Download price elasticity of demand

Chapter 21
Demand and
Supply Elasticity
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
21-2
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
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21-3
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
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21-4
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
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21-5
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?
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21-6
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
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21-7
Price Elasticity (cont'd)
• Price Elasticity of Demand (Ep)
Ep =
Percentage change in quantity demanded
Percentage change in price
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21-8
Price Elasticity (cont'd)
• Example
 Price of oil increases 10%
 Quantity demanded decreases 1%
–1%
Ep =
= –.1
+10%
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21-9
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.
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21-10
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.
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21-11
Calculating Elasticity
• Elasticity formula:
Ep =
Change in Q
Change in P
Sum of quantities/2
Sum of quantities/2
or
Ep =
in Q
(Q1 + Q2)/2
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in P
(P1 + P2)/2
21-12
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?
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21-13
Example: The Price Elasticity
of Demand for Gasoline (cont'd)
• Use the elasticity formula:
9.42 – 9.04
(9.42 + 9.04)/2
÷
$3.07 – $2.61
($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.
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21-14
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
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21-15
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
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21-16
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
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21-17
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
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21-18
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.
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21-19
Figure 21-1 Extreme Price
Elasticities, Panel (a)
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21-20
Price Elasticity Ranges (cont'd)
• Extreme elasticities
 Perfectly Elastic Demand
 A demand
 It
curve that is a horizontal line
has only one price for every quantity.
 The
slightest increase in price leads to zero
quantity demanded.
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21-21
Figure 21-1 Extreme Price
Elasticities, Panel (b)
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21-22
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.
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21-23
Figure 21-2 Price Elasticity and a
Cigarette Tax, Panels (a) and (b)
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21-24
Figure 21-2 Price Elasticity and a
Cigarette Tax, Panel (c)
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21-25
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.
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21-26
Figure 21-3 The Relationship Between Price
Elasticity of Demand and Total Revenues for
Cellular Phone Service, Panel (a)
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21-27
Figure 21-3 The Relationship Between Price
Elasticity of Demand and Total Revenues for
Cellular Phone Service, Panel (b)
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21-28
Figure 21-3 The Relationship Between Price
Elasticity of Demand and Total Revenues for
Cellular Phone Service, Panel (c)
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21-29
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.
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21-30
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.
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21-31
Table 21-1 Relationship Between
Price Elasticity of Demand and
Total Revenues Example
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21-32
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.
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21-33
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.
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21-34
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.
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21-35
Figure 21-4 Short-Run and LongRun 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
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21-36
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.
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21-37
Table 21-2 Price Elasticities
of Demand for Selected Goods
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21-38
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
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21-39
Cross Price Elasticity
of Demand (cont'd)
• Formula for computing cross price
elasticity of demand between good X
and good Y
Exy =
% Change in demand for good X
% Change in price of good Y
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21-40
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.
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21-41
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.
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21-42
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
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21-43
Income Elasticity of Demand (cont'd)
Ei =
Percentage change in demand
Percentage change in income
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21-44
Table 21-3 How Income Affects
Quantity of DVDs Demanded
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21-45
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
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21-46
Income Elasticity of Demand (cont'd)
• Calculating the income elasticity of demand
Ei = Change in quantity
Average quantity
÷
Change in income
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.
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21-47
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
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21-48
Price Elasticity of Supply (cont'd)
• Formula for computing price elasticity
of supply
ES =
Percentage change in quantity supplied
Percentage change in price
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21-49
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
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21-50
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
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21-51
Figure 21-5
The Extremes in Supply Curves
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21-52
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.
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21-53
Figure 21-6 Short-Run and LongRun 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
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21-54
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.
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21-55
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.
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21-56
Table 21-4 Estimated Price Elasticities of
Demand for Selected Illicit Drugs
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21-57
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
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21-58
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.
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21-59
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
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21-60
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.
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21-61
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.
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21-62
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.
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21-63
End of
Chapter 21
Demand and
Supply Elasticity