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Describing Supply and Describing Supply and Demand: ElasticitiesDemand: Elasticities

Describing Supply and Describing Supply and Demand: ElasticitiesDemand: Elasticities

Chapter 6Chapter 6

Classifying Demand and Supply as to their relative

responsiveness to price changes: Elasticity

• It is helpful to describe the relative responsiveness of consumers and suppliers to price changes.

• For example, after a large price increase there may be a large or small drop in the quantity demanded.

• We call this relative responsiveness to price changes the elasticity of demand or supply.

Responsiveness of DemandHere we have two different demand curves. Let’s pretend that they possibly represent the demand behavior of consumers in the antacid market. The problem is that we don’t which curve is the real demand curve. If the real curve is DA then raising the price from P1 to P2 will

cause quantity demanded to drop from QA,1 to QA,2. However, if the real curve is DB then demand falls from QB,1 to QB,2

Quantity Demanded

Q

P

Pri

ce

P2

DADB

P1

QB,2 QA,2 QB,1 QA,1

Responsiveness of SupplyHere we have two different supply curves. Let’s pretend that they

possibly represent the supply curves of your firm in the antacid market. The problem is that you don’t which curve is the real supply curve. If

the real curve is SA then raising the price from P1 to P2 will cause quantity supplied to rise from QA,1 to QA,2. However, if the real curve is SB then demand falls from QB,1 to QB,2. Think what happens to profits if you get it wrong. Either your costs rise faster than your revenues or

your revenues do not expand due to increased opportunity.

Quantity Demanded

Q

P

Pri

ce

P2

SASB

P1

QB,1 QA,2 QA,1 QA,2

Elasticity: Definition

• Elasticity is defined as the percentage change in Quantity Demanded or Supplied relative to a percentage change in Price.

• We usually “normalize” the change in price to a 1% increase.

• The change in Quantity Demanded or Supplied as being less than 1%, 1% also, or more than 1%.

Price Elasticity: Formula

• The formula for computing an elasticity is to divide the percentage change in price by the percentage change in quantity demanded or supplied:

P

QE

%

%

Elastic Demand and Supply

• For elastic points on curves, the percentage change in quantity is greater than the percentage change in price.

E > 1

Elastic Demand and Supply

• Common sense tells us that an elastic supply means that quantity changes by a greater percentage than the percentage change in price.

• The same holds true for demand.

Inelastic Demand and Supply

• For inelastic points on curves, the percentage change in quantity is less than the percentage change in price.

E < 1

Inelastic Demand and Supply

• Common sense tells us that an inelastic supply means that quantity doesn't change much with a change in price.• The same holds true for demand.

What Information Price Elasticity Provides

• Price elasticity gives of demand and supply gives information about the exact quantity response to a price change.

• As elasticity increases, responsiveness of quantity to price also increases.

Elasticity Is Independent of Units

• Percentages allow us to have a measure of responsiveness that is independent of units.

Elasticity Is Independent of Units

• Having a measure of responsiveness that is independent of units makes comparisons of responsiveness of different goods easier.

Calculating Elasticities

• To determine elasticity divide the percentage change in quantity by the percentage change in price.

The End-Point Problem

• The end-point problem is that the percentage change differs depending on whether you view the change as a rise or a decline in price.

The Arc Convention

• Economists use the arc convention to get around the end-point problem.

• The arc elasticity method entails the calculating the percentage change at the midpoint of the range.

The Arc Convention

• Using the arc convention, the average of the two end points are used as the starting point when calculating percentage change.

Graphs of Elasticities

Elasticity of demand = 1.3

Pric

e

Quantity of software (in hundred thousands)

$26242220181614

0

D

B

A

10 12 14

C (midpoint)

Graphs of Elasticities

Elasticity of supply = 0.18

Wag

e pe

r ho

ur

Quantity of workers

$6.005.505.004.504.003.503.00

0

CB

A

470

(midpoint)

480 490

Graphs of ElasticitiesP

rice

(c) Some examplesQuantity

$10987654321

C

DF

E

B

A

5 10 15 20 25 30 35 40 45 50 55 60

E = 0.54

E = 0.67

E = 4

Calculating Elasticity at a Point

• Let us now turn to a method of calculating the elasticity at a specific point, rather than over a range or an arc.

Calculating Elasticity at a Point

• To calculate elasticity at a point, determine a range around that point and calculate the arc elasticity.

