1. Chapter 21 Demand and Supply Elasticity

2. Did You Know That... The government predicted it would raise $6 million per year in new revenues from a new 10 percent luxury tax on private airplane and yacht sales a few years ago It actually collected only $53,000? How can that be?

3. Price Elasticity Price Elasticity of Demand (E p ) –The responsiveness of quantity demanded of a commodity to changes in its price

4. Price Elasticity Price Elasticity of Demand (E p ) E p = percentage change in quantity demanded percentage change in price E p = %Qd%Qd %P%P

5. Price Elasticity Example –Price of oil increases 10% –Quantity demanded decreases 1% E p = -1% +10% = -.1

6. Price Elasticity Question –How would you interpret an elasticity of -0.1? Answer –A one percent increase in the price of oil will lead to a one percent decrease in quantity demanded

7. Price Elasticity 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

8. Calculating Elasticity Calculating elasticity % change in Q d = change in Q d original Q d % change in price = change in price original price

9. Price Elasticity The basics of measuring percentage changes –If price increases from $1 to $2 the percent change in price is: %  P = 1 1 = 100%

10. Price Elasticity The basics of measuring percentage changes –If price falls from $2 to $1 the percent change in price is: %  P = 1 2 = 50%

11. Price Elasticity The basics of measuring percentage changes –The percentage is influenced by the base of the original value.

12. Calculating Elasticity Adjusting for the percent change bias change in Q sum of quantities/2 Ep =Ep = change in P sum of Prices/2 or change in Q (Q 1 + Q 2 )/2 Ep =Ep = change in P (P 1 + P 2 )/2  Q Avg. Q Ep =Ep =  P Avg. P or

13. Calculating Elasticity Example –If the price increases from 1 to 2: 1 3/2 %  P = =.67

14. Calculating Elasticity Example –If the price decreases from 2 to 1: 1 3/2 %  P = =.67

15. Price of Today was lowered 25 pence to 10 pence Circulation increased from 590,000 to 1.05 million copies International Example: The Price Elasticity of Demand for Newspapers

16.  Q (Q 1 + Q 2 )/2 Ep =Ep =  P (P 1 + P 2 )/2 Ep =Ep = 1,050,000 - 590,000 (590,000 + 1,050,000)/2 25 - 10 (10 + 25)/2

17. International Example: The Price Elasticity of Demand for Newspapers Interpretation –A 60% decrease in price will increase quantity demanded by.66 percent. 460,000 820,000 Ep =Ep = 15 17.5 =.66

18. Price Elasticity Ranges Elastic Demand –Percentage change in quantity demanded is larger than the percentage change in price –E p > 1

19. Price Elasticity Ranges Unit Elasticity of Demand –Percentage change in quantity demanded is equal to the percentage change in price –E p = 1

20. Price Elasticity Ranges Inelastic Demand –Percentage change in quantity demanded is smaller than the percentage change in price –E p < 1

21. Price Elasticity Ranges Elastic demand Unit elastic Inelastic demand %  Q > %  P; E p > 1 %  Q = %  P; E p = 1 %  Q < %  P; E p < 1

22. Real World Examples… analysis includes historic sales data, both public and private, and use of present-day surveys of customers' preferences. Data as of 3-9-2011

23. Airline travel (US) –-0.3 (First Class) –-0.9 (Discount) –-1.5 (for Pleasure Travelers)

24.  Soft drinks  -0.8 to -1.0 (general)  -3.8 (Coca-Cola)  -4.4 (Mountain Dew)

25. Car fuel –-0.25 (Short run) –-0.64 (Long run)

26. Steel -0.2 to -0.3

27. Eggs –0.1 (US: Household only) –0.35 (Canada) –0.55 (South Africa)

28. Live Performing Arts (Theater, etc.) –-0.4 to -0.9

29. Rice –0.47 (Austria) –0.80 (Bangladesh) –0.80 (China) –0.25 (Japan) –0.55 (US)

30. Cinema visits (US) –-0.87 (General)

31. 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 There can be NO close substitutes

32. Perfectly Inelastic Demand Example:

33. BUT WAIT ! Mine has treplobivium HG9 Perfectly Inelastic Demand Example:

34. Extreme Price Elasticities Quantity Demanded per Year (millions of units) Price 0

35. Extreme Price Elasticities Quantity Demanded per Year (millions of units) Price D Perfect inelasticity, or zero elasticity 80 Figure 20-1, Panel (a)

36. Extreme Price Elasticities Quantity Demanded per Year (millions of units) Price D 80 P0P0 P1P1 Perfect inelasticity, or zero elasticity

