Download Chapter 20 Demand & Supply Elasticities & Government

20
C HAPTE R
Elasticity of
Demand & Supply
From Ch. 3 make sure you know the following:
• Define demand and supply and state the laws of
demand and supply.
• Determine equilibrium price and quantity from supply
and demand graphs and schedules.
• From law of demand, a consumer will buy more
when price declines, or
P↓ → Qd ↑
• But how much more or less?
• Will you buy more of 2 different goods as their P
decline by 1 KD?
• We use the concept of elasticity
• Elasticity of demand measures:
how much the Qd changes with a given change in P
of the good, change in consumers’ income (I), or
change in price of related product, or:
%∆Qd to %∆P, or %∆I, or %∆Pof related goods
• Price elasticity is a concept that also relates to
supply.
II.
Price Elasticity of Demand
- The degree of responsiveness or sensitivity of consumers
to a change in price is measured by the concept of
price elasticity of demand.
1.
If consumers are relatively responsive to price
changes, demand is said to be elastic.
2. If consumers are relatively unresponsive to
price changes, demand is said to be inelastic.
3. Note that with both elastic and inelastic
demand, consumers behave according to the
law of demand: they are responsive to price
changes.
Price elasticity formula:
change in quantity/percentage change in price. Or
εd = %∆Qd / %∆P
Or:
εd = (Qd2-Qd1) / ( P2-P1 )
Q d1
P1
• Using two price-quantity combinations of a
demand schedule, calculate the percentage
change in quantity by dividing the absolute
change in quantity by one of the two original
quantities. Then calculate the percentage change
in price by dividing the absolute change in price
by one of the two original prices.
PRICE ELASTICITY OF DEMAND
Measures Responsiveness to
Price Changes
P
The percentage change in quantity
The percentage change in price
.01
.02
P2
P1
Q2 Q1
D Elasticity is .5
Q
PRICE ELASTICITY OF DEMAND
Commonly Expressed as…
P
The percentage change in quantity
The percentage change in price
%Q d
% P
P2
P1
Q2 Q1
D Elasticity is .5
Q
PRICE ELASTICITY OF DEMAND
The Price-Elasticity Coefficient and Formula
εd =
Percentage change in quantity
demanded of product X
Percentage change in price
of product X
Or equivalently…
εd =
Percentage change in quantity demanded of X
Original quantity demanded of X

Change in price of X
Original price of X
Elimination of the Minus Sign
PRICE ELASTICITY OF DEMAND
Interpretations of Ed
Elastic Demand
εd =
.04
.02
=2
Inelastic Demand
εd =
.01
.02
= .5
Unit Elasticity
εd =
.02
.02
=1
Percentages also make it possible to compare elasticities of demand
for different products.
Because of the inverse relationship between price and quantity
demanded, the actual elasticity of demand will be a negative
number. However, we ignore the minus sign and use the
absolute value of both percentage changes.
• If the coefficient of elasticity of demand is > 1, we say
demand is elastic;
• The quantity demanded is “relatively responsive” when
εd is >1.
• If the coefficient is < 1, demand is inelastic.
• Demand is “relatively unresponsive” when εd <1.
• A special case is if εd = 1; this is called unit elasticity.
Note: Inelastic demand does not mean that
consumers are completely unresponsive. This
extreme situation called perfectly inelastic
demand would be very rare, and the demand
curve would be vertical.
• Perfectly inelastic demand
P
D
Po
Q*
Q
• Perfectly inelastic demand
P
D
P1
Po
Q*
Q
• Perfectly inelastic demand
P
D
Changes in P
will no affect
Qd
P1
Po
Q*
Q
• Perfectly inelastic demand
P
D
Changes in P
will no affect
Qd
P1
Po
ε d = Zero
Q*
Q
• Elastic demand does not mean consumers are
completely responsive to a price change. This
extreme situation, in which a small price
reduction would cause buyers to increase their
purchases from zero to all that it is possible to
obtain, is perfectly elastic demand, and the
demand curve would be horizontal.
• Perfectly elastic demand
P
Any Change
in P will
cause a huge
change in
Qd
εd =∞
Q
• Consider the following example:
Price
Qd
5
4
4
5
To calculate elasticity, which price-quantity
combination should we use as P1 and Qd1?
