1. DESCRIBING SUPPLY AND DEMAND: ELASTICITIES
Chapter 6
DESCRIBING SUPPLY AND DEMAND: ELASTICITIES

2. Today’s lecture will:
Use the terms price elasticity of supply and price elasticity of demand to describe the responsiveness of quantities to changes in price.
Calculate elasticity graphically and numerically.
Distinguish five elasticity terms that are used to differentiate varying degrees of responsiveness.

3. Today’s lecture will:
Explain the importance of substitution in determining elasticity of supply and demand.
Relate price elasticity of demand to total revenue.
State how other elasticity concepts are useful in describing the effect of shift factors of demand.
Explain how the concept of elasticity makes supply and demand more useful.

4. Price Elasticity Price elasticity of demand (ED)
Price elasticity of supply (ES)

5. Calculating Elasticity of Demand
$26 B 24 22
midpoint C
Price 20
Elasticity between A and B: A 18 16 14 10 12 14
Quantity of software (in thousands)

6. Calculating Elasticity of Supply
$6.00
5.50
5.00 B
Wage per hour
4.50 C A
4.00
Elasticity between A and B:
3.50
3.00
476
485
Quantity of workers

7. Calculating Elasticity at a Point
Price
Quantity
$10 9 8 7 6 5 4 3 2 1 C B A 24 40 28 20
To calculate elasticity at a point determine a range around that point and calculate the arc elasticity.

8. Elasticities and Supply and Demand Curves
Price
Price
Quantity
Perfectly inelastic demand curve
Perfectly elastic demand curve
Quantity

9. Elasticity Along a Demand Curve
Ed = ∞
Elasticity declines along the demand curve as we move toward the quantity axis
$10 9 8
Ed > 1 7 6
Ed = 1
Price 5 4 3
Ed < 1 2 1
Ed = 0 1 2 3 4 5 6 7 8 9 10
Quantity

10. Elasticity Along a Supply Curve
If the supply curve intersects the vertical axis, Es declines as you go up the supply curve. S1
$10
Es declines 9 8 7 6
Es = 
Price 5
Es rises 4
If the supply curve intersects the quantity axis, Es increases as you go up the supply curve. 3 2
Es = 0 1 1 2 3 4 5 6 7
Quantity

11. Elasticity Summary
Perfectly elastic – quantity responds enormously to price changes (E=∞)
Elastic – the %Δ Q > the %Δ P (E>1).
Unit elastic – the %Δ Q = the %Δ P (E=1).
Inelastic – the %Δ Q < the %Δ P (E<1).
Perfectly inelastic – quantity does not respond at all to a change in price (E=0).

12. Substitution and Demand
As a general rule, the more substitutes a good has, the more elastic is its supply and demand.
The larger the time interval considered, the more elastic is the demand curve.
The less a good is a necessity, the more elastic is its demand curve.
Demand becomes more elastic as the definition of the good becomes more specific.
Demand for goods that represent a large portion of one’s budget are more elastic.

13. Substitution and Supply
The longer the time period considered, the more elastic the supply.
There are three time periods relevant to supply:
The instantaneous period – supply is fixed, perfectly inelastic.
The short run – some substitution is possible, supply is somewhat elastic.
The long run – significant substitution is possible, supply is very elastic.

14. Short-Run and Long-Run Elasticities of Demand

15. Elasticity, Total Revenue, and Demand
The elasticity of demand tells suppliers how their total revenue (PxQ) will change if their price changes.
If ED > 1, an increase in price decreases total revenue.
If ED = 1, an increase in price leaves total revenue unchanged.
If ED < 1, an increase in price increases total revenue.

