Elasticity Of Demand And Supply

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Elasticity of Demand and Supply

Chapter 5

© 2006 Thomson/South-Western

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Price Elasticity of Demand

Price elasticity of demand measures how responsive consumers are to price change; elasticity is another word for responsiveness

Price elasticity of demand = Percentage change in quantity demanded / Percentage change in price

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Exhibit 1: Demand Curve for Tacos

For the price elasticity to be a useful measure, we should come up with the same result between points a and b as we get between b and a. To do this we must take the average of the initial price and the new price and use that as the base in computing the percent change in price

Price elasticity between a and b = 10% / - 20% = - 0.5

0.90

0

b

Thousands per day

D

$1.10 a

95 105

Pri

ce

4


Generalize the price elasticity formula

2/)pp(p

2/)qq(q

DE

5


Because the average quantity and average price are used as a base for computing percent change, the same elasticity results whether going from the higher price to the lower price or the other way around

Since the focus is on the percent change, we need not be concerned with how output or price is measured

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Because price and quantity demanded are inversely related, the price elasticity of demand has a negative sign

This tends to be cumbersome, thus it is commonplace to discuss the price elasticity of demand as an absolute value positive number

For example, absolute value of the elasticity for tacos computed earlier will be referred to as 0.5 rather than –0.5

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Categories of Price Elasticity

Three general categories Percent change in quantity demanded is smaller than the

percent change in price, the price elasticity has an absolute value between 0 and 1.0 demand is inelastic quantity demanded is relatively unresponsive to a change in price

Percent change in quantity demanded just equals the percent change in price a price elasticity with an absolute value of 1.0 unit-elastic demand

Percent change in quantity demanded exceeds the percent change in price, the price elasticity has an absolute value exceeding 1.0 demand is said to be elastic quantity is responsive to changes in price

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Elasticity and Total Revenue

Total revenue (TR) is the price (p) multiplied by the quantity demanded (q) at that price TR = p x q

What happens to total revenue when price decreases? Lower price producers get less for each unit sold

total revenue declines Lower price increases quantity demanded

total revenue increasesOverall impact of lower price on total revenue

depends on the net result of these opposite effects

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Elasticity and Total Revenue

When demand is elastic, the percent increase in quantity demanded exceeds the percent decrease in price total revenue increases

When demand is unit elastic, the two are equal total revenue remains unchanged

When demand is inelastic, the percent increase in quantity demanded is more than offset by the percent decrease in price total revenue decreases

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Exhibit 2: Demand, Price Elasticity and Total Revenue

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(a) Demand and Price Elasticity


Panel (a) shows the linear demand curve and panel (b) shows the total revenue generated by each price-quantity combination along the demand curveBecause the demand curve is linear, its slope is constant: a given decrease in price always causes the same unit increase in priceHowever, the price elasticity of demand is larger on the high end of the demand curve than it is on the low price end

$100 90 80 70 60 50 40 30 20 10

D

0 Quantity per period

100 200 500 800 900 1,000

$25,000

Tota

l re

ven

ue

0

Total revenue

(b) Total Revenue

TR = p x q

Pri

ce p

er u

nit

Quantity per period 1,000500

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(a) Demand and Price Elasticity$100

90

80

70

60

50

40

30

20

10 e

d

c

b

a

D

0

Quantity per period

100 200 500 800 900 1,000

Pri

ce p

er u

nit

Consider a movement from point a to point b on the demand curve. The 100-unit increase in quantity demanded is a percent change of 100/150 = 0.67% while the $10 drop in price is a percent change of 10/85 = 12% the price elasticity of demand here is 5.6 Between points d and e, the 100 quantity increase is a 12% change and the $10 price decrease is a 67% price decrease price elasticity of 0.2


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(a) Demand and Price Elasticity$100 90 80 70 60 50 40 30 20 10 e

d

c

b

a

D

Inelastic ED < 1

Unit elastic ED = 1

Elastic ED > 1


100 200 500 800 900 1,000

$25,000

Tota

l re

ven

ue

0

Total revenue

(b) Total Revenue

TR = p x q

Pri

ce p

er u

nit

Quantity per period 1,000500

When demand is elastic, a decrease in price (from a to b) will increase total revenue because the gain in revenue from selling more units (blue box) exceeds the loss in revenue from selling all units at a lower price (red box)When demand is elastic, a price decrease (from d to e) reduces total revenue because the gain in revenue from selling more units (blue box) is less than the loss in revenue at the lower price (red box)


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Exhibit 3: Constant Elasticity Demand CurvesP

rice

per

uni

t

Pri

ce p

er u

nit

Pri

ce p

er u

nit

p


Quantity per period

Quantity per period

E = D

(a) Perfectly elastic demand curve

$10

6

0 60 100

E = D 1

(c) Unit elastic demand curve

D

0

E = D 0

(b) Perfectly inelastic demand curve

D'

Q

D"

a

b

This demand curve indicates consumers will demand all that is offered at the given price, p. If the price rises above p, quantity demanded drops to zero.

This demand curve indicates that quantity demanded does not vary when the price changes; no matter how high the price, consumers will purchase the same quantity.

