Elasticity Dianna DaSilva-Glasgow Department of Economics University of Guyana 5 October, 2017

Elasticity of demand and supply WK 4 Lecture II and III. . . Elasticity of demand and supply

Price Elasticity of Demand The law of demand tells us that consumers will buy more of a product when its price declines and less when its price increases. But how much more or less will they buy? The amount varies from product to product and over different price ranges for the same product.

Responsiveness of Demand Here we have two different demand curves Responsiveness of Demand Here we have two different demand curves. Ron DA raising the price from P1 to P2 will cause quantity demanded to drop from QA,1 to QA,2; On DB demand falls from QB,1 to QB,2 Q P Price P2 DA DB P1 QB,2 QA,2 QB,1 QA,1 Quantity Demanded

Price Elasticity of Demand The responsiveness (or sensitivity) of consumers to a price change is measured by a product’s price elasticity of demand. For some products consumers are highly responsive to price changes. Moderate price changes cause very large changes in quantity purchased. For other products consumers pay less attention to price changes. Substantial price changes cause only small changes in the amount purchased. .

The price elasticity of demand, ED, measures the responsiveness of the quantity demanded to changes in the good's own price. ED is the percentage change in the quantity demanded that results per one percent change in price. 2

Calculating the Price Elasticity of Demand Q P1 P2 Q1 Q2 D P1  P2 Q1  Q2

Important points: The minus sign is dropped when calculating ED. The formula is based on percentage changes, not unit changes. The average price and quantity (midpoints) are used.

1 2 3 4 5 6 7 8 ED > 1 ED < 1 ED = 1 ED = 0.23 ED = 4.33 Q P a c b

Demand is said to be elastic with respect to price if ED > 1 Demand is said to be elastic with respect to price if ED > 1. %Qd > %P Demand is said to be inelastic with respect to price if ED < 1. %Qd < %P Demand is said to be unit elastic with respect to price if ED = 1. %Qd = %P 2

Suppose that a 10% increase in the price of cigarettes results in a 4% decrease in the quantity demanded. For each 1% increase in price, the quantity demanded goes down 0.4%. 2

Suppose that a 10% increase in the price of tickets to a Ry Cooder concert results in a 25% decrease in the quantity demanded. The demand for concert tickets is more responsive to price than is the demand for cigarettes. We say the demand for concert tickets is more elastic (w.r.t. price) than is the demand for cigarettes. 2

Example: ED = 0.58 for food ED = 1.26 for furniture. Goods that are necessities typically have price elasticities of demand that are relatively smaller. Example: ED = 0.58 for food ED = 1.26 for furniture. 2

Goods having ready substitutes typically have higher price elasticities of demand. Example: ED = 0.4 for gasoline ED = 1.4 for natural gas 2

Inferences that can be made when the price elasticity of demand is known.

Inferences that can be made when the price elasticity of demand is known. Example 1: Suppose that ED = 2.5 and that there is a 5% increase in price. What will be the percentage increase in the quantity demanded?

Example 2: Suppose that the price elasticity of demand for cigarettes is 0.7 for teens. How much would the price have to increase in order for teen smoking to be reduced 35%?

Example 2: Suppose that the price elasticity of demand for cigarettes is 0.7 for teens. How much would the price have to increase in order for teen smoking to be reduced 35%?

The End-Point Problem The end-point problem is that the percentage change differs depending on whether you view the change as a rise or a decline in price. Economists use the arc convention to get around the end-point problem. The arc elasticity method entails the calculating the percentage change at the midpoint of the range.

The Arc Convention Using the arc convention, the average of the two end points are used as the starting point when calculating percentage change. Mid-point formula

Calculating Elasticity at a Point Price Quantity $10 9 8 7 6 5 4 3 2 1 C B A 24 40 28 20

Determinants of Price Elasticity of Demand generalizations ...

the number of substitutes: generally, the larger the number of substitutes a product has, the greater the price elasticity of demand for that product. the proportion of the consumer’s income spent on the product: other things equal, the higher the price of a good relative to consumers’ incomes, the greater the price elasticity of demand. luxuries versus necessities: in general, the more that a good is considered to be a luxury rather than necessities, the greater is the price elasticity of demand. e.g. bread and electricity. time: generally, product demand is more elastic the longer the time period under consideration. consumers often need time to adjust to change in prices. for example. consumers may not immediately reduce their purchases very much when the price of beef rises by 10 percent, but in time they may shift to chicken or fish.

Price Elasticity of Demand and Total Revenue The importance of elasticity for firms relates to the effect of price changes on total revenue and thus on profits (total revenue less total cost). Total revenue (TR) is the total amount the seller receives from the sale of a product in a particular time period; it is calculated by multiplying the product price (P) by the quantity demanded and sold (Q). that is: TR = P*Q

The relationship between price and revenue changes: The importance of ED 1 2 3 4 5 6 7 8 ED > 1 ED < 1 ED = 1 ED = 0.23 ED = 4.33 Q P a c b Demand is elastic Demand is inelastic

ED > 1 implies that %Qd > %P. 2 3 4 5 6 7 8 ED > 1 ED < 1 ED = 1 ED = 0.23 ED = 4.33 Q P a c b Demand is elastic Demand is inelastic When demand is elastic (ED > 1), there is an inverse relationship between changes in price and changes in total revenue. P  TR P  TR ED > 1 implies that %Qd > %P. TR = P • Q   