Assumption 1: let P1=5 and P2=4, and Qd1=4 while
Qd2=5, then:
εd = [(5-4)/4] / [(4-5)/5]
= 1/4 * (-5) (ignoring the minus)
= |-5/4| or 1.25
so demand is elastic
• Consider the following example:
Price
Qd
5
4
4
5
To calculate elasticity, which price-quantity
combination should we use as P1 and Qd1?
Assumption 2: let P1=4 and P2=5, and Qd1=5 while
Qd2=4, then:
εd = [(4-5)/5] / [(5-4)/4]
= -1/5 * (4) (ignoring the minus)
= |- 4/5| or 0.8
so demand is inelastic
• This is a problem since demand is elastic and
inelastic!
If P1 is 5:
P
D
5
4
4
5
• This is a problem since demand is elastic and
inelastic!
Then D is
elastic
P
D
5
4
4
5
• This is a problem since demand is elastic and
inelastic!
If P1 is 4:
P
D
4
5
• This is a problem since demand is elastic and
inelastic!
Then D is
inelastic
P
D
5
4
4
5
• To solve this problem, we use the average, or
“the midpoint formula” for elasticity:
εd = (Qd2- Qd1)
( P2-P1 )
÷
d
d
(Q 2+ Q 1)/2
( P2-P1 )/2
• To solve this problem, we use the average, or
“the midpoint formula” for elasticity:
εd = (Qd2- Qd1)
( P2-P1 )
÷
d
d
(Q 2+ Q 1)/2
( P2+P1 )/2
Applying to our example:
εd = (5-4)/(4.5) ÷ (4-5)/(4.5)
εd = |-1| = 1
• To solve this problem, we use the average, or
“the midpoint formula” for elasticity:
εd = (Qd2- Qd1)
( P2-P1 )
÷
d
d
(Q 2+ Q 1)/2
( P2+P1 )/2
Applying to our example:
εd = (5-4)/(4.5) ÷ (4-5)/(4.5)
εd = |-1| = 1
Demand is Unitary
Elastic!
PRICE ELASTICITY OF DEMAND
Refinement –
The Midpoint Formula
ε
d=
Change in
quantity
Sum of
Quantities/2

Change in
price
Sum of
prices/2
Elasticity varies over range of prices.
a. Demand is more elastic in upper left portion of curve
(because price is higher and quantity smaller).
Elasticity varies over range of prices.
b. Demand is inelastic in lower right portion of curve
(because price is lower and quantity larger).
Elasticity varies over range of prices.
a. Demand is unitary elastic in the middle.
• It is impossible to judge elasticity of a single demand
curve by its flatness or steepness, since demand elasticity
can measure both as elastic and as inelastic at different
points on the same demand curve.
Total Revenue Test
• TR = PxQ
• A total-revenue test is the easiest way to judge
whether demand is elastic or inelastic.
• This test can be used in place of an elasticity
formula, unless there is a need to determine the
elasticity coefficient.
• Elastic demand and the total-revenue test:
Demand is elastic if a decrease in price results in
a rise in total revenue, or if an increase in price
results in a decline in total revenue. (Price and
revenue move in opposite directions).
• Elastic demand and the total-revenue test:
• Demand is elastic if a decrease in price results in
a rise in total revenue,
• or if an increase in price results in a decline in
total revenue.
• Price and revenue move in opposite directions.
• Inelastic demand and the total-revenue test:
• Demand is inelastic if a decrease in price results
in a fall in total revenue,
• or an increase in price results in a rise in total
revenue.
• (Price and revenue move in same direction).
• Unit elasticity and the total-revenue test:
• Demand is unitary elastic if total revenue does
not change when the price changes.
• Table 20-2 provides a summary of the rules and
concepts related to elasticity of demand.
PRICE ELASTICITY & TOTAL REVENUE
P
When prices are
low,
So is total revenue
TR
D
Q
Q
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUE
Total revenue rises
with price to a
P
TR
point...
D
Q
Q
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUE
Total revenue rises
then declines
with price to a
P
TR
point...
D
Q
Q
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUE
Total revenue rises
then declines
with price to a
P
TR
point...
D
Q
Q
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUE
Total revenue rises
then declines
with price to a
P
TR
point...
Total Revenue Test
D
Q
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUE
Total revenue rises
then declines
with price to a
P
TR
point...
Inelastic
Demand
D
Q
Inelastic
Demand
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUE
Total revenue rises
then declines
with price to a
P
TR
point...
Elastic
Demand
Inelastic
Demand
D
Q
Elastic Inelastic
Demand Demand
Quantity Demanded
PRICE ELASTICITY & TOTAL REVENUE
Total revenue rises
then declines
with price to a
P
TR
point...