This demand curve is unit-elastic everywhere: any percent change in price results in an identical offsetting percent change in quantity demanded.

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Availability of Substitutes

The greater the availability of substitutes for a good and the closer the substitutes, the greater the good’s price elasticity of demand

The number and similarity of substitutes depend on how we define the good the more broadly we define a good, the fewer the substitutes and the less elastic the demand

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Proportion of Consumer’s Budget

Because spending on some goods represents a large share of the consumer’s budget, a change in the price of such a good has a substantial impact on the amount consumers are able to purchase

Generally, the more important the item is as a share of the consumer’s budget, other things constant, the greater will be the income effect of a change in price, the more price elastic will be the demand for the item

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Exhibit 5: Demand Becomes More Elastic over Time

$1.25

Suppose the price increases from the initial price of $1.00 to $1.25. Dw shows that one week after the price increase, the quantity demanded has not changed much, from 100 to 95After one month, Dm, it has declined to 75, and after one year, Dy, to 50 The longer the time period the larger the response to a given price change

Quantity per period

1.00

0

Dw

1007550 95

Dm

DyPri

ce p

er u

nit

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Price Elasticity of Supply

The price elasticity of supply measures how responsive producers are to a price change

Equals the percent change in quantity supplied divided by the percent change in price

Since the higher price usually results in an increased quantity supplied, the percent change in price and the percent change in quantity supplied move in the same direction the price elasticity of supply is usually a positive number

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Exhibit 7: Price Elasticity of Supply

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Exhibit 7: Price Elasticity of Supply

If the price increases from p to p', the quantity supplied increases from q to q‘

The price elasticity of Es is

Where q is the change in quantity supplied and p is the change in price.

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Categories of Supply Elasticity

The terminology for supply elasticity is the same as for demand elasticity If supply elasticity is less than 1.0, supply is inelastic If it equals 1.0, supply is unit elastic If it exceeds 1.0, supply is elastic

Exhibit 8 illustrates some special cases of supply elasticity to consider

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Exhibit 8: Constant-Elasticity Supply CurvesP

rice

per

un

it

Pri

ce p

er

un

it

Pri

ce p

er u

nit

p

0

E = S

(a) Perfectly elastic

$10 5

0 10 20

E = S 1

(c) Unit elastic

S

0

E = S 0

(b) Perfectly inelastic

S'

Q

S"

Quantity per period

Quantity per periodQuantity per period

At one extreme is the horizontal supply curve. Here producers will supply none of the good at a price below p, but will supply any amount at a price of p

The most unresponsive relationship is where there is no change in the quantity supplied regardless of the price where the supply curve is perfectly vertical.

Any supply curve that is a straight line from the origin such as shown above is a unit-elastic supply curve.

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Determinants

The responsiveness of sellers depends on how easy it is to alter output when price changes If the cost of supplying additional units rises

sharply as output expands, then a higher price will elicit little increase in quantity supplied

But if the marginal cost rises slowly as output expands, the lure of a higher price will prompt a large increase in output

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Length of Time

Supply also becomes more elastic over time as producers adjust to price changes

The longer the time period under consideration, the more able producers are to adjust to changes in relative prices

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Exhibit 9: Supply Becomes More Elastic over Time

1.00

Sw is the supply curve when the period of adjustment is a week. Sm is the supply curve when the adjustment period is one month; supply more elastic and quantity supplied increases to 140After one year the supply curve becomes Sy and the quantity supplied increases to 200


Sw Sm

Sy

100110

140 200

$1.25P

rice

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Income Elasticity of Demand

Measures how responsive demand is to a change in income

Equals the percent change in demand divided by the percent change in income

Categories Goods with income elasticities less than zero are

called inferior goods demand declines when income increases

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Income Elasticity of Demand

Normal goods have income elasticities greater than zero demand increases when income increases Normal goods with income elasticities greater than

zero but less than 1 are called income inelastic goods demand increases but not as much as does income

Goods with income elasticity greater than 1 are called income elastic demand not only increases when income increases but increases by more than does income

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Exhibit 11: The Demand for Grain

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Exhibit 12: Effect of Increases in Supply and Demand on Farm Revenue

$8

Billions of bushels per year

D

S

0

4

14

D'

S'

10

Over time, technological advances in farming have sharply increased the supply of grain

In addition, increases in household income over time have increased the demand for farm products

But because increases in the supply of grain have exceeded increases in demand, the combined effect has been a drop in the market price and a fall in total farm revenue

Pri

ce p

er b

ush

el

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Cross-Price Elasticity of Demand

Since firms often produce an entire line of products, it has a special interest in how a change in the price of one product will affect the demand for another

The responsiveness of the demand for one good to changes in the price of another good is called the cross-price elasticity of demand

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Cross-Price Elasticity of Demand

Defined as the percent change in the demand of one good divided by the percent change in the price of another good If an increase in the price of one good leads to an

increase in the demand for another good, their cross-price elasticity is positive the two goods are substitutes

If an increase in the price of one good leads to a decrease in the demand for another, their cross-price elasticity is negative the two goods are complements

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Elasticity Of Demand And Supply