Lecture 2 Elasticity of Demand and Supply

Elasticity of

Demand & Supply

20C H A P T E R

From Ch. 3 make sure you know the following:

• Define demand and supply and state the laws of demand and supply.

• Determine equilibrium price and quantity from supply and demand graphs and schedules.

• From law of demand, a consumer will buy more when price declines, or

P↓ → QP↓ → Qdd ↑ ↑

• But how much more or less?

• Will you buy more of 2 different goods as their P decline by 1 KD?

• We use the concept of elasticityelasticity

• Elasticity of demand measures:

how much the Qd changes with a given change in P of the good, change in consumers’ income (I), or change in price of related product, or:

%∆Qd to %∆P, or %∆I, or %∆Pof related goods

• Price elasticity is a concept that also relates to supply.

II. Price Elasticity of Demand

- The degree of responsivenessresponsiveness or sensitivitysensitivity of consumers to a change in price is measured by the concept of price elasticity of demand.

1. If consumers are relatively responsive to price changes, demand is said to be elasticelastic.

2. If consumers are relatively unresponsive to price changes, demand is said to be inelasticinelastic.

3. Note that with both elastic and inelastic demand, consumers behave according to the law of demand: they are responsive to price changes.

Price elasticity formula: change in quantity/percentage change in price. Or

εd = %∆Qd / %∆P

Or: εd = (Qd2-Qd

1) / ( P2-P1 ) Qd

1 P1

• Using two price-quantity combinations of a demand schedule, calculate the percentage change in quantity by dividing the absolute change in quantity by one of the two original quantities. Then calculate the percentage change in price by dividing the absolute change in price by one of the two original prices.

The percentage change in price

The percentage change in quantity

.01

.02

Elasticity is .5Q

P

P1

P2

Q1Q2

D

Measures Responsiveness to Price Changes

PRICE ELASTICITY OF DEMAND

The percentage change in price

The percentage change in quantity

Q

P

P1

P2

Q1Q2

D

Commonly Expressed as…

PRICE ELASTICITY OF DEMAND

% P% Q d

Elasticity is .5

The Price-Elasticity Coefficient and Formula

PRICE ELASTICITY OF DEMAND

εd =

Percentage change in quantitydemanded of product X

Percentage change in priceof product X

Or equivalently…

εd =

Percentage change in quantity demanded of X

Original quantity demanded of X

Change in price of X Original price of X

Elimination of the Minus Sign

Interpretations of Ed

PRICE ELASTICITY OF DEMAND

Elastic Demand

εd =

.04

.02= 2

Inelastic Demand

εd =

.01

.02= .5

Unit Elasticity

εd =

.02

.02= 1

Percentages also make it possible to compare elasticities of demand for different products.

Because of the inverse relationship between price and quantity demanded, the actual elasticity of demand will be a negative number. However, we ignore the minus sign and use the absolute value of both percentage changes.

• If the coefficient of elasticity of demand is > 1, we say demand is elasticelastic;

• The quantity demanded is “relatively responsive” when εd is >1.

• If the coefficient is < 1, demand is inelasticinelastic. • Demand is “relatively unresponsive” when εd <1.

• A special case is if εd = 1; this is called unit elasticityunit elasticity.

Note: Inelastic demand does not mean that consumers are completely unresponsive. This extreme situation called perfectly inelastic perfectly inelastic demanddemand would be very rare, and the demand curve would be vertical.

• Perfectly inelastic demandPerfectly inelastic demand

P

Q Q*

Po

D

• Perfectly inelastic demandPerfectly inelastic demand

P

Q Q*

P1

Po

D

• Perfectly inelastic demandPerfectly inelastic demand

P

Q

Changes in P will no affect Qd

Q*

P1

Po

D

• Perfectly inelastic demandPerfectly inelastic demand

P

Q

Changes in P will no affect Qd

Q*

P1

Po

D

ε d = Zero

• Elastic demand does not mean consumers are completely responsive to a price change. This extreme situation, in which a small price reduction would cause buyers to increase their purchases from zero to all that it is possible to obtain, is perfectly elastic demandperfectly elastic demand, and the demand curve would be horizontal.

• Perfectly elastic demandPerfectly elastic demand

P

Q

Any Change in P will cause a huge

change in Qd

ε d = ∞

• Consider the following example:

To calculate elasticity, which price-quantity combination should we use as P1 and Qd

1?

