Download Describing Supply and Demand: Elasticities

Describing Demand and
Supply: Elasticities
Chapter 6
The Concept of Elasticity
• Elasticity is a measure of the
responsiveness of one variable to a
change in another.
• The most commonly used elasticity
concept is price elasticity of demand.
Price Elasticity
• The price elasticity of demand is the
percentage change in quantity demanded
divided by the percentage change in price.

D
Percentage change in quantity demanded
=
Percentage change in price
Things to Note About Elasticity
• Price elasticity of demand is always
negative because price and quantity
demanded are inversely related—when
price rises, quantity demanded falls, and
vice versa.
Things to Note About Elasticity
• Economists have developed a
convention and talk about price elasticity
of demand as an absolute value of the
number.
• Thus, price elasticity of demand is
reported as if it were positive.
Elasticity Is Independent of
Units
• Elasticity is calculated as a ratio of
percentages.
• Percentages allow us to have a measure
of responsiveness that is independent of
units.
Elasticity Is Independent of
Units
• Having a measure of responsiveness that
is independent of units makes
comparisons of responsiveness of
different goods easier.
Calculating Elasticities
• To determine elasticity, divide the
percentage change in quantity by the
percentage change in price.
The Mid-point Formula
• Using the mid-point formula, the average
of the two end points are used when
calculating percentage change.

D
=
(Q2 - Q1)
½Q1  Q2 
(P2 - P1)
½P1 + P2 
Graph of Price Elasticity of
Demand, Fig.6-1a, p 136
B
$2
6
23
C (midpoint)
A
20
D
0
5
7
9
Quantity of software (in thousands)
Elasticity of demand = 1.3
Graph of Price Elasticity of
Demand, Fig.6-1b, p 136
$10
9
8
7
6
5
4
3
2
1
B
D = 4
A
C
D = 0.54
D
5 10 15 20 25 30 35 40 45 50 55
Quantity
b) Some examples
Calculating Elasticity at a Point
• Let us now turn to a method of calculating
the elasticity at a specific point, rather than
over a range.
Calculating Elasticity at a Point
• To calculate elasticity at a point, determine
a range around that point and calculate
the elasticity using the mid-point formula.
Calculating Elasticity at a Point,
Fig a) p 138
$10
9
8
7
6
5
4
3
2
1
(28 - 20)
 =
D
(5 - 3)
½28  20
 0.66
½5 + 3
C
A
B
20 24 28
40
Quantity
Calculating Elasticity at a Point
Fig b) p 138
$10
9
8
7
6
5
4
3
2
1
Demand
A
D= 2.33
D = 0.11
B
6
12 18 24 30 36 42 48 54 60
Quantity
Elastic Demand
• For elastic points on curves, the
percentage change in quantity is greater
than the percentage change in price, in
absolute value.
D > 1
Elastic Demand
• Common sense tells us that an elastic
demand means that quantity changes by a
greater percentage than the percentage
change in price, in absolute value.
Inelastic Demand
• For inelastic points on curves, the
percentage change in quantity is less than
the percentage change in price, in
absolute value.
D < 1
Inelastic Demand
• Common sense tells us that an inelastic
demand means that the percent change in
quantity is less than the percentage
change in price, in absolute value.
Classifying Demand as Elastic
or Inelastic
• It is helpful to classify demand by relative
responsiveness as elastic or inelastic.
Elasticity and Demand Curves
• Two important points to consider:
– Elasticity is related to (but is not the same as)
slope.
– Elasticity changes along a straight-line
demand curve.
Elasticity Is Not the Same as
Slope
• The relationship between elasticity and
slope means that the steeper the curve,
the less elastic is demand.
• There are two limiting examples of this.
Elasticity Is Not the Same as
Slope
• When the curve is horizontal, it is perfectly
elastic.
• Perfectly elastic demand is a horizontal
line in which quantity changes
enormously in response to any change
in price (D = ).
Elasticity Is Not the Same as
Slope
• When the curve is vertical, we call the
demand perfectly inelastic.
• Perfectly inelastic demand is a vertical line
in which quantity does not change at all in
response to a change in price (D = 0).