Calculating Elasticity at a PointP

rice

Quantity

$10 9 8 7 6 5 4 3 2 1

C

BA

24 402820

Calculating Elasticity at a Point

6 12 18 30 36 42 48

Pric

e

Quantity

87654321

$109

A

24 6054

D

BC

SupplyEA = 2.33

EB = 0.11

Demand

EC = 0.75

ED = 0.86

Elasticity and Supply and Demand Curves

• Two important points to consider:– Elasticity is related (but is not the

same as) slope.– Elasticity changes along straight-line

demand and supply curves.

Elasticity Is Not the Same as Slope

• The relationship between elasticity and slope means that the steeper the curve begins at a given point, the less elastic is supply or demand.

Elasticity Is Not the Same as Slope

• There are two limiting examples of this.

Elasticity Is Not the Same as Slope

• When the curves are flat, we call the curves perfectly elastic.• Perfectly elastic curves are flat

curves in which quantity changes enormously in response to a proportional change in price (E = ).

Elasticity Is Not the Same as Slope

• When the curves are vertical, we call the curves perfectly inelastic.

• Perfectly inelastic curves are vertical curves in which quantity does not change at all in response to an enormous proportional change in price (E = 0).

Perfectly inelastic demand curve

Pric

e

0Quantity

Perfectly Inelastic Demand Curve

Perfectly inelastic demand curve

Pric

e

0Quantity

Perfectly Elastic Demand Curve

Elasticity Changes Along Straight-Line Curves

• Elasticity is not the same as slope.• Elasticity changes along the

straight line supply and demand curves—slope does not.

Elasticity Changes Along Straight-Line Curves

• On a demand curve, elasticity is perfectly elastic (E = ) at the price intercept.• It becomes smaller as you move

down the demand curve until it becomes zero at the quantity intercept.

Elasticity Changes Along Straight-Line Curves

• Elasticity is perfectly elastic (E = ) where a straight line supply curve intercepts the price axis.• Points become less elastic as you

move out along the supply curve.

Pric

e

Elasticity declines along demand curve as one moves toward

the quantity axis

$10987654321

0 1 2 3 4 5 6 7 8 9 10

Ed =

Ed = 1

Ed = 0

Quantity

Elasticity Along a Demand Curve

Ed < 1

Ed > 1

Elasticity Along a Supply CurveP

rice

$10987654321

00 1 2 3 4 5 6 7 8 9 10Quantity

Es declines

Es risesEs =

Es = 0

S1

S0

Elasticity Review

• Perfectly elastic – quantity responds enormously to price changes (E = ).

• Elastic – the percentage change in quantity exceeds the percentage change in price (E >1).

Elasticity Review

• Unit elastic – the percentage change in quantity is the same as the percentage change in price (E = 1).

Elasticity Review

• Inelastic – the percentage change in quantity is less than the percentage change in price (E <1).• Perfectly inelastic – quantity

does not respond at all to price changes (E = 0).

Substitution and Elasticity

• As a general rule, the more substitutes a good has, the more elastic is its supply and demand.

Substitution and Elasticity

• Factors that affect a good’s substitutability of demand differ from factors that affect a good’s substitutability of supply.

Substitution and Demand

• The larger the time interval considered, or the longer the run, the more elastic is the good’s demand curve.

– There are more substitutes in the long run than in the short run.

– The long run provides more options for change.

Substitution and Demand

• The less a good is a necessity, the more elastic its demand curve.• Necessities tend to have fewer

substitutes than do luxuries.

Substitution and Demand

• As the definition of a good becomes more specific, demand becomes more elastic.

– If the good is broadly defined—say, transportation—there are not many substitutes and demand will be inelastic.

Substitution and Demand

• As the definition of a good becomes more specific, demand becomes more elastic.

– If the definition of a good is narrowed—say to transportation by bus—there are more substitutes.

Substitution and Demand

• Demand for goods that represent a large proportion of one's budget are more elastic than demand for goods that represent a small proportion of one's budget.

Substitution and Demand

• Goods that cost very little relative to your total expenditures are not worth spending a lot of time figuring out if there is a good substitute.• It is worth spending a lot of time

looking for substitutes for goods that take a large portion of one’s income.

Substitution and Supply

• The longer the time period considered, the more elastic the supply.

Substitution and Supply

• The reasoning is the same as for demand.

