Law of Demand.pptxnnnnnnnnnnnnnnnnnnnnnnnnnnnnnnnnnnnnnnnnnnn
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Chapter 5
1. PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
Elasticity
CHAPTER
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2. Price Elasticity of Demand
⢠Elasticity
âSensitivity of one market variable to
another
⢠Slope = ÎP/ÎQD
âNot a measure of price sensitivity of
demand
⢠Depends on the arbitrary units of
measurement
⢠Doesnât tell us the significance of ÎP or ÎQD
2
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3. Price Elasticity of Demand
⢠Price elasticity of demand (ED)
âSensitivity of quantity demanded to price
âPercentage change in quantity demanded
caused by a 1 percent change in price
âThe greater the elasticity value the more
sensitive quantity demanded is to price
3
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%
%
%
%
D
D
Q
E
P
ď
ď˝
ď
Change in Quantity Demanded
Elasticity of Demand =
Change in Price
4. Price Elasticity of Demand
⢠Midpoint formula, percentage change in a
variable
⢠Change in the variable divided by the average
of the old and new values
⢠When calculating elasticity values from data
on prices and quantities
4
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ď¨ ďŠ
ď¨ ďŠ
ď¨ ďŠ
ď¨ ďŠ
1 0
1 0
1 0
1 0
%
2
%
2
Change in Price =
Change in Quantity Demanded =
P P
P P
Q Q
Q Q
ď
ďŤďŠ ďš
ďŞ ďş
ďŤ ďť
ď
ďŤďŠ ďš
ďŞ ďş
ďŤ ďť
5. Figure
Using the Midpoint Formula for Elasticity
5
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1
Quantity of
Avocados per Week
Price per
Avocado
$1.00
$1.50
4,500 5,500
D
A
B
1. Using the midpoint
formula, the
percentage drop in
price is $0.50/$1.25 =
0.40 or 40% âŚ
2. and the percentage rise in quantity
is 1,000 / 5,000 = 0.2 or 20%.
3. Elasticity of demand for
the move from A to B is
20% / 40% = 0.5
6. Categorizing Demand
⢠Inelastic demand
âED between 0 and 1
âQuantity demanded is relatively insensitive
to price changes
⢠Elastic demand: ED > 1
âQuantity demanded is relatively sensitive
to price changes
⢠Unit elastic demand: ED = 1
âQuantity demanded changes by the same
percentage as the price
6
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7. Categorizing Demand
⢠Perfectly inelastic demand
âED = 0
âVertical demand curve
⢠Perfectly (infinitely) elastic demand
âED approaching infinity
âHorizontal demand curve
7
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8. Figure
Categories of Demand Behavior (a, b)
8
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2
(a) Inelastic Demand (ED < 1) (b) Elastic Demand (ED > 1)
Q
P
95 105
Price rises by 20%
D
Quantity falls
by less than 20%
$11
9
Q
P
Price rises by 20%
D
85 115
Quantity falls
by more than 20%
$11
9
9. Figure
Categories of Demand Behavior (c, d, e)
9
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2
(c) Unit-Elastic
Demand (ED = 1)
(e) Perfectly Elastic
Demand (ED = â)
Q
P
90 110
Price rises by 20%
D
Quantity falls by 20%
$11
9
(d) Perfectly Inelastic
Demand (ED = 0)
Q
P
9
$11
D
100
Price rises
Quantity doesnât change
Q
P
Consumers will buy
any quantity at $9,
none at a higher
price
D
$9
10. Straight-Line Demand Curves
⢠Straight-line demand curve
âDemand becomes less elastic (ED gets
smaller)
⢠As we move downward and rightward
âSlope of demand is constant
10
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11. Figure
How Elasticity Changes along a Straight-Line Demand Curve
11
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3
Quantity of
Laptops
Price
1,500
$2,000
5,000 15,000
Each time P
drops by
another $500,
the percentage
drop is larger.
Each time Q rises by another 10,000, the
percentage rise is smaller.
D
A
1,000
35,00025,000
C
B
Elasticity falls as we
move rightward along a
straight-line demand
curve.
12. Elasticity and Total Revenue
⢠Total revenue (TR = P ˣ Q)
âPrice per unit (P) times quantity (Q)
âThe area of a rectangle with height equal
to price and width equal to quantity
demanded
⢠A price increase
âInelastic demand, ED < 1, then TR â
âElastic demand, ED > 1, then TR â
âUnit elastic demand, ED = 1, then TR
doesnât change
12
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13. Figure
In panel (a), demand is inelastic, so a rise in price causes total revenue to increase. Specifically,
at a price of $9 (point A), total revenue is $9 Ă 105 = $945. When price rises to $11 (point B),
total revenue increases to $11 Ă 95 = $1,045. In panel (b), demand is elastic, so a rise in price
causes total revenue to decrease. Specifically, at a price of $9 (point A), total revenue is $9 Ă
115 = $1,035. When price rises to $11 (point B), total revenue falls to $11 Ă 85 = $935.
