View
224
Download
2
Category
Tags:
Preview:
Citation preview
CHAPTER
Elasticity of Demand and Supply
price elasticities of demand and supply, income and cross
elasticities of demand, and using elasticity to forecast the impact of
taxes on prices
Copyright © 2010 Pearson Education, Inc. All rights reserved. 1
% change in quantity demanded % change in price
Q2/QP2/P
= = P2QQ2P
Price
Quantity demanded
P2
Q2
0
Calculating Price Elasticity of DemandPrice elasticity
of demand=
2Copyright © 2010 Pearson Education, Inc. All rights reserved.
3
Elasticity and Slope
Both slope and elasticity are measures of responsiveness. Slope is expressed in units such as $ per bushel. Elasticity is a pure number.
Elasticity is related to slope in the following way: Elasticity = (P/Q)(1/slope).
Because the demand curve’s slope is negative, price elasticity of demand is a negative number.
4
= =
Price
Quantity demanded
P2
Q2
0
Although slope is constant along a linear demand curve, price elasticity of demand varies from zeroto minus infinity along the curve.
Elasticity = –infinity
Elasticity = zero
Q2/QP2/P
P2QQ2P
5
Some Examples
1. Suppose a 20% increase in the price of gasoline causes a 10% decline in the quantity demanded.
The price elasticity of demand is:
–10%/20% = –0.5.
6
Some Examples
2. Suppose the price elasticity of demand for men’s suits is –3. How much of a price cut will result in a 30% increase in quantity demanded?
The answer is –10%, because:
30%/10% = –3.
7
A Real World Example
In 1991, Apple computer lowered the prices of its Macintosh machines by an average of 50%.
The resulting increase in quantity demanded amounted to 85%.
The price elasticity of demand for Macs at that time was, therefore, 85%/-50% = –1.7.
8
Categorizing Elasticity of Demand
Demand is inelastic if the value of price elasticity of demand (ignoring the sign) is between zero and 1.
Demand is unit elastic if the value of price elasticity of demand (ignoring the sign) is 1.
Demand is elastic if the value of price elasticity of demand (ignoring the sign) exceeds 1.
9
A Perfectly Inelastic Demand
DemandPrice
Quantity demanded
10
A Perfectly Elastic Demand
Demand
Quantity demanded
Price
11
Total RevenueTotal revenue =
Total expenditure.TR = PQ. Total revenue
taken in by sellers can be represented by the area whose height is market price and whose length is quantity sold.
Price
Quantity
Supply
Demand
P
Q
12
What happens to total revenue when market price goes up?
The increase in price contributes to higher total revenue.
However, when the price goes up, quantity demanded falls. A decrease in quantity sold will contribute to decreased revenue. Quantity
Supply
Price
Demand
P’
P
QQ’
New supply
P Q
TR?
13
Price Elasticity of Demand and Total Revenue If you know the price elasticity of demand of
a product, you can forecast the effects of price changes on total revenue.
If demand is elastic, the percentage change in quantity demanded will exceed the percentage change in price that caused it (ignoring direction of change).
If demand is elastic, the positive effect of a price increase on revenue will be offset by the negative effect of the fall in quantity demanded. Total revenue will, therefore, fall.
14
Price Elasticity of Demand and Total Revenue If demand is inelastic, a price increase will
cause total revenue to rise. If demand is unit elastic, any change in price
will have no effect on total revenue. To test your understanding of the relationship
between changes in price, elasticity, and total revenue, work out the effects of a price decrease on revenue in cases of elastic, inelastic, and unit elastic demand.
15
The equation of this demand curve is PQ = k.
Question: What is the price elasticity of demand at any point on this demand curve?
Answer: Price elasticity is always –1 because, no matter what happens to price, quantity adjusts to make total expenditure (or revenue) constant.
P
Q
Demand
16
Box 1. Price Elasticity of Demand as a Gauge of Demand Responsiveness
17
Box 6. Price Elasticity of Demand and Total Revenue or Expenditure
18
Price Elasticity of Supply
Measures the sensitivity of changes in quantity supplied to changes in price of a good or service.
Price elasticity of supply is a positive number that can range from zero to infinity
Price elasticityof supply
% change in quantity supplied % change in price
=
19
Examples
A 10-percent increase in the price of steel causes a 15-percent increase in the quantity supplied.
The price elasticity of supply for steel is 15%/10% = 1.5.
20
Examples
Suppose the price elasticity of supply of bread is 2.
A 10-percent decline in the price of bread will, therefore, result in a 20-percent reduction in quantity supplied, because
–20%/ –10% = 2.
21
Perfectly Inelastic Supply
Price
Quantity supplied
Supply
22
Price
Quantity supplied
Supply
Perfectly Elastic Supply
23
Using Elasticity to Analyze the Effect of Taxes on Prices
Taxes can affect incentives to buy and sell goods and services.
An excise tax is a tax on the production or sale of a particular product, such as gasoline.
24
Effect of a 10-Cent-per-Gallon Gasoline Tax
Price(dollars per gallon)
Gasoline (millions of gallons per month)
Demand
Initial supply
1.00
1.00
25
Price(dollars per gallon)
Gasoline (millions of gallons per month)
Demand
Initial supply
Supply after tax
1.04
1.10
1.00
0.94
1.00.95.75
Effect of a 10-Cent-per-Gallon Gasoline Tax
26
Price(dollars per gallon)
Gasoline (millions of gallons per month)
Demand
Initial supply
Supply after tax
1.04
1.10
1.00
0.94
1.00.95.75
Tax paid by buyersTax paid by sellers Total tax collected
is $95,000 per month.
Effect of a 10-Cent-per-Gallon Gasoline Tax
27
Conclusions
A tax on the sale of an item is unlikely to raise its equilibrium price by the full amount of the tax per unit.
The tax is likely to increase the price paid by buyers and to decrease the net price received by sellers.
In effect, the tax revenues paid are collected from both buyers and sellers of the product.
28
Cases in which an Excise Tax is Fully Shifted Forward to Buyers
Case 1: Demand for the product is perfectly inelastic.
This case is extremely unlikely.
P
Q
Demand
Initialsupply
Supplyaftertax
1.00
1.10
29
Case 2: Supply of the product is perfectly elastic.
This is a likely case, over long periods, if sellers must receive at least $1 net per gallon to cover costs. If price doesn’t rise to $1.10, some firms will go out of business.
P
Q
Demand
Supply after tax
Initial supply1.001.10
Q1Q2
Cases in which an Excise Tax is Fully Shifted Forward to Buyers
30
Box 7. Price Elasticity of Supply as a Gauge of Supply Responsiveness
Recommended