37. ($4.79 – 1,000 Pack) Price Elasticity Ranges 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 Burt’s Office Equipment Barry’s Office SpaceErnie’s Inc. ($4.79 – 1,000 Pack) ($5.79 – 1,000 Pack) ($4.79 – 1,000 Pack)

38. Extreme Price Elasticities Quantity Demanded per Year (millions of units) Price (cents) 0

39. Extreme Price Elasticities Quantity Demanded per Year (millions of units) Price (cents) 30 0 Perfect elasticity, or infinite elasticity D Figure 20-1, Panel (b)

40. Extreme Price Elasticities Quantity Demanded per Year (millions of units) Price (cents) 30 P1P1 0 P 1 never touches the demand curve Perfect elasticity, or infinite elasticity D

41. Policy Example: Who Pays Higher Cigarette Taxes? In recent years Congress and state legislatures have increased cigarette taxes. –These taxes are a flat amount per pack –Sellers pay the tax but supply the same quantity only at the old price plus the tax –Supply decreases Who pays the tax depends on price elasticity of demand

42. Price Elasticity: A Cigarette Tax Figure 20.2, Panels (a) and (b)

43. Policy Example: Who Pays Higher Cigarette Taxes? Figure 20.2, Panel (c)

44. The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service

45. Quantity per period (billions of minutes) Price per Minute ($) 0.10.20.30.40.50.60.70.80.90 1.00 1.10 1234567891011 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service

46. Price per Minute ($) The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service Quantity per period (billions of minutes) 0.10.20.30.40.50.60.70.80.90 1.00 1.10 1234567891011 D Demand, or average revenue curve Elastic (E p > 1) Unit-Elastic (E p = 1) Inelastic (E p < 1) Figure 20-3, Panel (b)

47. Quantity per period (billions of minutes) Total Revenue ($ billions) 0 0.5 1.0 1.5 2.0 2.5 1234567891011 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service 3.0

48. Quantity per period (billions of minutes) Total Revenue ($ billions) 0 0.5 1.0 1.5 2.0 2.5 1234567891011 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service D Total revenue curve Elastic Unit-Elastic Inelastic 3.0 Figure 20-3, Panel (c)

49. Elasticity and Total Revenues Elastic Demand –A negative relationship exists between small changes in price and changes in total revenue

50. Elasticity and Total Revenues Unit-Elastic Demand –Changes in price do not change total revenue

51. Elasticity and Total Revenues Inelastic Demand –A positive relationship exists between changes in price and total revenues

52. Inelastic(E p < 1)TRTR Unit-elastic(E p = 1)No change in TRNo change in TR Elastic(E p > 1)TRTR Price ElasticityEffect of Price Change of Demandon Total revenues (TR) Price DecreaseIncrease Relationship Between Price Elasticity of Demand and Total Revenues

53. 1995 –Prices were lowered from 250 francs to 195 francs –Quantity demanded increased by 700,000 –Total revenue increase by 22% Was the demand elastic or inelastic? International Example: A Pricing Decision at Disneyland Paris

54. 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.

55. Determinants of Price Elasticity of Demand The length of time allowed for adjustment –The longer any price change persists, the greater is the price elasticity of demand. Price elasticity is greater in the long-run than in the short-run.

56. Determinants of Price Elasticity of Demand 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.

57. Short-Run and Long-Run Price Elasticity of Demand In the short run, quantity demanded falls slightly. However, with more time for adjustment the demand curve becomes more elastic and quantity demanded falls by a greater amount. D1D1 PePe Q2Q2 E D2D2 Q1Q1 QeQe P1P1 Price per Unit Quantity Demanded per Period

58. Short-Run and Long-Run Price Elasticity of Demand In the short run, quantity demanded falls slightly. However, with more time for adjustment the demand curve becomes more elastic and quantity demanded falls by a greater amount. D1D1 PePe Q2Q2 E D2D2 Q1Q1 QeQe P1P1 Q2Q2 D3D3 Price per Unit Quantity Demanded per Period Figure 20-4

59. Demand Elasticity for Selected Goods CategoryShort RunLong Run Estimated Elasticity Lamb2.75—— Bread.2—— Tires and related items.81.2 Auto repair and related services1.42.4 Radio and television repair.53.8 Legitimate theater and opera.2.3 Motion pictures.93.7 Foreign travel by U.S. residents.11.8 Taxicabs.6—— Local public transportation.61.2 Intercity bus.22.2 Electricity.11.8 Jewelry and watches.4.6

