Chapter 4 Elasticities of Demand and Supply ©McGraw-Hill Companies, 2010

The price elasticity of demand Measures the sensitivity of the quantity demanded of a good to a change in its price It is defined as: % change in quantity demanded % change in price See Section 4-1 in the main text. ©McGraw-Hill Companies, 2010 2

©McGraw-Hill Companies, 2010 Elastic demand Demand is ELASTIC when the price elasticity (ignoring the negative sign) is greater than -1 i.e., when the % change in quantity demanded exceeds the change in price e.g., if quantity demanded falls by 7% in response to a 5% increase in price elasticity is -7  5 = -1.4 See Section 4-1 in the main text. ©McGraw-Hill Companies, 2010 3

©McGraw-Hill Companies, 2010 Inelastic demand Demand is INELASTIC when the price elasticity lies between -1 and 0 i.e., when the % change in quantity demanded is smaller than the change in price e.g., if quantity demanded falls by 3.5% in response to a 5% increase in price elasticity is -3.5  5 = - 0.7 See Section 4-1 in the main text. ©McGraw-Hill Companies, 2010 4

©McGraw-Hill Companies, 2010 Unit elastic demand Demand is UNIT ELASTIC when the price elasticity is exactly -1 i.e., when the % change in quantity demanded is equal to the change in price e.g., if quantity demanded falls by 5% in response to a 5% increase in price elasticity is -5  5 = -1 See Section 4-1 in the main text. ©McGraw-Hill Companies, 2010 5

Price elasticity for a linear demand curve The price elasticity varies along the length of a straight-line demand curve. D Unit elasticity Elastic Inelastic Quantity Price  ©McGraw-Hill Companies, 2010 6

What determines the price elasticity? The ease with which consumers can substitute another good. EXAMPLE: Consumers can readily substitute one brand of detergent for another if the price rises, so we expect demand to be elastic, but if all detergent prices rise, the consumer cannot switch, so we expect demand to be inelastic. In general, the more narrowly we define a commodity, the easier it is to find a substitute, so the larger will be the price elasticity. See Section 4-1 in the main text. ©McGraw-Hill Companies, 2010 7

Elasticity is higher in the long run In the short run, consumers may not be able (or ready) to adjust their pattern of expenditure. If price changes persist, consumers are more likely to adjust. Demand thus tends to be more elastic in the long run but relatively inelastic in the short run. See Section 4-4 in the main text. ©McGraw-Hill Companies, 2010 8

Elasticity and revenue When price is changed, the impact on a firm’s total revenue (TR) will depend upon the price elasticity of demand. Demand is elastic Demand is unit elastic Demand is inelastic For a price increase TR decreases TR does not change TR increases For a price decrease TR increases TR does not change TR decreases See Section 4-2 in the main text, and Figure 4-4. ©McGraw-Hill Companies, 2010 9

Elasticity and price reductions Unit elasticity Elastic Inelastic Quantity Price  For a price fall: if demand is elastic, revenue from new sales will exceed the fall in revenue from existing sales - total revenue will rise. Quantity Total Revenue (+)TR< (-)TR See section 4-2 and Figure 4-4 in the main text. If demand is inelastic, revenue from new sales will be less than the fall in revenue from existing sales - total revenue will fall. ©McGraw-Hill Companies, 2010 10

Elasticity and tube fares How should tube fares be changed to increase revenues? Passengers can use buses, taxis, cars etc so demand may be elastic (e.g., -1.4) and an increase in fares will reduce the number of journeys demanded and total spending If passengers do not have travel options demand may be inelastic (e.g. -0.7) so raising fares will have less effect on journeys demanded and revenue will improve ©McGraw-Hill Companies, 2010 11

The cross price elasticity of demand The cross price elasticity of demand for good i with respect to the price of good j is: % change in quantity demanded of good i % change in the price of good j This may be positive or negative The cross price elasticity tends to be negative if two goods are substitutes: e.g., tea and coffee The cross price elasticity tends to be positive if two goods are complements e.g., tea and milk. See Section 4-5 in the main text. ©McGraw-Hill Companies, 2010 12

Price elasticities in the UK with respect to a 1% price change in: Percentage change in the quantity demanded of Food Clothing Transport 0.1 Food –0.4 –0.5 See Section 4-5 in the main text, and Table 4-6. The animation holds back the own-price elasticities. Clothing and footwear 0.1 –0.1 Travel and communications 0.3 –0.1 ©McGraw-Hill Companies, 2010 13

The income elasticity of demand The income elasticity of demand measures The sensitivity of quantity demanded to a Change in income: % change in quantity demanded of a good % change in consumer income See Section 4-6 in the main text. The income elasticity may be positive or negative. ©McGraw-Hill Companies, 2010 14

Normal and inferior goods A NORMAL GOOD has a positive income elasticity of demand an increase in income leads to an increase in the quantity demanded e.g., dairy produce An INFERIOR GOOD has a negative income elasticity of demand an increase in income leads to a fall in quantity demanded e.g., coal A LUXURY GOOD has an income elasticity of demand greater than 1 e.g., wine See Section 4-6 in the main text. ©McGraw-Hill Companies, 2010 15

Income and the demand curve For an increase in income: Quantity Price D0 NORMAL GOOD INFERIOR GOOD D1 Demand curve moves to the right D1 Demand curve moves to the left See Section 4-6 in the main text, and Figure 4-5. ©McGraw-Hill Companies, 2010 16

UK income elasticities Broad categories Narrower categories Tobacco 0.5 Coal 2.0 Fuel 0.3 Bread & cereals 0.1 Food 0.5 Margarine -0.37 Alcohol 1.1 Liquid wholemilk -0.17 Clothing 1.2 Vegetables 0.9 Durables 1.5 Leisure goods 2.0 Services 1.8 Wines and spirits 2.6 See Section 4-6 in the main text. ©McGraw-Hill Companies, 2010 17

UK income elasticities Broad categories Narrower categories Tobacco 0.5 Fuel 0.3 Food 0.5 Alcohol 1.1 Clothing 1.2 Durables 1.5 Services 1.8 Margarine -0.37 Liquid Wholemilk -0.17 Bread & cereals 0.1 Vegetables 0.9 Coal 2.0 Leisure goods 2.0 Wines & spirits 2.6 ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Summary % change in quantity supplied % change in quantity demanded Induced by: (Own-) price elasticity 1% rise in own price of demand Cross price elasticity 1% rise in price of of demand a related good Income elasticity of 1% rise in income Demand Elasticity of supply 1% rise in own price ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Some maths Price elasticity of supply: This measures the elasticity of supply between two different points on a given supply function. The point elasticity of supply is defined as: Where measures the slope of the supply function in a given point. For example if QS =2 + 5P If P=10 then QS =52; = 5 the point elasticity is 5 x 10/52 = 0.96 ©McGraw-Hill Companies, 2010