Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 1 ECON Designed by Amy McGuire, B-books, Ltd. McEachern CHAPTER Elasticity of Demand and Supply Micro

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 2 Price Elasticity of Demand LO 1  Elasticity –Responsiveness  Price elasticity of demand –Consumers’ responsiveness to a change in price –Percentage change in quantity demanded divided by percentage change in price

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 3 Price Elasticity of Demand LO 1  Law of demand  E D negative  Absolute value of E D positive

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 4 Exhibit 1 LO 1 Demand Curve for Tacos D Thousands per day Price per taco $1.10 b a If the price of tacos drops from $1.10 to $0.90, the quantity demanded increases from 95,000 to 105,000.

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 5 Categories of E D LO 1  If %∆q < %∆p –E D between 0 and 1 –Inelastic D  If %∆q > %∆p –E D greater than 1 –Elastic D  If %∆q = %∆p –E D = 1 –Unit elastic D

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 6 Elasticity and Total Revenue LO 1  Total revenue = price * quantity demanded at this price  TR= p * q  As p decreases  If D elastic, TR increases  If D inelastic, TR decreases  If D unit elastic, TR constant

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 7 Price Elasticity and the Linear D Curve LO 1  Linear D curve –Constant slope –Different elasticity –D becomes less elastic as we move downward  D upper half: elastic  D lower half: inelastic  D midpoint: unit elastic

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 8 Exhibit 2 LO 1 Demand, Price Elasticity, and Total Revenue Where D is elastic, a lower P increases TR Where D is inelastic, a lower P decreases TR TR reaches a maximum at the rate of output where D is unit elastic

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 9 Constant Elasticity Demand Curves LO 1  Perfectly elastic D curve –Horizontal; E D = ∞ –Consumers don’t tolerate P increases  Perfectly inelastic D curve –Vertical; E D = 0 –‘Price is no object’  Unit-elastic D curve –%∆p causes an exact opposite %∆q

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 10 Exhibit 3 LO 1 Constant-Elasticity Demand Curves 0 Quantity per period Price per unit p E D = ∞ (a) Perfectly elastic D Price per unit E D’ = 0 (b) Perfectly inelastic E D’’ = 1 (c) Unit elastic D’ 0 Quantity per period Q Price per unit $ Quantity per period D’’ a Consumers demand all quantity offered for sale at p, but demand nothing at a price above p Consumers demand Q regardless of price Total revenue is the same for each p-q combination b

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 11 Exhibit 4 LO 1 Summary of Price Elasticity of Demand

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 12 Determinants of Price Elasticity of D LO 2  E D is greater: –The greater the availability of substitutes, and the more similar the substitutes –The more important the good as a share of the consumer’s budget –The longer the period of adjustment (time)

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 13 Exhibit 5 LO 2 Demand Becomes More Elastic over Time DwDw Price per unit $ DmDm Quantity per day DyDy e D y is more elastic than D m, which is more elastic than D w D w : one week after the price increase D m : one month after the price increase D y : one year after the price increase

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 14 Elasticity Estimates LO 2  Short run –Consumers have little time to adjust  Long run –Consumers can fully adjust to a price change  Demand is more elastic in the long run

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 15 Exhibit 6 LO 2 Selected Price Elasticities of Demand (Absolute Values)

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 16 LO 2 Case Study Deterring Young Smokers  Health hazard  Kills 440,000 Americans a year  Lung cancer; Heart disease; Emphysema; Stroke  Cost to society  $7.18 per pack sold  Higher health cost  Lost worker productivity  Total: $150 billion a year  $3,400 per smoker per year

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 17 LO 2 Case Study Deterring Young Smokers  Discouraging smoking  Prohibit the sale of cigarettes to minors  Higher cigarette tax  E D is higher for teens  Big share of budget  Less peer pressure  Not an addiction yet  Reduces teen smoking  Change consumer tastes

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 18 Price Elasticity of Supply LO 3  Elasticity –Responsiveness  Price elasticity of supply –Producers’ responsiveness to a change in price –Percentage change in quantity supplied divided by percentage change in price

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 19 Price Elasticity of Supply LO 3  Law of supply  E S positive

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 20 Exhibit 7 LO 3 Price Elasticity of Supply S Price per unit p p’ Quantity per periodqq’0 If the price increases from p to p’, the quantity supplied increases from q to q’. Price and quantity supplied move in the same direction, so the price elasticity of supply is a positive number.

