Download Lecture Demand and Supply Elasticity Elasticity - definition

24.10.2016
Lecture
Demand and Supply Elasticity
dr Magdalena Klimczuk-Kochańska
Elasticity - definition
• Elasticity allows us to analyze supply and
demand with greater precision.
• Elasticity is a measure of how much buyers
and sellers respond to changes in market
conditions.
• When we talk about elasticity, that
responsiveness is always measured in
percentage terms.
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Elasticity - Example
If price rises by 11% what happens to demand?
We know demand will fall, but by more than
11% or by less than 11%?
Elasticity measure the extent to which demand
will change.
Elasticity of Demand and Supply Types
• Price elasticity of demand
• Cross elasticity of demand
• Income elasticity of demand
• Price elasticity of supply
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Price Elasticity of Demand
• A measure of the responsiveness of quantity
demanded to changes in price.
• Measured by dividing the percentage change in the
quantity demanded of a good by the percentage
change in its price.
• Economists compute price elasticity of demand using
midpoints as the base values of changes in prices and
quantities demanded.
Computing the Price Elasticity of
Demand
• The price elasticity of demand is computed as the
percentage change in the quantity demanded
divided by the percentage change in price.
• Because the demand curve is downward sloping and
the supply curve is upward sloping the elasticity of
demand is negative and the elasticity of supply is
positive. Often these signs are implicit and ignored.
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
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Computing the Price Elasticity of
Demand
• The formula used to calculate the coefficient
of price elasticity of demand is:
Elasticity =
E DP
ΔQ
Q
=
%ΔP
ΔP
P
%ΔQ
Q2  Q1
Q  Q1  / 2
 2
P2  P1
P2  P1  / 2
Elastic vice Inelastic
• The responsiveness of demand to changes in
price
– Where % change in demand is greater than %
change in price – elastic
– Where % change in demand is less than % change
in price - inelastic
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Elastic and Inelastic Demand
• Elastic Demand (Ed > 1): the numerator is
greater than the denominator, the
coefficient is greater than 1 and demand is
elastic.
• Inelastic Demand (Ed < 1): the numerator is
smaller than the denominator , the
coefficient is smaller than 1, and demand is
inelastic.
Perfectly Elastic and Perfectly Inelastic
Demand
• Perfectly Elastic Demand (Ed = ∞): If the
quantity demanded is extremely responsive to
a change in price.
• Perfectly Inelastic Demand (Ed = 0): If
quantity demanded is completely
unresponsive to changes in price, demand is
perfectly inelastic. A change in price causes
no change in quantity demanded.
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Unit Elastic Demand
• Unit Elastic Demand (Ed = 1): If the numerator and
denominator are the same, the coefficient is equal to one.
The quantity demanded changes proportionally to a change
in price.
Elasticity Along a Demand Curve
•
$10
9
8
7
6
5
4
3
2
1
•
Perfectly
elastic
Ed = ∞
•
Ed > 1
Elastic
Price
0
•
Unit elastic
Ed = 1
Ed < 1
Inelastic
Ed = 0
1
2
3
4
5
6
7
8
•
Perfectly
inelastic
Elasticity is not the same
as slope.
Elasticity changes along
straight line demand
curves –slope does not.
Elasticity declines along
demand curve as we
move toward the
quantity axis.
The price elasticity of
demand decreases as we
move downward along a
linear demand curve.
Demand is elastic on the
upper half of the demand
curve and inelastic on the
lower half.
9 10 Quantity
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Price Elasticity of Demand Along a
Straight Line Demand Curve - Example
The Price Demand Elasticity
Price
• The demand curve
can be a range of
shapes each of which
is associated with a
different relationship
between price and the
quantity demanded.
• They all have
differing levels of
elasticity.
Quantity Demanded
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Price Elasticity of Demand
Perfectly Inelastic Demand Curve Example
Price
£400
£300
£200
• The demand curve is vertical,
the quantity demanded is
totally unresponsive to the
price. Changes in price have no
effect on consumer demand.
• When demand is perfectly
inelastic, the quantity
demanded is the same at
every price, so the price
elasticity of demand is zero.
• Perfectly inelastic demand
curve represents the demand
for insulin by the diabetic. A
certain quantity is necessary
to satysfy the need regardless
of the price.