– In the long run there are more options for change so it is easier (less costly) for suppliers to change into the production of another good.

Substitution and Supply

• Economists distinguish three time periods relevant to supply:

– The instantaneous period.– The short run.– The long run.

Substitution and Supply

• In the instantaneous period, quantity supplied is fixed so the elasticity of supply is perfectly inelastic.• This supply is sometimes called

the momentary supply.

Substitution and Supply

• In the short run, some substitution is possible, so the short-run supply curve is somewhat elastic.

Substitution and Supply

• In the long run, significant substitution is possible; the supply curve becomes very elastic.

Substitution and Supply

• An additional factor to consider:– Many goods are produced, so we

must take into account how easy it is to substitute for existing goods by producing more of those same goods.

How Substitution Factors Affect Specific Decisions

• Suppose you’ve been asked to evaluate the potential impact of a 10¢ gas tax increase in Washington, D.C. and in the nation.

Impact of a 10¢ Gas Tax Increase

• In the short run the demand curve for gasoline would be less elastic than in the long run.

• In the long run, motorists would switch to fuel efficient cars.

Impact of a 10¢ Gas Tax Increase

• Although gasoline is considered a necessity, it is only a small part of what it costs to drive, demand would probably be inelastic.

Impact of a 10¢ Gas Tax Increase

• For the entire U.S., demand would be inelastic, but for Washington, it would be very elastic since there are many alternative choices of transportation.

Impact of a 10¢ Gas Tax Increase

• Some may switch to an alternative form of transportation.• Others would go to neighboring

states to buy gasoline.

Impact of a 10¢ Gas Tax Increase

• Smaller geographic areas have more elastic demands.• This limits how highly state and

local governments can tax goods relative to their neighboring localities or states.

Empirical Estimates of Elasticities

• The following table provides short- and long-term estimates of elasticities for a number of goods.

Empirical Estimates of Elasticities

• These demand estimates are for the entire U.S.• If they were for specific regions or

cities, the examples would show greater elasticity.

Empirical Estimates of Elasticities

Empirical Estimates of Elasticities

• There are many fewer empirical measurements of elasticity of supply than there are of demand.

Empirical Estimates of Elasticities

• One does find empirical measurements of elasticity of supply in factor markets, such as the market for labor services.

Empirical Estimates of Elasticities

• Other areas in which elasticities of supply are estimated are agricultural and raw materials markets.– In these markets, economists have

generally found that the short-run supplies are highly inelastic, and that the long-run supplies are highly elastic.

Elasticity, Total Revenue, and Demand

• Knowing the elasticity of demand tells suppliers how their total revenue will change if their price changes.

• Total revenue equals total quantity sold multiplied by price of good.

Elasticity, Total Revenue, and Demand

• If ED is elastic (ED > 1), a rise in price lowers total revenue.• Price and total revenue move in

opposite directions.

Elasticity, Total Revenue, and Demand

• If ED is unit elastic (ED = 1), a rise in price leaves total revenue unchanged.

Elasticity, Total Revenue, and Demand

• If ED is inelastic (ED < 1), a rise in price increases total revenue.• Price and total revenue move in

the same direction.

A

(a) Unit Elastic DemandE = 1

Elasticity and Total Revenue

TR constant

C

0 6

Pric

e

Quantity

$10

8

6

4

2

1 2 3 4 5 7 8 9

E

F

B

Lost revenue

Gained revenue

A

Pric

e

(b) Inelastic DemandE < 1

Quantity

$10

8

6

4

2

0 1 2 3 4 5 6 7 8 9

Elasticity and Total Revenue

TR rises

C

H

BG

Lost revenue

Gained revenue

A

Pric

e

(c) Elastic DemandE = 1

Quantity

$10

8

6

4

2

0 1 2 3 4 5 6 7 8 9

Elasticity and Total Revenue

TR fallsC

B

KJ

Lost revenue

Gained revenue

Total Revenue Along a Demand Curve

• ED is elastic at prices above the point where demand is unit elastic – a rise in price lowers total revenue.

• If ED is inelastic at prices below the point where demand is unit elastic – a rise in price increases total revenue.

Pri

ce

Elastic range ED > 1

ED = 1

Inelastic range

ED < 1

Q0 Quantity(a)

0 0Quantity

(b)

How Total Revenue Changes Along a Demand Curve

Q0

To

tal r

eve

nu

e

Elasticity of Individual and Market Demand

• Market demand elasticity is influenced both by:– Many people drop out totally when

price increases.– How much an existing consumer

marginally changes his or her quantity demanded.

