1. Elasticity of Demand and Supply
CHAPTER 5
© 2003 South-Western/Thomson Learning

2. Price Elasticity of Demand
Thus far we have talked about the impact of changes in prices, incomes, costs, on demand and supply in rather general terms
In fact, in real world, more precision is needed
Law of demand says that a higher price will reduce quantity demanded, BUT BY HOW MUCH  that is, will the number sold decline by only a little or by a lot?

3. Price Elasticity of Demand
Price elasticity of demand measures in a standardized way how responsive consumers are to price change  elasticity is another word for responsiveness
In simplest terms, the price elasticity of demand measures the percent change in quantity demanded divided by the percent change in price

4. Price Elasticity of Demand
To illustrate this process, consider the demand curve for tacos in Exhibit 1

5. Exhibit 1: Demand Curve for Tacos
For the price elasticity to be a useful measure, we should come up with the same result between points a and b as we get between b and a. To do this we must take the average of the initial price and the new price and use that as the base in computing the percent change in price  in our example the base used for price is the average of $1.10 and $0.90 = $1.00  the change in price is -$0.20 divided by $1.00  -20%
$1.10 a
0.90 b
Price per taco D
The same process should be used for changes in quantity demanded  the average quantity demanded is 100,000 and the change in quantity demanded is 10,000  10% change
Thousands per day 95
105
Price elasticity between a and b = 10% / - 20% = - 0.5

6. Price Elasticity of Demand
Generalize the price elasticity formula
If the price drops from p to p’, other things constant, the quantity demanded increases from q to q’
The change in price can be represented as Δp and the change in quantity as Δq

7. Price Elasticity of Demand
Because the average quantity and average price are used as a base for computing percent change, the same elasticity results whether going from the higher price to the lower price or the other way around
Since the focus is on the percent change, we need not be concerned with how output or price is measured

8. Price Elasticity of Demand
Elasticity expresses a relationship between two amounts
The percent change in quantity demanded
The percent change in price
Because the law of demand states that price and quantity demanded are inversely related, the change in price and the change in quantity demanded have opposite signs  the price elasticity of demand has a negative sign

9. Price Elasticity of Demand
Since constantly referring to elasticity as a negative number gets cumbersome, we will discuss the price elasticity of demand as an absolute value  positive number
For example, absolute value of the elasticity for tacos computed earlier will be referred to as 0.5 rather than –0.5

10. Categories
The price elasticity of demand can be divided into three general categories depending on how responsive quantity demanded is to a change in price
If the percent change in quantity demanded is smaller than the percent change in price, the resulting price elasticity has an absolute value between 0 and 1.0  demand is inelastic  quantity demanded is relatively unresponsive to a change in price
If the percent change in quantity demanded just equals the percent change in price  a price elasticity with an absolute value of 1.0  unit-elastic demand

11. Categories
If the percent change in quantity demanded exceeds the percent change in price, the resulting price elasticity has an absolute value exceeding 1.0  demand is said to be elastic  quantity is responsive to changes in price
Summary
Inelastic  absolute value between 0 and 1.0  unresponsive
Unit elastic  absolute value equal to 1.0
Elastic  absolute value greater than 1.0  responsive

12. Elasticity and Total Revenue
Knowledge of price elasticity is especially valuable because it indicates the effect of a price change on total revenue
Total revenue (TR) is the price (p) multiplied by the quantity demanded (q) at that price  TR = p x q
What happens to total revenue when price decreases?

13. Elasticity and Total Revenue
A lower price means producers get less for each unit sold which tends to decrease total revenue
However, a lower price increases quantity demanded which tends to increase total revenue
Thus, the overall impact of a lower price on total revenue depends on the net result of these opposite effects

14. Elasticity and Total Revenue
Specifically
When demand is elastic, the percent increase in quantity demanded exceeds the percent decrease in price  total revenue increases
When demand is unit elastic, the two are equal  total revenue remains unchanged
When demand is inelastic, the percent increase in quantity demanded is more than offset by the percent decrease in price  total revenue decreases

15. Elasticity and Total Revenue
These relationships can be tied together by looking at a linear demand curve
A linear demand curve is simply a straight-line demand curve
Exhibit 2 presents these ideas

16. Exhibit 2: Demand, Price Elasticity and Total Revenue
(a) Demand and Price Elasticity
Panel (a) shows the linear demand curve and panel (b) shows the total revenue generated by each price-quantity combination along the demand curve.
$100 90 80 70 60 50
Price per unit 40 30 20 10 D
Since the demand curve is linear, its slope is constant  a given decrease in price always causes the same unit increase in quantity demanded.
100
200
500
800
900
1,000
Quality per period
(b) Total Revenue
TR = p x q
$25,000 T o t a l r e v n u
The price elasticity of demand is greater on the higher-price end of the demand curve than on the lower-price end.
Total
revenue
500
1,000
Quantity per period