Perfectly Inelastic Demand
Curve, Fig 6-2a, p 139
Price
Perfectly inelastic
demand curve
0
Quantity
Perfectly Elastic Demand Curve
Fig 6-2b, p 139
Price
Perfectly elastic
demand curve
0
Quantity
Elasticity and slope, Fig.6-3, p 140
$10
9
8
7
6
5
4
3
2
1
Over the $3 to $4 price
interval, D (D1) = 0.47
while D (D2) = 4.2
G
C
A
D1
D2
10 20 30 40 50 60 70 80 90
Quantity
Elasticity Changes Along
Straight-Line Curves
• Elasticity is not the same as slope.
• Elasticity changes along the straight line
supply and demand curves—slope does
not.
Elasticity Changes Along
Straight-Line Curves
• A demand curve is perfectly elastic ( D =
) at the vertical (price) intercept.
• Elasticity becomes smaller as you move
down the demand curve until it
becomes zero ( = 0) at the horizontal
(quantity) intercept.
Price
Elasticity Along a Straight Line
Demand Curve Fig 6-4, p 141
$10
9
8
7
6
5
4
3
2
1
0
D = 
Elasticity declines along demand
curve as we move toward the
quantity axis
D>1
D=1
D<1
D=0
1
2
3
4
5
Quantity
6
7
8
9 10
Interpreting elasticities
• We know by the law of demand that
consumers buy less as price rises
• Price elasticity of demand tells us if
whether consumers reduce their
purchases by a lot (elastic demand) or a
little (inelastic demand).
Interpreting Price Elasticity of Demand, Table 6-1, p 141
D
Description of
demand
Interpretation
D=
Perfectly elastic
Quantity responds enormously
to changes in price
D>1
Elastic
Consumers are responsive to
price changes
D=1
Unit elastic
Percent change in price and
quantity are equal
D<1
Inelastic
Consumers are unresponsive to
price changes
D=0
Perfectly inelastic
Consumers are completely
unresponsive to price change
Factors influencing Price Elasticity of Demand
• The closeness of substitutes
• The proportion of income spent on good
• The time elapsed since a price change
Substitution and Price Elasticity
of Demand
• As a general rule, the more substitutes a
good has, the more elastic is its demand.
Substitution and Price Elasticity
of Demand
• How many substitutes a good has is
affected by many factors:
– Time to Adjust
– Luxuries versus Necessities
– Narrow or Broad Definition
– Budget Proportion
Time to Adjust
• The larger the time interval considered, or
the longer the run, the more elastic is the
good’s demand curve.
– There are more substitutes in the long run
than in the short run.
– The long run provides more options for
change.
Luxuries versus Necessities
• The less a good is a necessity, the more
elastic its demand curve.
• Necessities tend to have fewer
substitutes than do luxuries, so their
demand is less elastic.
Narrow or Broad Definition
• As the definition of a good becomes more
specific, demand becomes more elastic.
– If the good is broadly defined—for
example, transportation—there are not
many substitutes and demand will be
inelastic.
Narrow or Broad Definition
• As the definition of a good becomes more
specific, demand becomes more elastic.
– If the definition of a good is narrowed—to
travel by bus, for example—there are more
substitutes.
Budget Proportion
• Demand for goods that represent a large
proportion of one's budget are more elastic
than demand for goods that represent a
small proportion of one's budget.
Budget Proportion
• Most people shop around for the lowest
price on expensive items – the demand
elasticity is large for those goods.
• It is not worth spending the time looking
for substitutes for goods which do not take
much out of one’s income.
Empirical Estimates of
Elasticities
• The following table provides short- and
long-term estimates of elasticities for a
number of goods.
Empirical Estimates of
Elasticities, Table 6-2, p 143
Product
Tobacco products
Electicity (household)
Health Services
Nondurable toys
Movies/motion pictures
Beer
Wine
University tuition
Price elasticity
Short Run Long Run
1.89
0.46
1.89
0.13
0.92
0.20
1.02
0.30
3.67
0.87
1.39
0.56
0.84
0.68
—
0.52
Price Elasticity of Demand and
Total Revenue
• Total revenue is the total amount of money a
firm receives from selling its product.
• Revenue equals total quantity sold multiplied by
the price of good.
• Knowing the elasticity of demand is useful to
firms because from it they can tell what happens
to total revenue when they raise or lower their
prices.
Price Elasticity of Demand and
Total Revenue
• If demand is elastic ( D > 1), a rise in price
lowers total revenue.