16. Elasticity and Total Revenue
Unit Elastic Demand
E = 1 6
Price
Quantity
$10 8 4 2 1 3 5 7 9
TRE= $4x6=$24
TRF= $6x4=$24
TR constant F
Gained revenue C E
Lost revenue A B

17. Elasticity and Total Revenue
Inelastic Demand
E < 1
$10
TR rises if price increases 8
TRG = $1 x 9 = $9
TRH = $2 x 8 = $16 6
Price
Gained revenue
Lost revenue 4 H 2 C G A B 1 2 3 4 5 6 7 8 9
Quantity

18. Elasticity and Total Revenue
Elastic Demand
E > 1
$10 K J C
TR falls if price increases. 8
Gained revenue B
TRJ = $8 x 2 = $16
TRK = $9 x 1 = $9 6 A
Price 4
Lost revenue 2 1 2 3 4 5 6 7 8 9
Quantity

19. Total Revenue Along a Demand Curve
Price
Quantity
Elastic ED > 1
Total Revenue Along a Demand Curve
ED = 1 Q0
Inelastic ED < 1
Total revenue
Quantity

20. 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

21. Income Elasticity of Demand
Income elasticity of demand measures the responsiveness of demand to changes in income.

22. Income Elasticity of Demand
Normal goods are those whose consumption increases with an increase in income.
Normal goods can be luxuries or necessities:
Luxuries are goods that have an income elasticity greater than one.
A necessity has an income elasticity less than 1.
Inferior goods are those whose consumption decreases when income increases.
Inferior goods have income elasticities less than zero.

23. Calculating Income ElasticityP0 D0 D1 20
Quantity 26
Shift due to 20% rise in income

24. Income Elasticities of Selected Goods
Income elasticity
Product
Short Run
Long Run
Motion pictures
0.81
3.41
Foreign travel
0.24
3.09
Hard liquor —
2.5
Jewelry and watches
1.00
1.64
Tobacco products
0.21
0.86
Furniture
2.60
0.53
Homegrown food
-0.61 —

25. Cross-Price Elasticity of Demand
Cross-price elasticity of demand measures the responsiveness of demand to changes in prices of other goods.

26. Calculating Cross-Price ElasticityD0 D1 P0 P0
Shift due to 33% decrease in price of pork
104
108
Quantity of Beef

27. Complements and Substitutes
Substitutes are goods that can be used in place of another.
Substitutes have positive cross-price elasticities.
Complements are goods that are used in conjunction with one another.
Complements have negative cross-price elasticities.

28. Cross-Price Elasticities
Commodities
Elasticity
Beef in response to price change in pork
0.11
Beef in response to price change in chicken
0.02
U.S. cars in response to price changes
in European and Asian automobiles
0.28
European automobiles in response to price
changes in U.S. and Asian automobiles
0.61
Beer in response to changes in wine
0.23
Hard liquor in response to price changes in
beer
- 0.11

29. Effects of Shifts in Supply on Price and Quantity
Inelastic Demand
Elastic Demand D S0 S0
Price
Price S1 S1 D P0 P0 P1 P1 Q0 Q1 Q0 Q1
Quantity
Quantity

30. Elasticity and Shifting Supply and Demand
The more elastic the demand (supply), the greater the effect of a supply (demand) shift on quantity, and the smaller the effect on price.

31. Elasticity and Shifting Demand and Supply
Suppose that demand increases by 5%, the elasticity of demand is 0.8, and the elasticity of supply is 2. Price will increase by
Suppose that supply increases by 33%, the elasticity of demand and supply are both 1. Price will fall by

32. Summary
Elasticity is percentage change in quantity divided by percentage change in some variable that affects demand (supply). The most common elasticity is price.

33. Summary Five elasticity terms are:
Elastic E>1
Inelastic E<1
Unit elastic E=1
Perfectly inelastic E=0
Perfectly elastic E=∞
The more substitutes a good has, the greater its elasticity.
The most important factor affecting the number of substitutes in supply is time. The longer the time interval, the more elastic is supply.

34. 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
Demand becomes less elastic as we move down along a demand curve.

35. 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 – the percentage change in demand divided by the percentage change in income
Cross-price elasticity – the percentage change in demand divided by the percentage change in the price of a related good

36. Given the following demand and supply of pizza:
Price Quantity Quantity
per Pizza Supplied Demanded $
Review Question Calculate the elasticity of supply of
pizza between $7 and $8.

37. Review Question 6-2 Calculate the elasticity of demand for
Given the following demand and supply of pizza:
Price Quantity Quantity
per Pizza Supplied Demanded $
Review Question Calculate the elasticity of demand for
pizza between $6 and $7.