3. ELASTICITY OF DEMAND AND SUPPLY weeks 5-6

Elasticity of Demand Law of demand tells us that consumers will respond to a price drop by buying more, but it does not tell us how much more. The degree of sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand. Because of the inverse relationship between Qd and Price, the Ed coefficient will always be a negative number. But, we focus on the magnitude of the change by neglecting the minus sign and use absolute value

Elasticity If price rises by 10% - what happens to demand? We know demand will fall By more than 10%? By less than 10%? Elasticity measures the extent to which demand will change

Types of Elasticity Demand Price elasticity of demand – Point price elasticity – Arc price elasticity Cross-price elasticity of demand Income elasticity of demand

© Pilot Publishing Company Ltd What is price elasticity? Price elasticity of demand is equal to the percentage change in quantity demanded of a good divided by the percentage change in its own price.

Characteristics: Ed approaches infinity, demand is perfectly elastic. Consumers are very sensitive to price change. Ed > 1, demand is elastic. Consumers are relatively responsive to price changes. Ed = 1, demand is unit elastic. Consumers’ response and price change are in same proportion. Ed < 1, demand is inelastic. Consumers are relatively unresponsive to price changes. Ed approaches 0, demand is perfectly inelastic. Consumers are very insensitive to price change.

*The curves Conclusion: the effect of a price change on quantity demanded is greater on elastic demand than inelastic demand

Unit 1 : Macroeconomics National Council on Economic Education Calculation of Arc - Price Elasticity of Demand

Unit 1 : Macroeconomics National Council on Economic Education Arc-Price Elasticity along a Demand Curve

Determinants of Price Elasticity of Demand Various factors influence the price elasticity of demand. Here are some of them: 1. Number of Substitutes: If a product can be easily substituted, its demand is elastic, like Gap's jeans. If a product cannot be substituted easily, its demand is inelastic, like gasoline. 2. Luxury Vs Necessity: Necessity's demand is usually inelastic because there are usually very few substitutes for necessities. Luxury product, such as leisure sail boats, are not needed in a daily bases. There are usually many substitutes for these products. So their demand is more elastic.

3. Price/Income Ratio: The larger the percentage of income spent on a good, the more elastic is its demand. A change in these products' price will be highly noticeable as they affect consumers' budget with a bigger magnitude. Consumers will respond by cutting back more on these product when price increases. On the other hand, the smaller the percentage of income spent on a good, the less elastic is its demand. 4. Time lag: The longer the time after the price change, the more elastic will be the demand. It is because consumers are given more time to carry out their actions. A 1-day sale usually generate less sales change per day as a sale lasted for 2 weeks.

Elasticity and Total Revenue (TR) If demand is price elastic: Increasing price would reduce TR (%Δ Qd > % Δ P) Reducing price would increase TR (%Δ Qd > % Δ P) If demand is price inelastic: Increasing price would increase TR (%Δ Qd < % Δ P) Reducing price would reduce TR (%Δ Qd < % Δ P)

© Pilot Publishing Company Ltd Cross elasticity of demand is equal to the percentage change in quantity demanded of a good (e.g., good X) divided by the percentage change in price of another good (e.g., good Y). What is cross elasticity?

Elasticity Goods which are complements: – Cross Elasticity will have negative sign (inverse relationship between the two) Goods which are substitutes: – Cross Elasticity will have a positive sign (positive relationship between the two)

© Pilot Publishing Company Ltd Income elasticity of demand is equal to the percentage change in quantity demanded divided by the percentage change in income. What is income elasticity?

Elasticity Income Elasticity of Demand: – The responsiveness of demand to changes in incomes Normal Good – it has a positive sign demand rises as income rises and vice versa Inferior Good – it has a negative sign demand falls as income rises and vice versa

Price Elasticity of Supply Definition: Law of supply tells us that producers will respond to a price drop by producing less, but it does not tell us how much less. The degree of sensitivity of producers to a change in price is measured by the concept of price elasticity of supply. Because of the direct relationship between Qs and Price, the Es coefficient will always be a positive number.

Elasticity of supply Price Elasticity of Supply: – The responsiveness of supply to changes in price – If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price – If Pes is elastic – supply can react quickly to changes in price Pes = % Δ Quantity Supplied ____________________ % Δ Price

Characteristics & Determinants Characteristics: Es approaches infinity, supply is perfectly elastic. Producers are very sensitive to price change. Es > 1, supply is elastic. Producers are relatively responsive to price changes. Es = 1, supply is unit elastic. Producers’ response and price change are in same proportion. Es < 1, supply is inelastic. Producers are relatively unresponsive to price changes. Es approaches 0, supply is perfectly inelastic. Producers are very insensitive to price change.

Determinants: 1. Time lag: How soon the cost of increasing production rises and the time elapsed since the price change influence the Es. The more rapidly the production cost rises and the less time elapses since a price change, the more inelastic the supply. The longer the time elapses, more adjustments can be made to the production process, the more elastic the supply. 2. Storage possibilities: Products that cannot be stored will have a less elastic supply. For example, produces usually have inelastic supply due to the limited shelf life of the vegetables and fruits.

Unit 1 : Macroeconomics National Council on Economic Education Effects of Different Demand Elasticities Which demand curve is more inelastic? What happens to the equilibrium price and quantity with an elastic demand curve if supply increases? What happens to the equilibrium price and quantity with an inelastic demand curve if supply increases?

Short-run and Long-run elasticity of supply S.R: 1. immediate effect. Quantity is not influenced by changes in price 2. Some effect later, SS is relatively less elastic. Quantity changes by smaller margin. L.R.: Quantity changes by a larger margin.SS is more elastic

Application of DD and SS elasticities *Read on subsidies, external costs and benefits The incidence of per unit tax: As tax is imposed on a commodity, its price will rise and quantity demanded/sold falls. However, the magnitude of these changes depends on the elasticities of demand and supply

Share of incidence of tax An imposition of a per unit tax shifts the supply curve inwards to the left. The burden of tax may be shared between the consumer and the producer, but no in equal proportion. How it is shared depends on the elasticities of demand. The consumer bears all if: demand is perfectly inelastic and The producer bears all if demand is perfectly elastic

The consumer bears greater part of the tax burden if demand is inelastic. The producer bears greater part of the tax burden if demand is elastic. **mathematical derivations