ELASTICITY OF SUPPLY APPLICATIONS

Today’s Class… Definition and Calculation Types of Supply Curves Determinants Applications of Elasticity in Economics 2

Price Elasticity The price elasticity of supply is the proportional change in quantity supplied relative to the proportional change in price.

Price Elasticity of Supply Percentage change in quantity of a good supplied, caused by a 1% change in the price of the good 4

Price Elasticity of Supply and Shape of Supply Curve The price elasticity of supply is either zero or a positive number. A zero price elasticity of supply means that the quantity supplied will not vary as the price varies. A positive price elasticity of supply means that as the price of an item rises, the quantity supplied rises.

Types of Supply curves 6

Types of Supply Curves Cont. 7

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For any usual upward sloping supply curve which does not pass through the origin, the elasticity of supply declines as quantity increases. 9 The elasticity of supply declines as we move up the supply curve.

Determinants of Elasticity of Supply Product type: This impacts how quickly a producer is able to respond to changes in price. – Manufacturing firm may be able to adjust production levels in respond to price changes with minor adjustments in equipment. – Agricultural products such as cocoa/coffee may require several months to grow. – Child care services require relatively low skills compared to a physician and therefore the elasticity of supply of child care services is relatively more elastic than that of physicians. 10

Determinants of Elasticity Cont. Production Capacity: If a firm is operating at full capacity, then increase in supply would require additional facilities and purchasing of new equipment. A firm operating below full capacity can respond to changes in prices quicker than a firm that is operating at full capacity. 11

Input substitution: supply would respond more quickly to price if the inputs that are used in the production of another good and easily be switched over to producing the good with the higher price. Examples?? Storage possibilities: items that have a short shelf life are more likely to be have inelastic supply compared to products with a relatively longer shelf life. 12

The shape of the supply curve depends primarily on the length of time being considered. – In the short run, at least one of the resources used in production cannot be changed. – Hence supply is more inelastic in the short run. – In the long run, the firm has long enough to change any aspect of production, and therefore can more fully respond. – Long run supply is therefore more elastic

Interaction of Elasticities Both the price elasticity of demand and the price elasticity of supply determine the full effect of a price change. If the price elasticity of supply of an item is large and the demand for it is price inelastic, then the firm can raise the price without losing revenue. Conversely, if the price elasticity of supply is small and the price elasticity of demand is large, then the firm is unable to raise the price because the consumer will switch to another product 14

Applications of Elasticity Concept The ‘war on drugs’ by many governments in many countries has been unsuccessful mainly because these governments have focused on supply reduction. To win this war, some economists believe that governments will have to concentrate on reducing demand through drug education programs etc. Do you agree? Why or Why not? 15

Suppose the price elasticity of demand for cocaine is What will happen to the equilibrium price, quantity and total expenditures on cocaine if the government succeeds in its efforts to reduce demand? What is likely to happen to the incentive to traffic cocaine? 16

 The price elasticity of demand for cocaine is -0.5  demand is relatively inelastic  Suppose government succeeds in reducing demand  equilibrium price ↓ and equilibrium quantity ↓.  What happens to total expenditure on cocaine? If price↓, total expenditure ↓ because demand is price inelastic.  What happens to incentive to traffic cocaine? ↓ Reduced revenues is likely to deter drug trafficking. 17

Option 2 Suppose the government continues to concentrate its efforts on supply reduction and is able to reduce the supply of cocaine. As a result of the reduction in supply the price of cocaine increases by 25 percent. If the price elasticity of demand is -0.5, what is likely to happen to the incentive to traffic cocaine? 18

 Suppose government succeeds in reducing supply  equilibrium price ↑ and equilibrium quantity ↓.  What happens to total expenditure on cocaine? If price↑, total expenditure ↑ because demand is price inelastic.  What happens to incentive to traffic cocaine? ↑ Increased revenues raises the incentive to traffic cocaine. 19

Application: How the burden of tax is determined  If the price elasticity of demand (in absolute terms) is higher than the price elasticity of supply, then buyers are more willing to do without the product and will avoid most of the tax. Thus, the consumers’ burden of the tax is less than the producers’ burden.  If the price elasticity of supply is higher than the price elasticity of demand elasticity (in absolute terms), then, sellers are more responsive to price changes and can avoid most of the tax. Thus, the consumers’ burden is greater than the producers’ burden. 20

Example 1 Consider the cigarette market. Suppose at “e”, the absolute value of the price elasticity of demand is 0.7 and the price elasticity of supply is 1.1. Now a per-unit tax is imposed on every unit sold. How is the tax burden shared? 21

Since the price elasticity of supply > price elasticity of demand (in absolute value), the consumer’s burden is greater than the producer’s burden. Verify: Shift the supply curve upwards by the full amount of the tax. The vertical distance jk represents the amount of the tax. 22

Example 2 Consider a market in which supply is perfectly elastic and the demand curve is the usual downward-sloping curve. If a $0.20 unit tax is imposed in this market, how is the tax burden shared? 23

At point f the price elasticity of supply is infinity and the absolute value of the price elasticity of demand is less than infinity. In this case, consumers bear the entire burden of the tax. 24

Next Class… Consumer Choice Theory 25