describing supply and demand:...

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


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


ELASTICITY OF DEMAND

McGraw-Hill/Irwin Colander, Economics 3


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)




• 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



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

• Elastic demand =ED > 1

7-6


Characteristics of Elastic Goods

• Many substitutes

• Luxuries

• Large portion of income

• Plenty of time to decide

• Elasticity coefficient greater than 1



Draw the Graph: Relatively Elastic Demand

D

P

Q

7-8


Perfectly Elastic Demand


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

D

P

Q


Elastic Demand



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



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



Characteristics of Inelastic Goods

• Few substitutes

• Necessities

• Small portion of income

• Required now, rather than later

• Elasticity coefficient less than 1



Draw the Graph: Inelastic Demand

D

P

Q

7-14


Perfectly Inelastic Demand


• 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


Elasticity of Demand: Draw the Graphic



Inelastic Demand



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


Calculating Elasticities: Using the Midpoint Formula—An easier formula

• Let’s simplify the formula:


%ΔQ midpoint

/ %ΔP midpoint

4 12 / 6

23=1.27


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


Total Revenue Test

• Uses elasticity to show how changes in price will affect total revenue (TR)

• Total Revenue = Price x Quantity



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



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


Figuring Out Elasticity

• You can use the midpoint formula to figure of elasticity OR you can use the total revenue test

• Know both ways



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



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



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


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


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


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


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



• 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




• Inferior goods are those whose consumption decreases with an increasein income

EIncome < 0 (negative number)



Income Elasticity of Demand: Draw the Graphic



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



• 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




• 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)




• 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)



ELASTICITY OF SUPPLY



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



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


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


Drawing the Graph: Relatively Elastic Supply


P

Q

S


Drawing the Graph: Inelastic Supply


P

Q

S


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


Elasticity Along a Supply Curve


P

Q

$2

10

$6

42

$4

$8

$10

6 8

Es = ∞ (perfectlyelastic)

Es = 0

Unit elastic (intercepts origin)

Perfectly inelasticEs = 1


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


Calculating Elasticities: Using the Midpoint Formula—An easier formula

• Let’s simplify the formula:


%ΔQ midpoint

/ %ΔP midpoint

9 480.5 / .50

4.75=0.18


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


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


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


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


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


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


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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