Elasticity and Demand and Supply Applications

• Review: – Changes in quantity demand and supplied or movements

along the curves– Changes in demand and supply or shifts of the curve

• Comparative Statics– Changes in demand

• Increase in demand: price increases, quantity increases• Decrease in demand: price decreases, quantity decreases

– Changes in supply• Increase in supply: price decreases, quantity increases• Decrease in supply: price increases, quantity decreases

– Changes in both

Increase inDemand

Decrease inDemand

Increase in Supply

P ambiguousQ increases

P decreasesQ ambiguous

Decrease in Supply

P increasesQ ambiguous

P ambiguousQ decreases

Dynamics• Shifts in demand or supply create surpluses or shortages• Surpluses cause price to fall and shortages cause price to

rise• Increases in prices cause quantity demanded to decrease

(law of demand) and quantity supplied to increase (law of supply)

• Decreases in prices cause quantity demanded to increase (law of demand) and quantity supplied to decrease (law of supply)

• These price changes occur until surpluses or shortages are eliminated at the new equilibrium price and quantity

Using Demand and Supply

• Step 1: Determine if the change in the determinant affects the demand or supply curve.

• Step 2: Determine which way it shifts the curve

• Step 3: Determine how the equilibrium price and quantity change (dynamic adjustment)

Elasticity: Responsiveness versus Directions

• Demand and Supply analysis allows us to see the direction of changes in the equilibrium price and quantity

• We need another concept to see how responsive demand and supply are to change in their determinants

• The concept that helps us measure that sensitivity is elasticity

Price Elasticity of Demand• The concept of elasticity helps understand how

responsive demand is to price changes• Intuitively, if we are a businessperson and we want to

increase revenues, one important question is whether we increase price or decrease price

• Increases in price decreases the quantity demanded, but we get more for each unit we sell

• Decreases in price increases the quantity demanded, but we get less for each unit we sell

• How can we tell whether the price or the quantity effect wins out to increase our revenues

• The answer is the concept of elasticity

Definition of Elasticity

• Price elasticity of demand = %change in quantity demanded/ % change in price• Or using symbols: Ep = %ΔQd /%ΔP• For example, if the %ΔQd = 10% and the

%ΔP = 2%, the price elasticity of demand = 5, OR for every 1% change in price the quantity demand changes by 5%.

• Ep > 1 Responsive or elastic – %ΔQd > %ΔP

• Ep < 1 Not responsive or inelastic– %ΔQd < %ΔP

• Ep = 1 unit elastic– %ΔQd = %ΔP

BUT I Hate Percentages!!!

• OK, but they come in mighty handy. Why?– They always measure the change relative to a starting

point. (e.g. a $1 increase in your hourly wage is different if you make $5/hr. or $100/hr.)

– Absolute changes are affected by changes in the units with which they are measured ( 100 boxes of apples = 5,000 apples, but the later looks like a bigger change)

– Percentages are everywhere!!!! (Stores usually use percentage discounts during sales, increases in pay are generally in percentages, batting averages are in percentages, grades are given in percentages)

The Farmer’s Dilemma• For many crops, a strange situation arises a bad crop year

results in a good year for farm incomes, and a good crop year results in a bad year for farm incomes. How can this be?

• Price elasticity gives us the answer:– Bad crop year: supply decreases, prices for farm products rise, but

quantity demanded doesn’t fall very much. The quantity demanded of farm products is not very responsive to changes in prices

– Good crop year: supply increases, prices for farm products fall, but quantity demanded doesn’t increase very much. The quantity demanded of farm products is not very responsive to changes in prices

• It is easy to show this with a graph. But first we need yet another concept: Total Revenue = Price x Quantity

Elasticity and Total Revenue

• TR = P x Q• If P goes down Q goes up, but what

happens to TR?• If P goes up Q goes down, but what

happens to TR?• Elasticity can answer the question….

Elasticity to the Rescue….

• Ep > 1 Responsive or elastic – %ΔQd (10%) > %ΔP (5%) if P goes down (up) total

revenue goes up (down)

• Ep < 1 Not responsive or inelastic– %ΔQd (5%) < %ΔP (10%) if P goes down (up) total

revenue goes down (up)

• Ep = 1 unit elastic– %ΔQd (5%)= %ΔP (5%) if P goes down (up) total revenue

stays the same

The Farm Example

• During bad crop years, prices rise and quantity falls (but not that much) so total revenue to farmers goes up.

• During good crop years, prices fall and quantity increases (but not that much) so total revenue to farmers goes down.

• The graphs….

Figure 8 An Increase in Supply in the Market for Wheat

Copyright©2003 Southwestern/Thomson Learning

Quantity ofWheat

0

Price ofWheat

3. . . . and a proportionately smallerincrease in quantity sold. As a result,revenue falls from $300 to $220.

Demand

S1 S2

2. . . . leadsto a large fallin price . . .

1. When demand is inelastic,an increase in supply . . .

2

110

$3

100

Can Elasticity Tell Us More?

• What a minute, first we need to talk about what increases or decreases the price elasticity of demand.

• Determinants of Price Elasticity– Availability of close substitutes– Necessity versus luxury– Definition of the market– Time horizon– Percentage of consumer budget

Price elasticity of demandElasticity of Demand

elasticity coefficientitem short run long run

Airline travel 0.1 2.4Medical care 0.3 0.9Natural gas 1.4 2.1Auto tires 0.9 1.2Stationery 0.5 0.6Gasoline 0.2 0.7Housing 0.3 1.9Automobiles 1.9 2.2Movies 0.9 3.7Jewelry & watches 0.4 0.7Radio & TV repair 0.5 3.8Foreign travel 0.1 1.8Glass, china, etc. 1.5 2.5

Estimated price elasticities of demand

Ed

Percentage Change inQuantity Demanded

Percentage Change in Price

Elasticity of Supply

• How how about the price elasticity of supply? How responsive are suppliers to changes in price?

• Price elasticity of supply = %change in quantity supplied/% change in price

• Determinants of elasticity of supply:– Flexibility in altering the amount of a good produced.– Time period

Price elasticity of supplyElasticity of Supply

Price elasticityVegetable short run long run

Lima beans 0.10 1.70Cabbage 0.36 1.20Carrots 0.14 1.00Cucumbers 0.29 2.20Onions 0.34 1.00Green peas 0.31 4.40Green peppers 0.07 0.26Tomatoes 0.16 0.90Cauliflower 0.14 1.10Celery 0.14 0.95Spinach 0.20 4.70

Estimated price elasticities of supply

Es

Percentage Change inQuantity Supplied

Percentage Change in Price

Further Examples of Elasticity

• Inelastic demand and addictive drugs:– Supply side prevention– Demand side prevention

• Luxury Taxes– Who pays a tax? But with elasticity we find

out…– Who really pays the tax? (tax incidence or

burden).