1 Elasticity of Demand and Supply CHERYL CARLETON ASHER Villanova University Chapter 5 © 2006 Thomson/South-Western

2 ELASTICITY We know that various factors cause the Demand and Supply curves to shift We know that if P falls, the Q D and the Q S respond BUT, the AMOUNT OF THE RESPONSE isn’t always the same! Examples: P cars, P milk, P electricity SO, want to say something about the degree of responsiveness

3 Price Elasticity of Demand  Price elasticity of demand measures how responsive consumers are to price change; elasticity is another word for responsiveness  Price elasticity of demand = Percentage change in quantity demanded / Percentage change in price

4 Exhibit 1: Demand Curve for Tacos  For the price elasticity to be a useful measure, we should come up with the same result between points a and b as we get between b and a.  To do this we must take the average of the initial price and the new price and use that as the base in computing the percent change in price Price elasticity between a and b = 10% / - 20% = b Thousands per day D $1.10 a Price

5 Price Elasticity of Demand  Generalize the price elasticity formula

6 Price Elasticity of Demand  Because the average quantity and average price are used as a base for computing percent change, the same elasticity results whether going from the higher price to the lower price or the other way around  Since the focus is on the percent change, we need not be concerned with how output or price is measured

7 Price Elasticity of Demand  Because price and quantity demanded are inversely related, the price elasticity of demand has a negative sign  This tends to be cumbersome, thus it is commonplace to discuss the price elasticity of demand as an absolute value  positive number  For example, absolute value of the elasticity for tacos computed earlier will be referred to as 0.5 rather than –0.5

8 PRICE ELASTICITY OF DEMAND Let’s look at some examples: MINK COATS: PriceQuantity demanded $ Reduce price form $500 to $300 What happens to demand? What about the percentage change in P and Q? What about total revenue?

9 PRICE ELASTICITY OF DEMAND ANOTHER EXAMPLE: MILK PriceQuantity Demanded $ Reduce price from $5 to $3. What happens to demand? What happens to percentage change in P and percentage change in q? What happens to total revenue?

10 PRICE ELASTICITY OF DEMAND PIZZA PRICEQUANTITY DEMANDED $ ½ Reduce price from $5 to $3. What happens to quantity demanded? What happens to percentage change in P and Q? What happens to total revenue?

11 Categories of Price Elasticity  Three general categories  Percent change in quantity demanded is smaller than the percent change in price, the price elasticity has an absolute value between 0 and 1.0  demand is inelastic  quantity demanded is relatively unresponsive to a change in price  Percent change in quantity demanded just equals the percent change in price  a price elasticity with an absolute value of 1.0  unit-elastic demand  Percent change in quantity demanded exceeds the percent change in price, the price elasticity has an absolute value exceeding 1.0  demand is said to be elastic  quantity is responsive to changes in price

12 Elasticity and Total Revenue  Total revenue (TR) is the price (p) multiplied by the quantity demanded (q) at that price  TR = p x q  What happens to total revenue when price decreases?  Lower price  producers get less for each unit sold  total revenue declines  Lower price  increases quantity demanded  total revenue increases  Overall impact of lower price on total revenue depends on the net result of these opposite effects

13 Elasticity and Total Revenue  When demand is elastic, the percent increase in quantity demanded exceeds the percent decrease in price  total revenue increases  When demand is unit elastic, the two are equal  total revenue remains unchanged  When demand is inelastic, the percent increase in quantity demanded is more than offset by the percent decrease in price  total revenue decreases

14 Exhibit 2: Demand, Price Elasticity and Total Revenue

15 (a) Demand and Price Elasticity Exhibit 2: Demand, Price Elasticity and Total Revenue  Panel (a) shows the linear demand curve and panel (b) shows the total revenue generated by each price-quantity combination along the demand curve  Because the demand curve is linear, its slope is constant: a given decrease in price always causes the same unit increase in price  However, the price elasticity of demand is larger on the high end of the demand curve than it is on the low price end $ D 0 Quantity per period ,000 $25,000 T o t a l r e v e n u e 0 Total revenue (b) Total Revenue TR = p x q Price per unit Quantity per period 1,000500

