Describing Supply and Demand: Elasticites 7 Describing Supply and Demand: Elasticities The master economist must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought. — J. M. Keynes CHAPTER 7 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Describing Supply and Demand: Elasticites 7 Price Elasticity: Demand Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price This tells us exactly how quantity demanded responds to a change in price E D = Elasticity is independent of units % change in Quantity Demanded % change in Price Price elasticity of demand is always expressed as a positive number 7-2

Describing Supply and Demand: Elasticites 7 Price Elasticity: Demand Demand is elastic if the percentage change in quantity is greater than the percentage change in price Elastic demand is when E D > 1 Demand is inelastic if the percentage change in quantity is less than the percentage change in price Inelastic demand is when E D < 1 7-3

Describing Supply and Demand: Elasticites 7 Calculating Elasticities: Price elasticity of Demand D P Q What is the price elasticity of demand between A and B? $20 10 $26 14 Midpoint B A E D = %ΔQ%ΔP%ΔQ%ΔP Q 2 –Q 1 ½(Q 2 +Q 1 ) P 2 –P 1 ½(P 2 +P 1 ) = C 12 $23 = 10–14 ½(10+14) 26–20 ½(26+20) = 1.27 = 7-4

Describing Supply and Demand: Elasticites 7 Price Elasticity: Supply Price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price This tells us exactly how quantity supplied responds to a change in price E S = Elasticity is independent of units % change in Quantity Supplied % change in Price 7-5

Describing Supply and Demand: Elasticites 7 Price Elasticity: Supply Supply is elastic if the percentage change in quantity is greater than the percentage change in price Elastic supply is when E S > 1 Supply is inelastic if the percentage change in quantity is less than the percentage change in price Inelastic supply is when E S < 1 7-6

Describing Supply and Demand: Elasticites 7 Calculating Elasticities: Price elasticity of Supply P Q What is the price elasticity of supply between A and B? $ $ B A E S = %ΔQ%ΔP%ΔQ%ΔP Q 2 –Q 1 ½(Q 2 +Q 1 ) P 2 –P 1 ½(P 2 +P 1 ) = = 485–476 ½( ) 5–4.50 ½(5+4.50) Midpoint C $ = 0.18 = S 7-7

Describing Supply and Demand: Elasticites 7 Elasticity and Supply and Demand Curves Elasticity is not the same as slope, but, the steeper a curve is at a given point, the less elastic supply or demand This curve is perfectly elastic, meaning that Q responds enormously to changes in price, E D = ∞ This curve is perfectly inelastic, meaning that Q does not respond at all to changes in price, E D = 0 P Q D D P Q 7-8

Describing Supply and Demand: Elasticites 7 Elasticity Along Straight-Line Curves On straight-line supply and demand curves, slope stays constant, but elasticity changes P Q Elasticity declines along this straight-line demand curve as we move towards the Q axis $2 10 $6 42 $4 $8 $10 68 E D = 0 E D = 1 E D = ∞ E D > 1 E D < 1 7-9

Describing Supply and Demand: Elasticites 7 Substitution and Elasticity A general rule is: the more substitutes a good has, the more elastic its supply or demand If a good has substitutes, a rise in the price of that good will cause the consumer to shift consumption to those substitute goods What makes supply or demand more or less elastic? Substitution 7-10

Describing Supply and Demand: Elasticites 7 Substitution and Demand The number of substitutes a good has is affected by several factors Four of the most important factors: 1.The time period being considered 2.The degree to which a good is a luxury 3.The market definition 4.The importance of the good in one’s budget 7-11

Describing Supply and Demand: Elasticites 7 Substitution and Supply The longer the time period considered, the more elastic the supply There are three time periods relevant to supply: 1.The instantaneous period where supply is fixed and is perfectly inelastic 2.The short run where some substitution is possible and supply is somewhat elastic 3.The long run where significant substitution is possible and supply is most elastic 7-12

Describing Supply and Demand: Elasticites 7 Product Price Elasticity of Demand Short – RunLong – Run Movies Tobacco products Electricity (households) Air travel0.80─ Beer Health Services Wine Gasoline University tuition0.52─ Substitution and Demand 7-13

Describing Supply and Demand: Elasticites 7 Elasticity, Total Revenue, and Demand The elasticity of demand tells suppliers how their total revenue will change if their price changes Total revenue is price multiplied by quantity, TR = (P)(Q) If E D > 1, an increase in price decreases total revenue If E D = 1, an increase in price leaves total revenue unchanged If E D < 1, an increase in price increases total revenue 7-14