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Quantity Demanded
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Perfectly Elastic Demand Curve
- Example
•
Price
•
•
£200
•
•
400
When demand is perfectly elastic, the
quantity demanded is infinitely responsive
to changes in price, so the price elasticity
of demand is infinite.
The demand curve is horizontal, any
change in price can and
will cause consumers to change their
consumption.
A perfectly elastic demand curve
represents the demand for one farmer’s
wheat. Because there are many other
suppliers, buyers purchase wheat from the
least expensive source. If this farmer’s
wheat is priced over so slightly above
others farmers’ wheat, buyers will switch
to another source.
Also because this farmer is just one small
producer in a huge market, he can sell
everything wants at the market price.
Other example: Pink marker pens
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Determinants of Price Elasticity of
Demand
• Number of Substitutes:
 The more substitutes for a good, the higher the price
elasticity of demand; is the fewer substitutes for a
good, the lower the price elasticity of demand.
 The more broadly defined the good, the fewer the
substitutes; the more narrowly defined the good, the
greater the substitutes.
• Necessities Versus Luxuries:
 The more a good is considered a luxury rather than a
necessity, the higher the price elasticity of demand.
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Determinants of Price Elasticity of
Demand
• Percentage of One’s Budget Spent on the Good:
 The greater the percentage of one’s budget that goes
to purchase a good, the higher the price elasticity of
demand; the smaller the percentage of one’s budget
that goes to purchase a good, the lower the elasticity
of demand.
• Time:
 The more time that passes, the higher the price
elasticity of demand for the good; the less time that
passes, the lower the price elasticity of demand for
the good.
The Elasticity of Demand in Short and
Long Time
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Total Revenue
• The importance of elasticity for firms relates to the effect of
price changes on total revenue and thus on profits.
• Profits = Total revenue – Total cost
 = TR - TC
• Total revenue = Price X Quantity
TR = P x Q
• The total inflow of receipts from selling a given amount of
output
• Each time the firm chooses a level of output, it also
determines its total revenue. Because once we know the level
of output, we also know the highest price the firm can charge
• Total revenue and price elasticity of demand are related. The
relationship will tell you if demand is elastic or inelastic.
Predicting Changes in Total Revenue
Price
Quantity of Tickets Sold
Total Revenue
4,00
100
$400
4,40
80
$352
• An increase in the ticket price
brings good news and bad news:
– Good news – you get more money for
each ticket sold.
– Bad news – you sell fewer tickets.
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Total Revenue and Elastic Demand
Relationship
Price
Price of TVs is $200 per unit and 400 units is sold.
Total revenue when price $200 = 200 x 400 = $80 000
$200
$100
1200
400
Quantity
Total Revenue and Elastic Demand
Relationship
Price
Now price of the TVs is $100 per unit and 1200 units are sold
Total revenue when price $100 = 100 x 1200 = $120 000
$200
$100
400
1200
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Total Revenue and Elastic Demand
Relationship
Revenue increases by $40 000
Price
Price elasticity of demand
% change in demand = 200%
% change in price = 100%
$200
Ep = 200 = 2
100
Loss
$100
Example: restaurant meals, air
travel, movies, specific brands of
coffee
Additional profit
1200
400
Total Revenue and Inelastic Demand
Relationship
Total revenue when price 400 = 400 x 350 = 140 000
Price
£400
£200
350
400
Quantity Demanded
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Total Revenue and Inelastic Demand
Relationship
Total revenue when price 400 = 400 x 350 = 140 000
Price
Total revenue when price 200 = 200 x 400 = 80 000
£400
£200
350
400
Quantity Demanded
Total Revenue and Inelastic Demand
Relationship
Revenue decreases by $60 000
Price
Price elasticity of demand
£400
% change in demand = (50 / 350) x 100 = 14%
% change in price = 100%
Ep = 14 = 0,14
100
Loss
£200
Additional profit
350
400
Example: eggs, coffee, cigarettes, shoes
Quantity Demanded
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Total Revenue and Unitary Elastic
Relationship
• An increase or decrease in the price leaves total revenue
unchanged.
• The loss in revenue from a lower price is exactly offset by
the gain in revenue from accompanying increase in sales.
