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

2. 22 Price Elasticity of Demand Elasticity A measure of the responsiveness of Q d or Q s to a change in price or other economic variable Price elasticity of demand % change in Q d for a 1% change in price

3. Price Elasticity of Demand ε d = %ΔQ d / %ΔP = ΔQ d / Q d ΔP / P = ΔQ d x P ΔP Q d Law of demand ε d negative 3

4. Categories of Elasticities |ε| between 0 and 1 Inelastic |ε| greater than 1 Elastic |ε| = 1 Unit elastic |ε| = infinite Perfectly elastic |ε| = 0 Perfectly inelastic 4

5. Midpoint Formula Use the average Q and average P in the elasticity formula: average Q = (Q 1 + Q 2 ) / 2 average P = (P 1 + P 2 ) / 2 ε = ΔQ / (average Q) ΔP / (average P) = (Q 1 - Q 2 ) / (Q 1 + Q 2 ) (P 1 - P 2 ) / (P 1 + P 2 ) 5

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

7. 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

8. Exhibit 2 Demand, price elasticity and total revenue 8 D 90 60 10 70 Price per unit $100 80 50 40 30 20 b a d e 800500200100Quantity per period1,000 0900 Total revenue $25,000 500Quantity 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

9. Exhibit 4 Summary of price elasticity of demand 9 Effects of a 10 percent increase in price Absolute value of price elasticity Type of demand What happens to quantity demanded What happens to total revenue 0 < ε d < 1InelasticDrops by less than 10 percent Increases by less than 10 percent ε d = 1Unit elasticDrops by 10 percent No change 1 < ε d <∞ElasticDrops by more than 10 percent Decreases

10. Determinants of Price Elasticity of D ε 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) 10

11. Exhibit 5 Demand becomes more elastic over time 11 DwDw Price per unit $1.25 1.00 DmDm Quantity per day 9510075500 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

12. 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 12

13. Exhibit 6 Selected price elasticities of D (absolute values) 13 ProductShort runLong run Cigarettes (among adults) Electricity (residential) Air travel Medical care and hospitalization Gasoline Milk Fish (cod) Wine Movies Natural gas (residential) Automobiles Chevrolets - 0.1 0.3 0.4 0.5 0.7 0.9 1.4 1.9 - 0.4 1.9 2.4 0.9 1.5 - 1.2 3.7 2.1 2.2 4.0

14. Income Elasticity of Demand % change in Q d for a 1% change in income ε I = %ΔQ d / %ΔI Normal goods (Q d increases when I increases) –Positive income elasticity Inferior goods (Q d decreases when I increases) –Negative income elasticity 14

15. Income Elasticity of Demand Normal goods –Income inelastic Elasticity between 0 and 1 Necessities –Income elastic Elasticity > 1 Luxuries 15

16. Exhibit 10 Selected income elasticities of demand 16 Product Income ElasticityProduct Income Elasticity Wine Private education Automobiles Owner-occupied housing Furniture Dental service Restaurant meals Spirits (‘hard’ liquor) Shoes Chicken Clothing 5.03 2.46 2.45 1.49 1.48 1.42 1.40 1.21 1.10 1.06 0.92 Physicians’ services Coca-Cola Beef Food Coffee Cigarettes Gasoline and oil Rental housing Pork Beer Flour 0.75 0.68 0.62 0.51 0.50 0.48 0.43 0.18 -0.09 -0.36

17. Cross-Price Elasticity of Demand % change in Q demanded of one good for a 1% change in the price of another good –ε X,Y = %ΔQ X / %ΔP Y –If positive: X and Y are substitutes –If negative: X and Y are complements –If zero: X and Y are unrelated 17

18. Price Elasticity of Supply Price elasticity of supply % change in Q s for a 1 percent change in price ε s = %ΔQ s / %ΔP Law of supply ε s positive 18

19. Constant Elasticity Supply Curves Perfectly elastic S curve –Horizontal; ε s = ∞ –Producers supply 0 at a price below P Perfectly inelastic S curve –Vertical; ε s = 0 –Goods in fixed supply Unit-elastic S curve – %∆p = %∆q –S is a ray from the origin 19

20. Determinants of Supply Elasticity ε s is greater: –cost and feasibility of storage –production process –the longer the period of adjustment (time) 20

21. Exhibit 9 Supply becomes more elastic over time 21 SwSw Price per unit 1.00 $1.25 Quantity per day1102000100140 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

22. Price Elasticity and Tax Incidence Tax –Decrease in S by the amount of tax S shifts upward by the tax Tax incidence –distribution of the tax burden 22

23. Price Elasticity and Tax Incidence The more price elastic the D: –The more tax producers pay –The less tax consumers pay The more elastic the S: –The less tax producers pay –The more tax consumers pay 23

24. Price Elasticity and Tax Incidence The issue of tax incidence depends on the relationship between ε d and ε s If | ε d | > ε s producers bear more of the burden of the tax If | ε d | < ε s consumers bear more of the burden of the tax 24