1 describing supply and demand: elasticities 6 6-1 price elasticity: demand price elasticity of...

1Describing Supply and Demand: Elasticities 6

6-1

Price Elasticity: Demand

Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price

This tells us exactly how quantity demanded responds to a change in price

ED =

Elasticity is independent of units

% change in Quantity Demanded% change in Price

Price elasticity of demand is always expressed as a positive number


6-2

Price Elasticity: Demand

Demand is elastic if the percentage change in quantity is greater than the percentage change in price

Elastic demand is when ED > 1

Demand is inelastic if the percentage change in quantity is less than the percentage change in price

Inelastic demand is when ED < 1


6-3

Calculating Elasticities: Price Elasticity of Demand

D

P

Q

What is the price elasticity of demand between A and B?

$20

10

$26

14

B

A

ED = %ΔQ%ΔP

Q2–Q1

½(Q2+Q1)P2–P1

½(P2+P1)

=

C

12

$23

=

10–14½(10+14)

26–20½(26+20)

-.33.26 = 1.27 =


6-4


ED = %ΔQ%ΔP

Q2–Q1

½(Q2+Q1)P2–P1

½(P2+P1)

=

Compute the approximate elasticity of demandfrom the following data: Price QuantityInitial situation $23 11.5 New situation $20 13.5


6-5


ED = %ΔQ%ΔP

Q2–Q1

½(Q2+Q1)P2–P1

½(P2+P1)

=


6-6

Elasticity is Not the Same as Slope

Elasticity is not the same as slope, but, the steeper a curve is at a given point, the less elastic demand or supply

This curve is perfectly elastic, meaning that Q responds enormously to changes in price, ED = ∞

This curve is perfectly inelastic, meaning that Q does not respond at all to changes in price, ED = 0

P

Q

D

D

P

Q


6-7

Elasticity Changes Along Straight-Line Curves On straight-line supply and demand curves,

slope stays constant, but elasticity changes P

Q

Elasticity declines along this straight-line demand curve as we move towards the Q axis

$2

10

$6

42

$4

$8

$10

6 8ED = 0

ED = 1

ED = ∞

ED > 1

ED < 1


6-8

Elasticity Changes Along Straight-Line Curves On straight-line supply curve, slope stays

constant, but elasticity changes P

Q

If it intersects the vertical axis (S0), elasticity starts at infinity and declines, and eventually approaches 1.

If it intersects the horizontal axis (S1), it starts at zero and increases, and eventually approaches 1.

$2

10

$6

42

$4

$8

$10

6 8

S0

S1

Es = ∞

Es = 0

Es declines

Es rises


6-9

Price Elasticity: Supply

Price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price

This tells us exactly how quantity supplied responds to a change in price

ES =

Elasticity is independent of units

% change in Quantity Supplied% change in Price


6-10

Price Elasticity: Supply

Supply is elastic if the percentage change in quantity is greater than the percentage change in price

Elastic supply is when ES > 1

Supply is inelastic if the percentage change in quantity is less than the percentage change in price

Inelastic supply is when ES < 1


6-11

Calculating Elasticities: Price Elasticity of Supply

P

Q

What is the price elasticity of supply between A and B?

$4.50

476

$5.00

485

B

A

ES = %ΔQ%ΔP

Q2–Q1

½(Q2+Q1)P2–P1

½(P2+P1)

=

=

485–476½(485+476)

5–4.50½(5+4.50)

Midpoint

C

480.5

$4.750.01870.105 = 0.18 =

S


6-12

Substitution and Elasticity

A general rule is:

• the more substitutes a good has, the more elastic its supply or demand

If a good has substitutes, a rise in the price of that good will cause the consumer to shift consumption to those substitute goods

What makes supply or demand more or less elastic?

Substitution


6-13

Substitution and Demand

The number of substitutes a good has is affected by several factors. Four of the most important factors:

1. The time period being considered

2. The degree to which a good is a luxury

3. The market definition

4. The importance of the good in one’s budget


6-14

Elasticity, Total Revenue, and Demand

The elasticity of demand tells suppliers how their total revenue will change if their price changes

Total revenue is price multiplied by quantity, TR = (P)(Q)

• If ED > 1, an increase in price decreases total revenue. (Price and total revenue move in opposite directions.)

• If ED = 1, an increase in price leaves total revenue unchanged.

• If ED < 1, an increase in price increases total revenue. (Price and total revenue move in the same direction.)


6-15

Elasticity and Total Revenue

P

Q

If ED = 1, an increase in price leaves total revenue

unchanged

$2

10

$6

42

$4

$8

$10

6 8

TRE = PxQ = areas A+B = $4x6 = $24

E

F

TRF = PxQ = areas A+C = $6x4 = $24

A

C

B

Demand

Application: Unit Elastic Demand

ED = 1


6-16


P

Q

If ED < 1, an increase in price increases total revenue

$2

10

$6

42

$4

$8

$10

6 8

TRG = PxQ = areas A+B = $1x9 = $9

GH

TRH = PxQ = areas A+C = $2x8 = $16

AC

B Demand

Application: Inelastic Demand

ED < 1


6-17


P

Q

If ED > 1, an increase in price decreases total revenue

$2

10

$6

42

$4

$8

$10

6 8

TRJ = PxQ = areas A+B = $8x2 = $16

J

K TRK = PxQ = areas A+C = $9x1 = $9

A

C

B

Demand

Application: Elastic Demand

ED > 1


6-18

Relationship Between Elasticity and Total Revenue

Price Rise Price Decline

Elastic (ED > 1) TR decreases TR increases

Unit Elastic (ED = 1) TR constant TR constant

Inelastic (ED < 1) TR increases TR decreases


6-19

Elasticity of Individual and Market Demand

Price discrimination occurs when a firm separates the people with less elastic demand from those with more elastic demand

Firms that price discriminate charge more to the individuals with inelastic demand and less to individuals with elastic demand

Examples of price discrimination:

• Airlines pricing• The phenomenon of selling new cars• The almost-continual-sale phenomenon


6-20

Income and Cross-Price Elasticity

Income elasticity of demand measures the responsiveness of demand to changes in income

Normal goods are those whose consumption increases with an increase in income

EIncome = % change in Demand% change in Income

• Necessity: 0 < EIncome > 1

• Luxury: EIncome > 1

Inferior goods are those whose consumption decreases with an increase in income, EIncome < 0


6-21

Income and Cross-Price Elasticity

Cross–price elasticity of demand measures the responsiveness of demand to changes in prices of other goods

Substitutes are goods that can be used in place of another, Ecross-price > 0

Ecross-price = % change in Demand

% change in P of related good

Complements are goods that are used conjunction with other goods, Ecross-price < 0


6-22

Elasticity and Shifting Supply and Demand The more elastic the demand (supply), the greater the effect of a

supply (demand) shift on quantity and the smaller the effect on price.

S1

D

P

Q

Demand is relatively elastic

S0

Supply shifts out and caused a greater effect on quantity

than on price

Q0 Q1

P0

P1


6-23

S1

D

P

Q

Demand is relatively inelastic

S0

Supply shifts out and caused a greater effect on price than

on quantity

P0

P1

Elasticity and Shifting Supply and Demand

Q0 Q1

1 describing supply and demand: elasticities 6 6-1 price elasticity: demand price elasticity of...

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