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Describing Supply and Demand: Elasticites 7
Describing Supply and Demand: Elasticities
The master economist must
understand symbols and speak in
words. He must contemplate the
particular in terms of the general,
and touch abstract and concrete in
the same flight of thought.
— J. M. Keynes
CHAPTER 7
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Describing Supply and Demand: Elasticites 7
What is Elasticity?
• Elasticity: shows how sensitive a change in quantity is to a change in price
• There are 4 types:
• 1. Elasticity of Demand
• 2. Elasticity of Supply
• 3. Cross-Price Elasticity (Substitutes or Complements)
• 4. Income Elasticity (Normal or Inferior goods)McGraw-Hill/Irwin Colander, Economics 2
Describing Supply and Demand: Elasticites 7
ELASTICITY OF DEMAND
McGraw-Hill/Irwin Colander, Economics 3
Describing Supply and Demand: Elasticites 7
Price Elasticity of Demand: Elastic Demand
• It is a measurement of consumersresponsiveness to a change in price
• What will happen if price increases?
• How much will it affect quantity demanded?
• Price elasticity of demand is always expressed as a positive number (E>1)
McGraw-Hill/Irwin Colander, Economics 4
Describing Supply and Demand: Elasticites 7
Price Elasticity of Demand: Elastic Demand
• Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price (independent of units)
ED =% change in Quantity Demanded
% change in Price
7-5
Describing Supply and Demand: Elasticites 7
Price Elasticity of Demand: Elastic Demand
• Demand is elastic if the percentage change in quantity is greater than the percentage change in price
• Elastic demand =ED > 1
7-6
Describing Supply and Demand: Elasticites 7
Characteristics of Elastic Goods
• Many substitutes
• Luxuries
• Large portion of income
• Plenty of time to decide
• Elasticity coefficient greater than 1
McGraw-Hill/Irwin Colander, Economics 7
Describing Supply and Demand: Elasticites 7
Draw the Graph: Relatively Elastic Demand
D
P
Q
7-8
Describing Supply and Demand: Elasticites 7
Perfectly Elastic Demand
McGraw-Hill/Irwin Colander, Economics 9
• This curve is perfectly elastic, meaning that Q responds enormously to changes in price, ED = ∞
D
P
Q
Describing Supply and Demand: Elasticites 7
Elastic Demand
McGraw-Hill/Irwin Colander, Economics 10
Describing Supply and Demand: Elasticites 7
Price Elasticity of Demand: Inelastic Demand
• When demand is inelastic, quantity demanded is insensitive to a change in price—meaning there will be little change
• If price increases, quantity demanded will fall a little
• If price decreases, quantity demanded will increase a little
• In other words, people will continue to buy it
McGraw-Hill/Irwin Colander, Economics 11
Describing Supply and Demand: Elasticites 7
Price Elasticity of Demand: Inelastic Demand
• Demand is inelastic if the percentage change in quantity is less than the percentage change in price
• Inelastic demand=ED < 1
McGraw-Hill/Irwin Colander, Economics 12
Describing Supply and Demand: Elasticites 7
Characteristics of Inelastic Goods
• Few substitutes
• Necessities
• Small portion of income
• Required now, rather than later
• Elasticity coefficient less than 1
McGraw-Hill/Irwin Colander, Economics 13
Describing Supply and Demand: Elasticites 7
Draw the Graph: Inelastic Demand
D
P
Q
7-14
Describing Supply and Demand: Elasticites 7
Perfectly Inelastic Demand
McGraw-Hill/Irwin Colander, Economics 15
• This curve is perfectly inelastic, meaning that Q does not respond at all to changes in price, ED = 0 . Q is insensitive to changes in P.
P
Q
D
Describing Supply and Demand: Elasticites 7
Elasticity of Demand: Draw the Graphic
McGraw-Hill/Irwin Colander, Economics 16
Describing Supply and Demand: Elasticites 7
Inelastic Demand
McGraw-Hill/Irwin Colander, Economics 17
Describing Supply and Demand: Elasticites 7
Calculating Elasticities: Using the Midpoint Formula
D
P
Q
What is the price elasticity of demand between A and B?
