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Copyright © 2004 South-Western

Demand and Supply Elasticity


Price Elasticity• Price Elasticity of Demand (Ep)

• The responsiveness of quantity demanded of a commodity to changes in its price

Ep = percentage change in quantity demanded

percentage change in price

Ep = -1%

+10% = -.1

• Example• Price of oil increases 10 percent• Quantity demanded decreases 1 percent


Calculating Elasticity

• Elasticity formula:

change in Qsum of quantities/2

Ep =change in P

sum of quantities/2

or change in Q(Q1 + Q2)/2

Ep =change in P(P1 + P2)/2


Example: The Price Elasticity of Demand for Beer

• Lowenbrau, a beer imported from Germany, recently increased in price from $4.67 to $7.00 per six-pack.

• In response, annual sales of six-packs fell from 25 million to 16.67 million.

• What is the elasticity of demand?


Example: The Price Elasticity of Demand for Beer

• Use the elasticity formula: • 25-16.67 ÷ $7.00 – 4.67

(25 + 16.67)/2 ($7.00 +$4.67)/2• Solve the formula, and you will find that

elasticity equals 1.


Price Elasticity Ranges

• Elastic demand

• Unit elastic

• Inelastic demand

% change in Q > % change in P; Ep > 1

% change in Q = % change in P; Ep = 1

% change in Q < % change in P; Ep < 1


Extreme Price Elasticities

Quantity Demanded per Year(millions of units)

Pric

eD

Perfect inelasticity, or zero elasticity

80

Figure 21-1, Panel (a)




Pric

eD

80

P0

P1

Perfect inelasticity, or zero elasticity

Figure 21-1, Panel (a)




Pric

e (c

ents

)

30

0

Perfect elasticity, or infinite elasticity

D

Figure 21-1, Panel (b)


Short-Run and Long-RunPrice Elasticity of Demand

In the short run, quantitydemanded falls slightly.However, with more timefor adjustment the demand curve becomesmore elastic and quantitydemanded falls by a greater amount.

D1

Pe

Q2

E

D2

Q1 Qe

P1

Pric

e pe

r Uni

t

Quantity Demanded per PeriodFigure 21-4


Short-Run and Long-RunPrice Elasticity of Demand

In the short run, quantitydemanded falls slightly.However, with more timefor adjustment the demand curve becomesmore elastic and quantitydemanded falls by a greater amount.

D1

Pe

Q2

E

D2

Q1 Qe

P1

Q3

D3

Pric

e pe

r Uni

t

Quantity Demanded per PeriodFigure 21-4


Example: Real-WorldElasticities of Demand

Table 21-2


350.00 25 50

12.50

5.00

10.00

20.00

25.00

0 25 50

150.00

200.00

250.00

312.50

Tot

al R

even

ue (

bill

ions

of

doll

ars)

Maximum total revenue

When demandis inelastic, price cut decreasestotal revenue

Unitelastic

Elasticdemand

Quantity (pizza per hour)

Pric

e (d

olla

rs p

er p

izza

)

15.00

Inelastic demand

300.00

100.00

50.00

0

When demandis elastic, price cut increasestotal revenue


Some Real-World Price Elasticities of Demand

Good or Service ElasticityElastic Demand

Metals 1.52Electrical engineering products 1.30Mechanical engineering products 1.30Furniture 1.26Motor vehicles 1.14Instrument engineering products 1.10Professional services 1.09Transportation services 1.03

Inelastic DemandGas, electricity, and water 0.92Oil 0.91Chemicals 0.89Beverages (all types) 0.78Clothing 0.64Tobacco 0.61Banking and insurance services 0.56Housing services 0.55Agricultural and fish products 0.42Books, magazines, and newspapers 0.34Food 0.12


Price Elasticities in 20 Countries


Cross PriceElasticity of Demand

• Cross Price Elasticity of Demand (Exy)• The percentage change in the demand for one good

(holding its price constant) divided by the percentage change in the price of a related good

• The responsiveness of change in demand of one good to the change in prices of related goods


Cross Price Elasticity of Demand

• Formula for computing cross elasticity of demand

% change in demand for good X

% change in price of good YExy =

• Substitutes• Exy would be positive

• An increase in the price of X would increase the quantity of Y demanded at each price.