Elasticity and Total Revenue
13
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4
Q
P
D
Q
P
D
B
95 105
$11
9
$11
85 115
9A A
B
(a) Inelastic Demand (b) Elastic Demand
14. Table
Effects of Price Changes on Revenue
14
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1
15. Determinants of Elasticity
⢠Availability of substitutes
âClose substitutes are available for a
product
âMore elastic demand
⢠Necessities versus luxuries
âNecessities tend to have less elastic
demand than luxuries
⢠Importance in buyersâ budgets
âLarger proportion of familiesâ budgets
âMore elastic demand
15
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16. Table
Some Short-Run Price Elasticities of Demand
16
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2
17. Determinants of Elasticity
⢠Time horizon
âThe longer the time horizon, the more
elastic the demand
⢠Short-run elasticity
âMeasured just a short time after a price
change
⢠Long-run elasticity
âMeasured a year or more after a price
change
âLarger than short-run elasticity
17
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18. Table
Short-Run versus Long-Run Elasticities
18
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3
19. Table
Adjustments After a Rise in the Price of Gasoline
19
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4
20. Figure
When the price of gasoline rises by $1, the decrease in quantity demanded (and the price
elasticity of demand) depends on how long we wait before measuring buyersâ response. If we
waited just a few months after the price change, weâd move along demand curve DSR, from point
A to point B. If we waited a year or longer, weâd move from point A to point E along demand
curve DLR, with quantity demanded falling even more.
Short-Run versus Long-Run Price Elasticity of Demand
20
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5
Quantity of Gasoline (millions of
gallons per day)
Price per
gallon
2.00
$3.00
320 400
DSR
B
DLR
A
360
E
21. Elasticity and Mass Transit
⢠Elasticity and mass transit
âInelastic demand
⢠Both short and long run
âA rise in fares would likely raise mass-
transit revenue for a city
âWhy cities donât raise fares:
⢠Elasticity estimates come from past data
⢠Want to provide affordable transportation,
reduce traffic congestion on city streets, and
limit pollution
21
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22. Price Elasticity of Supply
⢠Price elasticity of supply
âPercentage change in quantity supplied
caused by a 1 percent change in its price
âSensitivity of quantity supplied to price
changes
⢠As we move along the supply curve
22
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%
%
%
%
S
Q
P
ď
ď
Change in Quantity Supplied
Elasticity of Supply =
Change in Price
Elasticity of Supply =
23. Determinants of Supply Elasticity
⢠Easier to find alternatives in production
âThe more elastic the supply
⢠The narrow the market definition
âThe more elastic the supply
⢠The longer the time horizon
âThe more elastic the supply
⢠Long-run supply elasticities are greater
than short-run supply elasticities
23
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24. Figure
When the price of corn rises from $4.50 to $5.50 per bushel, the increase in quantity supplied (and the
price elasticity of supply) depends on how long we wait before measuring the response. If we wait just
a few months after the price change, weâd move along supply curve SSR, from point A to point B. If we
wait a year or longer, weâd move along supply curve SLR, from point A to point C. The same rise in
price causes a greater increase in quantity supplied after a year or longer, because farmers can make
further adjustments in quantity supplied if given more time.
Short-Run versus Long-Run Price Elasticity of Supply
24
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6
Quantity (millions of bushels per week)
Price per
bushel
4.50
$5.50
190
SSR
210 230
B
SLR
A
C
25. Income Elasticity of Demand
⢠Income elasticity of demand
âThe percentage change in quantity
demanded caused by a 1 percent change
in income
âRelative shift in the demand curve
âIs > 0 for normal goods
âIs < 0 for inferior goods
25
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%
%
Change in Quantity Demanded
Income elasticity =
Change in Income
26. Cross-Price Elasticity of Demand
⢠Cross-price elasticity of demand
âThe percentage change in the quantity
demanded of one good (X)
⢠Caused by a 1 percent change in the price of
another good (Z)
âIf > 0 â substitutes
âIf < 0 â complements
26
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
%
%
Change in Quantity Demanded of X
Change in Price of Z
27. The war on drugs:
should we fight supply or demand?
