Elasticities of Demand and Supply1 ELASTICITIES OF DEMAND AND SUPPLY ECO 2023 Principles of Microeconomics Dr. McCaleb

Elasticities of Demand and Supply 1

ELASTICITIES OF DEMAND AND SUPPLY

ECO 2023Principles of Microeconomics

Dr. McCaleb


TOPIC OUTLINE

I. Price Elasticity of Demand

II. Application: Elasticity and the Demand for Smoking

III. Price Elasticity of Supply

IV. Cross Price Elasticity and Income Elasticity


Price Elasticity of Demand


PRICE ELASTICITY OF DEMAND

What Is the Price Elasticity of Demand?

The price elasticity of demand is the ratio of the percentage change in the quantity demanded to the percentage change in price.

Price elasticity ofdemand

Percent change in quantity demanded

Percent change in price=

What Is the Price Elasticity of Demand Used For?

It measures the size of the change in quantity demanded when the price of a good changes.



How Is the Price Elasticity of Demand Calculated?

Mid-point method

Calculate the change in quantity demanded as a percent of the average of the two quantities and multiply by 100 to convert to percent

x 100Percent change

in quantity

New quantity – Initial quantity

(New quantity + Initial quantity) ÷ 2=



How Is the Price Elasticity of Demand Calculated?

Calculate the change in price as a percent of the average of the two prices and multiply by 100 to convert to percent

x 100Percent change in price =New price – Initial price

(New Price + Initial Price) ÷ 2



Why Do Economists Use Elasticity to Measure the Size of the Change?

Because elasticity is a ratio of two percentages, the percentages “cancel out” so that elasticity is a pure number, a number with no units of measurement attached to it.

That allows us to compare the demands for different goods even though they are measured in different units or to compare goods at different points in time or even to compare goods in different countries that use different currencies.


The quantity demanded of lattes at a Starbucks decreases from 15 cups per hour to 5 cups per hour when the price increases from $3.00 to $5.00. Using the mid-point method, what is the percent change in quantity demanded? (Hint: Make sure the answer is in percent. Include the negative sign if it is negative, but do not include the percent sign.)


The quantity demanded of lattes at a Starbucks decreases from 15 cups per hour to 5 cups per hour when the price increases from $3.00 to $5.00. Using the mid-point method, what is the percent change in price? (Hint: Make sure the answer is in percent. Include the negative sign if it is negative, but do not include the percent sign.)


The quantity demanded of lattes at a Starbucks decreases from 15 cups per hour to 5 cups per hour when the price increases from $3.00 to $5.00. What is the elasticity of demand? (Hint: No decimal numbers. If the answer is negative, include the negative sign.)



What Does the Elasticity Number or Coefficient Mean?

The absolute value of the elasticity coefficient shows whether the quantity change is bigger than the price change, the same size as the price change, or smaller than the price change.

The bigger the absolute value, the more sensitive or responsive consumers are to a price change.

The smaller the absolute value, the less sensitive or responsive they are to a price change.



What Does an Elasticity Coefficient Greater than 1 in Absolute Value Mean?

Demand is elastic.

The percent change in quantity demanded is greater than the percent change in price

Consumers are relatively sensitive or responsive to price changes.



What Does an Elasticity Coefficient Smaller than 1 in Absolute Value Mean?

Demand is inelastic.

The percent change in quantity demanded is smaller than the percent change in price

Consumers are relatively insensitive or not very responsive to price changes.



What Does an Elasticity Coefficient Equal to 1 in Absolute Value Mean?

Demand is unit elastic.

The percent change in quantity demanded equals the percent change in price

Consumers are neither very sensitive or responsive to price changes nor are they very insensitive or unresponsive.



What Does It Mean When the Elasticity Coefficient Is Equal to 0?

Demand is perfectly inelastic.

The percentage change in quantity demanded is zero when the price changes.

Consumers are completely insensitive or unresponsive to the price change. They want the same quantity no matter what the price is.

A perfectly inelastic demand curve is vertical.



When the price rises, . . . the quantity demanded does not change.

There is no change in the quantity demanded when price changes. Therefore, demand is perfectly inelastic.

Special Case: Perfectly Inelastic Demand



What Does It Mean If the Elasticity Coefficient Is Infinite?

Demand is perfectly elastic.

Even an infinitesimally small percentage price change will cause a very (“infinitely”) large percentage change in quantity demanded.

The numerator (the percent change in quantity demanded) is so large and the denominator (the percent change in price) is so small that the coefficient of elasticity approaches infinity in the limit.

The demand curve is horizontal are almost so.



For even a very small change in the price of spring water, . . . the quantity demanded of spring water changes by a very large amount.

The change in the quantity demanded is much (infinitely) larger than the change in price. Therefore, the demand for spring water is perfectly elastic.

Special Case: Perfectly Elastic Demand


If the price elasticity of demand for furniture is 1.26, the demand for furniture is

1. Perfectly elastic

2. Elastic but not perfectly elastic

3. Unit elastic

4. Inelastic but not perfectly inelastic

5. Perfectly inelastic


If the price elasticity of demand for furniture is 1.26, the percent change in quantity demanded is _____ the percent change in price and buyers are _____ sensitive to price changes.