60. 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 –The responsiveness of change in demand of one good to the change in prices of related goods

61. Cross Price Elasticity of Demand Formula for computing cross elasticity of demand %  in demand for good X %  in price of good Y E xy =

62. Cross Price Elasticity of Demand 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.

63. 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

64. Income Elasticity of Demand percentage change in demand percentage change in income Ei =Ei =

65. Income Elasticity of Demand 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

66. How Income Affects Quantity of CDs Demanded Number of CDs PeriodDemanded per MonthIncome per Month 16$400 28600

67. How Income Affects Quantity of CDs Demanded Income increases from $400 to $600/month (8 - 6)/6 (600 - 400)/400 Ei =Ei = = 1/3 1/2 2 3 ==.667

68. How Income Affects Quantity of CDs Demanded Income decreases from $600 to $400/month (6 - 8)/8 (400 - 600)/600 Ei =Ei = = -1/4 -1/3 3 4 ==.75

69. Income Elasticity of Demand Eliminating the bias of the base  Quantity sum of quantities/2 Ei =Ei =  Income sum of income/2

70. Income Elasticity of Demand Demand and elasticities –Accurate estimates of E p and E i can yield accurate forecasts of the demand for goods and services.

71. Elasticity of Supply Price Elasticity of Supply (E i ) –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

72. Elasticity of Supply Formula for computing price elasticity of supply percentage change in quantity supplied percentage change in price ES =ES =

73. Elasticity of Supply Classifying supply elasticities –Perfectly Elastic Supply Quantity supplied falls to 0 when there as any decrease in price. The supply curve is horizontal at a given price.

74. Elasticity of Supply 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.

75. The Extremes in Supply Curves Price per Unit Quantity Supplied per Period Q1Q1 S’ Perfect inelasticity

76. The Extremes in Supply Curves Q1Q1 Price per Unit Quantity Supplied per Period P1P1 S S’ Perfect elasticity Perfect inelasticity Figure 20-5

77. Elasticity of Supply Price elasticity of supply and length of time for adjustment –The longer the time allowed for adjustment, the more elastic is supply. Firms can find ways to increase (or decrease) output. Resources can flow into (or out of) an industry through expansion (or contraction) of existing firms.

78. The Extremes in Supply Curves Price per Unit Quantity Supplied per Period

79. The Extremes in Supply Curves QeQe Price per Unit Quantity Supplied per Period S1S1 In the short run the supply curve, S 1, is vertical with price P e and quantity supplied of Q e. PePe E

80. Short-Run and Long-Run Price Elasticity of Supply PePe QeQe Price per Unit Quantity Supplied per Period P1P1 S1S1 If price increases to S 3 quantity stays unchanged E

81. Short-Run and Long-Run Price Elasticity of Supply PePe QeQe Price per Unit Quantity Supplied per Period S1S1 S2S2 P1P1 Q1Q1 As time passes the supply curve rotates to S 1 then to S 2 and quantity supplied rises first to Q 1. E

82. Short-Run and Long-Run Price Elasticity of Supply PePe QeQe Price per Unit Quantity Supplied per Period Q1Q1 S1S1 S2S2 P1P1 As time passes the supply curve rotates to S 2 then to S 3 and quantity supplied rises first to Q 1 and then to Q 2. E S3S3 Figure 20-6 Q2Q2

83. Chinese competition caused the price of French truffles to fall 30 percent in 1996. Accordingly French production decreased by 25%. Short-run E S =.83 International Example: French Truffle Production Takes a Nosedive

84. Issues and Applications: Discovering the Value of Garbage Charlottesville, Virginia recently experimented with a per-unit price for trash collection –Previously trash collection was financed from property taxes –Per unit cost was zero –The cost of trash disposal became high for the city

85. Issues and Applications: Discovering the Value of Garbage Consequences of the $0.80 charge per 32 gallon bag of garbage –The quantity of trash-collection services declined by 37 percent –The town’s revenues increased –Some illegal dumping occurred –Revenues from the program did not cover costs

86. 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

87. Summary Discussion of Learning Objectives 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 elastic total revenue does not change when price changes

88. Summary Discussion of Learning Objectives 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

89. Summary Discussion of Learning Objectives 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 another –If cross elasticity is positive, the goods are substitutes –If cross elasticity is negative, the goods are complements

90. Summary Discussion of Learning Objectives Income elasticity of demand –Percentage change in the demand for a good divided by the percentage in income

91. Summary Discussion of Learning Objectives 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