Elasticity and Demand and Supply Applications

Review: –Changes in quantity demand and supplied or movements along the curves –Changes in demand and supply or shifts of the curve Comparative Statics –Changes in demand Increase in demand: price increases, quantity increases Decrease in demand: price decreases, quantity decreases –Changes in supply Increase in supply: price decreases, quantity increases Decrease in supply: price increases, quantity decreases

–Changes in both Increase in Demand Decrease in Demand Increase in Supply P ambiguous Q increases P decreases Q ambiguous Decrease in Supply P increases Q ambiguous P ambiguous Q decreases

Dynamics Shifts in demand or supply create surpluses or shortages Surpluses cause price to fall and shortages cause price to rise Increases in prices cause quantity demanded to decrease (law of demand) and quantity supplied to increase (law of supply) Decreases in prices cause quantity demanded to increase (law of demand) and quantity supplied to decrease (law of supply) These price changes occur until surpluses or shortages are eliminated at the new equilibrium price and quantity

Using Demand and Supply Step 1: Determine if the change in the determinant affects the demand or supply curve. Step 2: Determine which way it shifts the curve Step 3: Determine how the equilibrium price and quantity change (dynamic adjustment)

Elasticity: Responsiveness versus Directions Demand and Supply analysis allows us to see the direction of changes in the equilibrium price and quantity We need another concept to see how responsive demand and supply are to change in their determinants The concept that helps us measure that sensitivity is elasticity

Price Elasticity of Demand The concept of elasticity helps understand how responsive demand is to price changes Intuitively, if we are a businessperson and we want to increase revenues, one important question is whether we increase price or decrease price Increases in price decreases the quantity demanded, but we get more for each unit we sell Decreases in price increases the quantity demanded, but we get less for each unit we sell How can we tell whether the price or the quantity effect wins out to increase our revenues The answer is the concept of elasticity

Definition of Elasticity Price elasticity of demand = %change in quantity demanded/ % change in price Or using symbols: E p = %ΔQ d /%ΔP For example, if the %ΔQ d = 10% and the %ΔP = 2%, the price elasticity of demand = 5, OR for every 1% change in price the quantity demand changes by 5%.

E p > 1 Responsive or elastic –%ΔQ d > %ΔP E p < 1 Not responsive or inelastic –%ΔQ d < %ΔP E p = 1 unit elastic –%ΔQ d = %ΔP

BUT I Hate Percentages!!! OK, but they come in mighty handy.Why? – They always measure the change relative to a starting point. (e.g. a $1 increase in your hourly wage is different if you make $5/hr. or $100/hr.) –Absolute changes are affected by changes in the units with which they are measured ( 100 boxes of apples = 5,000 apples, but the later looks like a bigger change) –Percentages are everywhere!!!! (Stores usually use percentage discounts during sales, increases in pay are generally in percentages, batting averages are in percentages, grades are given in percentages)

The Farmer’s Dilemma For many crops, a strange situation arises a bad crop year results in a good year for farm incomes, and a good crop year results in a bad year for farm incomes. How can this be? Price elasticity gives us the answer: –Bad crop year: supply decreases, prices for farm products rise, but quantity demanded doesn’t fall very much. The quantity demanded of farm products is not very responsive to changes in prices –Good crop year: supply increases, prices for farm products fall, but quantity demanded doesn’t increase very much. The quantity demanded of farm products is not very responsive to changes in prices It is easy to show this with a graph. But first we need yet another concept: Total Revenue = Price x Quantity

Elasticity and Total Revenue TR = P x Q If P goes down Q goes up, but what happens to TR? If P goes up Q goes down, but what happens to TR? Elasticity can answer the question….

Elasticity to the Rescue…. E p > 1 Responsive or elastic –%ΔQ d (10%) > %ΔP (5%) if P goes down (up) total revenue goes up (down) E p < 1 Not responsive or inelastic –%ΔQ d (5%) < %ΔP (10%) if P goes down (up) total revenue goes down (up) E p = 1 unit elastic –%ΔQ d (5%)= %ΔP (5%) if P goes down (up) total revenue stays the same

The Farm Example During bad crop years, prices rise and quantity falls (but not that much) so total revenue to farmers goes up. During good crop years, prices fall and quantity increases (but not that much) so total revenue to farmers goes down. The graphs….

Figure 8 An Increase in Supply in the Market for Wheat Copyright©2003 Southwestern/Thomson Learning Quantity of Wheat 0 Price of Wheat and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220. Demand S1S1 S2S leads to a large fall in price When demand is inelastic, an increase in supply $3 100

Can Elasticity Tell Us More? What a minute, first we need to talk about what increases or decreases the price elasticity of demand. Determinants of Price Elasticity –Availability of close substitutes –Necessity versus luxury –Definition of the market –Time horizon –Percentage of consumer budget

Price elasticity of demand Elasticity of Demand elasticity coefficient itemshort runlong run Airline travel Medical care Natural gas Auto tires Stationery Gasoline Housing Automobiles Movies Jewelry & watches Radio & TV repair Foreign travel Glass, china, etc Estimated price elasticities of demand

Elasticity of Supply How how about the price elasticity of supply? How responsive are suppliers to changes in price? Price elasticity of supply = %change in quantity supplied/% change in price Determinants of elasticity of supply: –Flexibility in altering the amount of a good produced. –Time period

Price elasticity of supply Elasticity of Supply Price elasticity Vegetableshort runlong run Lima beans Cabbage Carrots Cucumbers Onions Green peas Green peppers Tomatoes Cauliflower Celery Spinach Estimated price elasticities of supply

Further Examples of Elasticity Inelastic demand and addictive drugs: –Supply side prevention –Demand side prevention Luxury Taxes –Who pays a tax? But with elasticity we find out… –Who really pays the tax? (tax incidence or burden).

Government and Markets Price Controls –Price Ceilings (e.g. rent control) –Price Floors (e.g. water) Taxes –Who appears to pay the tax? Buyers “pay” tax Sellers “pay” tax –Who really pays the tax? Tax incidence and burden

Elasticity and Tax Incidence Intuitive approach: –If the buyers can respond relatively more to price changes more than suppliers, suppliers pay more of the tax. –If the suppliers can respond relatively more than the buyers, then the buyers pay more of the tax.

Application: Who pays the luxury tax? Elasticity of demand is quite high for luxury goods: –Many subsitutes –Not a necessity