Describing Supply and Demand: Elasticites 7 Elasticity Along Straight-Line Curves P Q If E D = 1, an increase in price leaves total revenue unchanged $2 10 $6 42 $4 $8 $10 68 TR E = PxQ = areas A+B = $4x6 = $24 E F TR F = PxQ = areas A+C = $6x4 = $24 A C B Demand Application: Unit Elastic Demand E D =

Describing Supply and Demand: Elasticites 7 Elasticity Along Straight-Line Curves P Q If E D < 1, an increase in price increases total revenue $2 10 $6 42 $4 $8 $10 68 TR G = PxQ = areas A+B = $1x9 = $9 G H TR H = PxQ = areas A+C = $2x8 = $16 A C B Demand Application: Inelastic Demand E D <

Describing Supply and Demand: Elasticites 7 Elasticity Along Straight-Line Curves P Q If E D > 1, an increase in price decreases total revenue $2 10 $6 42 $4 $8 $10 68 TR J = PxQ = areas A+B = $8x2 = $16 J K TR K = PxQ = areas A+C = $9x1 = $9 A C B Demand Application: Elastic Demand E D >

Describing Supply and Demand: Elasticites 7 Relationship Between Elasticity and Total Revenue Price RisePrice Decline Elastic (E D > 1)TR decreasesTR increases Unit Elastic (E D = 1)TR constant Inelastic (E D < 1)TR increasesTR decreases 7-18

Describing Supply and Demand: Elasticites 7 Elasticity of Individual and Market Demand Price discrimination occurs when a firm separates the people with less elastic demand from those with more elastic demand Firms that price discriminate charge more to the individuals with inelastic demand and less to individuals with elastic demand Examples of price discrimination: Airlines’ Saturday stay-over specials Sales of new cars Almost-continual sales 7-19

Describing Supply and Demand: Elasticites 7 Other Elasticity Concepts Income elasticity of demand measures the responsiveness of demand to changes in income Normal goods are those whose consumption increases with an increase in income E Income = % change in Demand % change in Income Necessity: 0 1 Luxury: E Income > 1 Inferior goods are those whose consumption decreases with an increase in income, E Income <

Describing Supply and Demand: Elasticites 7 Other Elasticity Concepts Cross–price elasticity of demand measures the responsiveness of demand to changes in prices of other goods Substitutes are goods that can be used in place of another, E cross-price > 0 E cross-price = % change in Demand % change in P of related good Complements are goods that are used conjunction with other goods, E cross-price <

Describing Supply and Demand: Elasticites 7 S1S1 D P Q Demand is relatively elastic S0S0 Supply shifts out and caused a greater effect on quantity than on price P0P0 P1P1 Elasticity and Shifting Supply and Demand Q0Q0 Q1Q1 7-22

Describing Supply and Demand: Elasticites 7 S1S1 D P Q Demand is relatively inelastic S0S0 Supply shifts out and caused a greater effect on price than on quantity P0P0 P1P1 Elasticity and Shifting Supply and Demand Q0Q0 Q1Q1 7-23

Describing Supply and Demand: Elasticites 7 Elasticity and Shifting Supply and Demand Summary: % change in Supply E D + E S % change in P = % change in Demand E D + E S 7-24 % change in P =

Describing Supply and Demand: Elasticites 7 Chapter Summary Elasticity is percentage change in quantity divided by percentage change in some variable that affects demand (supply). The most common elasticity is price. E S = % change in Quantity Supplied % change in Price E D = % change in Quantity Demanded % change in Price 7-25

Describing Supply and Demand: Elasticites 7 Chapter Summary Five price elasticity of demand or supply terms are: Elastic E>1 Inelastic E<1 Unit elastic E=1 Perfectly inelastic E=0 Perfectly elastic E=∞ Demand becomes less elastic as we move down along a demand curve The most important factor affecting the number of substitutes in supply is time. The longer the time interval, the more elastic is supply. 7-26

Describing Supply and Demand: Elasticites 7 Chapter Summary Factors affecting the number of substitutes in demand are: Time period Degree to which the good is a luxury Market definition Importance of the good in one’s budget The more substitutes a good has, the greater its elasticity 7-27

Describing Supply and Demand: Elasticites 7 Chapter Summary When a supplier raises price: If demand is inelastic total revenue increases If demand is elastic, total revenue decreases If demand is unit elastic, total revenue remains constant Other important elasticities are: Income elasticity is the percentage change in demand divided by the percentage change in income Cross-price elasticity is the percentage change in demand divided by the percentage change in the price of a related good 7-28