Assumption 1: let P1=5 and P2=4, and Qd1=4 while Qd

2=5, then:

εd = [(5-4)/4] / [(4-5)/5]

= 1/4 * (-5) (ignoring the minus)

= |-5/4| or 1.25 so demand is elastic

Price Qd

5 4

4 5

• Consider the following example:

To calculate elasticity, which price-quantity combination should we use as P1 and Qd

1?

Assumption 2: let P1=4 and P2=5, and Qd1=5 while Qd

2=4, then:

εd = [(4-5)/5] / [(5-4)/4]

= -1/5 * (4) (ignoring the minus)

= |- 4/5| or 0.8 so demand is inelastic

Price Qd

5 4

4 5

• This is a problem since demand is elastic and inelastic!

PD

5

4

54

If P1 is 5:

• This is a problem since demand is elastic and inelastic!

PD

5

4

54

Then D is elastic

• This is a problem since demand is elastic and inelastic!

PD

4

5

If P1 is 4:

• This is a problem since demand is elastic and inelastic!

PD

5

4

54

Then D is inelastic

• To solve this problem, we use the average, or “the midpoint formula” for elasticity:

εd = (Qd2- Qd

1) ( P2-P1 )

(Qd2+ Qd

1)/2 ( P2-P1 )/2

÷

• To solve this problem, we use the average, or “the midpoint formula” for elasticity:

εd = (Qd2- Qd

1) ( P2-P1 )

(Qd2+ Qd

1)/2 ( P2+P1 )/2

Applying to our example:

εd = (5-4)/(4.5) (4-5)/(4.5) εd = |-1| = 1

÷

÷

• To solve this problem, we use the average, or “the midpoint formula” for elasticity:

εd = (Qd2- Qd

1) ( P2-P1 )

(Qd2+ Qd

1)/2 ( P2+P1 )/2

Applying to our example:

εd = (5-4)/(4.5) (4-5)/(4.5) εd = |-1| = 1

÷

÷Demand is Unitary Demand is Unitary

Elastic!Elastic!

Refinement – The Midpoint Formula

PRICE ELASTICITY OF DEMAND

ε d =

Change inquantity

Sum ofQuantities/2

Change inprice

Sum ofprices/2

Elasticity varies over range of prices.

a. Demand is more elastic in upper left portion of curve (because price is higher and quantity smaller).

Elasticity varies over range of prices.

b. Demand is inelastic in lower right portion of curve (because price is lower and quantity larger).

Elasticity varies over range of prices.

a. Demand is unitary elastic in the middle.

• It is impossible to judge elasticity of a single demand curve by its flatness or steepness, since demand elasticity can measure both as elastic and as inelastic at different points on the same demand curve.

Total Revenue Test• TR = PxQ• A total-revenue test is the easiest way to judge

whether demand is elastic or inelastic.• This test can be used in place of an elasticity

formula, unless there is a need to determine the elasticity coefficient.

• Elastic demand and the total-revenue test: Demand is elastic if a decrease in price results in a rise in total revenue, or if an increase in price results in a decline in total revenue. (Price and revenue move in opposite directions).

• Elastic demand and the total-revenue test:

• Demand is elastic if a decrease in price results in a rise in total revenue,

• or if an increase in price results in a decline in total revenue.

• Price and revenue move in opposite directions.

• Inelastic demand and the total-revenue test:

• Demand is inelastic if a decrease in price results in a fall in total revenue,

• or an increase in price results in a rise in total revenue.

• (Price and revenue move in same direction).

• Unit elasticity and the total-revenue test:

• Demand is unitary elastic if total revenue does not change when the price changes.

• Table 20-2 provides a summary of the rules and concepts related to elasticity of demand.

Q

P

D

When prices are low,

TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

So is total revenue

Q

Q

P

D

Total revenue riseswith price to a

point... TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

Q

Q

P

D

Total revenue riseswith price to a

point...

then declines

TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

Q

Q

P

D

Total revenue riseswith price to a

point...

then declines

TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

Q

Q

P

D

Total revenue riseswith price to a

point...

then declines

TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

Total Revenue Test

Q

P

D

Total revenue riseswith price to a

point...

then declines

InelasticDemand

InelasticDemand

TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

Q

P

D

Total revenue riseswith price to a

point...

then declines

ElasticDemand

ElasticDemand

InelasticDemand

TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

InelasticDemand

Q

P

D

Total revenue riseswith price to a

point...

then declines

ElasticDemand

ElasticDemand

InelasticDemand

TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

InelasticDemand

UnitElastic

Determinants of Price Elasticity:

There are several determinants of the price elasticity of demand.

