Download DESCRIBING SUPPLY AND DEMAND: ELASTICITIES

Chapter 6
DESCRIBING
SUPPLY AND
DEMAND:
ELASTICITIES
Today’s lecture
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Elasticity
The Price Elasticity of Demand
The Price Elasticity of Supply
Calculate elasticity graphically
numerically.
and
The Concept of Elasticity
• Elasticity is a measure of the
responsiveness of one variable to another.
• The greater the elasticity, the greater the
responsiveness.
• In economics, elasticity is used to
describe the responsiveness of quantity
supplied or quantity demanded to price.
The Price Elasticity of Demand
• The price elasticity of demand measures
how much the quantity demanded
responds to a change in price.
Price elasticity of demand (ED)
Percentage change in quantity demanded
ED 
Percentage change in price
Example
• Suppose that a 10-percent increase in the
price of an ice-cream cone causes the
amount of ice cream you buy to fall by 20
percent.
The related price elasticity of demand:
-20 percent / 10 percent = 2
The Price Elasticity of Supply
• The price elasticity of supply measures
how much the quantity supplied responds
to a change in price.
Price elasticity of supply (ES)
Percentage change in quantity supplied
ES 
Percentage change in price
Example
• Suppose a 10 percent increase in the
price of an ice-cream causes a 5 percent
increase in the supply of ice-cream.
The related price elasticity of supply:
5 percent/ 10 percent = 0.5
Classifying Demand and Supply
as Elastic or Inelastic
• Demand or supply is elastic if the
percentage change in quantity is greater
than the percentage change in price.
E>1
• Demand or supply is inelastic if the
percentage change in quantity is less than
the percentage change in price.
E<1
Unit Elastic Demand or Supply
• Demand or supply is unit elastic if the
percentage change in quantity is the
same as the percentage change in price.
E=1
Elasticities and Supply and
Demand Curves
Perfectly
inelastic
demand
curve
Perfectly
elastic
demand
curve
P
0
0
Quantity
Quantity
Elasticity is Not the
Same as Slope, But
• The steeper the curve at a given point, the
less elastic is supply or demand.
• Perfectly elastic supply or demand
– The curves are flat
– The quantity responds enormously to a change
in price (E = ∞)
• Perfectly inelastic supply or demand
– The curves are vertical
– The quantity does not response to a change in
price (E=0).
Example
• A diabetic, who will die without insulin,
would be willing to pay any price for the
life-saving quantity of insulin.
----The diabetic has a perfectly inelastic
demand of insulin.
Example
• In
agriculture
individual
producers
generally have no control over the price
because she or he will not be able to sell
any of the crop if she or he raise the price
slightly above the market price.
---- The demand of crop is perfectly elastic.
Question
• The elasticity of demand is same along the
demand curve?
----To find out the answer, we just calculate
them by ourselves.
Calculating Elasticity of Demand
Between Two Points
$26
24
22
20
18
16
Elasticity of demand
between A and B:
B
midpoint
C
A
% Q
E
% P
10  14
4
1
 .33
2 (14  10)
ED 
 12 
 1.27
26  20
6
.26
1
23
2 (26  20)
Demand
14
0
10
12
14
Quantity of software (in hundred thousands)
Question
• A major cereal producer decides to lower
price from $3.60 to $3 per 15-ounce box.
Q: If quantity demanded increases by 18
percent, what is the price elasticity of
demand?
Calculating Elasticity at a Point
$10
9
8
7
6
5
4
3
2
1
To calculate elasticity at a point determine
a range around that point and calculate
the arc elasticity.
C
Eat A
A
B
20 24 28
Quantity
28  20
8
1
.33
2 (28  20)
24



