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Chapter 19 Demand and Supply Elasticity Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Introduction Economists have estimated that if the price of satellite delivered TV services decreases by a certain percentage, the demand for cable TV falls by about the same percentage, but a given percentage decline in the price of cable TV causes less than half of the percentage decrease in the demand for satellite TV. What does this tell us about how consumers perceive consumption of cable TV versus satellite TV? This chapter will help you understand this question through the concept called the cross price elasticity of demand. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-2 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-3 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-4 Chapter Outline • • • • Price Elasticity Price Elasticity Ranges Elasticity and Total Revenues Determinants of the Price Elasticity of Demand • Cross Price Elasticity of Demand • Income Elasticity of Demand • Price Elasticity of Supply Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-5 Did You Know That ... • Economists have estimated that when bank debitcard transaction fees increase by 10 percent, the number of debit-card transactions that people wish to utilize declines by nearly 67 percent? • A special name for quantity responsiveness is elasticity, which is one of the topics in this chapter. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-6 Price Elasticity • Price Elasticity of Demand (Ep) – 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-7 Price Elasticity (cont'd) • Price Elasticity of Demand (Ep) Ep = Percentage change in quantity demanded Percentage change in price Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-8 Price Elasticity (cont'd) • Example – Price of oil increases 10% – Quantity demanded decreases 1% –1% Ep = = –.1 +10% Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-9 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. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-10 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-11 Price Elasticity (cont’d) • Calculating Elasticity Ep = change in Q change in P sum of quantities/2 sum of prices/2 or Ep = in Q (Q1 + Q2)/2 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. in P (P1 + P2)/2 19-12 Example: The Price Elasticity of Demand for Natural Gas • During a recent three-month period, the price of natural gas decreased from $4.81 per 1,000 cubic feet to $4.44 per 1,000 cubic feet. • During this period the total quantity of natural gas consumed in the United States increased from 62.21 billion cubic feet per day to 62.64 billion cubic feet per day. • What is the price elasticity of demand? Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-13 Example: The Price Elasticity of Demand for Natural Gas (cont'd) • Use the elasticity formula: 62.64 - 62.21 ÷ $4.81 - $4.44 (62.64 + 62.21)/2 ($4.81+$4.44)/2 = 0.43 ÷ $0.37 124.85/2 $9.25/2 = 0.09 • The price elasticity of 0.09 means that a 1% increase in price generated a 0.09% decrease in the quantity of oranges demanded Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-14 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 – Ep > 1 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-15 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 – Ep = 1 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-16 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 – Ep < 1 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-17 Price Elasticity Ranges (cont'd) • Elastic demand – % change in Q > % change in P; Ep > 1 • Unit-elastic – % change in Q = % change in P; Ep = 1 • Inelastic demand – % change in Q < % change in P; Ep < 1 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-18 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-19 Figure 19-1 Extreme Price Elasticities, Panel (a) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-20 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. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-21 Figure 20-1 Extreme Price Elasticities, Panel (b) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-22 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-23 Figure 19-2 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service, Panel (a) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-24 Figure 19-2 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service, Panel (b) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-25 Figure 19-2 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service, Panel (c) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-26 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. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-27 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-28 Table 19-1 Relationship Between Price Elasticity of Demand and Total Revenues Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-29 Determinants of the 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-30 Determinants of the 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-31 Figure 19-3 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 In the short run, quantity demanded falls slightly Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-32 Why Not … always raise prices when demand is inelastic? • Even if the market demand is inelastic, you have competitors. • If you increase the price of your product, but your competitors do not raise the prices of their products, your competitors will pick off your customers. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-33 Determinants of the 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-34 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. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-35 Table 19-2 Price Elasticities of Demand for Selected Goods Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-36 Cross Price Elasticity of Demand • Cross Price Elasticity of Demand (Exy) – 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-37 Cross Price Elasticity of Demand (cont'd) • Formula for computing cross price elasticity of demand between good X and good Y Exy = % change in amount of good X demanded % change in price of good Y Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-38 Cross Price Elasticity of Demand (cont'd) • Substitutes – Exy would be positive • An increase in the price of X would increase the quantity of Y demanded at each price. • Complements – Exy would be negative • An increase in the price of X would decrease the quantity of Y demanded at each price. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-39 Income Elasticity of Demand • Income Elasticity of Demand (Ei) – 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-40 Income Elasticity of Demand (cont'd) Ei = Percentage change in demand Percentage change in income Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-41 Income Elasticity of Demand (cont'd) • Calculating the income elasticity of demand Ei = Change in quantity income Average quantity ÷ Change in 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. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-42 Table 19-3 How Income Affects Quantity of Blu-Ray Discs Demanded Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-43 Income Elasticity of Demand (cont'd) • From Table 19-3, income elasticity of demand for Blu-ray discs: Ei = = 2/[(6+8)/2] = 2/7 $2000/[($4000+$60000)/2] 2/5 0.71 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-44 Example: The Income Elasticity of Demand for Dental Services • During a few weeks in the depths of the Great Recession of the late 2000s, U.S. household income declined by 1 percent, while the amount of dental services that people purchased nationwide fell by 5.8 percent. • Thus, the income elasticity of demand for U.S. dental services was equal to 5.8 (-5.8%/-1%). Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-45 Price Elasticity of Supply • Price Elasticity of Supply (Es) – 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-46 Price Elasticity of Supply (cont'd) • Formula for computing price elasticity of supply ES = Percentage change in quantity supplied Percentage change in price Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-47 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-48 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-49 Figure 19-4 The Extremes in Supply Curves Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-50 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. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-51 International Example: Price Elasticities of Salmon Supply in Norway • A study of prices and quantities of salmon supplied by Norwegian salmon-farming firms shows that a 1 percent rise in the price of salmon induces a percentage increase in quantity supplied that is 28 times greater in the long run than that in the short run. • In the long run, these firms have sufficient time to respond to a price increase by changing varieties and amounts of feed and capital equipment. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-52 Figure 19-5 Short-Run and Long-Run Price Elasticity of Supply As time passes the supply curve rotates from S1 to S2 and quantity supplied rises to Q1 As more time passes the supply curve rotates from S2 to S3 and quantity supplied rises from Q1 to Q2 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-53 You Are There: Pricing the iPad: Learning Lessons from the iPhone • While most industry observers anticipated that a basic iPad would be priced at $1,000, Apple set its initial price at only $499 in 2010. • Apple learned a lesson from its experience with the iPhone in mid-2007: the estimated price elasticity of demand for smart cellphones like the iPhone was about 1.4. • The company set this lower price in anticipation that the demand for the new gadget would also be elastic, so a lower price would ultimately yield higher revenues. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-54 Issues & Applications: Measuring the Substitutability of Satellite and Cable TV • Researchers Austan Goolsbee and Amil Petrin estimated that the price elasticity of demand was elastic for cable TV and satellite TV. • They also found that their cross price elasticities were positive, so they are substitutes. • The cross price elasticities also suggest that consumers of satellite TV perceive cable TV to be less substitutable for satellite TV services than do cable TV consumers. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-55 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-56 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-57 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-58 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. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-59 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. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-60 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. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 19-61