17. Exhibit 2: Demand, Price Elasticity and Total Revenue
(a) Demand and Price Elasticity
Consider a movement from point a to point b on the demand curve. The 100-unit increase in quantity demanded is a percent change of 100/150 = 0.67 while the $10 drop in price is a percent change of 10/85 = 12%  the price elasticity of demand here is 5.6
$100 90 a 80 b 70 60 50 c
Price per unit 40 30 20 d 10 e D
100
200
500
800
900
1,000
Quality per period
(b) Total Revenue
TR = p x q
Between points d and e on the lower end, the 100-unit quantity increase is a percent change of 100/850 = 12% and the $10 price decrease is a percent decline of 10/15 = 67%  a price elasticity of 0.2
$25,000 T o t a l r e v n u
Total
revenue
500
1,000
Quantity per period

18. Exhibit 2: Demand, Price Elasticity and Total Revenue
Demand becomes less elastic as we move down the curve. Halfway down, the elasticity equals Since we have a linear demand curve, the slope is constant but the elasticity varies  slope is not the same thing as elasticity.
(a) Demand and Price Elasticity
$100 90 a
Elastic ED > 1 80 b 70 60
Unit elastic ED = 1 50 c
Price per unit 40
Inelastic ED < 1 30 20 d 10
Where demand is elastic, a decrease in price will increase total revenue because the gain in revenue from selling more units exceeds the loss in revenue from selling at the lower price. e D
100
200
500
800
900
1,000
Quality per period
(b) Total Revenue
TR = p x q
$25,000 T o t a l r e v n u
Where demand is inelastic, a price decrease reduces total revenue because the gain in revenue from selling more units is less than the loss in revenue at the lower price.
Total
revenue
500
1,000
Quantity per period

19. Exhibit 3: Constant Elasticity Demand Curves
(a) Perfectly elastic
(b) Perfectly inelastic
(c) Unit elastic D' t i t n i i t n n u u u
E = 1 r D e
E = r r e e p D p D p p e
E = e D e c c c
$10 a r i i r i r P P P b 6
D"
Quantity Q
Quantity
Quantity
per period
per period
per period
Demand curve in (a) indicates consumers will demand all that is offered at the given price, p. If the price rises above p, quantity demanded drops to zero  perfectly elastic demand curve.
Demand curve in (b) is vertical, quantity demanded does not vary when the price changes  no matter how high the price, consumers will purchase the same quantity  perfectly inelastic demand curve.
(c) shows a unit-elastic demand curve where any percent change in price results in an identical offsetting percent change in quantity demanded.

20. Determinants
Time to turn to the issue of why price elasticities of demand vary for different goods
Three basic determinants
Availability of substitutes
Proportion of the consumer’s budget spent on the good
A matter of time

21. Availability of Substitutes
The greater the availability of substitutes for a good and the closer the substitutes, the greater the good’s price elasticity of demand
The number and similarity of substitutes depend on how we define the good  the more broadly we define a good, the fewer the substitutes and the less elastic the demand

22. Proportion of Consumer’s Budget
Because spending on some goods represents a large share of the consumer’s budget, a change in the price of such a good has a substantial impact on the amount consumers are able to purchase
Generally, the more important the item is as a share of the consumer’s budget, other things constant, the greater will be the income effect of a change in price  the more price elastic will be the demand for the item

23. A Matter of Time The process of finding substitutes takes time
Thus, the longer the adjustment period, the greater the consumers’ ability to substitute away from relatively higher-priced products toward lower-priced substitutes  the more responsive the change in quantity demanded is to a given change in price
Exhibit 5 demonstrates this

24. Exhibit 5: Demand Becomes More Elastic over Time
Initial price = $1.00
Dw = the demand curve one week after the price change
Dm = one month after
Dy, = one year after.
$1.25
Suppose the price now increases to $ The more time for consumers to respond to price increase, the greater the reduction in quantity demanded.
1.00 Dw
Price per unit
Dw shows that one week after the price increase, the quantity demanded has not changed much – in this case from 100 to 95 per day. Conversely, after one month, the quantity demanded has declined to 75, and after one year to 50 per day. Dm Dw
Quantity per period 50 75 95
100
Note that among these demand curves and over the range starting from the point where the demand curves intersect, the flatter the demand curve, the more price elastic the demand.