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.

Elasticity of Individual and Market Demand

• Firms that price discriminate can charge more to the individuals with inelastic demand and less to individuals with elastic demands.

Elasticity of Individual and Market Demand

• Examples of price discrimination include:

– Airlines’ Saturday stay-over specials.– The phenomenon of selling new cars.– The almost-continual-sale

phenomenon.

Other Elasticity Concepts

• Other elasticities can be useful in specifying the effects of a shift factor of demand:– Income elasticity of demand.– Cross-price elasticity of demand.

Income Elasticity of Demand

• Income elasticity of demand is defined as the percentage change in demand divided by the percentage change in income.

Income Elasticity of Demand

• Income elasticity of demand tells us the responsiveness of demand to changes in income.

Income Elasticity of Demand

• An increase in income generally increases one’s consumption of almost all goods, although the increase may be greater for some goods than for others.

Income Elasticity of Demand

• Normal goods are those whose consumption increases with an increase in income.• They have income elasticities

greater than zero.

Income Elasticity of Demand

• Normal goods are divided into luxuries and necessities.

Income Elasticity of Demand

• Luxuries are goods that have an income elasticity greater than one.• Their percentage increase in

demand is greater than the percentage increase in income.

Income Elasticity of Demand

• Shoes are a necessity—a good that has an income elasticity less than 1.• The consumption of a necessity

rises by a smaller proportion than the rise in income.

Income Elasticity of Demand

• Inferior goods are those whose consumption decreases when income increases.• Inferior goods have income

elasticities less than zero.• Dried milk is an example of an

inferior good.

Income Elasticities of Selected Goods

Cross-Price Elasticity of Demand

• Cross-price elasticity of demand is defined as the percentage change in demand divided by the percentage change in the price of another good.

Cross-Price Elasticity of Demand

• Cross-price elasticity of demand tells us the responsiveness of demand to changes in prices of other goods.

Complements and Substitutes

• Substitutes are goods that can be used in place of another.• When the price of a good goes up,

the demand for the substitute good also goes up.

Complements and Substitutes

• Complements are goods that are used in conjunction with other goods.• A fall in the price of a good will increase

the demand for its complement.• The cross-price elasticity of

complements is negative.

CommoditiesCross-Price

ElasticityBeef in response to price change in pork 0.11Beef in response to price change in chicken 0.02U.S. automobiles in response to price changes

in European and Asian automobiles 0.28European automobiles in response to price

changes in U.S. and Asian automobiles 0.61Beer in response to changes in wine 0.23Hard liquor in response to price changes in

beer - 0.11

Cross-Price Elasticities

P0

D0 D1

P0

20 Quantity26

Shift due to 20% rise in income

Some Examples

Some Examples

S0

P0

S1

P0

104 Quantity108

Shift due to 33% rise in priceof pork

The Power of Supply and Demand Analysis

• A number of questions may be answered by combining supply and demand analysis with elasticity.

When Should a Supplier Raise Price?

• The supplier should raise his price when it faces an inelastic demand. – Total revenue increases with a price

increase because quantity drops proportionally less than price goes up.

– Since costs also fall, profit rise.

When Should a Supplier Raise Price?

• When you have an elastic demand, you should hesitate to increase price.

Elasticity and Shifting Supply and Demand

• Elasticity can tell us more exactly the effect of shifting supply and demand.

Elasticity and Shifting Supply and Demand

• The more elastic the demand, the greater the effect of a supply shift on quantity, and the smaller effect on price.

Elasticity and Shifting Supply and Demand

• The more elastic the supply, the greater the effect of a demand shift on quantity, and the smaller the effect on price.

Effects of Shifts in Supply on Price and Quantity

Inelastic Supply and Inelastic Demand

P0

P1

DemandPrice

Quantity

S0 S1

Q0 Q1

Effects of Shifts in Supply on Price and Quantity

Inelastic Supply and Elastic Demand

P0

P1

DemandPrice

Quantity

S0 S1

Q0 Q1

Describing Supply and Describing Supply and Demand: ElasticitiesDemand: Elasticities

Describing Supply and Describing Supply and Demand: ElasticitiesDemand: Elasticities

End of Chapter 6End of Chapter 6