1. Greater than; very

2. Greater than; not very

3. Less than; very

4. Less than; not very


If the price elasticity of demand for tobacco is 0.61, the demand for tobacco is

1. Perfectly elastic

2. Elastic but not perfectly elastic

3. Unit elastic

4. Inelastic but not perfectly inelastic

5. Perfectly inelastic


If the price elasticity of demand for tobacco is 0.61, the percent change in quantity demanded is _____ the percent change in price and buyers are _____ sensitive to price changes.

1. Greater than; very

2. Greater than; not very

3. Less than; very

4. Less than; not very



What Causes the Demand for Some Goods To Be More Elastic or More Inelastic than Others?

• Substitution effects

• Income effects

• Time



Substitution effects

If it is easy to find a substitute for a good, then, ceteris paribus, the demand for the good tends to be more elastic or less inelastic.

More or better substitutes Higher elasticity

If it is harder to find a substitute for a good, then, ceteris paribus, the demand for the good tends to be more inelastic or less elastic.

Few or poorer substitutes Lower elasticity



Substitution effects: Examples

• Ceteris paribus, the demand for Toyota Camrys is likely to be more elastic (or less inelastic) than the demand for automobiles which in turn is more elastic (or less inelastic) than the demand for motor vehicles.

• The demand for a college textbook is likely to be more inelastic (or less elastic), ceteris paribus, than the demand for a popular novel.



Income Effects

If consumers spend a relatively larger percent of their income on a good, then, ceteris paribus, the demand for the good tends to be more elastic or less inelastic.

Larger share of income Higher elasticity

If consumers spend a relatively smaller percent of their income on a good, then, ceteris paribus, the demand for the good tends to be less elastic or more inelastic.

Smaller share of income Lower elasticity



Income Effects: Examples

• Purchases of automobiles require a larger proportion of income than purchases of gasoline so, ceteris paribus, the demand for automobiles is likely to be more elastic (or less inelastic) than the demand for gasoline.

• Households spend more of their income on steak than on the salt to put on the steak. Ceteris paribus, the demand salt is likely to be more inelastic (or less elastic) than the demand for steak.



Time

The longer the time period over which elasticity is measured, the larger, ceteris paribus, it is likely to be because consumers have more time to find good substitutes and adjust their consumption.

Longer time Higher elasticity

Shorter time Lower elasticity

Example: The elasticity of demand for gasoline is very low one day or one week after a change in the price, but the elasticity is higher (although still inelastic) one year after the price change. In fact, the demand for gasoline becomes elastic after several years have passed.


Universal to cut price of CD's to raise salesAmy Harmon New York Times

Friday, September 5, 2003

Universal Music Group's plan to cut prices on compact discs by as much as 30 percent represents a big gamble in its aggressive bid to lure consumers back into record stores.

The deep price cut, announced on Wednesday, is the only one to apply to new CD's since the format was introduced in the early 1980's.

Universal, owned by Vivendi Universal, is betting that consumers will buy more CD's once the price dips below $13.



Total Revenue and Price Elasticity of Demand

Relationship between price elasticity of demand and total revenue

There is a unique relationship between the price elasticity of demand, a change in the price of the good, and sellers’ total revenue from (or buyers’ total expenditure on) the good.

This relationship is valid for the price elasticity of demand only. It is not valid for any other elasticity (that is, income elasticity of demand, price elasticity of supply, or cross-elasticities).



Total Revenue and Price Elasticity of Demand

Elastic demand

• If demand is elastic, a price change results in a change in total revenue (or total expenditure) in the opposite direction.

P increase TR decreaseP decrease TR increase

• According to the law of demand, a price change causes a change in quantity demanded in the opposite direction. Because demand is elastic, the quantity change is bigger than the price change. So the quantity change determines what happens to total revenue.


PRICE ELASTICITY OF DEMAND Total Revenue and Price Elasticity of Demand

Inelastic demand

• If demand is inelastic, a price change results in a change in total revenue (or total expenditure) in the same direction.

P increase TR increaseP decrease TR decrease

• According to the law of demand, a price change causes a change in quantity demanded in the opposite direction. Because demand is inelastic, the price change is bigger than the quantity change. So the price change determines what happens to total revenue.


PRICE ELASTICITY OF DEMAND Total Revenue and Price Elasticity of Demand

Unit elastic demand

• If demand is unit elastic, a price change results in no change in total revenue (or total expenditure).

P increase TR unchangedP decrease TR unchanged

• According to the law of demand, a price change causes a change in quantity demanded in the opposite direction. Because demand is unit elastic, the quantity change equals the price change. So the quantity change and the price change offset each other and total revenue doesn’t change.


The price elasticity of demand for automobiles is 1.35. If Toyota wants to increase its revenues, it should

1. Raise price

2. Leave price unchanged

3. Lower price


President Weatherell wants to raise tuition (price) by a significant amount to increase the University's budget (total revenue). Therefore, he must be assuming that your demand for an FSU education is

1. elastic

2. unit elastic

3. inelastic


The demand for most agricultural commodities is inelastic. Therefore, when a freeze reduces the size of the orange crop, total revenue of all orange growers increases even though the incomes of growers who lose a large part of their crop falls.