• Price and total revenue move in
opposite directions.
Price Elasticity of Demand and
Total Revenue
• If demand is unit elastic ( D = 1), a rise in
price leaves total revenue unchanged.
Price Elasticity of Demand and
Total Revenue
• If demand is inelastic ( D < 1), a rise in
price increases total revenue.
• Price and total revenue move in the
same direction.
Elasticity and Total Revenue Fig. 65a, p 144
$10
Price
8
6
Elastic Demand
 D >1
F
E
C
A
Gained
revenue
B
4
Lost
revenue
2
0
1
2
3
4
5
6
7
8
9
Quantity
Elasticity and Total Revenue Fig. 65b, p 144
Inelastic Demand
 D <1
$10
Price
8
6
4
Gained
revenue
Lost
revenue
H
2
0
G
C
A
1
2
B
3
4
5
6
7
8
9
Quantity
Elasticity and Total Revenue
Fig. 6-5c, p 144
Unit Elastic
Demand
 D =1
$10
Price
8
K
6
Gained revenue
C
J
4
A
2
0
1
2
Lost
revenue
B
3
4
5
6
7
8
9
Quantity
Total Revenue Along a Demand
Curve
• Demand is elastic at prices above the
middle point where demand is unit elastic
– a rise in price in that range lowers total
revenue.
• Demand is inelastic at prices below the
middle point where demand is unit elastic
– a rise in price in that range increases
total revenue.
How Total Revenue Changes Along
a Demand Curve Fig. 6-6, p 145
P
TR
Elastic range
D >1
D =1
Inelastic range
D <1
0
(a)
Q0
0
Quantity
(b)
Q0
Quantity
Elasticity of Individual and
Market Demand
• Market demand elasticity is influenced
both by:
– How many people reduce their quantity to
zero when price increases.
– How much an existing consumer marginally
changes his or her quantity demanded.
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.
Elasticity of Individual and
Market Demand
• Firms that price discriminate can charge
more to the individuals with inelastic
demand and less to individuals with elastic
demand.
Elasticity of Individual and
Market Demand
• Examples of price discrimination include:
– Airlines’ Saturday stay-over specials.
– Selling new cars at a discount.
– The almost-continual-sale phenomenon.
Other Elasticities of Demand
• Two other demand elasticities are
important in describing consumer
behaviour:
– Income elasticity of demand.
– Cross-price elasticity of demand.
Income Elasticity of Demand
• Income elasticity of demand is defined
as the percentage change in demand
divided by the percentage change in
income.
Percentage change in quantity demanded
=
Percentage change in income
Income Elasticity of Demand
• Income elasticity of demand tells us how
demand responds to changes in income.
Income Elasticity of Demand
• An increase in income generally increases
one’s consumption of almost all goods,
although the increase may be greater for
some goods than for others.
Income Elasticity of Demand
• Normal goods are those goods whose
consumption increases with an increase in
income.
• They have income elasticities greater
than zero (positive).
Income Elasticity of Demand
• Normal goods are usually divided into two
categories:
– luxuries and
– necessities.
Income Elasticity of Demand
• Luxuries are goods that have an income
elasticity greater than 1.
• Their percentage increase in quantity
demanded is greater than the
percentage increase in income.
• They are an “income elastic normal
good”.
Income Elasticity of Demand
• Shoes are a necessity—a good that has
an income elasticity less than 1, but still
positive (shoes are an “income inelastic
normal good”).
• The consumption of a necessity rises by
a smaller proportion than the rise in
income.
Income Elasticity of Demand
• Inferior goods are those whose
consumption decreases when income
increases.
• Inferior goods have income elasticities
less than zero (negative).
• Generic (store-brand) cereals are one
example of inferior goods.
Income Elasticities of Selected
Goods, Table 6-3, p 148
Income elasticity
Product
Short Run Long Run
Motion pictures
0.81
3.41
Foreign travel
0.24
3.09
Tobacco products
0.21
0.86
Furniture
2.60
0.53
Jewelry and watches
1.00
1.64
Hard liquor
—
2.50
Private university tuition
—
1.10
Interpreting Income Elasticity of
Demand,Table 6-4, p 149
Coefficient
Description
Interpretation
0
Normal
good
 I   Qd
Two cases of normal good:
0  1
 1
0
Inferior
good
Income inelastic normal good
(“necessity”)
Income elastic normal good
(“superior” good)
 I   Qd
Cross-Price Elasticity of
Demand
• Cross-price elasticity of demand is
computed by dividing the percentage
change in quantity demand by the
percentage change in the price of another
good.

