Elasticity and Its Application

00:01 Hello and welcome back to your online presentation in Microeconomics.

00:05 My name is James deNicco, this presentation is gonna be about elasticity and its applications.

00:11 We're gonna find out what elasticity is, we're gonna look at different types of elasticity.

00:16 We're gonna look at factors that affect elasticity, how we calculate it.

00:21 and the relationship between the price elasticity of demand and revenue.

00:25 Those are all the things we're gonna learn as we go through this presentation.

00:29 So first, what is elasticity? Well elasticity just tells you how much demand or supply are gonna change when one of the factors that determine it changed.

00:40 So if one of its determinant changed, how much are supply or demand gonna change? Something that's very inelastic means that one of its determinant has changed, supply or demand change very little.

00:53 Very inelastic means it is rigid, it doesn't change very much as its determinant's changed.

00:58 If it's very elastic, that means demand or supply will change a lot when one if its determining factors is altered or changed.

01:06 So first, we're gonna take a look at price elasticity of demand.

01:10 So how does our demand change as prices change? We know demand is downward-sloping from our market forces of demand and supply presentation.

01:18 So as prices go down, we demand more, but how much more is the question.

01:24 If it's very elastic, its prices go down, we demand a lot more.

01:28 If it's inelastic, which means it's very steep, it's very rigid, as prices change our demand doesn't change that much.

01:35 So just giving you factors that affect the price elasticity of demand, one of those is the availability of close substitutes.

01:44 If there's a lot of close substitutes, then the price elasticity of demand for a good is gonna be very high, it will be very elastic.

01:53 So what that means is, if the price of the good changes we have close substitutes that we can get away from this good and go to another good, so say the price goes up for butter.

02:05 Well we're very likely to switch to margarine.

02:07 So our consumption of butter will change a lot as the price goes up for butter because we have the availability of close substitutes.

02:16 Another factor, necessities vs luxuries.

02:20 So necessities are always gonna be more inelastic or less elastic than luxuries so we think about necessities, you think about heart medication.

02:29 So when the price of your heart medication changes, your demand for heart medication isn't gonna change that much, you still need it.

02:36 If the price goes up - it doubles or it triples, you still need that heart medication to stay alive.

02:42 Its very inelastic, you're not gonna change your demand for your heart medication but how about a cruise, right? you want to take your family on a vacation, you want to go on a cruise.

02:51 If the price of going on a cruise jumps up very high, well then you might not demand it.

02:57 Right you mightsay, "Hey we'll wait for another time till I have more money or till the prices come back down" Luxury items are very elastic because you don't need them.

03:06 Necessities, by definition, you need them so as the price changes, your quantity doesn't change as much but for luxuries, you don't need those items so when the price changes, your demands those items changes a lot.

03:19 If the price goes up, your demand falls way off If the price goes down, you might demand a lot more of those luxuries.

03:25 Another factor is the definition of the market or the broadness of the market.

03:30 So the broader a market, the less elastic it is.

03:34 So let's take an example of pants versus jeans.

03:38 So jeans will be more elastic than pants. jeans is very specific.

03:44 As the price of jeans go up, you might substitute to khakis.

03:49 But as price of pants go up in general, you need pants, you can't walk around without your pants so your demand for pants doesn't change as much.

03:57 So pants in general, are less elastic specific types of pants that you can interchange so the broader the market, the less elastic it is, the more specific the market, the more elastic it is.

04:12 Also, time horizons are gonna affect elasticity.

04:16 So in the short run, your demand for goods is much less elastic than in the long run because in the long run, you have more of an ability to change your behavior.

04:26 So let's take the price of gasoline for an example.

04:28 So you commute to work, as the price of gasoline goes up, you're not gonna change, in the short run, you're not gonna change your demand for gasoline too much.

04:36 you still have to get to work, you're gonna drive your car but in the long run you have ability to change your behaviour.

04:42 maybe you start to carpool if prices are too high or maybe you get yourself a bike if you're close enough.

04:48 So over the long run, you can adjust your behavior so that your demand can change lot more as prices changed as opposed to the short-run where adjusting is more difficult so you don't change your demand as much as prices changed.

05:01 Availability of close substitutes: the more substitutes we have, the more elastic.

