Demand and Supply Elasticity Chapter 21 Demand and Supply Elasticity

Calculating Elasticity Elasticity formula: Change in Q Sum of quantities/2 Ep = Change in P or in Q (Q1 + Q2)/2 Ep = in P (P1 + P2)/2

No Calculators on the exam

Did You Know That... A 10% reduction in the price of beer is associated with an increase in the incidence of campus violence of just over 3.5%? Consumers respond to changing prices in ways that influence total revenues that businesses receive? Economists have a special name for quantity responsiveness—elasticity, which is the subject of this chapter?

Price Elasticity Price Elasticity of Demand (Ep) The responsiveness of quantity demanded of a commodity to changes in its price Defined as the percentage change in quantity demanded divided by the percentage change in price

Price Elasticity (cont'd) Relative quantities only Elasticity is measuring the change in quantity relative to the change in price. Always negative An increase in price decreases the quantity demanded, ceteris paribus.

Example: The Price Elasticity of Demand for Gasoline After Hurricane Katrina in 2005 the nationwide price of gasoline rose from $2.61 to $3.07. The total quantity of gasoline consumed in the United States declined from 9.42 to 9.04 million barrels. What is the price elasticity of demand?

Example: The Price Elasticity of Demand for Gasoline (cont'd) Use the elasticity formula: 9.42 – 9.04 ÷ $3.07 – $2.61 (9.42 + 9.04)/2 ($3.07 +$2.61)/2 The price elasticity of 0.25 means that a 1% increase in price generated a 0.25% decrease in the quantity of gasoline demanded.

What Is Elasticity of Demand? Elasticity of demand is a measure of how consumers react to a change in price. Demand for a good that consumers will continue to buy despite a price increase is inelastic. Demand for a good that is very sensitive to changes in price is elastic. Chapter 4, Section 3

Price Elasticity Ranges (cont'd) Extreme elasticities Perfectly Inelastic Demand A demand curve that is a vertical line It has only one quantity demanded for each price. No matter what the price, quantity demanded does not change. A demand that exhibits zero responsiveness to price changes.

Figure 21-1 Extreme Price Elasticities, Panel (a)

Price Elasticity Ranges (cont'd) Extreme elasticities Perfectly Elastic Demand A demand curve that is a horizontal line It has only one price for every quantity. The slightest increase in price leads to zero quantity demanded.

Figure 21-1 Extreme Price Elasticities, Panel (b)

Policy Example: Who Pays Higher Cigarette Taxes? State governments impose cigarette taxes, which are assessed as an amount per pack sold. These taxes are paid by sellers of cigarettes from the revenues they earn from their total sales. To receive the same price per quantity the seller would need a price higher by the tax amount.

Figure 21-2 Price Elasticity and a Cigarette Tax, Panels (a) and (b)

Figure 21-2 Price Elasticity and a Cigarette Tax, Panel (c)

Elasticity and Total Revenues When demand is elastic, a negative relationship exists between changes in price and changes in total revenues. When demand is inelastic, a positive relationship exists between changes in price and total revenues.

Elasticity and Total Revenues (cont'd) Elasticity-revenue relationship Total revenues are the product of price times units sold. The law of demand states along a given curve, price is inverse to quantity.

Elasticity and Total Revenues (cont'd) Price elasticity of demand is designed to measure responsiveness of quantity demanded to a change in price.

Determinants of Price Elasticity of Demand Factors that determine price elasticity of demand Availability of substitutes Percentage of a person’s budget spent on the good The length of time allowed for adjustment to a price change

Determinants of Price Elasticity of Demand Existence of substitutes The closer the substitutes and the more substitutes there are, the more elastic is demand. Share of the budget The greater the share of the consumer’s total budget spent on a good, the greater is the price elasticity.

Determinants of Price Elasticity of Demand (cont'd) The length of time allowed for adjustment The longer any price change persists, the greater is the elasticity of demand. Price elasticity is greater in the long run than in the short run.

Determinants of Price Elasticity of Demand (cont'd) How to define the short run and the long run The short run is a time period too short for consumers to fully adjust to a price change. The long run is a time period long enough for consumers to fully adjust to a change in price, other things constant.

Figure 21-4 Short-Run and Long-Run Price Elasticity of Demand With more time for adjustment the demand curve becomes more elastic and quantity demanded falls by a greater amount In the short run, quantity demanded falls slightly

Price Elasticity of Supply Price Elasticity of Supply (Es) The responsiveness of the quantity supplied of a commodity to a change in its price The percentage change in quantity supplied divided by the percentage change in price

Price Elasticity of Supply (cont'd) Price elasticity of supply and length of time for adjustment The longer the time allowed for adjustment, the more resources can flow into (out of) an industry through expansion (contraction) of existing firms. The longer the time allowed for adjustment, the entry (exit) of firms increases (decreases) production in an industry.