Price Elasticity ofDemand and Supply

• Key Concepts• Summary

©2005 South-Western College Publishing

2

What will this chapter teach me?

This chapter teaches you to calculate the percentage change in the quantity demanded when the price changes by a given percentage. Then you will see how this relates to total revenue.

3

How is the percent increase or decrease

of two numbers calculated?

Percent change is the difference between the two numbers divided by the original number

4

Suppose the price of a rock concert

increases by 10%, what effect will this

have on sales?That all depends on the price elasticity of demand for this rock concert

5

What is elasticity?A term economists use to describe responsiveness, or sensitivity, to a change in price

6

What is priceelasticity of demand? The ratio of the percentage change in the quantity demanded of a product to a percentage change in its price

7

% in Q demanded% in priceEd =

Price Elasticity of Demand

8

Supposing a university’s enrollment drops by 20% because tuition rises by 10%, what is the price elasticity of demand?

9

Ed =-20%+10%

=-.20+.10

= 2

10

Why is elasticity 2 in the previous example

and not -2? Economists drop the negative sign because we know from the law of demand that quantity demanded and price are inversely related

11

If there is an increase from 3 units

to 5, what is the percentage increase?

2/3 = 66%

12

If there is a decrease from 5 units to 3, what

is the percentage decrease?

2/5 = 40%

13

Problem - When we move along a demand curve between two points, we get different answers to elasticity depending on whether we are moving up or down the demand curve

14

A

B2

3

P

Q

D

15

Economists can solve this problem of different base points by using the midpoints as the base points of changes in prices and quantity demanded

16

in quantity demanded

sum of quantities/2

divided by

in price

sum of prices/2

Price elasticity equals the

17

What is elastic demand?A condition in which the percentage change in quantity demanded is greater than the percentage change in price

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$40

$30

$20

$10

10 20 30 40

A

B

Elastic Demand Ed > 1P

Q

19

Why is the demand curve in the previous

slide elastic?The percentage change in the quantity demanded is greater than the percentage change in price

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Price decrease

Increase in total revenue

Elastic Demand

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1015

= .66% change in Q =

% change in P = 1025

= .40

Ed = % change in Q% change in P = .66

.40Ed = 1.65

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$40$30

$20

$10

10 20 30 40

A

B

Inelastic Demand Ed < 1

23

Why is the demand curve in the previous

slide inelastic?The percentage change in the quantity demanded is less than the percentage change in price

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Price decrease

Decrease in total revenue

Inelastic Demand

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513 = .38% change in Q =

% change in P = 1025 = .40

Ed = % change in Q% change in P =

.38

.40

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What is a unitary elastic demand curve?The percentage change in the quantity demanded is equal to the percentage change in price

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$40

$30

$20

$10

10 20 30 40

EF

Unitary Elastic Demand Ed = 1

D

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Price decrease

No change in total revenue

Unitary Elastic Demand

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What is a perfectly elastic demand curve?

A condition in which a small percentage change in price brings about an infinite percentage change in the quantity demanded

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$40$30

$20

$10

10 20 30 40

Perfectly Elastic Demand Ed =

8

31

Price change

Infinite change in quantity demanded

Perfectly Elastic Demand

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What is a perfectly inelastic demand curve?

A condition in which the quantity demanded does not change as the price changes

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$40$30

$20

$10

10 20 30 40

Perfectly Inelastic Demand Ed = 0

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Price change

Zero change in quantity demanded

Perfectly Inelastic Demand

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If demand is elastic - total revenue goes down

If demand is inelastic - total revenue goes up

If a college raises tuition, what happens

to revenue?

36

If price increases and the revenue gained is greater than the revenue lost, the demand curve is price inelastic, < 1

37

If price increases and the revenue gained is less than the revenue lost, the demand curve is price elastic, > 1

38

If total revenue does not change when price increases, the demand curve is unitary elastic, value equals 1

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$20$15$10$5

5 10 15 20

$25$30$35$40

25 30 35 40 45

Price Elasticity of Demand RangesElastic

Inelastic

Unitary elastic

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$200$150$100

$50

5 10 15 20

$250$300$350$400

25 30 35 40 45

Total Revenue Curve

Ela

stic Inelastic

Unitary Elastic

41

What factors influence demand sensitivity?

• Availability of substitutes• Share of budget on the product

• Adjustment to a price change over time

42

What do substitutes have to do with a

price change?The more substitutes a product has, the more sensitive consumers are to a price change, and the more elastic the demand curve

43

P

Q0

P

Q0

A B

D D

Which demand curve is for a vital medicine and which is for candy?

44

Why is A the demand curve for medicine? Because medicine is a necessity with few substitutes, and the price can change with little effect on the quantity demanded

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Why is B the demand curve for candy?

Because candy has many substitutes, a price change can bring about a big change in the quantity demanded

46

What does the share of one’s budget

have to do with a price change?

The larger the purchase is to one’s budget, the more sensitive consumers are to a price change, and the more elastic the demand curve

47

What does time have to do with sensitivity?The longer consumers have to adjust, the more sensitive they are to a price change, and the more elastic the demand curve

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What are other elasticity measures?

Income elasticity of demandCross-elasticity of demand

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What is Income elasticity of demand?