ED < 1 implies that %Qd < %P. 2 3 4 5 6 7 8 ED > 1 ED < 1 ED = 1 ED = 0.23 ED = 4.33 Q P a c b Demand is elastic Demand is inelastic When demand is inelastic (ED < 1), there is a direct relationship between changes in price and changes in total revenue. P  TR P  TR ED < 1 implies that %Qd < %P. TR = P • Q   

“Good weather is often bad for farmers' incomes." This follows from the “total revenue test” and demand for many farm products being price inelastic. S1 S2 D P Q P1 P2 Q1 Q2 TR1 = P1  Q1 TR2 = P2  Q2 P  TR

Consider two alternative demand curves for a particular good. Q P Figure 1a Figure 1b Consider two alternative demand curves for a particular good. 10 12 14 1.00 0.80 D1 D2 Figure 2 Q P ED = .8182 ED =1.5 At the point where two demand curves intersect, the flatter demand curve is relatively more elastic with respect to price, as compared to the steeper demand curve.

Cross Elasticity of Demand The cross elasticity of demand measures how sensitive consumer purchases of one product are to a change in the price of some other product.

E x/y = % change in quantity demanded of x/ % change in the price of y The cross elasticity (cross price elasticity) concept allows us to quantify and more fully understand substitute and complementary goods.

substitute goods: if cross elasticity of demand is positive, meaning that sales of x move in the same direction as a change in the price of y, then x and y are substitutes. Example; kodak (x) and fuji film (y). An increase in the price of kodak film causes consumers to buy more fuji film, resulting in a positive cross elasticity. The larger is the positive cross elasticity coefficient, the greater the substitutability between the two products.

Complementary goods: when cross elasticity is negative, we know that x and y “go together or are complements”; an increase in the price of one decreases the demand for the other. Example, an increase in the price of cameras will decrease the amount of film purchased. The larger the negative cross elasticity coefficient, the greater is the complementarity between the two goods.

Independent goods: a zero or near zero cross elasticity suggests that the two products being considered are unrelated or independent goods. An example is nuts and film: we would not expect a change in the price of nuts to have any effect on the purchases of film, and vice versa.

Income Elasticity of Demand Income elasticity of demand measures the degree to which consumers respond to a change in their incomes by buying more or less of a particular good. The coefficient of income elasticity of demand ei is determined with the formula: Ei = % change in quantity demanded/ % change in income

Normal goods: for most goods, the income elasticity coefficient Ei is positive, meaning that more is demanded as incomes rise. Such goods are called normal goods. Inferior goods: a negative income elasticity coefficient designates an inferior good. For example used clothing, used tires are likely candidates. Consumers decrease their purchases of inferior goods as income rises.

Price Elasticity of Supply If producers are relatively responsive to price changes, supply is elastic. If they are relatively insensitive to price changes, supply is inelastic. We measure the degree of price elasticity of supply with the coefficient Es, defined as: Es = % change in quantity supplied of product x / % change in price of product x

Responsiveness of Supply With SA raising the price from P1 to P2 will cause quantity supplied to rise from QA,1 to QA,2. However, with SB demand falls from QB,1 to QB,2. Q P Price P2 SA SB P1 QB,1 QA,2 QA,1 QA,2 Quantity Demanded

Price Elasticity of Supply When Es is greater than 1 supply is elastic. If Es is less than 1 then supply is inelastic and if Es is equal to 1, supply is unit elastic. Es is never negative since price and quantity supplied are directly related.

Price Elasticity of Supply The main determinant of price elasticity of supply is the amount of time producers have for responding to a change in product price. A firm’s response to, say, an increase in the price of christmas trees depends on its ability to shift resources from the production of other goods (whose prices we assume to be constant) to the production of trees.

Price Elasticity of Supply Shifting resources takes time: the longer the time, the greater the resource “shiftability.” so we can expect a greater response and therefore greater elasticity of supply, the longer a firm has to adjust to a price change. In analyzing the impact of time on elasticity, economists distinguish among the immediate market period, the short run and the long run.

Price elasticity of supply The Market Period The market period is the period that occurs when the time immediately after a change in market price is too short for producers to respond with a change in quantity supplied.

Price Elasticity of supply The Short Run In the short run, the plant capacity of individual producers and the entire industry is fixed. Even so, firms do have time to use their plant more or less intensively.

Price Elasticity of supply The Short Run the result is a somewhat greater output in response to a presumed increase in demand; this greater output is reflected in a more elastic supply of tomatoes, as shown by s in the graph below. Note now that the increase in demand from d1 to d2 is met with an increase in quantity (from q0 to qs) so there is a smaller price adjustment (from p0 to ps) than would be the case in the market period. the equilibrium price is therefore lower in the short run than in the market period.

Price Elasticity of Supply The Long Run The long run is the time period long enough for firms to adjust their plant sizes and for new firms to enter (or exit) the industry. In the” tomato industry” for example, our farmer has the time to acquire additional land and buy more machinery and equipment.

Price Elasticity of supply The Short Run Furthermore, other farmers may, over time, be attracted to tomato farming by the increased demand and higher price. such adjustments create a larger supply response, as represented by the more elastic supply curve SL in the graph below. the outcome is a smaller price (Po to Pl) and a larger output increase (Q0 to Ql) in response to the increase in demand from D1 to D2.

There is no total revenue test for elasticity of supply There is no total revenue test for elasticity of supply. Regardless of the degree of elasticity or inelasticity, price and total revenue always move in the same direction.