Application: Elasticity and the Demand for Smoking


ELASTICITY AND THE DEMAND FOR SMOKING

Example: Oregon’s Anti-Smoking Campaign

In November 1996, residents of Oregon approved a ballot measure increasing the excise tax on sellers of cigarettes by $0.30 per pack.

The average price per pack increased from $1.75 to $2.05.

Annual per capita consumption decreased from 92 packs to 86 packs.

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Example: Oregon’s Anti-Smoking Campaign

10% of the additional tax revenue was allocated to the Oregon Health Division (OHD) to develop and implement a tobacco-use prevention program.

Because of the fall in demand, annual per capita consumption decreased by an additional 4 packs, from 86 to 82.

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Addiction and Elasticity

Nonusers

Nonusers’ demand for addictive substances is elastic. For example, the estimated elasticity of demand for cigarettes among teenage nonusers is 1.2.

Therefore, a moderately higher price leads to a substantially smaller number of people trying a drug.



Addiction and Elasticity

Users

Existing users’ demand for addictive substances is inelastic. For example, the estimated elasticity of demand for cigarettes among adult smokers is 0.4.

Therefore, a substantial price rise brings only a modest decrease in the quantity demanded. Even addicted users, however, may reduce their consumption at the margin so demand is not perfectly inelastic.



Price Elasticity of Supply


PRICE ELASTICITY OF SUPPLY

What Is the Price Elasticity of Supply?

The price elasticity of supply is the ratio of the percent change in the quantity supplied to the percent change in price.

Price elasticity ofsupply

Percentage change in quantity supplied

Percentage change in price=

The price elasticity of supply is interpreted in the same way as the price elasticity of demand.



• What Causes the Supply of Some Goods To Be More Elastic or More Inelastic than Others?

• Substitution effects

• Time: Same effect as elasticity of demand



Substitution effects

If it is easy for sellers to switch production and sales to another good, if they have good alternative uses for their productive inputs, then, ceteris paribus, the supply of the good tends to be more elastic or less inelastic.

More or better substitutes Higher elasticity

If it is harder for sellers to switch to production and sales of alternative goods, if inputs tend to be more specialized, then, ceteris paribus, the supply of the good tends to be more inelastic or less elastic.

Few or poorer substitutes Lower elasticity



Substitution effects: Examples

• Ceteris paribus, the supply of physicians is likely to be more elastic (or less inelastic) than the supply of surgeons which in turn is more elastic (or less inelastic) than the supply of neurosurgeons. The more specialized the resources required to produce a good, the less elastic its supply is likely to be.

• Storage provides sellers with a way of substituting between current sales and future sales. Ceteris paribus, the lower the cost of storing a good, frozen fish for example, the more elastic is its supply. On the other hand, the supply of a non-storable good like fresh fish is highly inelastic.


Cross Price Elasticity and Income Elasticity of Demand


CROSS PRICE ELASTICITY AND INCOME ELASTICITY OF DEMAND

What Is the Cross Price Elasticity of Demand?

Cross elasticityof demand

Percent change in quantity demanded of agood

Percent change in the price of one of itssubstitutes or complements

=

The ratio of the percent change in quantity demanded of a good to the percent change in the price of a substitute or a complement.


CROSS ELASTICITY AND INCOME ELASTICITY OF DEMAND

Substitutes

Suppose that when the price of a burger falls by 10 percent, the quantity of pizza demanded decreases by 5 percent.

Cross elasticity ofdemand for pizza

– 5 percent

– 10 percent= = 0.5

The cross price elasticity of demand between substitutes is positive.



Complements

Suppose that when the price of a burger falls by 10 percent, the quantity of pizza demanded decreases by 5 percent.

The cross price elasticity of demand between complements is negative.

Cross elasticity ofdemand for pizza

2 percent

– 10 percent= = -0.2


What Is the Income Elasticity of Demand?

The ratio of the percent change in quantity demanded to the percent change in buyers’ incomes.


Income elasticityof demand

Percentage change in quantity demanded

Percentage change in income=

Positive income elasticity normal good

Negative income elasticity inferior good


If the cross price elasticity of demand between two goods is positive, the two goods are

1. Normal

2. Inferior

3. Substitutes

4. Complements

5. Elastic

6. inelastic


If the cross price elasticity of demand between two goods is negative, the two goods are

1. Normal

2. Inferior

3. Substitutes

4. Complements

5. Elastic

6. inelastic


True or false: If the income elasticity of demand for a good is positive and less than 1 in absolute value, the good is a normal good and the demand for the good is inelastic.


True or false: If the income elasticity of demand for a good is negative and greater than 1 in absolute value, the good is an inferior good and the demand for the good is elastic.

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Elasticities of Demand and Supply1 ELASTICITIES OF DEMAND AND SUPPLY ECO 2023 Principles of Microeconomics Dr. McCaleb