05:10 We have necessities versus luxuries.

05:12 A necessity is always less elastic than a luxury because you need it.

05:17 We had the broadness of the market: the broader the market, the less elastic.

05:22 You don't need jeans but you need pants.

05:26 And also, the time horizons, we're able to change your behaviour over the longer periods of time much easier than we can in shorter periods of time.

05:34 Sso over the long horizon, demand tends to be more elastic.

05:39 So how do we calculate our price elasticity of demand? It's just gonna be our percent change in the quantity demanded over our percent change in the price.

05:48 So again we'll use an example of my favourite beer Firestone Walker Double Jack So let's say, what do we have here, the price goes up by 10% and the quantity demanded goes down by 20% Our price elasticity of demand is gonna be 20% divided by 10%, or 2.

06:07 You notice tha there's no negative sign there.

06:10 We know that as prices go up, the quantities go down.

06:13 We know that, however we don't put the negative sign in there, We know the relationship between demand and prices, we just leave that up, We're just looking for the amount of change, or the magnitude of change in demand as prices change.

06:29 So we leave the sign off there, we report price elasticities of demand in absolute values.

06:37 however there's a problem using the simple percent changes, okay, so we use an example here to take a look.

06:42 So the problem with just using this simple percent changes to calculate the price elasticity of demand, so here from A to B, what do we have? We're gonna prices are gonna go from $4 to $6 So what is that, that's a 50% increase in prices.

07:00 Now we'll notice here, the quantity's gonna go from 120 to 80, that means the quantity falls by 33% That indicates a price elasticity of 0.66, so the change in our quantity 33% divided by the change in a prices 50% but now let's go back the other way.

07:20 Let's go from B to A, what you'll find here dividing 33% by 50% gives us a price elasticity of 1.5, that's not good.

07:30 Going in either direction, it should be the same number so we need your account that, we need to change the way we're doing our percent changes so that going up or down the demand curve, you get the same change or you get the same price the elasticity of demand.

07:45 We fix that using what's called the midpoint method.

07:49 The midpoint method takes the change in quantity instead of dividing it by just the first quantity, it divides it by the average.

07:58 So you take Q2 plus Q1, and divide it by 2.

08:01 So here in our example, alright, we're gonna have 80 minus 120 divide by 80 + 120 divided by 2 Okay, that gives us a price elasticity of 1.

08:13 You can go either direction, using the midpoint method and you'll get to the same price elasticity.

08:20 Okay, so whether you're going from point A to B, or from point B to A, you'll get the same price elasticity of demand using the midpoint method.

08:30 It's just a little bit different way to calculate it that alleviates that problem of using simple percent changes.

08:36 So let's take a look at some pictures, it's always nice to look a things in pictures.

08:40 So in our top left of the graph here, we're gonna have it we call something that's perfectly inelastic.

08:47 So inelastic means things don't change a lot, alright, so the quantity demand is not gonna change a lot as prices change.

08:54 If something's perfectly inelastic, that means as prices change, the quantity we demand doesn't change at all.

09:01 So here, you'll see your price goes up from 4 to 5 but the quantity demand stays at 100 - that's perfectly inelastic.

09:08 Now if we go down here to the bottom left - perfectly elastic, if the price goes up at all, our quantity demand is gonna fall to 0.

09:17 If the price goes down at all,our quantity demand, it goes to infinity - that's perfectly elastic.

09:24 Our middle graph right here is what we're gonna call unit elastic.

09:27 That means a percent change price will result in the exact same percent change in quantity.

09:33 So here we have a 22% increase in price, it's gonna result in a 22% decrease in quantity.

09:40 Quantity divided by price 22% divided by 22% is 1.

09:45 Now on the top right here, we have inelastic demand curve.

09:49 Inelastic demand is less than 1.

09:52 What that means is that the percent change in quantity is gonna be less than the perecent change in price.

09:59 The quantity doesn't change that much, behavior doesn't change as much when prices change.

10:04 So here, at 22% increase in the price results in only an 11% decrease in the quantity.

10:11 You'll notice inelastic demand is very steep.

10:14 Okay, it's very steep so things don't change a lot as prices change.

10:19 Now we go to the bottom right, we have the elastic demand, that's greater than 1.

