Chapter 20

Elasticity Supply and Demand

How do demand and supply change in response to changes in price and quantity?=Elasticity

Elasticity of Demand and Elasticity of Supply

Bottom Line on Elasticity of Supply

If producers are relatively responsive to price changes supply is elastic

If producers are relatively insensitive to price changes supply is inelastic

If producers are responsive to price changes, supply is elastic.

If they are relatively insensitive to price changes, supply is inelastic

When a large percentage change in price brings about a small percentage change in quantity supplied = inelastic….

(examples: Rise in costs of computers… takes time to shift resources)

Over Time… more plants built, more engineers trained, and more computers supplied

Elasticity and Inelasticity Supply

70

60

50

40

30

200 10 20 30 40 50 60 70 80 90 100 120 140 160

Supply Elasticity (small percentage increase in price = large percentage increase in quantity

A

B

A

B

Antiques…. Supply elastic or inelastic?

Inelastic…. Only a few authentic pieces, reproductions would be elastic

Gold………Supply elastic or inelasticGold is perfectly inelastic…

(supply fixed)…

When a small percentage change in price brings about a large percentage change in quantity supplied = elastic

Example: Cowboys beat Philadelphia Eagles for wildcard playoff… T-shirt producer can raise his price just a “tad” and sell a ton more shirts…

MAIN DETERMINATION OF ELASTICY OF SUPPLY?

TIME

Many times this only has to do with the producers ability to shift resources…

If resources are not shiftable, then new mix of inputs has to be determined.

Ability to Respond to Price varies

Often the ability of an individual firm to respond to an increase in price is limited or constrained by its existing scale of operations, or capacity, or ability to obtain resources….. IN IN SHORT RUNSHORT RUN

Examples:

IN LONG RUNIN LONG RUN… can adjust. The greater the amount of time producers have to adjust, the greater their output response.

TIME AND ELASTICITY OF SUPPLY

Sm

D1

D2

Ss

D1

D2

SL

D1

D2

Note: perfectly inelastic. (price)(quantity)

Inelastic (price) (quantity)

Elastic (price) (quantity)

See relationship between small percentage increase in P and Q that follows.

Terms to remember Market Period = period that occurs

when the quantity output is fixed. Producer will not produce more until some is sold. No change in quantity supplied.

SR in Micro = period of time too short to change plant capacity, but long enough to use current capacity more or less intensively.

Examples of adjusting to the market period.

truck farmer (farmer’s market)*limited growing season*accepts price as it is brought to

market*can’t hold back on what is sold

because of spoilage.*has to take price even if cost of

production not met.

Perfectly elastic supply curve

Relatively elastic supply curve

Perfectly inelastic supply curve

Relatively inelastic supply curve

Supply tends to be inelastic in SR

Example:After WWII… cars impossible to get at

any price.Resources needed to be converted back from tanks, jeeps and plane production.Even if you had the $1,000 it took to buy a car… had to put name on year waiting list.

1946 Billboard Ad by Ford

Remember

Supplier is looking at revenueRevenue Test = P x Q = TR

What is profit?TR-TC

Question is: If I decrease the price of steak $1 what will happen to my revenue?

Math for Measuring Price Elasticity

Problem: Sirloin steak drops $4.00 to $3.00

Butcher sales increase from 500 lbs to 1,000 lbs

e Formula: Pe = % Change in Q % Change in P

500 lbs to 1000 lbs = 500 / 500 = 1 (Q change = 100%)

$4.00 to $3.00 = 1/ 4 = .251 / .25 = 4The steak at this price is very elastic.Anything over 1 is elastic.Anything .01 to .99 is inelastic

Helpful HintsTo find coefficient of price

elasticity supply or demand simply:

Find % change in quantity and % change in price, then divide Q/P

Hint: former-current/formerPrice increase $1 to $2, quantity decrease 10 to 81/1 x 100 = 100% = P2/10 x 100 = 20% = Q20/100 = .2 = inelastic

Another Helpful Hint!What is the first movement for variables?i.e.. When a producer wants to check if

he can get more $$ for increasing or decreasing, what is the first thing he does?

Price OR Price Then the quantity adjusts accordinglyP = triggerQ = response

Elasticity of Demand

Logic Dictates that:

Firms contemplating a price hike want to know how consumers will respondGM advertises 0% financing for 60 months… huge reductions on Suburban's, Tahoes,Trucks) What do they expect consumers to do?

What do the dealers expect to receive?

Bottom Line for Elasticity of Demand

The responsiveness or (sensitivity) of consumers to a price change is measured by a product’s price elasticity of demand

Inelastic demand perfectly inelastic totally elastic

Explanation of Perfectly Inelastic Demand

Unit Elasticity (Percentage change in price and resulting change in quantity demanded are the same.