$20
10
$26
14
MidpointB
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 =
7-18
Describing Supply and Demand: Elasticites 7
Calculating Elasticities: Using the Midpoint Formula—An easier formula
• Let’s simplify the formula:
McGraw-Hill/Irwin Colander, Economics 19
%ΔQ midpoint
/ %ΔP midpoint
4 12 / 6
23=1.27
Describing Supply and Demand: Elasticites 7
Elasticity Along a Demand Curve
P
Q
Elasticity declines along this straight-line demand
curve as we move towards the Q axis
ED = 0
ED = 1
ED = ∞
ED > 1
ED < 1
7-20
Perfectly elastic (where intersects P)
Elastic
Unit elastic(at midpoint)
Inelastic
Perfectly inelastic (where intersects Q)
Elastic Inelastic
Describing Supply and Demand: Elasticites 7
Total Revenue Test
• Uses elasticity to show how changes in price will affect total revenue (TR)
• Total Revenue = Price x Quantity
McGraw-Hill/Irwin Colander, Economics 21
Describing Supply and Demand: Elasticites 7
Total Revenue Test
• Elastic Demand: If ED > 1
• Price increase causes TR to decrease
• Price decrease causes TR to increase
• Inelastic Demand: If ED < 1
• Price increase causes TR to increase
• Price decrease causes TR to decrease
• Unit Elastic: If ED = 1
• A change in price changes leaves TR unchanged
McGraw-Hill/Irwin Colander, Economics 22
Describing Supply and Demand: Elasticites 7
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
7-23
Describing Supply and Demand: Elasticites 7
Figuring Out Elasticity
• You can use the midpoint formula to figure of elasticity OR you can use the total revenue test
• Know both ways
McGraw-Hill/Irwin Colander, Economics 24
Describing Supply and Demand: Elasticites 7
Elasticity Along Straight-Line Curves
P
Q
If ED > 1, an increase in price decreases
total revenue
$2
10
$6
42
$4
$8
$10
6 8
JK
A
C
B
Demand
Application: Elastic Demand
TRJ = PxQ = areas A+B = $8x2 = $16
TRK = PxQ = areas A+C = $9x1 = $9
ED > 1
7-25
Describing Supply and Demand: Elasticites 7
Elasticity Along Straight-Line Curves
P
Q
If ED < 1, an increase in price increases total
revenue
$2
10
$6
42
$4
$8
$10
6 8
GH
AC
B Demand
Application: Inelastic Demand
TRG = PxQ = areas A+B = $1x9 = $9
TRH = PxQ = areas A+C = $2x8 = $16
ED < 1
7-26
Describing Supply and Demand: Elasticites 7
Elasticity Along Straight-Line Curves
P
Q
If ED = 1, an increase in price leaves total revenue unchanged
$2
10
$6
42
$4
$8
$10
6 8
E
F
A
C
B
Demand
Application: Unit Elastic Demand
TRE = PxQ = areas A+B = $4x6 = $24
TRF = PxQ = areas A+C = $6x4 = $24
ED = 1
7-27
Describing Supply and Demand: Elasticites 7
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’ Saturday stay-over specials
• New cars
7-28
Describing Supply and Demand: Elasticites 7
Substitution and Elasticity
• What makes demand (or supply) more or less elastic?
• Substitution
• 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
7-29
Describing Supply and Demand: Elasticites 7
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
7-30
Describing Supply and Demand: Elasticites 7
Income Elasticity of Demand
• Income elasticity of demand measures the responsiveness of demand to changes in income
EIncome = % change in Demand
% change in Income
7-31
Describing Supply and Demand: Elasticites 7
Income Elasticity of Demand
• Normal goods are those whose consumption increases with an increase in income
• For normal goods: Eincome > 0
• Necessity: 0 < Eincome < 1 (greater than 0 and
less than 1)
• Luxury: EIncome > 1
McGraw-Hill/Irwin Colander, Economics 32
Describing Supply and Demand: Elasticites 7
Income Elasticity of Demand
• Inferior goods are those whose consumption decreases with an increasein income
EIncome < 0 (negative number)
McGraw-Hill/Irwin Colander, Economics 33
Describing Supply and Demand: Elasticites 7
Income Elasticity of Demand: Draw the Graphic
McGraw-Hill/Irwin Colander, Economics 34
Describing Supply and Demand: Elasticites 7
Cross–Price Elasticity of Demand
• Cross–price elasticity of demand measures the responsiveness of demand to changes in prices of other goods
Ecross-price = % change in Demand
% change in P of related good
7-35
Describing Supply and Demand: Elasticites 7
Cross–Price Elasticity of Demand
• Cross-price elasticity tells us if goods are substitutes or complements
• Here, positive and negative matters!