XY
Percentage change in quantity demanded
=
Percentage change in price of another good
Cross-Price Elasticity of
Demand
• Cross-price elasticity of demand tells us
the responsiveness of demand to changes
in prices of other goods.
 Cross-price
elasticity measures both
how and how strongly consumers
respond to changes in the price of
related products.
Cross-Price Elasticity of
Demand
• Depending on how consumers respond to
changes in the price of related products,
goods can be classified as
– Substitutes or
– Complements
Complements and Substitutes
• Substitutes are goods that can be used in
place of one another.
• When the price of a good goes up, the
demand for the substitute good also
goes up.
• Cross-price elasticity of substitutes is
positive
Complements and Substitutes
• Complements are goods that are used in
conjunction with other goods.
Complements and Substitutes
• A rise in the price of a good will decrease
the demand for its complement, and a fall
in the price of a good will increase the
demand for its complement.
• The cross-price elasticity of complements
is negative.
Interpretation of Cross-Price
Elasticity Table 6-5, p 150
Coefficient
Interpretation
Ratio
XY > 0
Substitute
Goods
PYQX
XY < 0
Complementary
Goods
PY QX
XY = 0
Unrelated Goods
PY 
QX=0
Calculating Income and CrossPrice Elasticities,Fig 6-7a, p 151
Price
=6.5
P0
D0
18
25
P0
Shift due to rise
in income
D1
Quantity
Calculating Income and CrossPrice Elasticities,Fig 6-7a, p 151
Price of
ketchup
Shift due to rise
in price
of hot dogs
XY= -0.7
P0
P0
D0
D1
3
4
Quantity of ketchup
Price Elasticity of Supply
• Measures the responsiveness of firms to a
change in the price of their product.
Price Elasticity of Supply
• The price elasticity of supply is
calculated as the percent change in
quantity supplied over the percent change
in price.

S
Percentage change in quantity supplied
=
Percentage change in price
Inelastic Supply
• Common sense tells us that an inelastic
supply means that the percent change in
quantity is less than the percentage
change in price.
Elastic Supply
• An elastic supply means that quantity
supplied changes by a larger percent than
the percent change in price.
Substitution and Supply
• The longer the time period considered, the
more elastic the supply.
Substitution and Supply
• The reasoning is the same as for demand.
– In the long run there are more alternatives
so it is easier (less costly) for suppliers to
change and produce other goods.
Substitution and Supply
• Economists distinguish three time periods
relevant to supply:
– The instantaneous period.
– The short run.
– The long run.
Substitution and Supply
• In the instantaneous period, quantity
supplied is fixed so supply is perfectly
inelastic.
• This supply is sometimes called the
momentary supply.
Substitution and Supply
• In the short run, some substitution is
possible, so the short-run supply curve is
somewhat elastic.
Substitution and Supply
• In the long run, significant substitution is
possible; the supply curve becomes very
elastic.
Substitution and Supply
• An additional factor to consider in
determining elasticity of supply:
– One must take into account how easy or
how difficult it is to produce more of the
same good. The easier it is to produce
additional units, the more elastic the
supply.
Empirical Estimates of
Elasticities
• There are fewer empirical measurements
of elasticity of supply than there are of
demand elasticities.
Effects of Shifts in Supply on
Price and Quantity
• An example of the importance of
elasticities of demand and supply can be
illustrated by the example of the world
market for oil
Effects of Shifts in Supply on
Price and Quantity
• If oil supply decreases, the world prices
will rise sharply if the demand for oil is
inelastic
• Oil prices will not be affected a lot if
demand is elastic
Effects of Shifts in Supply on
Price and Quantity, Fig 6-8a, p 154
Inelastic Supply and Inelastic Demand
Price
S1
Demand
S0
P1
P0
Q1 Q0
Quantity
Effects of Shifts in Supply on
Price and Quantity, Fig 6-8b, p 154
Inelastic Supply and Elastic Demand
S1
Price
S0
Demand
P1
P0
Q1 Q0
Quantity
Describing Supply and
Demand: Elasticities
End of Chapter 6