The ratio of the percentage change in the quantity demanded of a good to a given percentage change in income

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% in Q demanded% in incomeEd =

Income Elasticity of Demand

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What is cross-elasticity of demand?The ratio of the percentage change in quantity demanded of a good to a given percentage change in price of another good

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% Q demanded of good A% price of good BEc =

Cross-elasticity of Demand

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What is the price elasticity of supply?

The ratio of the percentage change in the quantity supplied of a product to the percentage change in its price

54

% in Q supplied% in priceEs =

Price Elasticity of Supply

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$40$30

$20

$10

10 20 30 40

Perfectly Elastic Supply =

8

56

$40

$30

$20

$10

10 20 30 40

Perfectly Inelastic Supply Es = 0

57

$40$30

$20

$10

10 20 30 40

Unit Elastic Supply Es = 1

S.5%

.5%

58

Who pays the tax levied on sellers of

goods such as gasoline, cigarettes,

and alcoholic beverages?

It all depends; the corporation pays all, some, or very little of the tax

59

What decides who pays what part of the tax increase?

The more elastic the demand, the more the corporation pays; the less elastic the demand, the more the consumer pays

60

$1.00$.75$.50$.25

5 10 15 20

$1.25$1.50$1.75

$2.00

25 30 35 40 45

s1

s2

D

BuyersSellers

Partially shifted tax to buyers

61

Increase in gasoline tax

Decrease in supply

Consumers and suppliers share burden of tax

62

$1.00$.75$.50$.25

5 10 15 20

$1.25$1.50$1.75$2.00

25 3035 40 45

s1

s2

D

Buyers

Fully shifted tax to buyers

63

Increase in gasoline tax

Decrease in supply

Consumers bear full burden of tax

64

Key Concepts

65

• What is elasticity?• What is price elasticity of demand?• What is elastic demand?• What is a unitary elastic demand curve?• What is a perfectly elastic demand curve?• What is a perfectly inelastic demand curve?• What factors influence demand sensitivity?• What are other elasticity measures?• What is Income elasticity of demand?• What is cross-elasticity of demand?• What is the price elasticity of supply?

66

Summary

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Price elasticity of demand is a measure of the responsiveness of the quantity demanded to a change in price. Specifically, price elasticity of demand is the ratio of the percentage change in quantity demanded to the percentage change in price.

68

% in Q demanded% in priceEd =

Price Elasticity of Demand

69

What is the midpoint formula for the price elasticity of demand?

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in quantity demanded

sum of quantities/2

divided by

in price

sum of prices/2

Price elasticity equals the

71

Elastic demand is a change of more than one percent in quantity demanded in response to a one percent change in price. Demand is elastic when the elasticity coefficient is greater than one and total revenue (price time quantity) varies inversely with the direction of the price change.

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$40$30

$20

$10

10 20 30 40

Elastic Demand

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Inelastic demand is a change of less than one percent in quantity demanded in response to a one percent change in price. Demand is inelastic when the elasticity coefficient is less than one and total revenue varies directly with the direction of the price change.

74

$40$30

$20

$10

10 20 30 40

Inelastic Demand

75

Unitary elastic demand is a one percent change in quantity demanded in response to a one percent change in price. Demand is unitary elastic when the elasticity coefficient equals one and total revenue remains constant as the price changes.

76

$40$30

$20

$10

10 20 30 40

Unitary elastic Demand

77

Perfectly elastic demand is a decline in quantity demanded to zero for even the slightest rise or fall in price. This is an extreme case in which the demand curve is horizontal and the elasticity coefficient equals infinity.

78

$40$30

$20

$10

10 20 30 40

Perfectly Elastic Supply =

8

79

Perfectly inelastic demand is no change quantity demanded in response to price changes. This is an extreme case in which the the demand curve is vertical and the elasticity coefficient equals zero.

80

$40

$30

$20

$10

10 20 30 40

Perfectly Inelastic Supply Es = 0

81

Determinants of price elasticity of demand include (a) the availability of substitutes, (b) the percentage of budget spent on the product, and (c) the length of time allowed for adjustment. Each of these factors is directly related to the elasticity coefficient.

82

Income elasticity of demand is the percentage change in quantity demanded divided by the percentage change in income. For a normal good or service, income elasticity of demand is positive. For an inferior good or service, income elasticity of demand is negative.

83

Cross elasticity of demand is the percentage change in the quantity demanded of one product caused by a change in the price of another product. When the cross-elasticity of demand is negative, the two products are complements.

84

Price elasticity of supply is a measure of the responsiveness of the quantity demanded to a change in price. Price elasticity of supply is the ratio of the percentage change in quantity supplied to the percentage change in price.

85

Tax incidence is the share of a tax ultimately paid by buyers and sellers. Facing a downward-sloping demand curve and an upward-sloping supply curve, sellers cannot raise the price by the full amount of the tax. If the demand curve is vertical, sellers will raise the price by the full amount of a tax.

86

$1.00$.75$.50$.25

5 10 15 20

$1.25$1.50$1.75$2.00

25 3035 40 45

s1

s2

D

Buyers

Fully shifted tax to buyers

87

$1.00$.75$.50$.25

5 10 15 20

$1.25$1.50$1.75$2.00

25 30 35 40 45

s1

s2

D

BuyersSellers

Partially shifted tax to buyers

END