Introduction to Economics

Lecture#03Extension of Demand and Supply

Analysis

PRICE ELASTICITY OF DEMAND

• THE LAW OF DEMAND SAYS...

Consumers will buy more when prices go down and less when prices go up

• HOW MUCH MORE OR LESS?• DOES IT MATTER?• to whom?

Price Elasticity Provides an Answer

Price Elasticity of Demand

• The responsiveness of consumers to a price change is measured by a product price elasticity of demand.

• It measures how much consumers are willing to move away from any product as its price rises

The percentage change in price

The percentage change in quantity

Q

P

P1

P2

Q1Q2

D

PRICE ELASTICITY OF DEMAND

% P% Q d

Economists compute the price elasticity of demand as percentage change in the quantity demanded divided by the percentage change in prices.

Ed =

The Price-Elasticity Coefficient and Formula

PRICE ELASTICITY OF DEMAND

Ed =

Percentage change in quantitydemanded of product X

Percentage change in priceof product X

Or equivalently…

Ed =Percentage change in quantity demanded of X

Original quantity demanded of X

Change in price of X Original price of X

Elimination of the Minus Sign

Types of Elasticity

• If modest or small changes in price cause substantial or large changes to quantity demanded then demand is said to be Elastic, than ED >1

• If large price changes cause only small changes in quantity of goods purchased the demand for such products is Inelastic, ED < 1

• When amount of change in price and resulted change in quantity demand are same it is called Unit Elastic, Ed =1

1. Elastic Demand (Responsive)

• when change in price leads to more than proportionate change in quantity demanded

• Small decrease in price cause larger increase in quantity demanded

• And 1>Ed< ∞• Shape of the curve:

Flatter

2. Inelastic Demand (Not responsive)

• When change in price causes a less than proportionate change in quantity demanded

• When change in price greater than proportionate change in quantity demanded, demand called Inelastic

• Than 0<Ed<1• Shape of the demand curve:

Steeply sloped (down ward)

• When change in price leads to an equal change in quantity demanded

• And Ed=1• Shape of the curve: 45-

degree angle

3. Unit Elastic Demand

Extreme Cases

Perfectly Inelastic Demand

Perfectly Elastic DemandP

0

P

0

D1

Ed = 0

D2Ed =

Q

Q

Interpretations of Ed

PRICE ELASTICITY OF DEMAND

Elastic Demand

Ed =.04.02

= 2

Inelastic Demand

Ed =.01.02

= .5

Unit Elastic Demand

Ed =.02.02

= 1

Professor D. Garvey, Spring 2004 12

Pric

e

Elasticity ??? along demand curve as one moves toward the quantity axis$10

9

8

7

65

4

32

1

0 1 2 3 4 5 6 7 8 9 10

Ed =

Ed = 1

Ed = 0

Quantity

Elasticity Along a Linear Demand Curve

Ed < 1

Ed > 1

The Midpoints Formula

Measuring the price elasticity of demand

Ed =

Change inquantity

Sum ofQuantities/2

Change inprice

Sum ofprices/2

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities.

The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.

P rice e las tic ity o f d em an d =( ) / [( ) / ]

( ) / [( ) / ]

Q Q Q QP P P P2 1 2 1

2 1 2 1

2

2

Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:

( )( ) /

( . . )( . . ) /

..

1 0 81 0 8 2

2 2 0 2 0 02 0 0 2 2 0 2

2 2 %

9 5 %2 3 2

Total Revenue Method• The simplest way to measure price

elasticity, it tells us whether demand is elastic, inelastic or unitary

• Price elasticity is the response of consumer to price change

• In this Total revenue method we find total revenue by multiplying the quantity sold by price

TR=P*QTR=Total Revenue, P=Price, Q= Quantity To find price elasticity of demand we

compare the total revenue at one price with the TR at other price

Interpretation

• When P and TR , demand is Elastic• When P and TR , demand is Inelastic• When P and TR is constant, demand is

Unit elasticAnd Vise versa

Total revenue riseswith price to a

point...

then declines

TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

$1098765

4321

0 1 2 3 4 5 6 7 8 9 10

Ed =

Ed = 1

Ed < 1

Ed > 1

Determinants of Price Elasticity of Demand

• Availability of close SubstitutesGoods with close substitutes tend to have more

elastic demand. A small change in price of such thing can cause large change in demand of other product for example butter or margarine.

• Necessities versus LuxuriesNecessities tend to have inelastic demands , whereas

luxuries have elastic demands. for example visiting to doctors or purchasing a new house.

• Time horizonSome goods tend to have more elastic demand

over longer time periods. As in some cases, consumers need time to adjust their demands according to price changes

• Proportion of incomeOther thing equal, the higher the price of a good

relative to consumer incomes, the greater is the price elasticity of demand.

Price Elasticity of Supply

• The Price Elasticity of Supply measures the responsiveness of producers towards the price changes in the market.

Es= The percentage change in quantity supply

The percentage change in price

Determinant of Elasticity of supply• Mobility of Inputs• The degree of price elasticity of supply depends on how

easily and quickly producer can shift resources between alternatives

• If producer can shift the resources more easily and quickly to increase the supply in response of higher prices, will have greater elasticity of supplye.g. A firm’s producing Jeans, dress pants, suits, sweaters etc.

If prices of Jeans increases, the firm’s response to increase in prices of Jeans will depend on its ability to shift the resources from production of other products i.e. dress pants, shirts, suits, sweeter etc. (whose prices are assumed remain constant) to the production of Jeans.

• Immediate Market PeriodAfter a change in price when time is too short

for producer to respond with the quantity supplied

In immediate period supply curve is vertical, which shows that producer unable to increase the supply, even high market price available

• No. of producers More producers there are, the easier it should

be for the industry to increase output in response to a price increase. Supply will thus be more elastic.

• The existence of spare capacity;

• The more capacity there is in the industry, the easier it should be to increase output if price goes up. This makes supply more elastic.

• Ease of Storing Stocks

• If it is easy to stock goods, then if the price rises the firm can sell these stocks and so supply is more elastic. In the case of goods such as fresh products, it may not be easy to store them and so the supply will not be very flexible

Cross Elasticity of Demand

• The cross elasticity of demand measures how sensitive consumer purchases of one product (say X) are to change in prices of some other product (say Y).

EXY= % change in QX

% change in PY • Positive Sign

Goods are Substitutes• Negative Sign

Goods are Complementary

Income Elasticity of Demand

It measures the responsiveness of quantity demanded for a particular product to change in a person’s income Ei = % change in Qd

% change in incomeBy Income elasticity of demand we find either goods are normal

(necessities or luxuries) or inferior • Positive Sign

Goods are Substitutes• Negative Sign

Goods are inferior