Unit 2: Consumer Choice, Demand, and Supply Lecture #4: Elasticity of Demand and Supply

ELASTICITY OF DEMAND (Price Elasticity of Demand) The degree to which a change in price affects the quantity demanded ED = % change in quantity demanded % change in price

MIDPOINT FORMULA FOR ELASTICITY OF DEMAND ED= (Q2 – Q1) (Q2 + Q1)/2 ____________________________ (P2 – P1) (P2 + P1)/2

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:

ELASTIC DEMAND When a small change in price leads to a relatively large change in the quantity demanded Ex. A 10 % increase in price leads to a 20% reduction in the quantity demanded ED > 1

Elastic Demand Reasons why demand for a good is elastic: The product is not necessary There are substitutes available The product takes a large portion of the consumer’s income The market is narrowly defined (like a particular brand name) The longer the time period to purchase the good Examples of goods with elastic demand Fresh peas 2.83 Lamb and mutton 2.65 Restaurant meals 2.27 Residential land 1.60 Beef 1.27

Figure 1 The Price Elasticity of Demand (e) Perfectly Elastic Demand: Elasticity Equals Infinity Price 1. At any price above $4, quantity demanded is zero. $4 Demand 2. At exactly $4, consumers will buy any quantity. 3. At a price below $4, quantity demanded is infinite. Quantity

ED < 1 INELASTIC DEMAND When a change in price leads to little or no change in the quantity demanded Ex. A 20% decrease in price leads to a 10% increase in the quantity demanded ED < 1

INELASTIC DEMAND Reasons why demand for a good is inelastic: The product is necessary with few/no substitutes Product takes a small portion of the consumer’s income The market is widely defined (in general, not a brand name, etc.) There is a short time period to buy the good Examples of goods with inelastic demand Electricity .13 Bread .15 Telephone service .26 Gasoline .6 Milk .63

Figure 1 The Price Elasticity of Demand (a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand 100 $5 1. An increase in price . . . 4 Quantity 2. . . . leaves the quantity demanded unchanged. Copyright©2003 Southwestern/Thomson Learning

UNIT ELASTIC DEMAND ED = 1 When the change quantity demanded is proportional to the change in price Ex. 20% change in price leads to 20% change in quantity demanded ED = 1

Figure 1 The Price Elasticity of Demand (c) Unit Elastic Demand: Elasticity Equals 1 Price Demand $5 80 1. A 22% increase in price . . . 4 100 Quantity 2. . . . leads to a 22% decrease in quantity demanded. Copyright©2003 Southwestern/Thomson Learning

The Variety of Demand Curves Perfectly Inelastic Quantity demanded does not respond to price changes. Perfectly Elastic Quantity demanded changes infinitely with any change in price. Unit Elastic Quantity demanded changes by the same percentage as the price.

TOTAL REVENUE TEST FOR ELASTICITY OF DEMAND Total Revenue (TR) = P x Q Elastic Demand Price goes up, total revenue goes down Price goes down, total revenue goes up Inelastic Demand Price goes up, total revenue goes up Price goes down, total revenue goes down Unit Elastic Demand Price goes up, total revenue remains unchanged Price goes down, total revenue remains unchanged

Figure 2 Total Revenue Price $4 P × Q = $400 P (revenue) Demand 100 Quantity Q Copyright©2003 Southwestern/Thomson Learning

Figure 3 How Total Revenue Changes When Price Changes: Inelastic Demand An Increase in price from $1 to $3 … … leads to an Increase in total revenue from $100 to $240 Demand Demand $3 80 Revenue = $240 $1 100 Revenue = $100 Quantity Quantity Copyright©2003 Southwestern/Thomson Learning

Figure 4 How Total Revenue Changes When Price Changes: Elastic Demand An Increase in price from $4 to $5 … … leads to an decrease in total revenue from $200 to $100 $5 20 Demand Demand Revenue = $100 $4 50 Revenue = $200 Quantity Quantity Copyright©2003 Southwestern/Thomson Learning

Elasticity of a Linear Demand Curve

Elasticity of a Linear Demand Curve A downward-sloping demand curve will have elastic, unit elastic, and inelastic segments. Elasticity does not equal slope. At the higher prices and lower quantities, the percent change in quantity will exceed the percent change in price and demand will be elastic At the lower prices and higher quantities, the percent change in price will exceed the percent change in quantity and demand will be inelastic

ELASTICITY OF SUPPLY (Price Elasticity of Supply) The degree of responsiveness to a change in price by suppliers Is calculated the same way as elasticity of demand Time periods are important to elasticity of supply In the market period, elasticity of supply is very inelastic In the short-run, supply is more elastic than in the market period and depends on the ability of producers to respond to changes in price In the long-run, supply is the most elastic because adjustments can be made by producers over time

ELASTICITY OF SUPPLY MEASURES ES > 1  Elastic ED = 1  Unit Elastic ED > 1  Inelastic

MIDPOINT FORMULA FOR ELASTICITY OF SUPPLY ES= (Q2 – Q1) (Q2 + Q1)/2 ____________________________ (P2 – P1) (P2 + P1)/2

Figure 6 The Price Elasticity of Supply (e) Perfectly Elastic Supply: Elasticity Equals Infinity Price 1. At any price above $4, quantity supplied is infinite. $4 Supply 2. At exactly $4, producers will supply any quantity. 3. At a price below $4, quantity supplied is zero. Quantity Copyright©2003 Southwestern/Thomson Learning

Figure 6 The Price Elasticity of Supply (a) Perfectly Inelastic Supply: Elasticity Equals 0 Price Supply $5 1. An increase in price . . . 4 100 Quantity 2. . . . leaves the quantity supplied unchanged. Copyright©2003 Southwestern/Thomson Learning

CROSS ELASTICITY OF DEMAND Refers to the effect of a change in a product’s price on the quantity demanded for another product Exy= % change in quantity of X % change in price of Y

CROSS ELASTICITY OF DEMAND (continued) Cross Elasticity > 0, Good X and Good Y are Substitute Goods Cross Elasticity is < 0, X and Y are Complementary Goods If Cross Elasticity is = 0, X and Y are unrelated, independent products

INCOME ELASTICITY OF DEMAND Refers to the % change in quantity demanded which results from some % change in consumer incomes Ei = % change in quantity demanded % change in income

INCOME ELASTICITY OF DEMAND (continued) Income Elasticity > 0 indicates a Normal Good Income Elasticity < 0 indicates an Inferior Good

Elasticity Scenarios 1) Price Coke up 20% QD Pepsi up 40% 2) Price hot dogs up 40% QD relish down 30% 3) Price econ up 30% QD fun unchanged

Elasticity Scenarios 4) Income up 20% QD for New York Mets, Pittsburgh Pirates, Houston Astros, Los Angeles Dodgers, tickets up 40% 5) Income up 20% QD for Atlanta Brave, Florida Marlins, Tampa Bay Rays, Minnesota Twins, Colorado Rockies tickets down 60%