⢠Every year, the U.S. government
âSends about $10 billion intervening in the
market for illegal drugs
⢠Most of this money is spent on efforts to
restrict the supply of drugs
27
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28. Figure
Panel (a) shows the market for heroin in the absence of government intervention. Total
expendituresâand total receipts of drug dealersâare given by the area of the shaded
rectangle. Panel (b) shows the effect of a government effort to restrict supply: Price rises, but
total expenditure increases. Panel (c) shows a policy of reducing demand: Price falls, and so
does total expenditure.
The War on Drugs
28
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
7
Quantity
Price
per
unit
P1
(a)
D1
Quantity
Price
per
unit
(b)
D1
Quantity
Price
per
unit
P1
(c)
D1
S1
A
P1
S1
A
S2
B
P2
Q2 Q1Q1 Q1
D2
S1
C
Q3
P3
A
29. The war on drugs:
should we fight supply or demand?
⢠No government intervention
âEquilibrium: P1, Q1
âTotal revenue by sellers = Total
expenditure by buyers: P1 ËŁ Q1
29
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30. The war on drugs:
should we fight supply or demand?
⢠Decreasing Supply
âVigilant customs inspections; arrest and
stiff penalties for drug dealers; efforts to
reduce drug traffic
âEquilibrium: Higher price P2, Lower
quantity Q2
âDemand: very price inelastic
âTotal revenue by sellers = Total
expenditure by buyers = Higher, P2 ËŁ Q2
30
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31. The war on drugs:
should we fight supply or demand?
⢠Decreasing Demand
âStiffer penalties on drug users; heavier
advertising against drug use; greater
availability of treatment centers for addicts;
more effort against drug retailers
âEquilibrium: Lower price P3, Lower
quantity Q3
âTotal revenue by sellers = Total
expenditure by buyers = Lower, P3 ËŁ Q3
31
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32. Forecasting Price in an Oil Crisis
⢠Oil supply disruptions
âIncreased output by other producers (due
to the rise in oilâs price or a decision by
OPEC) offset some of the lost production
⢠What if a major supply disruption occurred
âAnd only a price hike could restore the
market to equilibrium?
âElasticity
32
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33. Table
Oil Supply Disruptions
33
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5
34. Forecasting Price in an Oil Crisis
⢠Initial equilibrium
âPrice = $100 per barrel
âQuantity = 90 million barrels per day
⢠Suppose that 9 million barrels of oil were
temporarily removed from the market
âThe supply curves shift leftward
âExcess demand of 9 million barrels at the
original price
âThe price will rise to restore market
equilibrium
34
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35. Forecasting Price in an Oil Crisis
⢠Very elastic supply and demand in the
short run (unrealistic)
âOnly a relatively small price increase is
needed to increase quantity supplied and
decrease quantity demanded
⢠Very inelastic supply and demand in the
short run (realistic)
âA much larger price increase is needed to
restore market equilibrium
35
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36. Figure
If either supply or demand is very elastic, only a relatively small price increase will be needed to restore
equilibrium after decrease in supply. Panel (a) illustrates the case in which both supply and demand are
very elastic. The leftward shift in the supply curve causes equilibrium price to rise from $100 to $102.50.
Panel (b) has the same leftward shift in the supply curve, but with much less elastic supply and demand. A
much larger rise in price (from $100 to $211) is needed to restore equilibrium after the decrease in supply.
A Decrease in Oil Supply: Elastic versus Inelastic Demand
36
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8
Barrels per Day (millions)
Price per
Barrel
(a)
D
Barrels per Day (millions)
Price per
Barrel
(b)
D
$100.00
S1
A$102.50
90
S2
B
81
$100.00
S1
$211.00
90
S2
A
B
81
37. Spikes in Food Prices
⢠From mid-2010 to mid-2011
âPrices for wheat, corn, soybeans, sugar,
and other food crops spiked around the
world
âIncrease in demand
âDecrease in supply
⢠Bad weather for crops in several parts of the
world
37
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38. Spikes in Food Prices
⢠Demand is inelastic
âStaples like wheat or corn are commonly
regarded as necessities
âIn large parts of the world only a small
percentage of income is spent on these
foods
⢠Supply is inelastic (in the short run)
âFarm output depends on
⢠Planting decisions made many months earlier
⢠Weather conditions while crops are growing
38
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39. Figure
When the supply of wheat decreased from mid-2010 to mid-2011, creating an excess demand
at the original price of $4.16 per bushel, the price spiked upward. A large price rise was needed
to eliminate the excess demand because both the supply and the demand for wheat are so
inelastic in the short run.
Bad Weather and Food Prices with Inelastic Supply and
Demand
39
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9
Quantity of wheat (millions
of bushels per month)
Price per
Bushel
D
$4.16
S2010
$8.16
Q1
S2011
A
B
Q2