 .66
53
2
.5
1
4
2 (5  3)
40
Calculating Elasticity along the
Demand Curve
$10
9
8
7
6
5
4
3
2
1
The elasticity at point C:
[(16-24)/20]/[(6-4)/5]=0.4/0.4=1
G
F
The elasticity at point F:
[(16-0)/8]/[(6-10)/8]=4
E
D
C
The elasticity at point A:
[(28-20)/24]/[(3-5)/4]=0.65
A
B
8 12 16 20 24 28
Quantity
40
Elasticity Along a Demand Curve
Ed = ∞
$10
9
8
7
6
5
4
3
2
1
Elasticity declines along
demand curve as we move
toward the quantity axis
Price
Ed > 1
0
Ed = 1
Ed < 1
Ed = 0
1
2
3
4
5
6
7
8
9 10 Quantity
Question
• If a good have several substitutes, the
demand of this good is elastic or inelastic?
Substitutes are often pairs of goods that
are used in place of each other and an
increase in the price of one leads to an
increase in the demand for the other.
• If a good is necessary, such as salt, the
demand of this good is elastic or inelastic?
Elasticity and Demand
• As a general rule, the more substitutes a good has,
the more elastic is its supply and demand.
• The larger the time interval considered, the more
elastic is the demand curve.
• The less a good is a necessity, the more elastic is
its demand curve.
• Demand becomes more elastic as the definition of
the good becomes more specific.
• Demand for goods that represent a large portion of
one’s budget are more elastic.
Elasticity and Supply
• The longer the time period considered, the
more elastic the supply.
• There are three time periods relevant to
supply:
– The instantaneous period – supply is fixed,
perfectly inelastic.
– The short run – supply is somewhat elastic.
– The long run – supply is very elastic.
Elasticity and Total Revenue
Unit Elastic Demand
E=1
TR constant
$10
Price
8
F
6
E
O
A
2
0
Gained revenue:FO46(C)
C
4
1
2
Lost
revenueEO46
(B)
B
3
4
TRE= $4x6=$24
TRF= $6x4=$24
5
6
7
8
9
Quantity
Elasticity and Total Revenue
Elastic Demand
E>1
Price
$10
K
9
C
8
6
J
TR falls if price increases.
TR rises if price decreases.
TRJ = $8 x 2 = $16
TRK = $9 x 1 = $9
A B
4
2
0
1
2
3
4
5
6
7
8
9
Quantity
Elasticity and Total Revenue
Inelastic Demand
E<1
TR rises if price increases
$10
Price
8
TRG = $1 x 9 = $9
TRH = $2 x 8 = $16
6
4
H
2
G
C
A
0
1
2
B
3
4
5
6
7
8
9
Quantity
A
Elastic ED > 1
ED = 1
C
Inelastic ED < 1
0
B
Q0
Quantity
Total revenue
Total
Revenue
Along a
Demand
Curve
0
Q0
Quantity
Question
• If you find that in California where vanity
plates cost $28.75, the elasticity of
demand is 0.52. In Massachusetts where
vanity plates cost $50, the elasticity of
demand is 3.52.
Q: What recommendation would you have
for each state to maximize revenue?
Question
•
A newspaper recently lowered its price
from 50 cents to 30 cents. As it did, the
number of newspapers sold increased
from 240,000 to 280,000.
a. What was the newspaper’s elasticity of
demand?
b. Given that elasticity, did it make sense
for the newspaper to lower its price?
Question
• Comparing a rich person and a poor guy,
for a given good, which person has a more
elastic demand of the good?
• If you can charge different price for
different person, you will charge a higher
price or lower price to the person who has
a more elastic demand of the good?
Elasticity of Individual and Market
Demand
• Price discrimination occurs when a firm separates
the people with less elastic demand from those
with more elastic demand.
• Firms charge more to the individuals with inelastic
demand and less to individuals with elastic
demand.
• Examples of price discrimination:
– Airlines’ Saturday stay-over specials
– Sales of new cars
– Almost-continual sales
Income Elasticity of Demand
• Income elasticity of demand measures
the responsiveness of demand to
changes in income.
Eincome
Percentage change in demand

Percentage change in income
Income Elasticity of Demand
• Normal goods are those whose consumption
increases with an increase in income.
• Normal goods can be luxuries or necessities:
– Luxuries are goods that have an income elasticity greater
than one.
– A necessity has an income elasticity less than 1.
• Inferior goods are those whose consumption
decreases when income increases.
– Inferior goods have income elasticities less than zero.
Cross-Price Elasticity of Demand
• Cross-price elasticity of demand measures the
responsiveness of demand to changes in prices
of other goods.
Percentage change in demand
Ecrossprice 
Percentage change in price
of a related good
Complements and Substitutes
• Substitutes are goods that can be used in
place of another.
– Substitutes have positive cross-price elasticities.
• Complements are goods that are used in
conjunction with one another.
– Complements have negative cross-price
elasticities.