•Positive change indicates a substitute
•Negative change indicates a complement
McGraw-Hill/Irwin Colander, Economics 36
Describing Supply and Demand: Elasticites 7
Cross–Price Elasticity of Demand
• Substitutes are goods that can be used in place of another (when the price of a good goes up, the demand for the substitute goes up)
Ecross-price > 0 (positive number)
McGraw-Hill/Irwin Colander, Economics 37
Describing Supply and Demand: Elasticites 7
Cross–Price Elasticity of Demand
• Complements are goods that are used conjunction with other goods (a decrease in the price of a good will increase the demand for its complement)
Ecross-price < 0 (negative number)
McGraw-Hill/Irwin Colander, Economics 38
Describing Supply and Demand: Elasticites 7
Cross–Price Elasticity of Demand
McGraw-Hill/Irwin Colander, Economics 39
Describing Supply and Demand: Elasticites 7
ELASTICITY OF SUPPLY
McGraw-Hill/Irwin Colander, Economics 40
Describing Supply and Demand: Elasticites 7
Price Elasticity of Supply: Elastic Supply
• Elasticity of supply shows how sensitiveproducers are to a change in price
• Elasticity of supply is based on time limitations
• Producers need time to produce more
McGraw-Hill/Irwin Colander, Economics 41
Describing Supply and Demand: Elasticites 7
Price Elasticity of Supply: Elastic Supply
• Price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price
ES = % change in Quantity Supplied
% change in Price
• This tells us exactly how quantity supplied responds to a change in price (elasticity is independent of units)
7-42
Describing Supply and Demand: Elasticites 7
Elasticity of Supply
• Supply is elastic if the percentage change in quantity is greater than the percentage change in price
• Elastic supply=ES > 1
• Supply is inelastic if the percentage change in quantity is less than the percentage change in price
• Inelastic supply =ES < 1
7-43
Describing Supply and Demand: Elasticites 7
Drawing the Graph: Relatively Elastic Supply
McGraw-Hill/Irwin Colander, Economics 44
P
Q
S
Describing Supply and Demand: Elasticites 7
Drawing the Graph: Inelastic Supply
McGraw-Hill/Irwin Colander, Economics 45
P
Q
S
Describing Supply and Demand: Elasticites 7
Elasticity Along a Supply Curve • At the point on the supply curve that intercepts
the price axis, supply is perfectly elastic Es = ∞
• Points become less elastic as you move out along the supply curve
• At the point on the supply curve that intercepts the quantity axis, supply is perfectly inelastic Es = 0
• Points become more elastic as you move along the supply curve
• Supply is unit elastic if it intercepts the originMcGraw-Hill/Irwin Colander, Economics 46
Describing Supply and Demand: Elasticites 7
Elasticity Along a Supply Curve
McGraw-Hill/Irwin Colander, Economics 47
P
Q
$2
10
$6
42
$4
$8
$10
6 8
Es = ∞ (perfectlyelastic)
Es = 0
Unit elastic (intercepts origin)
Perfectly inelasticEs = 1
Describing Supply and Demand: Elasticites 7
Calculating Elasticities: Midpoint Formula
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
$4.75
0.01870.105
= 0.18 =
S
7-48
Describing Supply and Demand: Elasticites 7
Calculating Elasticities: Using the Midpoint Formula—An easier formula
• Let’s simplify the formula:
McGraw-Hill/Irwin Colander, Economics 49
%ΔQ midpoint
/ %ΔP midpoint
9 480.5 / .50
4.75=0.18
Describing Supply and Demand: Elasticites 7
Substitution and Elasticity
• What makes supply (or demand) more or less elastic?
• Substitution
• 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
7-50
Describing Supply and Demand: Elasticites 7
Substitution and Supply
• The longer the time period considered, the more elastic the supply
• There are three time periods relevant to supply:
1. The instantaneous period where supply is fixed and is perfectly inelastic
2. The short run where some substitution is possible and supply is somewhat elastic
3. The long run where significant substitution is possible and supply is most elastic
7-51
Describing Supply and Demand: Elasticites 7
Shifting Supply and Demand and Elasticity
• The more elastic the demand ( or supply), the greater the effect of a supply (or demand) shift on quantity and the smaller the effect on price
% change in P = % change in DED + ES
% change in P = % change in SED + ES
7-52
Describing Supply and Demand: Elasticites 7
Chapter Summary
• Elasticity is percentage change in quantity divided by
percentage change in some variable that affects demand
(supply). The most common elasticity is price.
ES = % change in Quantity Supplied
% change in Price
ED = % change in Quantity Demanded
% change in Price
7-53
Describing Supply and Demand: Elasticites 7
Chapter Summary
• Five price elasticity of demand or supply terms are:• Elastic E>1• Inelastic E<1• Unit elastic E=1• Perfectly inelastic E=0• Perfectly elastic E=∞
• Demand becomes less elastic as we move down along a demand curve
• The most important factor affecting the number of substitutes
in supply is time. The longer the time interval, the more
elastic is supply
7-54
Describing Supply and Demand: Elasticites 7
Chapter Summary
• Factors affecting the number of substitutes in demand are:
• Time period
• Degree to which the good is a luxury
• Market definition
• Importance of the good in one’s budget
• The more substitutes a good has, the greater its elasticity
7-55
Describing Supply and Demand: Elasticites 7
Chapter Summary
• When a supplier raises price:• If demand is inelastic, total revenue increases• If demand is elastic, total revenue decreases• If demand is unit elastic, total revenue remains
constant
• Other important elasticities are:
• Income elasticity is the percentage change in demand divided by the percentage change in income
• Cross-price elasticity is the percentage change in demand divided by the percentage change in the price of a related good
7-56
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