DESCRIBING SUPPLY AND DEMAND: ELASTICITIES Chapter 6 DESCRIBING SUPPLY AND DEMAND: ELASTICITIES

Today’s lecture will: Use the terms price elasticity of supply and price elasticity of demand to describe the responsiveness of quantities to changes in price. Calculate elasticity graphically and numerically. Distinguish five elasticity terms that are used to differentiate varying degrees of responsiveness.

Today’s lecture will: Explain the importance of substitution in determining elasticity of supply and demand. Relate price elasticity of demand to total revenue. State how other elasticity concepts are useful in describing the effect of shift factors of demand. Explain how the concept of elasticity makes supply and demand more useful.

Price Elasticity Price elasticity of demand (ED) Price elasticity of supply (ES)

Calculating Elasticity of Demand $26 B 24 22 midpoint C Price 20 Elasticity between A and B: A 18 16 14 10 12 14 Quantity of software (in thousands)

Calculating Elasticity of Supply $6.00 5.50 5.00 B Wage per hour 4.50 C A 4.00 Elasticity between A and B: 3.50 3.00 476 485 Quantity of workers

Calculating Elasticity at a Point Price Quantity $10 9 8 7 6 5 4 3 2 1 C B A 24 40 28 20 To calculate elasticity at a point determine a range around that point and calculate the arc elasticity.

Elasticities and Supply and Demand Curves Price Price Quantity Perfectly inelastic demand curve Perfectly elastic demand curve Quantity

Elasticity Along a Demand Curve Ed = ∞ Elasticity declines along the demand curve as we move toward the quantity axis $10 9 8 Ed > 1 7 6 Ed = 1 Price 5 4 3 Ed < 1 2 1 Ed = 0 1 2 3 4 5 6 7 8 9 10 Quantity

Elasticity Along a Supply Curve If the supply curve intersects the vertical axis, Es declines as you go up the supply curve. S1 $10 Es declines 9 8 7 6 Es =  Price 5 Es rises 4 If the supply curve intersects the quantity axis, Es increases as you go up the supply curve. 3 2 Es = 0 1 1 2 3 4 5 6 7 Quantity

Elasticity Summary Perfectly elastic – quantity responds enormously to price changes (E=∞) Elastic – the %Δ Q > the %Δ P (E>1). Unit elastic – the %Δ Q = the %Δ P (E=1). Inelastic – the %Δ Q < the %Δ P (E<1). Perfectly inelastic – quantity does not respond at all to a change in price (E=0).

Substitution and Demand As a general rule, the more substitutes a good has, the more elastic is its supply and demand. The larger the time interval considered, the more elastic is the demand curve. The less a good is a necessity, the more elastic is its demand curve. Demand becomes more elastic as the definition of the good becomes more specific. Demand for goods that represent a large portion of one’s budget are more elastic.

Substitution and Supply The longer the time period considered, the more elastic the supply. There are three time periods relevant to supply: The instantaneous period – supply is fixed, perfectly inelastic. The short run – some substitution is possible, supply is somewhat elastic. The long run – significant substitution is possible, supply is very elastic.

Short-Run and Long-Run Elasticities of Demand

Elasticity, Total Revenue, and Demand The elasticity of demand tells suppliers how their total revenue (PxQ) will change if their price changes. If ED > 1, an increase in price decreases total revenue. If ED = 1, an increase in price leaves total revenue unchanged. If ED < 1, an increase in price increases total revenue.

Elasticity and Total Revenue Unit Elastic Demand E = 1 6 Price Quantity $10 8 4 2 1 3 5 7 9 TRE= $4x6=$24 TRF= $6x4=$24 TR constant F Gained revenue C E Lost revenue A B

Elasticity and Total Revenue Inelastic Demand E < 1 $10 TR rises if price increases 8 TRG = $1 x 9 = $9 TRH = $2 x 8 = $16 6 Price Gained revenue Lost revenue 4 H 2 C G A B 1 2 3 4 5 6 7 8 9 Quantity

Elasticity and Total Revenue Elastic Demand E > 1 $10 K J C TR falls if price increases. 8 Gained revenue B TRJ = $8 x 2 = $16 TRK = $9 x 1 = $9 6 A Price 4 Lost revenue 2 1 2 3 4 5 6 7 8 9 Quantity

Total Revenue Along a Demand Curve Price Quantity Elastic ED > 1 Total Revenue Along a Demand Curve ED = 1 Q0 Inelastic ED < 1 Total revenue Quantity

Elasticity of Individual and Market Demand Price discrimination occurs when a firm separates the people with less elastic demand from those with more elastic demand. Firms that price discriminate charge more to the individuals with inelastic demand and less to individuals with elastic demand. Examples of price discrimination: Airlines’ Saturday stay-over specials Sales of new cars Almost-continual sales

Income Elasticity of Demand Income elasticity of demand measures the responsiveness of demand to changes in income.

