1. Chapter 21 Demand and Supply Elasticity

2. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-2 Introduction Should relatively substantial decreases in the prices of illicit drugs motivate concerns than consumption of these drugs may have risen dramatically? In this chapter, you will find that the answer to this question depends on how responsive quantities demanded are to decreases in the market prices of these illicit drugs.

3. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-3 Learning Objectives Express and calculate price elasticity of demand Understand the relationship between the price elasticity of demand and total revenues Discuss the factors that determine the price elasticity of demand

4. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-4 Learning Objectives (cont'd) Describe the cross price elasticity of demand and how it may be used to indicate whether two goods are substitutes or complements Explain the income elasticity of demand Classify supply elasticities and explain how the length of time for adjustment affects the price elasticity of supply

5. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-5 Chapter Outline Price Elasticity Price Elasticity Ranges Elasticity and Total Revenues Determinants of the Price Elasticity of Demand Determinants of the Price Elasticity of Demand Cross Price Elasticity of Demand Income Elasticity of Demand Price Elasticity of Supply

6. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-6 Did You Know That... A 10% reduction in the price of beer is associated with an increase in the incidence of campus violence of just over 3.5%? Consumers respond to changing prices in ways that influence total revenues that businesses receive? Economists have a special name for quantity responsiveness—elasticity, which is the subject of this chapter?

7. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-7 Price Elasticity Price Elasticity of Demand (E p )  The responsiveness of quantity demanded of a commodity to changes in its price  Defined as the percentage change in quantity demanded divided by the percentage change in price

8. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-8 Price Elasticity (cont'd) Price Elasticity of Demand (E p ) E p = Percentage change in quantity demanded Percentage change in price

9. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-9 E p = –1% +10% = –.1 Price Elasticity (cont'd) Example  Price of oil increases 10%  Quantity demanded decreases 1%

10. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-10 Price Elasticity (cont'd) Question  How would you interpret an elasticity of –0.1? Answer  A 10% increase in the price of oil will lead to a 1% decrease in quantity demanded.

11. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-11 Price Elasticity (cont'd) Relative quantities only  Elasticity is measuring the change in quantity relative to the change in price. Always negative  An increase in price decreases the quantity demanded, ceteris paribus.  By convention, the minus sign is ignored.

12. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-12 Calculating Elasticity Elasticity formula: Change in Q Sum of quantities/2 Ep =Ep = Change in P Sum of quantities/2 or in Q (Q 1 + Q 2 )/2 Ep =Ep = in P (P 1 + P 2 )/2

13. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-13 Example: The Price Elasticity of Demand for Gasoline After Hurricane Katrina in 2005 the nationwide price of gasoline rose from $2.61 to $3.07. The total quantity of gasoline consumed in the United States declined from 9.42 to 9.04 million barrels. What is the price elasticity of demand?

14. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-14 Example: The Price Elasticity of Demand for Gasoline (cont'd) Use the elasticity formula: 9.42 – 9.04 ÷ $3.07 – $2.61 (9.42 + 9.04)/2 ($3.07 +$2.61)/2 The price elasticity of 0.25 means that a 1% increase in price generated a 0.25% decrease in the quantity of gasoline demanded.

15. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-15 Price Elasticity Ranges Elastic Demand  Percentage change in quantity demanded is larger than the percentage change in price  Total expenditures and price are inversely related in the elastic region of the demand curve  E p > 1

16. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-16 Price Elasticity Ranges (cont'd) Unit Elasticity of Demand  Percentage change in quantity demanded is equal to the percentage change in price  Total expenditures are invariant to price changes in the unit-elastic region of the demand curve  E p = 1

17. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-17 Price Elasticity Ranges (cont'd) Inelastic Demand  Percentage change in quantity demanded is smaller than the percentage change in price  Total expenditures and price are directly related in the inelastic region of the demand curve  E p < 1

18. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-18 Price Elasticity Ranges (cont'd) Elastic demand  % change in Q > % change in P; E p > 1 Unit-elastic  % change in Q = % change in P; E p = 1 Inelastic demand  % change in Q < % change in P; E p < 1

19. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-19 Price Elasticity Ranges (cont'd) Extreme elasticities  Perfectly Inelastic Demand  A demand curve that is a vertical line  It has only one quantity demanded for each price.  No matter what the price, quantity demanded does not change.  A demand that exhibits zero responsiveness to price changes.

20. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-20 Figure 21-1 Extreme Price Elasticities, Panel (a)

21. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-21 Price Elasticity Ranges (cont'd) Extreme elasticities  Perfectly Elastic Demand  A demand curve that is a horizontal line  It has only one price for every quantity.  The slightest increase in price leads to zero quantity demanded.

22. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-22 Figure 21-1 Extreme Price Elasticities, Panel (b)

23. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-23 Policy Example: Who Pays Higher Cigarette Taxes? State governments impose cigarette taxes, which are assessed as an amount per pack sold. These taxes are paid by sellers of cigarettes from the revenues they earn from their total sales. To receive the same price per quantity the seller would need a price higher by the tax amount.

24. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-24 Figure 21-2 Price Elasticity and a Cigarette Tax, Panels (a) and (b)

25. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-25 Figure 21-2 Price Elasticity and a Cigarette Tax, Panel (c)

26. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-26 Elasticity and Total Revenues When demand is elastic, a negative relationship exists between changes in price and changes in total revenues. When demand is unit-elastic, changes in price do not change total revenues. When demand is inelastic, a positive relationship exists between changes in price and total revenues.

27. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-27 Figure 21-3 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service, Panel (a)

28. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-28 Figure 21-3 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service, Panel (b)

29. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-29 Figure 21-3 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service, Panel (c)

30. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-30 Elasticity and Total Revenues (cont'd) Elasticity-revenue relationship  Total revenues are the product of price times units sold.  The law of demand states along a given curve, price is inverse to quantity.

31. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-31 Elasticity and Total Revenues (cont'd) What happens to the product of price times quantity depends on which of the opposing forces exerts a greater force on total revenues. This is what price elasticity of demand is designed to measure: responsiveness of quantity demanded to a change in price.

32. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-32 Table 21-1 Relationship Between Price Elasticity of Demand and Total Revenues Example

33. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-33 Determinants of Price Elasticity of Demand Existence of substitutes  The closer the substitutes and the more substitutes there are, the more elastic is demand. Share of the budget  The greater the share of the consumer’s total budget spent on a good, the greater is the price elasticity.

34. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-34 Determinants of Price Elasticity of Demand (cont'd) The length of time allowed for adjustment  The longer any price change persists, the greater is the elasticity of demand.  Price elasticity is greater in the long run than in the short run.

35. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-35 Determinants of Price Elasticity of Demand (cont'd) How to define the short run and the long run  The short run is a time period too short for consumers to fully adjust to a price change.  The long run is a time period long enough for consumers to fully adjust to a change in price, other things constant.

36. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-36 In the short run, quantity demanded falls slightly Figure 21-4 Short-Run and Long- Run Price Elasticity of Demand With more time for adjustment the demand curve becomes more elastic and quantity demanded falls by a greater amount

37. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-37 Example: What Do Real-World Price Elasticities of Demand Look Like? Economists have found that estimated elasticities of demand are greater in the long run than in the short run. Remember that even though we are leaving off the negative sign, there is an inverse relationship between price and quantity demanded.

38. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-38 Table 21-2 Price Elasticities of Demand for Selected Goods

39. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-39 Cross Price Elasticity of Demand Cross Price Elasticity of Demand (E xy )  The percentage change in the demand for one good (holding its price constant) divided by the percentage change in the price of a related good

40. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-40 Cross Price Elasticity of Demand (cont'd) Formula for computing cross price elasticity of demand between good X and good Y % Change in demand for good X % Change in price of good Y E xy =

41. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-41 Cross Price Elasticity of Demand (cont'd) Substitutes  E xy would be positive  An increase in the price of X would increase the quantity of Y demanded at each price. Complements  E xy would be negative  An increase in the price of X would decrease the quantity of Y demanded at each price.

42. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-42 Example: Do People Substitute Wireless Phone Services for Wired Services Recently, two economists estimated that the cross price elasticity of demand between wireless and wired phone services is about 0.02. This estimate implies that a 10% increase in the price of land-wired phone services induces a 0.2% increase in the quantity of wireless phone services demanded. Thus, the two types of phone services appear to be substitutes, but the degree of substitution is very slight.

43. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-43 Income Elasticity of Demand Income Elasticity of Demand (E i )  The percentage change in demand for any good, holding its price constant, divided by the percentage change in income  The responsiveness of demand to changes in income, holding the good’s relative price constant

44. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-44 Income Elasticity of Demand (cont'd) Percentage change in demand Percentage change in income Ei =Ei =

45. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-45 Table 21-3 How Income Affects Quantity of DVDs Demanded

46. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-46 Income Elasticity of Demand (cont'd) Income Elasticity of Demand  Refers to a horizontal shift in the demand curve in response to changes in income Price Elasticity of Demand  Refers to a movement along the curve in response to price changes

47. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-47 Income Elasticity of Demand (cont'd) Calculating the income elasticity of demand E i = Change in quantity ÷ Change in income Average quantity Average income  The income elasticity of demand can be either negative or positive.  Remember that in calculating the income elasticity of demand, the price of the good is assumed to be constant.

48. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-48 Price Elasticity of Supply Price Elasticity of Supply (E s )  The responsiveness of the quantity supplied of a commodity to a change in its price  The percentage change in quantity supplied divided by the percentage change in price

49. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-49 Percentage change in quantity supplied Percentage change in price ES =ES = Price Elasticity of Supply (cont'd) Formula for computing price elasticity of supply

50. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-50 Price Elasticity of Supply (cont'd) Classifying supply elasticities  Perfectly Elastic Supply  Quantity supplied falls to zero when there is the slightest decrease in price  The supply curve is horizontal at a given price

51. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-51 Price Elasticity of Supply (cont'd) Classifying supply elasticities  Perfectly Inelastic Supply  Quantity supplied is constant no matter what happens to price  The supply curve is vertical at a given price

52. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-52 Figure 21-5 The Extremes in Supply Curves

53. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-53 Price Elasticity of Supply (cont'd) Price elasticity of supply and length of time for adjustment 1. The longer the time allowed for adjustment, the more resources can flow into (out of) an industry through expansion (contraction) of existing firms. 2. The longer the time allowed for adjustment, the entry (exit) of firms increases (decreases) production in an industry.

54. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-54 Figure 21-6 Short-Run and Long- Run Price Elasticity of Supply As time passes the supply curve rotates from S 1 to S 2 and quantity supplied rises to Q 1 As more time passes the supply curve rotates from S 2 to S 3 and quantity supplied rises from Q 1 to Q 2

55. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-55 Issues and Applications: The Price Elasticity of Demand for Illicit Drugs Of interest to policymakers is the price elasticity of demand for illicit drugs: the responsiveness of quantity consumed to a change in price. As is the price elasticity of participation: the responsiveness of the number of people using an illicit drug for the first time to a change in the price of that drug.

56. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-56 Issues and Applications: The Price Elasticity of Demand for Illicit Drugs (cont'd) Price elasticities of demand for illicit drugs: the long-run are not significantly larger than short-run elasticities. Most economists who study the issue of illicit drugs agree that the demand for cocaine and heroin is probably inelastic.

57. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-57 Table 21-4 Estimated Price Elasticities of Demand for Selected Illicit Drugs

58. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-58 Summary Discussion of Learning Objectives Expressing and calculating the price elasticity of demand  Percentage change in quantity demanded divided by the percentage change in price

59. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-59 Summary Discussion of Learning Objectives (cont'd) The relationship between the price elasticity of demand and total revenues  When demand is elastic, price and total revenue are inversely related.  When demand is inelastic, price and total revenue are positively related.  When demand is unit-elastic, total revenue does not change when price changes.

60. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-60 Summary Discussion of Learning Objectives (cont'd) Factors that determine price elasticity of demand  Availability of substitutes  Percentage of a person’s budget spent on the good  The length of time allowed for adjustment to a price change

61. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-61 Summary Discussion of Learning Objectives (cont'd) The cross price elasticity of demand and using it to determine whether two goods are substitutes or complements  Percentage change in the demand for one good divided by the percentage change in the price of a related good  If cross elasticity is positive, the goods are substitutes.  If cross elasticity is negative, the goods are complements.

62. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-62 Summary Discussion of Learning Objectives (cont'd) Income elasticity of demand  Responsiveness of the demand for the good to a change in income  Percentage change in the demand for a good divided by the percentage change in income.

63. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-63 Summary Discussion of Learning Objectives (cont'd) Classifying supply elasticities and how the length of time for adjustment affects price elasticity of supply  Elastic supply: price elasticity of supply is greater than 1  Inelastic supply: price elasticity of supply is less than 1  Unit-elastic supply: price elasticity of supply is equal to 1  The longer the time period for adjustment, the more elastic is supply.

64. End of Chapter 21 Demand and Supply Elasticity