 Electricity 0.20 Taxi cabs 0.22 Gasoline 0.35 Transatlantic air travel, first class 0.40 Wine 0.55 Beef 0.59 Transatlantic air travel, business class 0.62 Kitchen and household appliances 0.63 Rail transit 1.00 Computer 1.44 Cable TV, basic urban 1.51 Cable TV, premium 1.77 Restaurant meals 2.27 Elasticity of price The necessities such as housing and electricity are inelastic, while items that are not necessities such as restaurant meals are more price sensitive. If the price of the restaurant meal increases by 10%, the quantity demanded will decrease by 22.7%. A 10% increase in the price of housing will cause a slight decrease of 1.2% in the quantity of housing demanded.

21 Elasticity and pricing micro in theory The price elasticity of demand plays also a key role in determining if a firm can pass the costs on to consumers. Scenario 1: inelastic demand (f.e. cigarettes) Image credit: Figure 2 in "Polar Cases of Elasticity and Constant Elasticity" by OpenStaxCollege, CC BY 4.0

22 Elasticity and pricing micro in theory The price elasticity of demand plays also a key role in determining if a firm can pass the costs on to consumers. Scenario 2: elastic demand (f.e. youth smoking) Image credit: Figure 2 in "Polar Cases of Elasticity and Constant Elasticity" by OpenStaxCollege, CC BY 4.0

23 Conclusion I know the price elasticity of demand, I sell better.

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