CHAPTER 4Supply & Demand: Elasticity &

Applications

CHAPTER OUTLINEA. Price Elasticity of Demand & Supply

A.1. Price Elasticity of Demand A.2. Elasticity & RevenueA.3. Price Elasticity of Supply

B. Applications to Major Economic IssuesB.1 The Economics of AgricultureB.2. Impact of a Tax on Price of QuantityB.3. Minimum Floors & Maximum Ceilings

A- PRICE ELASTICITY OF DEMAND & SUPPLY Supply & demand can often tell us

whether certain forces increase or decrease quantities. But we need to know how much supply & demand respond to changes in price.

The quantitative relationship between price & quantity is analyzed using the crucial concept of elasticity.

A.1 PRICE ELASTICITY OF DEMAND

Price Elasticity of Demand:“measures how much the quantity demanded

of a good changes when its price changes” (the Sensitivity of QD to changes in Price)

Or“the percentage change in quantity

demanded divided by the percentage change in price”

Elastic demand: means that the QD of the good responds greatly to changes in price

Inelastic demand: means that the QD of the good responds little to price changes

A.1 PRICE ELASTICITY OF DEMAND (CONT.) Price elasticities tend to be higher when:

Price elasticities tend to be lower when???

The goods are luxuries

Substitutes are available

Consumers have more

time to adjust their

behavior

A.1 PRICE ELASTICITY OF DEMAND (CONT.) Calculating Elasticities:

Where Q1 & P1 represent the original quantity & price, while Q2 & P2 stand for the new quantity & price.

= ∆Q/Q ÷ ∆P/P Or more precisely:

A.1 PRICE ELASTICITY OF DEMAND (CONT.) Categories of price elasticity

•When 1% change in price causes more than 1% change in QD

Price Elastic Demand

•When 1% change in price causes less than 1% change in QD

Price Inelastic Demand

•When % change in price causes exactly the same % change in QD

Unit Elastic Demand

A.1 PRICE ELASTICITY OF DEMAND (CONT.)

A.1 PRICE ELASTICITY OF DEMAND (CONT.) 2 extreme cases of Elasticity:Perfectly

Elastic demand

Ed = ∞Occurs

when a tiny change in price leads

to an indefi nitely

large change in

QDThe demand

curve is a horizontal

curve

Perfectly Inelastic demand

Ed = 0Occurs when a

change in price leads

to no change at all in QD

The demand curve is a vertical

curve

A.1 PRICE ELASTICITY OF DEMAND (CONT.) Example:

We drop the minus sign in the value of elasticity as it only reflects the inverse relationship between P &QD. We use the % change rather than absolute change which imply that the change in the units of measurements doesn’t affect the elasticity

A.1 PRICE ELASTICITY OF DEMAND (CONT.)

A.1 PRICE ELASTICITY OF DEMAND (CONT.) A shortcut for calculating Elasticities:

1. The elasticity of a straight line at a point is given by the ratio of the length of the line segment below the point to the length of the line segment above the point.

“price elasticity is relatively large when we are up the linear DD curve & decreases as we go down the curve”

The elasticity at point B: the ratio of the line segment BZ to the segment AB equals 3:1 which means that the elasticity at this point is 3 (elastic).

The elasticity at point R: the ratio of the segment RZ to the segment AR is1/3 (inelastic)

Point M: unit elastic demand (ratio 2:2= 1)

A.1 PRICE ELASTICITY OF DEMAND (CONT.)

A.1 PRICE ELASTICITY OF DEMAND (CONT.)

2. The elasticity of a curved demand curve for a given point is given by drawing a line that is tangent to that point & then calculating the ratio of the segments for the tangent line.

The elasticity at point B in figure 4.5: the ratio of the line segment BZ to the segment AB equals 3:1 which means that the elasticity at this point is 3 (elastic).

A.1 PRICE ELASTICITY OF DEMAND (CONT.)

Elasticity is not the same as slope The slope is not the same as the elasticity

because the demand curve’s slope depends upon the changes in P & Q, whereas the elasticity depends upon the percentage changes in P & Q. The only exceptions are the polar cases of the completely elastic & inelastic demands.

Elasticities cannot be inferred by slope alone, it also depends on the specific price & quantity pair. The general rule is that the elasticity can be calculated as the ratio of the straight line or tangent segment below the demand point to the length of the segment above the point.

A.2. ELASTICITY & REVENUE

Many businesses want to know whether raising prices will raise or lower revenues. Let’s look at the relationship between price elasticity & total revenue.

Total Revenue (TR): is equal to price times quantity (P×Q). If consumers buy 5 units at $3 each, total revenue would be $15.

If you know the price elasticity of demand you will know what happen to TR when price changes:

A.2. ELASTICITY & REVENUE (CONT.)

A.2. ELASTICITY & REVENUE (CONT.) An example:A software company may have a wide range of

different prices for their products in an attempt to exploit different elasticities.

If a consumer is desperate about buying a new operating system immediately, his elasticity would be low & the company will profit from charging a relatively high price.

On the other hand, if he is not in a hurry for an upgrade, his elasticity would be high & the company will profit from charging a relatively low price.

The paradox of the bumper harvest??

A.3. PRICE ELASTICITY OF SUPPLY

Price Elasticity of Supply: “is the responsiveness of the quantity

supplied of a good to changes in its market price.”

OR“The percentage change in quantity supplied

divided by the percentage change in price.”

Cases of Elasticity of supply

A.3. PRICE ELASTICITY OF SUPPLY (CONT.)

As with demand elasticities, there are 2 extreme cases of supply elasticity (completely inelastic supply & completely elastic supply) between these extremes, we call supply elastic or inelastic depending on whether the % change in QS is larger (elastic) or smaller (inelastic) than or equal to (unit elastic) the % change in price.

A.3. PRICE ELASTICITY OF SUPPLY (CONT.)

What factors determine supply elasticity??

1. The ease with which production in the industry can be increased.

“If all inputs can be readily found at the going market prices, as is the case for the textile industry , then the output can be greatly increased with little increase in price. This would indicate that supply elasticity is relatively large. On the other hand, if production capacity is severely limited, as is the case for gold mining industry, then even large increases in the price of gold will call forth but a small response in supply. This would be inelastic supply.”

A.3. PRICE ELASTICITY OF SUPPLY (CONT.)

2. The time period under consideration.

“there’s a direct relationship between time & elasticity of supply. A change in price tends to have a larger effect on amount supplied as the time for suppliers to respond increases. But for very brief periods after a price increase, firms may be unable to increase their inputs of labor, materials, & capital, so supply may be price inelastic.”