Chapter 6 Elasticity Both the elasticity coefficient and the total revenue test for measuring price elasticity of demand are presented in this chapter. The text discusses the major determinants of price elasticity. The chapter reviews a number of applications and presents empirical estimates for a variety of products. Cross- and income elasticities of demand and price elasticity of supply are also examined. The Last Word is about how firms use price elasticities to set their price.

Price Elasticity of Demand Measures buyers’ responsiveness to price changes Elastic demand Sensitive to price changes Large change in quantity Inelastic demand Insensitive to price changes Small change in quantity The law of demand tells us that consumers will respond to a price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more. The degree of responsiveness or sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand. If demand is elastic, there is a large change in quantity demanded even when price changes by a small amount. When demand is inelastic, there is a very small change in quantity demanded even when there is a large change in price. LO1

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Price Elasticity of Demand Formula Formula for price elasticity of demand Ed = percentage change in quantity demanded of product X percentage change in price of product X Quantitative measure of elasticity, Ed = percentage change in quantity/ percentage change in price. LO1

Price Elasticity of Demand Formula Use the midpoint formula Ensures consistent results Change in quantity Change in price Ed = ÷ Sum of prices/2 Sum of quantities/2 Using traditional calculations, the measured elasticity over a given range of prices is sensitive to whether one starts at the higher price and goes down, or the lower price and goes up. The midpoint formula calculates the average elasticity over a range of prices to alleviate that problem. LO1

Total Revenue Test P and TR move in the same direction Total Revenue = Price X Quantity Total Revenue Test Inelastic demand P and TR move in the same direction Elastic demand P and TR move in opposite directions The total-revenue test is the easiest way to judge whether demand is elastic or inelastic. This test can be used in place of the elasticity formula, unless there is a need to determine the elasticity coefficient. The total revenue test is important to understand the relationship between price elasticity and total revenue. Demand is inelastic if a decrease in price results in a fall in total revenue, or an increase in price results in a rise in total revenue. Demand is elastic if a decrease in price results in a rise in total revenue, or if an increase in price results in a decline in total revenue. Demand is unit elastic if total revenue does not change when the price changes. LO2

Determinants of Price Elasticity of Demand Substitutability More substitutes, demand is more elastic Proportion of income Higher proportion of income, demand is more elastic With more substitutes available, consumers have more alternative options, so when there is a change in price, there is a greater percentage change in quantity demanded, making the demand more elastic. The broader the definition of the market, the more elastic the demand. With a more narrow definition of the market, demand is more inelastic. The greater the proportion of income needed to buy the good the more elastic the demand. Consumers will be more sensitive to changes in prices because the price change can result in thousands of dollars difference. LO3

Determinants of Price Elasticity of Demand Luxuries versus necessities Luxury goods, demand is more elastic Time More time available, demand is more elastic Since luxuries are goods that consumers can go without, they will change the amount they purchase by a greater amount even if the price changes by a small amount. It takes time to alter the amount being purchased, so the more time available, the more elastic the demand. A person doing their Christmas shopping on Christmas Eve has a very inelastic demand because he/she doesn’t have the time to look around for alternative purchases. LO3

Price Elasticity of Supply Measures sellers’ responsiveness to price changes Elastic supply, producers are responsive to price changes Inelastic supply, producers are not as responsive to price changes At higher prices firms are willing and able to produce more, whereas at lower prices firms are willing and able to produce less. Price elasticity of supply measures how sensitive firms are to price changes. If supply is elastic, small changes in price will result in firms greatly altering the quantity being produced. On the other hand, when supply is inelastic, the firm is unresponsive to price changes and therefore will not change the amount being produced by much, even when the change in price is large. LO4

Price Elasticity of Supply Formula for price elasticity of supply percentage change in quantity supplied of Product X Es = percentage change in price of product X Quantitative measure of elasticity, Ed = percentage change in quantity/ percentage change in price. The concept of price elasticity also applies to supply. We use percentages so it doesn’t matter which unit of measure we are using. The elasticity formula is the same as that for demand, but we substitute the word “supplied” for the word “demanded” everywhere in the formula. Just like with price elasticity of demand, we will compute the price elasticity of supply using the midpoint formula. Elasticity of supply will always be positive since price and quantity supplied move in the same direction. LO4

