Chapter 5 Elasticity of Demand and Supply © 2009 South-Western/Cengage Learning

Price Elasticity of Demand Elasticity – Responsiveness Price elasticity of demand (Pd) – Consumers’ responsiveness to a change in price – Pd = Percentage change in quantity demanded divided by percentage change in price 2 2

Price Elasticity of Demand Law of demand—move along the demand curve E D negative Absolute value of E D positive 3

Exhibit 1 Demand curve for tacos 4 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.

Categories of E D 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 5

Elasticity and Total Revenue Total revenue = price * quantity demanded at this price TR= p * q As price decreases – If D elastic, TR increases – If D inelastic, TR decreases – If D unit elastic, TR constant 6

Price Elasticity and the Linear D curve 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 7

Exhibit 2 Demand, price elasticity and total revenue 8 D Price per unit $ b a d e Quantity per period1, Total revenue $25, Quantity per period1,000 0 (a) Demand and price elasticity (b) Total revenue Total revenue Unit elastic, E D =1 Elastic, E D >1 Inelastic, E D <1 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 c

Constant Elasticity Demand Curves 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 9

Exhibit 3 Constant-elasticity demand curves 10 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

Exhibit 4 Summary of price elasticity of demand 11 Effects of a 10 percent increase in price Absolute value of price elasticityType of demand What happens to quantity demanded What happens to total revenue E D = 0Perfectly inelasticNo changeIncreases by 10 percent 0 < E D < 1InelasticDrops by less than 10 percent Increases by less than 10 percent E D = 1Unit elasticDrops by 10 percentNo change 1 < E D <∞ElasticDrops by more than 10 percent Decreases E D = ∞Perfectly elasticDrops to 0

Determinants of Price Elasticity of D 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) 12

Exhibit 5 Demand becomes more elastic over time 13 DwDw Price per unit $ DmDm Quantity per day DyDy e D w : one week after the price increase D m : one month after the price increase D y : one year after the price increase D y is more elastic than D m, which is more elastic than D w

Elasticity Estimates 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 14

Price Elasticity of Supply Elasticity – Responsiveness Price elasticity of supply (Es) – Producers’ responsiveness to a change in price – Percentage change in quantity supplied divided by percentage change in price 15

Price Elasticity of Supply Law of supply E S positive 16

Exhibit 7 Price elasticity of supply 17 S Price per unit p p’ 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. Quantity per periodqq’0

Categories of E S 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 18

Constant Elasticity Supply Curves 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 19

Exhibit 8 Constant-elasticity supply curves 20 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 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. S’’

Determinants of Supply Elasticity E S is greater: – If the marginal cost rises slowly as output expands—This will be discussed in greater detail in Chapter 7 – The longer the period of adjustment (time) 21

Exhibit 9 Supply becomes more elastic over time 22 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

Income Elasticity of Demand 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 23

Income Elasticity of Demand Normal goods – Income inelastic Elasticity between 0 and 1 Necessities – Income elastic Elasticity > 1 Luxuries 24

The market for food and ‘The Farm Problem’ 1950: 10 millions family farms Today: less than 3 millions Demand –Price inelastic Total revenue falls when P falls –Income inelastic D increases Technological improvements S increases 25

Exhibit 11 The demand for grain 26 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.

S’ D’ Exhibit 12 The effect on increases in D and S on farm revenue 27 D 51014Billions of bushels per year 0 Price per bushel $8 4 S Technological advance - sharp increase in S Increase in consumer income - small increase in D Drop in P Drop in total revenue

Cross-Price Elasticity of Demand 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 28