16 (a) Demand and Price Elasticity $ e d c b a D 0 Quantity per period ,000 Price per unit  Consider a movement from point a to point b on the demand curve. The 100-unit increase in quantity demanded is a percent change of 100/150 = 0.67% while the $10 drop in price is a percent change of 10/85 = 12%  the price elasticity of demand here is 5.6  Between points d and e, the 100 quantity increase is a 12% change and the $10 price decrease is a 67% price decrease  price elasticity of 0.2 Exhibit 2: Demand, Price Elasticity and Total Revenue

17 (a) Demand and Price Elasticity $ e d c b a D Inelastic E D < 1 Unit elastic E D = 1 Elastic E D > 1 0 Quantity per period ,000 $25,000 T o t a l r e v e n u e 0 Total revenue (b) Total Revenue TR = p x q Price per unit Quantity per period 1,  When demand is elastic, a decrease in price (from a to b) will increase total revenue because the gain in revenue from selling more units (blue box) exceeds the loss in revenue from selling all units at a lower price (red box)  When demand is elastic, a price decrease (from d to e) reduces total revenue because the gain in revenue from selling more units (blue box) is less than the loss in revenue at the lower price (red box) Exhibit 2: Demand, Price Elasticity and Total Revenue

18 Exhibit 3: Constant Elasticity Demand Curves P r i c e p e r u n i t P r i c e p e r u n i t P r i c e p e r u n i t p 0Quantity per period Quantity per period Quantity per period E = D  (a) Perfectly elastic demand curve $ E = D 1 (c) Unit elastic demand curve D 0 E = D 0 (b) Perfectly inelastic demand curve D' Q D" a b This demand curve indicates consumers will demand all that is offered at the given price, p. If the price rises above p, quantity demanded drops to zero. This demand curve indicates that quantity demanded does not vary when the price changes; no matter how high the price, consumers will purchase the same quantity. This demand curve is unit-elastic everywhere: any percent change in price results in an identical offsetting percent change in quantity demanded.

19 Availability of Substitutes  The greater the availability of substitutes for a good and the closer the substitutes, the greater the good’s price elasticity of demand  The number and similarity of substitutes depend on how we define the good  the more broadly we define a good, the fewer the substitutes and the less elastic the demand

20 Proportion of Consumer’s Budget  Because spending on some goods represents a large share of the consumer’s budget, a change in the price of such a good has a substantial impact on the amount consumers are able to purchase  Generally, the more important the item is as a share of the consumer’s budget, other things constant, the greater will be the income effect of a change in price, the more price elastic will be the demand for the item

21 Exhibit 5: Demand Becomes More Elastic over Time $1.25  Suppose the price increases from the initial price of $1.00 to $1.25.  D w shows that one week after the price increase, the quantity demanded has not changed much, from 100 to 95  After one month, D m, it has declined to 75, and after one year, D y, to 50  The longer the time period the larger the response to a given price change Quantity per period DwDw DmDm DyDy Price per unit

22 Price Elasticity of Supply  The price elasticity of supply measures how responsive producers are to a price change  Equals the percent change in quantity supplied divided by the percent change in price  Since the higher price usually results in an increased quantity supplied, the percent change in price and the percent change in quantity supplied move in the same direction  the price elasticity of supply is usually a positive number

23 Exhibit 7: Price Elasticity of Supply

24 Exhibit 7: Price Elasticity of Supply  If the price increases from p to p', the quantity supplied increases from q to q‘  The price elasticity of E s is  Where  q is the change in quantity supplied and  p is the change in price.

