Principles of Microeconomics Problem Set

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Understanding Elasticity Applying Elasticity

ECO 105: Principles of Microeconomics Elasticity

Brian Phelan DePaul University

September 17, 2017

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

Elasticity

The concept of elasticity describes the responsiveness of quantity to changes in price. There is:

price elasticity of demand - how quantity demanded changes when prices change price elasticity of supply - how quantity supplied changes when prices changes others as well (price elasticity of income and cross-price elasticity), but we’ll focus more on the two above

(As we will see it is) Useful in thinking about:

the magnitude of changes in equilibrium. the magnitudes of distortions caused by government policy.

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

Price Elasticity of Demand

Price Elasticity of Demand = Percent Change in Quantity Demanded Percent Change in Price

P.E.D < 1 means demand is inelastic – quantity is relatively unresponsive to price changes

If prices increase 10%, quantity demanded declines by less than 10%

P.E.D = 1 means demand is unitary elastic – quantity responds with a proportional change with price

If prices increase 10%, quantity demanded declines by 10%

P.E.D > 1 means demand is elastic – quantity demanded is quite responsive to a change with price

If prices increase 10%, quantity demanded declines by more than 10%

Elasticities of some general goods:

Close substitutes tend to be more elastic. Necessities tend to be more inelastic. Luxury items tend to be more elastic.

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

Seeing P.E.D in 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 (or more elastic the good is). The steeper the curve, the smaller the elasticity (or more inelastic the good is).

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

Perfectly Inelastic Demand

“Perfectly inelastic demand” (one extreme case) 0% 10%

= 0Price elasticity of demand = % change in Q % change in P

DPD curve: vertical

P Consumers’ price sensitivity:

vertical

P falls

price sensitivity: none

Q1 QP falls

by 10% Q changes

Elasticity: 0

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

g by 0%

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

Inelastic Demand

“Inelastic demand” < 10% 10%

< 1Price elasticity of demand = % change in Q % change in P

PD curve: relatively steep

P Consumers’ price sensitivity:

relatively steep

P falls

price sensitivity: relatively low

Q Q1 Q2

Q rises less

P falls by 10%Elasticity:

< 1

Q rises less than 10%

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

Elastic Demand

“Elastic demand” > 10% 10%

> 1Price elasticity of demand = % change in Q % change in P

PD curve: relatively flat

P Consumers’ price sensitivity:

relatively flat

P falls

price sensitivity: relatively high

Q Q1 Q2 Q rises more

P falls by 10%Elasticity:

> 1

Q rises more than 10%

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

Perfectly Elastic Demand

“Perfectly elastic demand” (the other extreme) any %

0% = infinityPrice elasticity of demand =

% change in Q % change in P

PD curve: horizontal

DP1P2 =Consumers’ price sensitivity:

horizontal

QP changes

price sensitivity: extreme

Q Q1

P changes by 0%

Q changes

Q2Elasticity: infinity

Q changes by any %

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

Calculating Elasticity of Demand

Elasticity is NOT the slope – even if it is related to the slope. It’s %∆Q

%∆P

To calculate percent change, use the midpoint method

Percent Change = End Value−Start Value Midpoint

∗ 100%

Calculating Percentage Changes Problem: The standard method gives

Demand for your websites

different answers depending on where you start.

$250 B

From A to B, P rises 25%, Q falls 33%,

l ti it 33/25 1 33

$200 A elasticity = 33/25 = 1.33

From B to A,

8 12

P falls 20%, Q rises 50%, elasticity = 50/20 = 2.50

8Percent Change in P= 250−200

225 ∗ 100 = 22.2

Percent Change in Q= 8−12 10

∗ 100 = −40 P.E.D = −40

22.2 = −1.8

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

Calculating Elasticity of Demand II

if old equilibrium is: P=$70 and QD =5000

and new equilibrium is: P=$90 and QD =3000...

Calculate the Price Elasticity of Demand:

P.E.D= −50% 25%

= −2 It is ok if you say it is 2 and not -2. We’ll actually always talk about elasticities in positive terms even though we know they are negative.

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

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

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

Price Elasticity of Supply

Price Elasticity of Supply = Percent Change in Quantity Supplied Percent Change in Price

Loosely speaking, it measures a sellers price sensitivity.

Why might a seller be insensitive to price? Sellers cannot adjust supply easily

Inputs are rare - e.g. ocean front property Already producing at full capacity, so in short-run may be inelastic. Time dimension important here.

Why might a seller be quite sensitive to price?

Sellers easily switches production between goods, e.g. farmers Time should be important here again.

Example about U.S. Auto Makers

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

Similar to the Price Elasticity of Demand

Similarly, the price elasticity of supply is calculated the same way using midpoint method.

Similarly, flat curves represent elastic (or responsive) changes to prices. Steep curves represent inelastic (or unresponsive) changes to price.

Similarly, vertical supply curve is perfectly inelastic. Horizontal supply curve is perfectly elastic.

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

Elasticity in Action

The price elasticity of supply and demand will affect the magnitude of changes in equilibrium.

Take our example from last class: the market for gasoline.

Price elasticity of demand for gas? So, demand curve...? Price elasticity of supply for gas? So, supply curve...?

What does this mean about the effects of wars, recessions, and an increasingly prosperous rest of the world on equilibrium P and Q for gas?

Hint: bigger change in P or Q?

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

Application of Elasticity: War on Drugs

Suppose that part of the reason why we engage in the War on Drugs is that it has consequences that affect non-users because drug users to to robbery and other violent crimes to be able to purchase drugs.

Will a drug policy based on trying to prevent drugs from coming into the country have the desired effect of lowering usage and decreasing crime against non-users? Why or Why not?

How will the policy affect equilibrium in drug market - i.e. which curve will shift? What happens to P and Q? How does the price elasticity come into play? Is the demand for drugs likely to be elastic or inelastic? Supply?

Are likely to increase crime as prices rise and quantity falls only slightly.

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

Policy 1: Interdiction Interdiction new value of drug

D1 Price of

Drugs S2

Interdiction reduces the supply

new value of drug- related crime

1 S1

P2 of drugs. Since demand f d i

for drugs is inelastic, P rises propor-

initial value of drug-P rises propor

tionally more than Q falls.

of drug related crime

Quantity of Drugs

Q1Q2 Result: an increase in total spending on drugs,

d i d l t d i © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

g and in drug-related crime

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

Application of Elasticity: War on Drugs

Would a policy that focused on reducing demand through an outreach and education program better achieve the stated goal?

Why or why not?

How does the equilibrium change? What can we say about prices? What can we say about the total value of crime?

Why doesn’t our government pursue a demand-based policy wrt drug use?

I think this is an important question with many possible answers.

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity Applying Elasticity

Alternate Policy

Policy 2: Education new value of drug

Price of Drugs

Education reduces the

new value of drug- related crime

D1 S

D2demand for drugs.

P1 P and Q fall.

Result: initial value of drug-

P2 Result: A decrease in total spending

of drug related crime

Quantity of Drugs

Q1Q2 on drugs, and in drug-related crime

gcrime.

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Understanding Elasticity
Applying Elasticity