19-Mar-20

Microeconomics

• Basic Economic concepts

• Suply, Demand and Market equilibrium
• Suply, Demand and Government Policies
• Elasticity
• Production and Cost
• Market structures

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 19-Mar-20

ELASTICITY
Elasticity: the responsiveness of demand/supply due to
the change in its determinants
• Own Price Elasticity of Demand/supply
• Cross price elasticity of Demand: complement or substitute
• Income Elasticity of Demand: Normal, luxury or inferior
goods

Price Elasticity of demand

• The response of consumers to a change in price is measured by
the price elasticity of demand.
• Arc Elasticity
• Point Elasticity
end value - start value
percentage change   100%
midpoint
(Q  Q1 ) / [(Q2  Q1 ) / 2 ]
Price elasticity of demand  2
(P2  P1 ) / [(P2  P1 ) / 2 ]

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Elasticity of Demand: Arc and Point

P 25
24
23
22
21
Point Elasticity
20
19
18
P
e  QSLOPE
17
16 e=-3 (d1)
15
14
13
12
e=-1(d1) Q
11 e=-5(d3)
Arc Elasticity
10
9 d3
8 e=-1(d2)
7
e=-0.33(d1)
Q P
6
5
4
d1 e 
(Q1  Q2 ) / 2 ( P1  P2 ) / 2
3 d2
2
1
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Q/t

Q=120-2P TR=PxQ dQ/dP

Demand Qd = 120 – 2P
P Q TR Slope e e
36 1810
25 70 1750 -2 -0.71 35
26 68 1768 -2 -0.76 -0.74 34
1800

27 66 1782 -2 -0.82 -0.79 33

1790
32
28 64 1792 -2 -0.88 -0.85
31 1780
29 62 1798 -2 -0.94 -0.90
30
30 60 1800 -2 -1.00 -0.97 29 1770
31 58 1798 -2 -1.07 -1.03 28
1760
32 56 1792 -2 -1.14 -1.11 27
26
33 54 1782 -2 -1.22 -1.18 1750
25
34 52 1768 -2 -1.31 -1.26
24 1740
35 50 1750 -2 -1.40 -1.35 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72

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Elasticity of Demand
• Variety of demand curves • Variety of demand curves
• Demand is elastic • Demand is perfectly inelastic
• Price elasticity of demand > 1 • Price elasticity of demand = 0
• Demand is inelastic • Demand curve is vertical
• Price elasticity of demand < 1 • Demand is perfectly elastic
• Demand has unit elasticity • Price elasticity of demand = infinity
• Price elasticity of demand = 1 • Demand curve is horizontal
• The flatter the demand curve
• The greater the price elasticity of
demand

Perfectly inelastic demand

Price elasticity % change in Q 0%
= = =0
of demand % change in P 10%

P
D • D curve : Vertical

P1 • Consumers’ price sensitivity:

None
P2
• Elasticity: 0
P falls Q •s
by 10% Q1
Q changes
by 0%
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Inelastic demand
Price elasticity % change in Q <10%
= = <1
of demand % change in P 10%
P
• D curve: relatively steep
P1
• Consumers’ price sensitivity:
P2 • relatively low
D
• Elasticity:<1
P falls Q
by 10% Q1 Q2

Q rises less
than 10%
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Unit elastic demand

Price elasticity % change in Q 10%
= = =1
of demand % change in P 10%

P • D curve: intermediate slope

• Consumers’ price sensitivity:

P1
intermediate
P2
D • Elasticity: =1
P falls Q
by 10% Q1 Q2
Q rises
by 10%
10

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Elastic demand
Price elasticity % change in Q >10%
= = >1
of demand % change in P 10%
P
• D curve: relatively flat
P1
• Consumers’ price sensitivity:
P2 D relatively high

• Elasticity: >1
P falls Q
by 10% Q1 Q2
Q rises more
than 10%
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Perfectly elastic demand

Price elasticity % change in Q any %
= = = infinity
of demand % change in P 0%
P
• D curve: horizontal
P2 = P1 D • Consumers’ price
P changes sensitivity: extreme
by 0%
• Elasticity: infinity
Q
Q1 Q2

Q changes
by any %
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 19-Mar-20

Elasticity of Demand
(a) (b) (c)
P P P
D2

Perfectly Perfectly Perfectly Unit

Elastic Inelastic Elastic

D1

D3

Q/t Q/t Q/t

Determinants of Elasticity
• Necessities vs. luxuries
• necessities : Some goods are so critical.
• Demand for necessities is relatively inelastic.
• A luxury good is something we’d like to have but aren’t likely to buy
unless our income jumps or the price declines sharply.
• Availability of substitutes
• The greater the availability of substitutes, the higher the price
elasticity of demand.
• Relative price
• Elasticity increases as the price of the product increases relative to the
consumer’s income.