25 SUPPLY ELASTICITY Example: Supply schedule for chocolate chip cookies PriceQuantity Supplied $ Calculate the supply elasticity for a price change from $2.50 to $2.00

26 Categories of Supply Elasticity  The terminology for supply elasticity is the same as for demand elasticity  If supply elasticity is less than 1.0, supply is inelastic  If it equals 1.0, supply is unit elastic  If it exceeds 1.0, supply is elastic  Exhibit 8 illustrates some special cases of supply elasticity to consider

27 Exhibit 8: Constant-Elasticity Supply Curves P r i c e p e r u n i t P r i c e p e r u n i t P r i c e p e r u n i t p 0 E = S  (a) Perfectly elastic $ E = S 1 (c) Unit elastic S 0 E = S 0 (b) Perfectly inelastic S' Q S" Quantity per period Quantity per period At one extreme is the horizontal supply curve. Here producers will supply none of the good at a price below p, but will supply any amount at a price of p The most unresponsive relationship is where there is no change in the quantity supplied regardless of the price where the supply curve is perfectly vertical. Any supply curve that is a straight line from the origin such as shown above is a unit-elastic supply curve.

28 Determinants  The responsiveness of sellers depends on how easy it is to alter output when price changes  If the cost of supplying additional units rises sharply as output expands, then a higher price will elicit little increase in quantity supplied  But if the marginal cost rises slowly as output expands, the lure of a higher price will prompt a large increase in output

29 Length of Time  Supply also becomes more elastic over time as producers adjust to price changes  The longer the time period under consideration, the more able producers are to adjust to changes in relative prices

30 Exhibit 9: Supply Becomes More Elastic over Time 1.00  S w is the supply curve when the period of adjustment is a week.  S m is the supply curve when the adjustment period is one month; supply more elastic and quantity supplied increases to 140  After one year the supply curve becomes S y and the quantity supplied increases to Quantity per period SwSw SmSm SySy $1.25 Price

31 Income Elasticity of Demand  Measures how responsive demand is to a change in income  Equals the percent change in demand divided by the percent change in income  Categories  Goods with income elasticities less than zero are called inferior goods  demand declines when income increases

32 Income Elasticity of Demand  Normal goods have income elasticities greater than zero  demand increases when income increases  Normal goods with income elasticities greater than zero but less than 1 are called income inelastic goods  demand increases but not as much as does income. They are also called necessities  Goods with income elasticity greater than 1 are called income elastic  demand not only increases when income increases but increases by more than does income. They are also called luxuries.

33 INCOME ELASTICITY OF DEMAND Problem: If a boom raises national income from $4.0 trillion to $4.4 trillion, and macademia nut sales jump from 3 to 5 million pounds annually, what is the income elasticity of demand for nuts? Are they a necessity or a luxury? EXPLAIN Are they normal or inferior? EXPLAIN Is demand elastic or inelastic? EXPLAIN.

34 Exhibit 11: The Demand for Grain

35 Exhibit 12: Effect of Increases in Supply and Demand on Farm Revenue $8 Billions of bushels per year D S D'D' S'S' 10  Over time, technological advances in farming have sharply increased the supply of grain  In addition, increases in household income over time have increased the demand for farm products  But because increases in the supply of grain have exceeded increases in demand, the combined effect has been a drop in the market price and a fall in total farm revenue Price per bushel

36 Cross-Price Elasticity of Demand  Since firms often produce an entire line of products, it has a special interest in how a change in the price of one product will affect the demand for another  The responsiveness of the demand for one good to changes in the price of another good is called the cross-price elasticity of demand

37 Cross-Price Elasticity of Demand  Defined as the percent change in the demand of one good divided by the percent change in the price of another good  If an increase in the price of one good leads to an increase in the demand for another good, their cross-price elasticity is positive  the two goods are substitutes  If an increase in the price of one good leads to a decrease in the demand for another, their cross- price elasticity is negative  the two goods are complements

38 TAX INCIDENCE We can use the concept of elasticity and shifting S and D curves to examine the issue of TAX INCIDENCE TAX INCIDENCE is the question of who actually bears the economic burden of a tax, as opposed to who has the legal obligation to make tax payments Do an example with a tax on a good