25. Elasticity Estimates
When estimating price elasticity, economists often distinguish between a period during which consumers have little time to adjust – the short run – and a period during which consumers can more fully adjust to a price change – the long run.
Exhibit 6 provides some short-run and long-run price elasticity estimates for selected products

26. Exhibit 6: Selected Price Elasticities of Demand
Product Short Run Long Run
Cigarettes (among adults) — 0.4
Electricity (residential)
Air travel
Medical care and hospitalization
Gasoline
Milk —
Fish (cod) —
Wine
Movies
Natural gas (residential)
Automobiles
Chevrolets — 4.0

27. Price Elasticity of Supply
Prices are signals to both sides of the market about the relative scarcity of products
High prices discourage consumption but encourage production
The price elasticity of supply measures how responsive producers are to a price change

28. Price Elasticity of Supply
The price elasticity of supply equals the percent change in quantity supplied divided by the percent change in price
Since the higher price usually results in an increased quantity supplied, the percent change in price and the percent change in quantity supplied move in the same direction  the price elasticity of supply is usually a positive number
Exhibit 7 depicts a typical upward-sloping supply curve

29. Exhibit 7: Price Elasticity of Supply
If the price increases from p to p', the quantity supplied increases from q to q' p' p
The price elasticity of Es, is
Price per unit
Where  q is the change in quantity supplied and  p is the change in price. q q'
Quantity per period

30. Categories of Supply Elasticity
The terminology for supply elasticity is the same as for demand elasticity
If supply elasticity is less than 1.0, supply is inelastic
If it equals 1.0, supply is unit elastic
If it exceeds 1.0, supply is elastic
Exhibit 8 illustrates some special cases of supply elasticity to consider

31. Exhibit 8: Constant-Elasticity Supply Curves
(a) Perfectly elastic
(b) Perfectly inelastic
(c) Unit elastic S' i t t t i i n n n
S" u u u r r r
E = 1 e
E = e e S p S S p p
$10 e p e
E = e c c S c i i i r r r P P P 5
Quantity per period
Quantity per period
Quantity per period 10 20 Q
At one extreme is the horizontal supply curve. Here producers will supply none of the good at a price below p, but will supply any amount at a price of p, as in (a).
The most unresponsive relationship is where there is no change in the quantity supplied regardless of the price, as shown in (b) where the supply curve is perfectly vertical.
Any supply curve that is a straight line from the origin such as shown in (c) is a
unit-elastic supply curve.

32. Determinants
The elasticity of supply indicates how responsive producers are to a change in price
Their responsiveness depends on how easy it is to alter output when price changes
If the cost of supplying additional units rises sharply as output expands, then a higher price will elicit little increase in quantity supplied
But if the marginal cost rises slowly as output expands, the lure of a higher price will prompt a large increase in output

33. Length of Time
Just as demand becomes more elastic over time as consumers adjust to price changes, supply also becomes more elastic over time as producers adjust to price changes
The longer the time period under consideration, the more able producers are to adjust to changes in relative prices
Exhibit 9 illustrates this

34. Exhibit 9: Supply Becomes More Elastic over Time
Sw is the supply curve when the period of adjustment is a week. In this situation, the higher price does not elicit much of a response in quantity supplied because firms have little time to adjust  supply curve is inelastic if the price increases from $1.00 to $1.25
Quantity per period S w m y
100
110
140
200
Price per unit
$1.25
1.00
Sm is the supply curve when the adjustment period is one month. Here the firms have a greater ability to vary output  supply is more elastic
Supply is even more elastic when the adjustment period is a year as shown by Sy

35. Income Elasticity of Demand
The income elasticity of demand measures how responsive demand is to a change in income
Measures the percent change in demand divided by the percent change in income
Categories
Goods with income elasticities less than zero are called inferior goods  demand declines when income increases

36. Income Elasticity of Demand
Normal goods have income elasticities greater than zero  demand increases when income increases
Normal goods with income elasticities greater than zero but less than 1 are called income inelastic goods  demand increases but not as much as does income
Goods with income elasticity greater than 1 are called income elastic  demand not only increases when income increases but increases by more than does income
Exhibit 10 presents some income elasticity estimates for various goods and services

37. Exhibit 10: Selected Income Elasticities of Demand
Income Income Product Elasticity Product Elasticity
Private education Physicians’ services 0.75
Automobiles Coca-Cola 0.68
Wine Beef 0.62
Owner-occupied housing Food 0.51
Furniture Coffee 0.51
Dental service Cigarettes 0.50
Restaurant meals Gasoline and oil 0.48
Shoes Rental housing 0.43
Chicken Beer 0.27
Spirits (“hard” liquor) Pork 0.18
Clothing Flour –0.36

38. Exhibit 11: The Demand for Grain

39. Exhibit 12: The Effect of Increases in Supply and Demand on Farm Revenue

40. Cross-Price Elasticity of Demand
Since firms often produce an entire line of products, it has a special interest in how a change in the price of one product will affect the demand for another
The responsiveness of the demand for one good to changes in the price of another good is called the cross-price elasticity of demand

41. Cross-Price Elasticity of Demand
Defined as the percent change in the demand of one good divided by the percent change in the price of another good
Its numerical value can be positive, negative, or zero depending on whether the goods are substitutes, complements, or unrelated, respectively

42. Substitutes and Complements
If an increase in the price of one good leads to an increase in the demand for another good, their cross-price elasticity is positive  the two goods are substitutes
If an increase in the price of one good leads to a decrease in the demand for another, their cross-price elasticity is negative  the two goods are complements