• Complements• Exy would be negative

• An increase in the price of X would decrease the quantity of Y demanded at each price.


Income Elasticity of Demand

• Income Elasticity of Demand (Ei)• The percentage change in demand for any good,

holding its price constant, divided by the percentage change in income

• The responsiveness of demand to changes in income, holding the good’s relative price constant



percentage change in demandpercentage change in income

Ei =

• Income elasticity of demand • refers to a horizontal shift in the demand curve in

response to changes in income• Price elasticity of demand

• refers to a movement along the curve in response to price changes



Formula:Change in Quantity ÷ Change in IncomeAverage Quantity Average Income

• The income elasticity of demand can be either negative or positive.

• Remember that, in calculating the income elasticity of demand, the price of the good is assumed to be constant.



Income elasticity can be:1 ) Greater than 1 (normal good, income elastic)

2 ) Between zero and 1 (normal good, income inelastic)

3 ) Less than zero (inferior good)


Some Real-World IncomeElasticities of Demand

Elastic DemandAirline Travel 5.82Movies 3.41Foreign Travel 3.08Electricity 1.94Restaurant meals 1.61Local buses and trains 1.38Haircutting 1.36Cars 1.07

Inelastic DemandTobacco 0.86Alcoholic beverages 0.62Furniture 0.53Clothing 0.51Newspapers and magazines 0.38Telephone 0.32Food 0.14


Income Elasticities in 15 Countries


Elasticity of Supply

• Price Elasticity of Supply (Ei)• The responsiveness of the quantity supplied of a

commodity to a change in its price • The percentage change in quantity supplied divided

by the percentage change in price

percentage change in quantity suppliedpercentage change in price

ES =


The Extremes in Supply Curves

Q1

Pric

e pe

r Uni

t

Quantity Supplied per Period

P1S

S’

Perfect elasticity

Perfect inelasticity

Figure 21-5


Short-Run and Long-Run Price Elasticity of Supply

Pe

Qe

Pric

e pe

r Uni

t

Quantity Supplied per PeriodQ1

S1

S2

P1

As time passes the supply curve rotates to S2 then to S3 and quantity supplied rises first to Q1 and then to Q2.

E

S3

Figure 21-6

Q2


A Compact Glossary of ElasticitiesPRICE ELASTICITIES OF DEMAND

A relationship isdescribed as

When itsmagnitude is

Which means that

Perfectly elasticor infinitely elastic

Unit elastic

In elastic

Perfectly inelasticor completely inelastic

Infinity The smallest possible increase in price causes an infinitely large decrease in quantity demanded

Less than infinitybut greater than 1

Greater than zerobut less than 1

Elastic

1

Zero

The percent decrease in the quantity demandedexceeds the percent increase in price

The percent decrease in the quantity demandedequals the percent increase in price

The percentage decrease in the quantity demandedis less than the percent increase in price.

The quantity demanded is the same at all prices


A Compact Glossary of ElasticitiesCROSS ELASTICITIES OF DEMAND



Which means that

Perfect substitutes Infinity The smallest possible increase in price of one good causes an infinitely large in the demand of the other good.

Positive, lessthan infinity

Substitutes If the price of one good increases, the quantitydemanded of the other good also increases.

Independent Zero The demand for one good remains constant,regardless of the price of the other good.

Complements Less than zero The demand for one good decreases when the price of the other good increases.


A Compact Glossary of ElasticitiesINCOME ELASTICITIES OF DEMAND



Which means that

Income elastic(normal good)

Greater than 1 The percent increase in the quantity demandedis greater than the percentage increase in income.

Less than 1 butgreater than zero

Income inelastic(normal good)

The percent increase in the quantity demandedis less than the percentage increase in income.

Negative income elastic(inferior good)

Less than zero When income increases, quantity demanded decreases.


A Compact Glossary of ElasticitiesELASTICITIES OF SUPPLY



Which means that

Perfectly elastic Infinity The smallest possible increase in price causes aninfinitely large increase in the quantity supplied.

Less than infinitybut greater than 1

Elastic The percent increase in the quantity supplied exceeds the percentage increase in the price.