• For example:
• Price of movie tickets is $6 per ticket and 1,000 tickets
are sold
• Price of movie tickets goes to $5 per ticket and 1,200
tickets are sold
• Total revenue = $6 X 1,000 = $6,000
• Total revenue = $5 X 1,200 = $6,000
• No change in total revenue
Elasticities, Price Changes and Total
Revenue
• As price increases and
– EDP < 1, then TR increases
– EDP = 1, then TR does not
change (remains constant)
– EDP > 1, then TR decreases
• As price decreases, and
– EDP < 1, then TR decreases
– EDP = 1, then TR does not
change (remains constant)
– EDP > 1, then TR increases
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Marginal Revenue
• Marginal revenue (MR)
–Change in total revenue from
producing one more unit of output
MR = ΔTR / ΔQ = (TR2 – TR1) / (Q2 – Q1)
• Tells us how much revenue rises per
unit increase in output
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Elasticity and Marginal Revenue
• If MR<0, demand is inelastic and the fall of
the price will decrease TR.
• If MR = 0, demand is unit elastic and the TR
achieves its maximum.
• If MR > 0, demand is elastic and the fall of
the price will increase TR.
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Predicting Changes in Total Revenue
• Demand is elastic along the
upper half of a linear demand
curve, so an increase in quantity
increases total revenue.
• Demand is inelastic along the
lower half of a linear demand
curve, so a decrease in price
decreases total revenue.
• Total revenue reaches its
maximum at the midpoint of
the demand curve, where
demand is unitary elastic.
Unit elastic demand
Marginal
Revenue
Elastic demand Inelastic demand
P
Unit-elastic demand
D
MR
Q
TR
TR
Q
Elastic demand Inelastic demand
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Cross Elasticity of Demand
• Measures the responsiveness in the quantity
demanded of one good to changes in the price of
another good.
• This concept is often used to determine whether two
goods are substitutes or complements and the
degree to which one good is a complement to or
substitute for another.
Cross Elasticity of Demand
•
The percentage change in the quantity demanded of one good associated
with a one-percent change in the price of another good.
 Q x1
Q x 2  Q x 1  / 2

Py 2  Py1
Q
E
DC
P
y 2
x 2

 Py1 / 2
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Cross Elasticity of Demand Substitutes and Complements
• Depending on whether the cross-price elasticity
of demand of given goods is less than or
greater than zero, goods may be classified as
substitutes or complements:
– If ECD < 0, goods are complements,
– If ECD > 0, goods are substitutes,
– If ECD = 0, goods are independent.
Cross Elasticity of Demand - Example
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Income Elasticity of Demand
• Measures the responsiveness of quantity demanded
to changes in income.
Income Elasticity of Demand
• The income elasticity of demand measures of
the responsiveness of demand to changes in
income, indicating how much more or less of a
particular product is purchased as income
changes.
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Income Elasticity of Demand
• If Ey >1, demand is considered to be income elastic.
• If Ey <1, demand is considered to be income inelastic.
• If Ey =1, demand is considered to be unit elastic.
Income Elasticity of Demand - Example
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Types of Goods
• Income elasticity of demand depends on kind
of the good. There are:
Normal good,
Necessity good,
Luxury good,
Inferior good.
Normal Good
• Normal goods are those goods which have a direct
relationship with the consumer’s income. The consumer’s
tends to demand more of the normal goods when they get
an increase in their income and their demand decreases
with a decrease in their income.
• Demand rises as income rises and vice versa.
• A positive sign (+) denotes a normal good.
• Normal goods have a positive income elasticity of demand.
• Normal goods have an income elasticity of demand of
between 0 and +1.
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Normal Good
• All normal goods have negatively sloped
demand curves and income elasticity of
demand is greater than 0 (EDI > 0).
• A good may be classified as a necessity or a
luxury, depending on whether its income
elasticity of demand is less than or greater
than one:
– EDI > 1 luxury goods
– EDI < 1 necessity goods
Luxury Good
• Luxury goods are those goods the demand for
which demand rises more than proportionate to
a change in income.
• Luxuries have an income elasticity of demand >
+1
• Example: international air travel, private
education, designer clothes, fine wines and
spirits, high quality chocolates (e.g. Lindt) and
luxury holidays overseas; audio visual equipment,
3G mobile phones and designer kitchens; sports
and leisure facilities (including gym membership
and sports clubs).
