elasticity of demand and supply 1 © 2012 cengage learning. all rights reserved. may not be copied,...

Elasticity ofDemand and Supply

1© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2

Price Elasticity of Demand• Elasticity

– Responsiveness • Price elasticity of demand

– How responsive quantity demanded is to a price change

– Percentage change in quantity demanded divided by percentage change in price

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Price Elasticity of Demand

• %Δq – percentage change in quantity– Δq – change in quantity

• %Δp – percentage change in price– Δp – change in price

3

2/)'(2/)'(

%

%

pp

p

qq

qE

p

qE

D

D


4

Price Elasticity of Demand

• Price elasticity of demand, ED

– Law of demand• Price and quantity demanded are inversely

related

– ED negative

– Absolute value of ED positive


Exhibit 1

5

Demand Curve for Tacos

D

10595 Thousands per day 0

0.90

Pric

e pe

r ta

co$1.10

b

a

If the price of tacos drops from $1.10 to $0.90, the quantity demanded increases from 95,000 to 105,000.


Categories of ED

• If %∆q < %∆p– A change in price has relatively little

effect on quantity demanded

– ED between 0 and 1

– Inelastic demand• If %∆q = %∆p

– ED = 1

– Unit elastic demand


Categories of ED

• If %∆q > %∆p – A change in price has a relatively large

effect on quantity demanded

– ED greater than 1

– Elastic demand


Elasticity and Total Revenue• Total revenue = price * quantity

demanded at this price• TR= p ˣ q• As price decreases

– If demand is elastic, TR increases– If demand is inelastic, TR decreases– If demand is unit elastic, TR constant


Price Elasticity and Linear Demand Curve

• Linear demand curve– Straight line demand curve– Constant slope– Varying elasticity

• Demand becomes less elastic as we move downward

– Upper half: elastic– Lower half: inelastic– Midpoint: unit elastic


Exhibit 2

10

Demand, Price Elasticity, and Total Revenue

D

90

60

10

70

Pric

e pe

r un

it

$100

80

50403020

b

a

de

800500200100 Quantity per period1,000 0 900

Tota

l rev

enue

$25,000

500 Quantity per period1,000 0

(a) Demand and price elasticity

(b) Total revenue

Total

revenue

Unit elastic, ED =1

Elastic, ED >1

Inelastic, ED <1

Where the demand curve is elastic, a lower price increases total revenue. Total revenue reaches a maximum at the rate of output where the demand curve is unit elastic.

c

Where the demand curve is inelastic, further decreases in price reduce total revenue.


Constant Elasticity Demand Curves

• Perfectly elastic demand curve– Horizontal line

• Any price increase would reduce quantity demanded to zero

– ED = ∞

– Consumers don’t tolerate price increases



• Perfectly inelastic demand curve– Vertical line

• Any price change has no effect on the quantity demanded

– ED = 0

– ‘Price is no object’



• Unit-elastic demand curve – Everywhere along the demand curve

• % Δp causes an equal but offsetting %Δq• Total revenue remains the same

– ED = 1

• Constant-elasticity demand curve– Price elasticity is the same everywhere

along the curve– Elasticity value is unchanged


Exhibit 3

14

Constant-Elasticity Demand Curves

0 Quantity

per period

Pric

e pe

r un

it

pED = ∞

(a) Perfectly elastic

D P

rice

per

unit

ED’ = 0

(b) Perfectly inelastic

ED’’ = 1

(c) Unit elastic

D’

0 Quantity

per period

Q

Pric

e pe

r un

it

$10

6

0 Quantity

per period

60 100

D’’

a

b

The three panels show constant-elasticity demand curves, so named because the elasticity value does not change along the demand curve. Along the perfectly elastic, or horizontal, demand curve of panel (a), consumers demand all that is offered for sale at price p, but demand nothing at a price above p. Along the perfectly inelastic, or vertical, demand curve of panel (b), consumers demand amount Q regardless of price. Along the unit-elastic demand curve of panel (c), total revenue is the same for each price-quantity combination.


Exhibit 4

15

Summary of Price Elasticity of Demand


Determinants of Price Elasticity of D

• ED is greater:

– The greater the availability of substitutes, and the more similar the substitutes

– The more important the good as a share of the consumer’s budget

– The longer the period of adjustment (time)


Exhibit 5

17

Demand Becomes More Elastic Over Time

Dw

Pric

e pe

r un

it

$1.25

1.00

Dm

Quantity per day95 10075500

Dy

e

Dw is the demand curve one week after a price increase from $1.00 to $1.25. Along this curve, quantity demanded per day falls from 100 to 95. One month after the price increase, quantity demanded has fallen to 75 along Dm. One year after the price increase, quantity demanded has fallen to 50 along Dy. At any given price, Dy is more elastic than Dm, which is more elastic than Dw.


Elasticity Estimates• Short run

– Consumers have little time to adjust• Long run

– Consumers can fully adjust to a price change

• Demand is more elastic in the long run


Exhibit 6

19

Selected Price Elasticities of Demand (Absolute Values)


Price Elasticity of Supply• Elasticity

– Responsiveness• Price elasticity of supply

– Responsiveness of quantity supplied to a price change

– Percentage change in quantity supplied divided by percentage change in price


Price Elasticity of Supply

• Law of supply• ES positive

21

2/)'(2/)'(

%

%

pp

p

qq

qE

p

qE

S

S


Exhibit 7

22

Price Elasticity of Supply

SP

rice

per

unit

p

p’

If the price increases from p to p’, the quantity supplied increases from q to q’.