Inelastic Greater than zerobut less than 1

The percentage increase in the quantity supplied is less than the percentage increase in price.

Perfectly inelastic Zero The quantity supplied is the same at all prices.


3 SUPPLY AND DEMAND II: MARKETS AND WELFARE


Welfare Economics

• Welfare economics is the study of how the allocation of resources affects economic well-being.

• Buyers and sellers receive benefits from taking part in the market.

• The equilibrium in a market maximizes the total welfare of buyers and sellers.


CONSUMER SURPLUS

• Willingness to pay is the maximum amount that a buyer will pay for a good.

• It measures how much the buyer values the good or service.

• Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it.

• Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it.


Table 1 Four Possible Buyers’ Willingness to Pay

Copyright©2004 South-Western


The Demand Schedule and the Demand Curve


Figure 1 The Demand Schedule and the Demand Curve

Copyright©2003 Southwestern/Thomson Learning

Price ofAlbum

0 Quantity ofAlbums

Demand

1 2 3 4

$100 John’s willingness to pay

80 Paul’s willingness to pay

70 George’s willingness to pay

50 Ringo’s willingness to pay


Figure 2 Measuring Consumer Surplus with the Demand Curve


(a) Price = $80Price of

Album

50

70

80

0

$100

Demand

1 2 3 4 Quantity ofAlbums

John’s consumer surplus ($20)


Figure 2 Measuring Consumer Surplus with the Demand Curve


(b) Price = $70Price of

Album

50

70

80

0

$100

Demand

1 2 3 4

Totalconsumersurplus ($40)

Quantity ofAlbums

John’s consumer surplus ($30)

Paul’s consumersurplus ($10)


Figure 3 How the Price Affects Consumer Surplus


Consumersurplus

Quantity

(a) Consumer Surplus at Price P

Price

0

Demand

P1

Q1

B

A

C


Figure 3 How the Price Affects Consumer Surplus


Initialconsumer

surplus

Quantity

(b) Consumer Surplus at Price P

Price

0

Demand

A

BC

D EF

P1

Q1

P2

Q2

Consumer surplusto new consumers

Additional consumersurplus to initial consumers


PRODUCER SURPLUS

• Producer surplus is the amount a seller is paid for a good minus the seller’s cost.

• It measures the benefit to sellers participating in a market.


The Supply Schedule and the Supply Curve


Figure 4 The Supply Schedule and the Supply Curve


Figure 5 Measuring Producer Surplus with the Supply Curve


Quantity ofHouses Painted

Price ofHouse

Painting

500

800$900

0

600

1 2 3 4

(a) Price = $600

Supply

Grandma’s producersurplus ($100)


Figure 5 Measuring Producer Surplus with the Supply Curve


Quantity ofHouses Painted

Price ofHouse

Painting

500

800

$900

0

600

1 2 3 4

(b) Price = $800

Georgia’s producersurplus ($200)

Totalproducersurplus ($500)

Grandma’s producersurplus ($300)

Supply


Figure 6 How the Price Affects Producer Surplus


Producersurplus

Quantity

(a) Producer Surplus at Price P

Price

0

Supply

B

A

C

Q1

P1


Figure 6 How the Price Affects Producer Surplus


Quantity

(b) Producer Surplus at Price P

Price

0

P1B

C

Supply

A

Initialproducersurplus

Q1

P2

Q2

Producer surplusto new producers

Additional producersurplus to initialproducers

D EF


Figure 7 Consumer and Producer Surplus in the Market Equilibrium


Producersurplus

Consumersurplus

Price

0 Quantity

Equilibriumprice

Equilibriumquantity

Supply

Demand

A

C

B

D

E


MARKET EFFICIENCY

• Three Insights Concerning Market Outcomes• Free markets allocate the supply of goods to the

buyers who value them most highly, as measured by their willingness to pay.

• Free markets allocate the demand for goods to the sellers who can produce them at least cost.

• Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.


Figure 8 The Efficiency of the Equilibrium Quantity


Quantity

Price

0

Supply

Demand

Costto

sellers

Costto

sellers

Valueto

buyers

Valueto

buyers

Value to buyers is greaterthan cost to sellers.

Value to buyers is lessthan cost to sellers.

Equilibriumquantity

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