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Necessity Good (Necessities)
• These are those goods which are not very
expensive and are necessary for everyday life.
Demand for such goods remains constant
throughout.
• Example: fresh vegetables and fruit, instant
coffee, shampoo, toothpaste, toilet paper,
cigarettes, low-priced own label foods in
supermarkets, council-owned properties.
Inferior Good
• Inferior goods are those goods that have an
inverse relationship with the consumer’s income.
The demand for inferior goods increases with the
decrease in consumer’s income and the demand
decreases with the increase in consumer’s
income.
• Demand falls as income rises and vice versa. And
that why we use a negative sign (-) denotes an
inferior good.
• Inferior goods have a negative income elasticity
of demand.
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Inferior Goods
• Inferior goods have negative income elasticity
of demand (EDI < 0)
• Example: canned meat, frozen fruits and
vegetables, store brand items, basic food mass
transport (bus and rail), beer and takeaway
pizza.
• Income elasticity of demand is positive (Ey > 0)
for a normal good.
• The demand for an inferior good decreases as
income increases.
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Income Elasticity and Different Goods
Good
Income
Elasticity
Customer
budget change
Demand
change
Normal good
Ei > 0
Increase /
decrease
Increase
Luxury good
Ei >1
Increase
Increase more
than 1%
Necessity good
0<E i <1
Decrease
Increase less
than 1%
Inferior good
Ei <1
Decrease
Decrease
Income Elastic or Inelastic Demand
• Elastic goods – are seen
as LUXURIES
• Inelastic goods – are seen
as NORMAL or
NECESSITIES
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Example
Ei = - 0.6
Good is an inferior good
but inelastic
• a rise in income of 10%
would lead to demand
falling by 6%.
Ei = + 1.6
Good is a normal good
and elastic
• a rise in incomes of 10%
would lead to demand
rising by 16%.
Ei = - 2.1
Good is an inferior good
and elastic
• a rise in incomes of 10%
would lead to a fall in
demand of 21%.
Ei = + 0.4
Good is a normal good
but inelastic
• a rise in incomes of 10%
would lead to demand
rising by 4%.
Price Elasticity of Supply
• Identical in concept to elasticity of demand.
– formula is the same,
– it is also related to the slope of the supply curve
but is not simply the slope of the supply curve,
– terminology is the same.
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Price Elasticity of Supply
• Measures the responsiveness of quantity
supplied to changes in price.
• Defined as the percentage change in quantity
supplied of a good divided by the percentage
change in the price of the good.
• Supply can be classified as elastic, inelastic,
unit elastic, perfectly elastic or perfectly
inelastic.
The Price Elasticity of Supply
• The price elasticity of supply measures the
responsiveness of producers to changes in
price.
E SP
Q2  Q1
Q  Q1  / 2
 2
P2  P1
P2  P1  / 2
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Price Elasticity of Supply
• Economists distinguish the following three
cases of the price elasticity of supply:
– EPS < 1, supply is said to be inelastic,
– EPS = 1, supply is said to be unit elastic,
– EPS > 1, supply is said to be elastic,
– in the case of vertical supply curve, supply is
said to be perfectly inelastic,
– in the case of a horizontal supply curve, supply is
said to be perfectly elastic.
Price Elasticity of Supply
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The Price Elasticity of Supply
• A 10% increase in the price of
milk (from $2 to $2.20)
increases the quantity
supplied by 20% (from 100
million gallons to 120
million), so the price
elasticity of supply is 2.0 =
20%/10%.
Perfectly Inelastic Supply and Perfectly
Elastic Supply
• When supply is perfectly inelastic, • When supply is perfectly elastic, the
quantity supplied is infinitely responsive to
the quantity supplied is the same at
changes in price, so the price elasticity of
every price, so the price elasticity of
supply is infinite.
supply is zero.
• Example: sand used to make silicon used by
• Example: water from a mineral
computer chip makers.
spring.
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Price Elasticity of Supply and Time
• The longer the period of adjustment to a change in
price, the higher the price elasticity of supply.
• Additional production takes time.
• Reducing production takes time.
Summary of the Four Elasticity
Concepts
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Importance of Elasticity
• Relationship between changes in price and
total revenue.
• Importance in determining what goods to tax
(tax revenue).
• Importance in analysing time lags in
production.
• Influences the behavior of a firm.
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