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 19-Mar-20

Price Elasticity and Total Revenue

• For a price increase, if demand is elastic

 E > 1: % change in Q > % change in P
 TR decreases: the fall in revenue from lower Q > the
increase in revenue from higher P
• For a price increase, if demand is inelastic
 E < 1: % change in Q < % change in P
 TR increases: the fall in revenue from lower Q < the
increase in revenue from higher P

Price Elasticity and Total Revenue

Demand for your websites • Elastic demand
(elasticity = 1.8)
increased
P revenue
due to lost
• If P = $200, Q = 12, and revenue
higher P revenue = $2400
$250 due to
$200
lower Q • If P = $250, Q = 8, and
D revenue = $2000

• When D is elastic, a price

Q increase causes revenue to fall.
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 19-Mar-20

Price Elasticity and Total Revenue

Demand for your websites • Inelastic demand
(elasticity = 0.82)
increased
P revenue • If P = $200, Q = 12, and
due to lost revenue = $2400
higher P revenue
$250 due to
lower Q
• If P = $250, Q = 10, and
$200 revenue = $2500
D
• When D is inelastic,
a price increase causes
Q revenue to rise.
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Does Drug Interdiction Increase or Decrease

APPLICATION:
Drug-Related Crime?
• One side effect of illegal drug use is crime: Users often turn
to crime to finance their habit.
• We examine two policies designed to reduce illegal drug
use and see what effects they have on drug-related crime.
• For simplicity, we assume the total dollar value of drug-
related crime equals total expenditure
on drugs.
• Demand for illegal drugs is inelastic, due to addiction
issues.

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Policy 1: Interdiction
Interdiction reduces the
supply of drugs. new value of drug-
Price of related crime
Drugs S2
D1
S1
Since demand for drugs is P2
inelastic,
P rises propor-tionally
more than Q falls. P1 initial value
of drug-
related
crime
Result: an increase in
total spending on drugs, and in Q2 Q1 Quantity
drug-related crime of Drugs

Policy 2: Education
new value of drug-
Education reduces the Price of related crime
demand for drugs. Drugs
D2 D1
S

P and Q fall.
P1 initial value
Result: of drug-
A decrease in total spending P2 related
on drugs, and in drug-related crime
crime.
Q2 Q1 Quantity
of Drugs

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Price elasticity of supply

Price elasticity of Percentage change in Qs
supply =
Percentage change in P

• Price elasticity of supply measures how much Qs

responds to a change in P.

 Loosely speaking, it measures sellers’

price-sensitivity.
 Again, use the midpoint method to compute the percentage changes.

Cross Price elasticity of demand

measures the response of demand for one good to changes in the price
of another good

Cross-price elast. % change in Qd for good 1

=
of demand % change in price of good 2
 For substitutes, cross-price elasticity > 0
(e.g., an increase in price of beef causes an increase in demand for
chicken)
 For complements, cross-price elasticity < 0
(e.g., an increase in price of computers causes decrease in demand for
software)

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Income elasticity of demand

measures the response of Qd to a change in
consumer income
Income elasticity of Percent change in Qd
=
demand Percent change in income

 An increase in income causes an increase in demand for a normal good.

 Hence, for normal goods, income elasticity > 0.
 For inferior goods, income elasticity < 0.

Elasticity of Supply
P
Si
SS

b
P2
c SL
P3
d
P4
P1
a

D2
D1
O Q1 Q3 Q 4 Q

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 19-Mar-20

Elasticity and Tax Incidence

CASE 1: Supply is more elastic than demand

P It’s easier for

sellers than buyers
Buyers’ share PB S to leave the
of tax burden market.
Tax
Price if no tax So buyers bear
most of the burden
Sellers’ share PS of the tax.
of tax burden
D
Q

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Elasticity and Tax Incidence

CASE 2: Demand is more elastic than supply

•It’s easier for

P buyers than sellers
S
to leave the
Buyers’ share market.
of tax burden PB
•Sellers bear most
Price if no tax of the burden of
Tax the tax.
Sellers’ share
of tax burden PS
D

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 19-Mar-20

The price elasticity of demand for a good will tend to increase as the:
(a) number of available substitutes increases.
(b) consumer income level increases.
(c) good is a less important budget item.
(d) time allowed for response decreases.
Most college students strongly oppose tuition increases. If only one student in fifty transfers to
another school following a ten percent tuition hike at your school, your economics professor
would probably conclude that most students’ demands for education at your college are:
(a) perfectly price elastic.
(b) relatively price elastic.
(c) unitarily price elastic.
(d) relatively price inelastic.

Scrutiny of demand curves DD and D0D0 reveals that:

(a) D0D0 is relatively more elastic at a price of P1.
(b) DD is relatively more elastic at a price of P2.
(c) D0D0 probably reflects the demand for a biological
necessity.
(d) DD probably represents the demand for a good with
more close substitutes.

If average income rises from $18,000 per year to At a price of $2 per can, the quantity of
$22,000 per year and annual gasoline applesauce supplied daily is 1000 cases; at
consumption per household rises from 1000 to $4, the quantity supplied is 3000 cases daily.
1500 gallons, the income elasticity of demand for The price elasticity of supply is:
gas is: (a) 2/3.
(a) in the inferior range. (b) 1/3.
(b) 0.5. (c) 3/2.
(c) 1.0. (d) 1/4.
(d) 2.0.

If a price hike from $15 to $20 for DVD disks The income elasticity of demand is a measure
causes sales of DVD players to fall from 100 to 50 of the:
units, the coefficient of cross-elasticity of (a) relative responsiveness of quantity
demand between these goods is roughly: demanded to changes in income.
(a) -1/10. (b) absolute change in demand yielded by an
(b) -10. absolute change in income.
(c) -7/3. (c) slope of the income-consumption curve.
(d) -3/7. (d) negative slope of a market demand curve.

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