10:23 That's because when it change, percent change in the price, percent change in quantity is gonna be larger.

10:29 You notice it's very flat, so it's price has changed, quantity changes a lot.

10:34 Here we have a 22% increase in price results in a 67% decrease in quantity.

10:40 The elasticity is greater than 1.

10:42 Again, we know as prices go up, quantity goes down, as prices go down, quantity goes up.

10:48 but we look at this in absolute values, we leave off the negative sign when we look at price elasticities of demand.

10:57 So elastciities are gonna have an impact on revenue, okay, so how do we calculate total revenue? Total revenue is just gonna be our price times our quantity so in our graph here, we have a price of 4 and a quantity of 100, so 100 times 4 is 400.

11:16 Alright, so total revenue - the amount paid by buyers and received by sellers of a good computed as the price of that good times the quantity sold, so exactly what I just said So now let's take a look at how elasticity affects our revenues and it's also gonna affect the way we price our goods.

11:34 We know elasticity, we know how we want to change our prices.

11:38 So in our first example here, in the case of inelastic demand, we're gonna go from a price of 4 to a price of 5, we're gonna raise the price.

11:48 Now what's gonna happen, we're gonna have a change in our revenue.

11:50 At first, we had $4, okay our price was $4 a quantity sold times 100.

11:56 Our revenue was $400, we're gonna raise the price, alright, we're gonna raise the price to $5 That's gonna decrease the demand for the good to $90, but now $5 dollars times 90 is 450 With inelastic demand, an elasticity of less than 1, raising the price is gonna raise the revenue.

12:19 so if you have a good that's in the inelastic range, you're gonna want to raise that price because if you raise your prices, you increase your revenue so if you know the elasticity, that's important to you as a firm.

12:31 Now let's take our second example here, we have a price of 4 and a quantity sold of 100.

12:37 Okay, so that our revenue was 400.

12:40 Now again, let's raise the price to $5.

12:42 Now the quantity demand is gonna fall a lot more, it's not gonna fall to 90 like our inelastic demand, our very steep curve with our very flat curve, quantity demanded falls off a lot.

12:53 it's gonna fall to 70 so that 5 times 70 is 350.

12:58 By raising your prices, you lost revenue, so again it is important for that firm if they can figure out the elasticity.

13:05 In the fist case, it's smart for them to raise their prices, some demand drops but the increase in price is enough to offset that so that you get higher revenue.

13:14 In the second example here, as we change the price, demand falls off a lot so that total revenue falls down.

13:23 So here you go, just words to make this a little easier for you maybe a little bit of a cheat sheet here for you.

13:30 When demand is inelastic, price and total revenue will move in the same direction When demand is elastic, price and revenue move in opposite directions.

13:41 But when demand is unit elastic, total revenue remains constant when price has changed.

13:47 Okay, so that's a little bit of cheat sheet for you to keep things in mind.

13:52 So again, inelastic - they move in the the same direction, elastic - they move in opposite directions.

13:58 So if you have an inelastic demand, you might want to raise prices.

14:02 If you have elastic demand, well you might not want to change those prices, you might not want to raise them because that will decrease your revenues.

14:09 Alright, so here we're gonna take a look at a linear demand curve, okay, so we have a constant slope.

14:17 So the idea of the slide is to show you, even with a constant slope, if you move along this curve, you're gonna see that elasticity's changed, so I did this whole chart out for you here but the point is that, when you high price and low quantity, so we're over here with high price and low quantity, you're gonna see that the curve is very elastic.

14:39 If you go through these numbers and calculate a change from this price that's 7 or a price that go from $7 to $6, or $6 to $5, you're gonna find that it's very elastic.

14:50 So as you lower your price, you 'll have a very large increase in quantity.

14:55 but as you move along this curve, you'll notice that it'll change.

14:59 Points with low price and high quantity are very inelastic.

15:04 Alright, so what that means is as you lower your prices, the quantity demanded doesn't change that much.

15:10 Again, that has implications for revenue.

15:13 If you're over on the left side of the curve with high prices and low quantity, sometimes you could lower your price and it increases the quantity enough that total revenue go will go up.

15:23 But you have to be careful as you move along this curve, if you get down towards the bottom on the right here, where you have low price and high quantity, now if you lower your price a little bit, quantity doesn't change that much in percentage terms.

