Lecture 4 Working with Supply and Demand: Elasticities

Elasticity: A measure of responsiveness of economic actors to changes in conditions Price elasticity of demand: What happens to the quantity demanded when the price of a good changes? What happens to the revenue?

Question: How will the firm best set the price for its product? The firm may try to test two different prices at two different locations with similar tastes and income levels Location A: P=5; Q=5 Location B: P=8; Q=4 The firm can then look at price elasticity of demand in order to find out how a price change affects its revenues.

Price inelastic demand Demand for a good is price inelastic if the effect of a price change on the quantity demanded is rather small In this case, revenues to the seller move in the same direction as the price Three reasons why demand might be inelastic: –There are few good, close substitutes for the good or service. –The good or service is something that people feel they need, rather than just want. –The good or service is a very small part of a buyer’s budget.

Price elastic demand The demand for a good is price elastic if the effect of a price change on the quantity demanded is rather large In this case, revenues to the seller move inversely with price. Three reasons why demand may be elastic: –There are a number of good, close substitutes for the good –The good is merely wanted, rather than needed –The good makes up a large part of the budget of the buyer

Elasticity and slope When you compare movements along demand curves that go through a specific point on graphs with the same scale: –The flatter curve represents the relatively more elastic demand –The steeper curve represents the relatively less elastic demand Note that: The curves that you are comparing must be on the same scale and go through one common point!

Elasticity and slope

BUT: Elasticity is not just the same thing as slope! A relatively elastic demand curve can be made to look «steep» just by changing the scale of the graph!!

Elasticity and Slope Elasticity is not just the same thing as slope! Elasticity varies at different points along a straight-line curve.

2 extreme cases Perfectly inelastic demand curve: A demand curve that is vertical, i.e. quantity demanded does not respond at all to price Perfectly elastic demand curve: A demand curve that is horizontal, i.e. quantity demanded is extremely sensitive to price Price-taker: a seller that faces perfectly elastic demand for its good

Elasticity and change in revenue

Price elasticity of supply The more inelastic the supply curve is, the more the buyer will have to push up the price to make suppliers respond, and the more she will end up paying.

Income elasticity of demand

Income elasticity of demand

Cross-price elasticity of demand

Income and substitution effects of a price change Price changes have two effects: –income effect (IE): the tendency of a price increase to reduce the quantity demanded of normal goods and to increase the quantity demanded of any inferior goods –substitution effect (SE): the tendency of a price increase for a particular good to reduce the quantity demanded of that good, as buyers turn to cheaper substitutes

Income and substitution effects of a price change These two effects act together when there is a price change: –If the good is normal and its price rises, both IE and SE will tend to lead to a reduction in the quantity demanded of the good. – If the good is inferior and its price rises, the IE will increase quantity demanded, at the same time, SE decreases the quantity demanded. In general, SE is stronger than IE for inferior goods, i.e., quantity demanded will fall. [The exception is the case of Giffen goods: as price rises, quantity demanded rises for Giffen goods]

Short-run vs. long-run elasticities Short-run elasticity: A measure of the relatively immediate responsiveness to a price change Long-run elasticity: A measure of the response to a price change after economic actors have had time to make adjustments