1. Substitutes for the productSubstitutes for the product: Generally, the more substitutes, the more elastic the demand.

2. The proportion of price relative to incomeThe proportion of price relative to income: Generally, the larger the expenditure relative to one’s budget, the more elastic the demand, because buyers notice the change in price more.

3. luxury vs. Necessity productsluxury vs. Necessity products: Generally, the less necessary the item, the more elastic the demand.

4. Time factorTime factor: Generally, the longer the time period involved, the more elastic the demand becomes.

practical applications:

There are many practical applications of the price elasticity of demand.

1. Inelastic demand for agricultural products helps to explain why bumper crops depress the prices and total revenues for farmers.

2. Governments look at elasticity of demand when levying excise taxes. Excise taxes on products with inelastic demand will raise the most revenue and have the least impact on quantity demanded for those products.

3. Demand for cocaine is highly inelastic and presents problems for law enforcement. Stricter enforcement reduces supply, raises prices and revenues for sellers, and provides more incentives for sellers to remain in business. Crime may also increase as buyers have to find more money to buy their drugs.

Price Elasticity of Supply

• The concept of price elasticity also applies to supply. The elasticity formula is the same as that for demand.

εs = % ∆Qs / % ∆ P

• As with price elasticity of demand, the midpoints formula is more accurate.

Now, compare the immediatemarket period, the short-run,

and long run...

PRICE ELASTICITY OF SUPPLY

εs =

Percentage change in quantitysupplied of good X

Percentage change in the price of good X

• The ease of shifting resources between alternative uses is very important in price elasticity of supply because it will determine how much flexibility a producer has to adjust output to a change in the price.

• The degree of flexibility, and therefore the time period, will be different in different industries. (Figure 20-3)

• Time and elasticity of supply

P P P

Q QQ QoQ1Qo Qo Q1

Immediate market period

SR LR

Perfectly Inelastic

Elastic More elastic

Even more elasticresponse - lessprice increase

• The market period is so short that elasticity of supply is inelastic; it could be almost perfectly inelastic or vertical. In this situation, it is virtually impossible for producers to adjust their resources and change the quantity supplied. (Think of adjustments on a farm once the crop has been planted.)

• The short‑run supply elasticity is more elastic than the market period and will depend on the ability of producers to respond to price change. Industrial producers are able to make some output changes by having workers work overtime or by bringing on an extra shift.

• The long‑run supply elasticity is the most elastic, because more adjustments can be made over time and quantity can be changed more relative to a small change in price, as in Figure 20-3c. The producer has time to build a new plant.

Applications of the price elasticity of supply.

1.1. Antiques and other non-reproducible Antiques and other non-reproducible commoditiescommodities are inelastic in supply, sometimes the supply is perfectly inelastic. This makes their prices subject to fluctuations in demand.

2. Gold prices Gold prices are volatile because the supply of gold is highly inelastic, and unstable demand resulting from speculation causes prices to fluctuate significantly.

Cross and income elasticity of demand:

Cross elasticity of demand refers to the effect of a change in a product’s price on the quantity demanded for another product. Numerically, the formula is shown for products X and Y.

εxy = %∆Qx / %∆Py

1. If εxy > 0, then X and Y are substitutes.

2. If εxy < 0, then X and Y are complements.

3. If εxy = 0, then X and Y are unrelated, independent products.

Income elasticity of demand The percentage change in quantity demanded that

results from some percentage change in consumer incomes.

εI = %∆Qx / %∆I

1.If εI >0, this is a normal good.

2. If εI >0, this is an inferior good.

LAST WORD: Elasticity and Pricing Power: Why Different Consumers Pay Different Prices

A. Sellers often charge different prices for goods based on differences in price elasticity of demand.

B. The ability to charge different prices depends on some market power; that is, some ability to control price (unlike the competitive model where all buyers and sellers exchange at exactly the same price).

• C. Customers are grouped according to elasticities: Business travelers have more inelastic demand for air travel, and can be charged a higher price than the more price elastic tourist.

Next: Chapter 21

Consumer Behaviorand

Utility Maximization