Income Elasticity of Demand Normal goods are those whose consumption increases with an increase in income. Normal goods can be luxuries or necessities: Luxuries are goods that have an income elasticity greater than one. A necessity has an income elasticity less than 1. Inferior goods are those whose consumption decreases when income increases. Inferior goods have income elasticities less than zero.

Calculating Income Elasticity P0 D0 D1 20 Quantity 26 Shift due to 20% rise in income

Income Elasticities of Selected Goods Income elasticity Product Short Run Long Run Motion pictures 0.81 3.41 Foreign travel 0.24 3.09 Hard liquor — 2.5 Jewelry and watches 1.00 1.64 Tobacco products 0.21 0.86 Furniture 2.60 0.53 Homegrown food -0.61 —

Cross-Price Elasticity of Demand Cross-price elasticity of demand measures the responsiveness of demand to changes in prices of other goods.

Calculating Cross-Price Elasticity D0 D1 P0 P0 Shift due to 33% decrease in price of pork 104 108 Quantity of Beef

Complements and Substitutes Substitutes are goods that can be used in place of another. Substitutes have positive cross-price elasticities. Complements are goods that are used in conjunction with one another. Complements have negative cross-price elasticities.

Cross-Price Elasticities Commodities Elasticity Beef in response to price change in pork 0.11 Beef in response to price change in chicken 0.02 U.S. cars in response to price changes in European and Asian automobiles 0.28 European automobiles in response to price changes in U.S. and Asian automobiles 0.61 Beer in response to changes in wine 0.23 Hard liquor in response to price changes in beer - 0.11

Effects of Shifts in Supply on Price and Quantity Inelastic Demand Elastic Demand D S0 S0 Price Price S1 S1 D P0 P0 P1 P1 Q0 Q1 Q0 Q1 Quantity Quantity

Elasticity and Shifting Supply and Demand The more elastic the demand (supply), the greater the effect of a supply (demand) shift on quantity, and the smaller the effect on price.

Elasticity and Shifting Demand and Supply Suppose that demand increases by 5%, the elasticity of demand is 0.8, and the elasticity of supply is 2. Price will increase by Suppose that supply increases by 33%, the elasticity of demand and supply are both 1. Price will fall by

Summary Elasticity is percentage change in quantity divided by percentage change in some variable that affects demand (supply). The most common elasticity is price.

Summary Five elasticity terms are: Elastic E>1 Inelastic E<1 Unit elastic E=1 Perfectly inelastic E=0 Perfectly elastic E=∞ The more substitutes a good has, the greater its elasticity. The most important factor affecting the number of substitutes in supply is time. The longer the time interval, the more elastic is supply.

Summary Factors affecting the number of substitutes in demand are: Time period Degree to which the good is a luxury Market definition Importance of the good in one’s budget Demand becomes less elastic as we move down along a demand curve.

Summary When a supplier raises price: If demand is inelastic total revenue increases. If demand is elastic, total revenue decreases. If demand is unit elastic, total revenue remains constant. Other important elasticities are: Income elasticity – the percentage change in demand divided by the percentage change in income Cross-price elasticity – the percentage change in demand divided by the percentage change in the price of a related good

Given the following demand and supply of pizza: Price Quantity Quantity per Pizza Supplied Demanded $8 200 60 7 150 80 6 100 100 5 50 120 Review Question 6-1 Calculate the elasticity of supply of pizza between $7 and $8.

Review Question 6-2 Calculate the elasticity of demand for Given the following demand and supply of pizza: Price Quantity Quantity per Pizza Supplied Demanded $8 200 60 7 150 80 6 100 100 5 50 120 Review Question 6-2 Calculate the elasticity of demand for pizza between $6 and $7.