Price and quantity supplied move in the same direction, so the price elasticity of supply is a positive number.

Quantity per periodq q’0


Categories of ES

• If %∆q < %∆p– A change in price has relatively little

effect on quantity supplied

– ES between 0 and 1

– Inelastic supply• If %∆q = %∆p

– ES = 1

– Unit elastic supply


Categories of ES

• If %∆q > %∆p – A change in price has a relatively large

effect on quantity supplied

– ES greater than 1

– Elastic supply


Constant Elasticity Supply Curves• Perfectly elastic supply curve

– Horizontal line • Any price decrease drops the quantity

supplied to zero

– ES = ∞

• Unit-elastic supply curve, ES=1

– %∆p causes an identical %∆q– Straight line from the origin


Constant Elasticity Supply Curves• Perfectly inelastic supply curve

– Vertical line• A price change has no effect on the quantity

supplied

– ES = 0

– Goods in fixed supply


Exhibit 8

27

Constant-Elasticity Supply Curves

0 Quantity

per period

Pric

e pe

r un

it

pES = ∞

(a) Perfectly elastic

S P

rice

per

unit

ES’ = 0

(b) Perfectly inelastic

ES’’ = 1

(c) Unit elastic

S’

0 Quantity

per period

Q

Pric

e pe

r un

it

$10

5

0 Quantity

per period

10 20

In each of the three panels is a constant-elasticity supply curve, so named because the elasticity value does not change along the curve. Supply curve S in panel (a) is perfectly elastic, or horizontal. Along S, firms supply any amount of output demanded at price p, but supply none at prices below p. Supply curve S’ is perfectly inelastic, or vertical. S’ shows that the quantity supplied is independent of the price. In panel (c), S”, a straight line from the origin, is a unit-elastic supply curve. Any percentage change in price results in the same percentage change in quantity supplied.

S’’


Determinants of Supply Elasticity

• ES is greater:

– If the marginal cost rises slowly as output expands

– The longer the period of adjustment (time)


Exhibit 9

29

Supply Becomes More Elastic Over TimeSw

Pric

e pe

r un

it

1.00

$1.25

Quantity per day110 2000 100 140

Sm

Sy

The supply curve one week after a price increase, Sw, is less elastic, at a given price, than the supply curve one month later, Sm, which is less elastic than the supply curve one year later, Sy. Given a price increase from $1.00 to $1.25, quantity supplied per day increases to 110 units after one week, to 140 units after one month, and to 200 units after one year.


Income Elasticity of Demand• Income elasticity of demand

– Demand responsiveness to a change in consumer income

– Percentage change in demand divided by the percentage change in income that caused it


Income Elasticity of Demand• Inferior goods

– Negative income elasticity• Normal goods

– Positive income elasticity – Income inelastic, necessities

• Elasticity between 0 and 1

– Income elastic, luxuries• Elasticity > 1


Exhibit 10

32

Selected Income Elasticities of Demand


Cross-Price Elasticity of Demand• Cross-price elasticity of demand

– The percentage change in the demand of one good, divided by the percentage change in the price of another good

– Positive for substitutes– Negative for complements– Zero for unrelated goods


Appendix Price Elasticity and Tax Incidence

• Tax–Decrease in supply by the amount of tax

• Tax incidence–Consumers : high price–Producers: lower net-of-tax receipt


Appendix Price Elasticity and Tax Incidence

• The more price elastic the demand:–The more tax producers pay –The less tax consumers pay

• The more elastic the supply:–The less tax producers pay–The more tax consumers pay


Exhibit 13

36

Effects of Price Elasticity of Demand on Tax Incidence

St

S

D’

St

S

D

$0.20 Tax

Pric

e pe

r ou

nce

$1.15

1.000.95

Millions of

ounces per day1090

$0.20 Tax

Pric

e pe

r ou

nce

$1.051.00

0.85

(a) Less elastic demand (b) More elastic demand

The imposition of a $0.20-per-ounce tax on tea shifts the supply curve leftward from S to S t. In panel (a), which has a less elastic demand curve, the market price rises from $1.00 to $1.15 per ounce and the market quantity falls from 10 million to 9 million ounces. In panel (b), which has a more elastic demand curve, the same tax leads to an increase in price from $1.00 to $1.05; market quantity falls from 10 million to 7 million ounces. The more elastic the demand curve, the more the tax is paid by producers in the form of a lower net-of-tax receipt.

107 Millions of

ounces per day


Exhibit 14

37

Effects of Price Elasticity of Supply on Tax Incidence

St’

S’

D’’

$0.20 Tax

Pric

e pe

r ou

nce

$1.15

1.000.95

(a) More elastic supply

St” S”

D’’

$0.20 Tax

109P

rice

per

ounc

e

$1.051.00

0.85

(b) Less elastic supply

Millions of ounces per day1080

The imposition of a $0.20-per-ounce tax on tea shifts the supply curve leftward from S to S t. In panel (a), which has a less elastic demand curve, the market price rises from $1.00 to $1.15 per ounce and the market quantity falls from 10 million to 9 million ounces. In panel (b), which has a more elastic demand curve, the same tax leads to an increase in price from $1.00 to $1.05; market quantity falls from 10 million to 7 million ounces. The more elastic the demand curve, the more the tax is paid by producers in the form of a lower net-of-tax receipt.


elasticity of demand and supply 1 © 2012 cengage learning. all rights reserved. may not be copied,...

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