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 21 Categories of E S LO 3  If %∆q < %∆p –E S between 0 and 1 –Inelastic S  If %∆q > %∆p –E S greater than 1 –Elastic S  If %∆q = %∆p –E S = 1 –Unit elastic S

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 22 Constant Elasticity Supply Curves LO 3  Perfectly elastic S curve –Horizontal; E S = ∞ –Producers supply 0 at a price below P  Perfectly inelastic S curve –Vertical; E S = 0 –Goods in fixed supply  Unit-elastic S curve – %∆p causes an exact opposite %∆q –S curve is a ray from the origin

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 23 Exhibit 8 LO 3 Constant-Elasticity Supply Curves 0 Quantity per period Price per unit p E S = ∞ (a) Perfectly elastic S Price per unit E S’ = 0 (b) Perfectly inelastic E S’’ = 1 (c) Unit elastic S’ 0 Quantity per period Q Price per unit $ Quantity per period 1020 S’’ Firms supply any amount of output demanded at p, but supply 0 at prices below p. Quantity supplied is independent of the price Any %∆p results in the same %∆q supplied.

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 24 Determinants of Supply Elasticity LO 3  E S is greater: –If the marginal cost rises slowly as output expands –The longer the period of adjustment (time)

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 25 Exhibit 9 LO 3 Supply Becomes More Elastic over Time SwSw Price per unit 1.00 $1.25 Quantity per day SmSm SySy S w : one week after the price increase S m : one month after the price increase S y : one year after the price increase S w is less elastic than S m, which is less elastic than S y

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 26 Income Elasticity of Demand LO 4  Demand responsiveness to a change in consumer income  Percentage change in demand divided by the percentage change in income that caused it  Inferior goods –Negative income elasticity  Normal goods –Positive income elasticity

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 27 Income Elasticity of Demand LO 4  Normal goods –Income inelastic Elasticity between 0 and 1 Necessities –Income elastic Elasticity > 1 Luxuries

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 28 Exhibit 10 LO 4 Selected Income Elasticities of Demand

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 29 LO 4 Case Study The Market for Food and ‘The Farm Problem’  1950: 10 million family farms  Today: less than 3 million  Demand  Price inelastic  Total revenue falls when P falls  Income inelastic  D increases  Technological improvements  S increases

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 30 The Demand for Grain LO 4 D 51011Billions of bushels per year0 Price per bushel $ The D for grain tends to be inelastic. As the market P falls, so does TR.

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 31 Exhibit 11 LO 4 The Effect on Increases in Demand and Supply on Farm Revenue S’ D’ D 51014Billions of bushels per year0 Price per bushel $8 4S Technological advance - sharp increase in S Increase in consumer income - small increase in D Drop in P Drop in total revenue

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 32 Cross-Price Elasticity of Demand LO 4  Responsiveness of D for one good to changes in P of another good  %∆ in demand for one good divided by %∆ in price of another good –If positive: substitutes –If negative: complements –If zero: unrelated

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 33 Price Elasticity and Tax Incidence Appendix  Tax –Decrease in S by the amount of tax  Tax incidence –Consumers: high P –Producers: net-of-tax receipt

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 34 Price Elasticity and Tax Incidence Appendix  The more price elastic the D: –The more tax producers pay –The less tax consumers pay  The more elastic the S: –The less tax producers pay –The more tax consumers pay

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 35 Effects of Price Elasticity of D on Tax Incidence StSt S D’ StSt S D $0.20 Tax Price per ounce $ Millions of ounces per day10 90 $0.20 Tax 107 Price per ounce $ (a) Less elastic demand(b) More elastic demand The more elastic the D curve, the more tax is paid by producers (lower net-of-tax receipt) Exhibit A

Chapter 5Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 36 Effects of Price Elasticity of Supply on Tax Incidence St’St’ S’ D’’ $0.20 Tax Price per ounce $ (a) More elastic supply St”St” S” D’’ $0.20 Tax 109 Price per ounce $ (b) Less elastic supply Millions of ounces per day 1080 The more elastic the S curve, the more tax is paid by consumers as a higher price. Exhibit B