15:36 So lowering your price doesn't result in that large of a change of quantity so you might decrease your revenue by lowering your prices in that instance.

15:45 So even with a linear curve with a constant slope, elasticity will change a long that curve.

15:56 Alright, so now some other demand elasticities, alright.

15:59 We talked about the price elasticity of demand, how about the income elasticity of demand? So that's calculated as the percent change in quantity demanded over the percent change in income.

16:10 We do put positive and negative signs on here.

16:13 That way, we know if it's a normal or inferior good.

16:16 So let's say your income goes up and there's an increase in your quantity demanded.

16:22 Well that will be a normal good, so positive sign is a normal good.

16:26 Right, as your income goes up, your demand goes up.

16:30 So income elasticity percent change in quantity demanded over percent change of income, again we use the midpoint method.

16:37 So you're gonna change your behaviour,you're gonna change your demand as your income changes.

16:43 We also have the cross-price elasticity of demand.

16:46 We calculate signs with that as well, we leave the sign in there for the cross-price elasticity of demand.

16:52 It tells us whether goods are compliments, or whether they're substitutes.

16:56 We calculate the cross-price elasticity of demand as the percent change in the quantity demand of good 1 over the percent change in the price of good 2.

17:06 So let's take a look.

17:07 If the percent change of price of good 2, if the price of good 2 goes up and the quantity demanded falls for good 1, that means they're compliments.

17:18 Right, that means they go together, say it's peanut butter and jelly.

17:22 So peanut butters are good2 here, the price of peanut butter goes up, you're gonna want less peanut butter.

17:28 You're also gonna want less jelly.

17:30 So if you have a negative sign, they're complements.

17:32 The demand for jelly will fall as the price of peanut butter goes up.

17:37 Now if there's substitutes, it's gonna be a positive sign.

17:41 So let's think of a coffee versus tea.

17:44 So our coffee will be good2 here.

17:47 So as the price of coffee goes up, the quantity demaned over good1 which is tea also goes up because we're gonna substitue away from the more expensive coffee, towards the tea.

17:58 So if the sign is positive, they're substitutes, if the sign is negative, they're complements.

18:07 We also calculate our price elasticity of supply, we've been concentrating on demand, we should also take a look at supply here.

18:13 So it's a measure of how much the quantity supplied changes as prices change.

18:18 calculated the percent change in quantity supplied over the percent change in price.

18:23 Again, this is all done using the midpoint method because if you don't, you get different answers going from A to B as opposed to B to A, so you'd want to use that midpoint method.

18:33 So we're gonna see just like demand, as we move along the supply curve, we're gonna have changes in the elasticity.

18:40 so here at low levels of price and low levels of quantity, an increase in price is gonna result in a larger percent change in quantity, it's gonna be elastic supply We've a lot of room to grow at that point, we have hit our capacity constraints.

18:57 But as we move along this curve, we're gonna see that our elasticity goes down.

19:02 Now maybe we would like to increase our production a lot as the prices go up but we hit our capacity constraints.

19:10 We don't have enough room to grow, we don't have enough machines to increase our quantity by that much.

19:15 So you see as we move along or supply curve here, the elasticity's gonna change So at first the high elasticity at low levels.

19:23 So we're gonna have a 67% increase in supply for a 29% increase in price.

19:29 Again, this is all using the midpoint method.

19:32 So right, 67% divided by 29%, you'll see that's greater than 1.

19:37 As we move along our supply curve, and maybe we become capacity constrained, we only have a maximum capacity for production in our factory and our warehouse, we can't increase our capacity that much so here, we're only gonna have a 5% increase in supply for a 22% increase in price.

19:55 so 5% divided by 22% is less than 1.

19:59 So as we move along this curve, our elasticity of supply or price elasticity of supply will change.

20:06 so what have we learned in this lesson? Well, we know what all our different elasticities are, our price elasticity of demand, our income elasticity of demand, our cross-price elasticity of demand and our price elasticity of supply.

20:20 We know how different factors affect the elasticity, we know how to calculate our elasticities and we know the relationship between price elasticity of demand and revenue.

20:30 So that's your presentation on elasticity and application, thank you.