Price Elasticity of Supply Es > 1 supply is elastic Es = 1 supply is unit elastic Es < 1 supply is inelastic Additionally, Es = 0 supply is perfectly inelastic Elasticity of supply depends on how easily producers can shift resources between alternative uses. LO4

Price Elasticity of Supply Time is primary determinant of elasticity of supply Time periods considered Immediate market period Short run Long run The ease of shifting resources between alternative uses is very important in price elasticity of supply because it will determine how much flexibility a producer has to adjust his/her output to a change in the price. The degree of flexibility, and therefore the time period, will be different in different industries. The immediate market period means that there is no time to adjust output in response to a price change. Some industries may not have an immediate market period if they are able to store their product. The short run means that there is enough time to adjust output by increasing or decreasing the variable inputs but not the fixed inputs. The long run means that there is enough time to adjust output by increasing or decreasing all inputs. LO4

Es: The Immediate Market Period Perfectly inelastic supply P Q Sm Pm There is no time to adjust to a price change, making supply perfectly inelastic. With a perfectly inelastic supply, the increase in demand does not change the quantity at all. P0 D2 D1 Q0 LO4

The Short Run Short run supply is more elastic than in the immediate market period P Q Ss Ps In the short run there is enough time to adjust output by increasing or decreasing the variable inputs but not the fixed inputs. Supply is therefore more elastic than in the immediate market period, thereby resulting in a somewhat greater increase in quantity. P0 D2 D1 Q0 Qs LO4

The Long Run Long run supply is even more elastic than in the short run P Q SL In the long run there is enough time to adjust output by increasing or decreasing all inputs since all inputs are variable by this time. This means that supply will be even more elastic and with the same increase in demand, there is an even greater increase in the quantity than in the short run. In the long run all inputs are variable even the size of the firm; the firm can expand (reduce) the size of the firm in regard to long run price increases (decreases). Pl P0 D2 D1 Q0 Ql LO4

Cross Elasticity of Demand Formula for cross elasticity of demand percentage change in quantity demanded of product X Ex,y = percentage change in price of product Y Consumption of a good can also be affected by a change in the price of a related good. Cross elasticity of demand will provide a way to quantify the degree of the change in consumption. LO5

Cross Elasticity of Demand Measures responsiveness of purchases of one good to change in the price of another good Substitute goods if elasticity is positive Complement goods if elasticity is negative Independent goods if elasticity is 0 Cross elasticity of demand refers to the effect of a change in a product’s price on the quantity demanded for another product. If the goods are substitutes, they will have a positive cross elasticity of demand since the change in the price of one good and the change in the demand for its substitute move in the same direction. If the goods are complements, they will have a negative cross elasticity of demand since the change in the price of one good and the demand for its complement move in opposite directions. If the goods are unrelated they will exhibit a cross elasticity of zero. LO5

Income Elasticity of Demand Formula for income elasticity of demand percentage change in quantity demanded Ei = percentage change in income Consumption of a good can also be affected by a change in income. Income elasticity of demand is a measurement that reflects the percentage change in quantity demanded due to some percentage change in consumer income. LO5

Income Elasticity of Demand Measures responsiveness of buyers to changes in their income Normal goods if elasticity is positive Inferior goods if elasticity is negative Most goods are normal goods that have a positive income elasticity but the value of elasticity of income can vary widely among these goods. Consumers decrease their purchases of inferior goods when their income rises. Those industries that are income elastic will expand at a higher rate as the economy grows. LO5

Income Elasticity Insights High income elasticities Most affected by a recession Low or negative income elasticity Not affected that much by a recession Income elasticity helps us understand which products and industries will be most affected when household incomes fall during economic downturns. LO5