Where a price change results in no change in quantity demanded, it = “Perfectly Inelastic” or “Unit Elastic”Example: Insulin for Diabetes

What else? (certain medicines.. BP… Heart problems… etc.)

In these cases… price-elasticity coefficient is zero (because no response to change in price)

What is elasticity of demand?

Elasticity of demand measures the percentage change in Quantity demanded in response to a percentage change in price.

Law of demand states that as P increases Q decreases. But how much decrease?

Measure responsiveness of QD to change in P by calculating the coefficient of price elasticity of demand (Ep)

Ep = Percentage change in QD Percentage Change in P

You have already done this!!

What does that mean?

If elasticity is greater than 1, demand is elastic.

Price change causes revenue to change in opposite direction Decrease in price will increase TR

Inelastic demand is defined as an elasticity of less than 1 (anything from 0 to .99)

Price changes causes TR to change in same direction. Decrease in price causes TR to fall

Unit elastic is 1 No change Price elasticity is 0 because an increase in price will not decrease

revenue…nor will it increase revenue… there is no change in revenue with unit elastic.

Elastic Demand = A small percentage change in price brings about a large percentage change in QD

Example: cars, steak, CDs, gold jewelry

Inelastic Demand = Large percentage change in price brings about a small percentage change in QD.

Drugs, gasoline, cigarettes, personal items, deodorant,

All of the inelastic demand concepts depend on available substitutes

Price of steak goes too high… substitute chicken

Price of gasoline too high… no substitute

Income EffectIncome effect simply indicates that at a

lower price one can afford more of the good without giving up alternative goods.

Decline in the price of a product will increase purchasing power of one’s money income

Higher price has opposite effect.Substitution Effect = one has the

incentive to substitute the cheaper good for similar goods which are now relatively more expensive.

Cheap products for dear products

Determinants of Elasticity Necessity vs Luxuries ….examples:

critical medicines, addiction, gas to drive, new car, boat, diamond ring….

Availability of Substitutes…Zirconia, salt substitute, powdered milk, tea vs coffee…

Proportion of Income…the higher the price of a good relative to a consumers’ income, the greater the price elasticity of demand.

Time….As a rule, product demand is more elastic the longer the time period under consideration.

Generally, the larger the number of substitute goods that are available, the greater the price elasticity of demand..(variety of beer options on the market)

Elasticity of Demand depends on how narrowly the product is defined. (Coach Handbag)

Normal or Superior Goods Income goes up… we buy more

expensive items…. (lobster/fish sticks)

Inferior or Poor Man’s Goods Income goes down… take the bus

rather than fly…second-hand clothing stores… garage sales.

How can we calculate coefficient of price elasticities?Let’s re-visit our last example

Let’s say that price is increased from $1.00 to $2.00 for a candy bar…..

The quantity demanded decreases from 10 to 8….

How will this producer know if the price increase brings in more $ relative to decrease in demand or otherwise????

Percent change in P1-2=1/1 x 100 = 100% change in P

Percent change in Q10-8 = 2/10 = 20% change in Q

Response/trigger (Q/P) …..Hence:E = 20/100 =.2 (% change in Q / % change

in P)Trigger was the price…. Response the quantityPrice moves…(trigger)… quantity change

(response)Because % change is less than 1, candy

producer will increase revenue by increasing price.

Meaning of Elasticity

Elasticity is > than 1 … means demand is elastic

(If elasticity is greater than 1, percentage change in quantity must be greater than percentage change in price.)

Inelasticity is anything < than 1 If elasticity is equal to 1 then it is

unitary elastic

Let’s try two more problemsKey chains are reduced from $5 to $4The number of key chains purchased

increases from 80 to 82Was this inelastic or elastic… Revenue went

up or down?Bottled Water increased from $3.00 to $5.00The number of bottles purchased decreased

from 250 to 125.Elastic or inelastic?Key chain- .125 (inelastic)Bottled water 1.25 (elastic)Inelastic –direct revenue relationship

elastic- indirect revenue relationship

Advertising Purpose

1) To sway the consumer. (Bayer and St. Joseph’s aspirin for children) which is better?

2) Producers through advertising want to increase our demand curve and make it more inelastic!

To be Discussed later

Total Revenue and Marginal Revenue….If your company sold 4 computers at

$3,200 each how much total revenue? (PxQ = $12,800)

Marginal Revenue = Increase in TR when output sold goes up by one unit.($12,800 +3,200=$16,000

The additional revenue derived from selling one more unit. (see above)

Kiley Dog Horn- Total Utility

THE END!