slides chapter 5 microeconomy

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Elasticity: Demand and Supply

Chapter 5

Michael Melvin and William Boyes

Principles of Microeconomics

9e

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Elasticity The responsiveness of quantity demanded or

quantity supplied to a change in one of the determinants of demand and/or supply.

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Price Elasticity of Demand Definitions of Price Elasticity of Demand:

the percentage change in the quantity demanded of a product divided by the percentage change in the price of that product.

The more price-elastic demand is, the more responsive consumers are to a price change. Conversely, the less price-elastic demand is, the less responsive consumers are to a price change.

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Price Elasticity: Mathematical Definition The price elasticity of demand, ed, is:

In plain english: the percentage change in quantity demanded divided bz the percentage change in price.

PQ

eD

d %%

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Defining Elasticities When price elasticity is between zero and -1

we say demand is inelastic.

When price elasticity is between -1 and - infinity, we say demand is elastic.

When price elasticity is -1, we say demand is unit elastic.

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Sign of Price Elasticity According to the law of demand, whenever

the price rises, the quantity demanded falls, and vice versa. There is an inverse relationship between price and quantity demanded. Thus the price elasticity of demand is always negative.

Because it is always negative, economists often state the value without the sign (absolute value).

In this case: 1 is unit elastic, 0 to 1 is inelastic, and 1 to infinity is elastic.

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Demand Curve Shapes and Elasticity Perfectly Elastic Demand Curve

The demand curve is horizontal, any change in price can and will cause consumers to change their consumption.

Perfectly Inelastic Demand Curve The demand curve is vertical, the quantity demanded

is totally unresponsive to the price. Changes in price have no effect on consumer demand.

In between the two extreme shapes of demand curves are the demand curves for most products.

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Demand Curve Shapes and Elasticity

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Price Elasticity Along a Straight Line Demand Curve

The price elasticity of demand changes as we move up or down a straight-line demand curve. The price elasticity becomes more inelastic as we move down the curve.

If an entire demand curve (D2) is more elastic than another (D1), it means that at every single price, D2 is more elastic than D1.

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Elastic and Inelastic All downward-sloping straight-line demand

curves are divided into three parts: Elastic region Unit elastic point Inelastic region

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The Price Elasticity of Demand along a Straight-Line Demand Curve

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Determinants of the Price Elasticity of Demand The degree to which the price elasticity of

demand is inelastic or elastic depends on: How many substitutes there are How well a substitute can replace the good or

service under consideration The importance of the product in the consumer’s

total budget The time period under consideration

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Other Demand Elasticities Demand may respond to changes in other

variables. The measures of such responses are also elasticities. Cross-Price Elasticity of Demand: The percentage

change in the quantity demanded for one good divided by the percentage change in price of a related good.

Measures the degree to which goods are substitutes or complements. If the cross-price elasticity is positive, then the goods

are substitutes. If the cross price elasticity is negative, then the goods

are complements.

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Other Demand Elasticities Income Elasticity of Demand: the percentage

change in the quantity demanded of a good divided by the percentage change in income. Normal goods: goods for which the income

elasticity of demand is positive. Inferior goods: goods for which the income

elasticity of demand is negative. Luxury goods: goods for which the income

elasticity of demand is a large positive number.

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Calculating Elasticity Price elasticity can be calculated in two ways:

Point elasticity: price elasticity of demand measured at a single point on the demand curve.

Arc elasticity: price elasticity of demand measured over a range of prices and quantities along the demand curve.

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Point Elasticity Point elasticity of demand = [Q/P]*[P/Q]. [Q/P] is the inverse of the slope of the

demand curve.

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Arc Elasticity Arc elasticity of demand =

[Q2 – Q1]/[Q2 + Q1]/2

[P2 – P1]/[P2 + P1]/2

This is the equivalent to:[Q/P][average P/average Q]

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Calculation of Income Elasticity The definition of income elasticity is:

Q/I * I/Q,Where I represents income.

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Calculation of Cross-Price Elasticity The definition of cross-price elasticity is:

Q/PX * PX/Q

Where PX is the price of a related good.

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The Price Elasticity of Supply The price elasticity of supply is the percentage

change in the quantity supplied divided by the percentage change in price.

So this can be stated as: percent change in quantity supply divided by the percent change in price.

PQ

eS

s %%

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Price Elasticity of Supply and Shape of Supply Curve

The price elasticity of supply is either zero or a positive number.

A zero price elasticity of supply means that the quantity supplied will not vary as the price varies.

A positive price elasticity of supply means that as the price of an item rises, the quantity supplied rises.

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Supply Curve Shapes and Elasticity

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Supply Elasticities in the Long and Short Runs The shape of the supply curve depends

primarily on the length of time being considered. In the short run, at least one of the resources used

in production cannot be changed. In the long run, the firm has long enough to

change any aspect of production, and therefore can more fully respond.

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Interaction of Price Elasticities of Demand and Supply

Both the price elasticity of demand and the price elasticity of supply determine the full effect of a price change.

If the price elasticity of supply of an item is large and the demand for it is price inelastic, then the firm can raise the price without losing revenue.

Conversely, if the price elasticity of supply is small and the price elasticity of demand is large, then the firm is unable to raise the price because the consumer will switch to another firm or product.

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Tax Incidence How much of a tax is paid by producers or

consumers is called the incidence of a tax. If producers pay a larger share, it is said that the

incidence of tax falls on producers. If consumers pay a larger share, it is said that the

incidence of tax falls on consumers.