Unit
Elastic
Elastic
Demand
Inelastic
Demand
D
Q
Elastic Inelastic
Demand Demand
Quantity Demanded
Determinants of Price Elasticity:
There are several determinants of the price elasticity of
demand.
1. Substitutes for the product: Generally, the more
substitutes, the more elastic the demand.
2. The proportion of price relative to income: Generally,
the larger the expenditure relative to one’s budget, the
more elastic the demand, because buyers notice the
change in price more.
3. luxury vs. Necessity products: Generally, the less
necessary the item, the more elastic the demand.
4. Time factor: Generally, the longer the time period
involved, the more elastic the demand becomes.
practical applications:
There are many practical applications of the price elasticity of
demand.
1. Inelastic demand for agricultural products helps to explain why
bumper crops depress the prices and total revenues for farmers.
2. Governments look at elasticity of demand when levying excise
taxes. Excise taxes on products with inelastic demand will raise
the most revenue and have the least impact on quantity demanded
for those products.
3. Demand for cocaine is highly inelastic and presents problems for
law enforcement. Stricter enforcement reduces supply, raises
prices and revenues for sellers, and provides more incentives for
sellers to remain in business. Crime may also increase as buyers
have to find more money to buy their drugs.
Price Elasticity of Supply
• The concept of price elasticity also applies to
supply. The elasticity formula is the same as that
for demand.
εs = % ∆Qs / % ∆ P
• As with price elasticity of demand, the midpoints
formula is more accurate.
PRICE ELASTICITY OF SUPPLY
ε
Percentage change in quantity
supplied of good X
s=
Percentage change in
the price of good X
Now, compare the immediate
market period, the short-run,
and long run...
• The ease of shifting resources between alternative uses is
very important in price elasticity of supply because it
will determine how much flexibility a producer has to
adjust output to a change in the price.
• The degree of flexibility, and therefore the time period,
will be different in different industries. (Figure 20-3)
• Time and elasticity of supply
P
P
Qo
Q
Immediate
market period
Perfectly
Inelastic
P
QoQ1
SR
Elastic
Q
Even more elastic
response - less
price increase
Qo Q1
LR
More
elastic
Q
• The market period is so short that elasticity of
supply is inelastic; it could be almost perfectly
inelastic or vertical. In this situation, it is
virtually impossible for producers to adjust their
resources and change the quantity supplied.
(Think of adjustments on a farm once the crop
has been planted.)
• The short-run supply elasticity is more elastic
than the market period and will depend on the
ability of producers to respond to price change.
Industrial producers are able to make some
output changes by having workers work overtime
or by bringing on an extra shift.
• The long-run supply elasticity is the most elastic,
because more adjustments can be made over time
and quantity can be changed more relative to a
small change in price, as in Figure 20-3c. The
producer has time to build a new plant.
Applications of the price elasticity of supply.
1. Antiques and other non-reproducible
commodities are inelastic in supply, sometimes
the supply is perfectly inelastic. This makes
their prices subject to fluctuations in demand.
2. Gold prices are volatile because the supply of
gold is highly inelastic, and unstable demand
resulting from speculation causes prices to
fluctuate significantly.
Cross and income elasticity of demand:
Cross elasticity of demand refers to the effect of a
change in a product’s price on the quantity demanded for
another product. Numerically, the formula is shown for
products X and Y.
εxy = %∆Qx / %∆Py
1. If εxy > 0, then X and Y are substitutes.
2. If εxy < 0, then X and Y are complements.
3. If εxy = 0, then X and Y are unrelated, independent
products.
Income elasticity of demand
The percentage change in quantity demanded that
results from some percentage change in consumer
incomes.
εI = %∆Qx / %∆I
1.If εI >0, this is a normal good.
2. If εI >0, this is an inferior good.
LAST WORD: Elasticity and Pricing Power: Why Different
Consumers Pay Different Prices
A. Sellers often charge different prices for goods based on
differences in price elasticity of demand.
B. The ability to charge different prices depends on some market
power; that is, some ability to control price (unlike the
competitive model where all buyers and sellers exchange at
exactly the same price).
• C. Customers are grouped according to
elasticities: Business travelers have more
inelastic demand for air travel, and can be
charged a higher price than the more price elastic
tourist.
Next:
Chapter 21
Consumer Behavior
and
Utility Maximization