Download Elastic Demand

CHAPTER 18 EXTENSIONS OF
DEMAND AND SUPPLY
AP ECONOMICS
1
Law of Demand
Consumers will buy more of a product
when its price declines and less when
its price increases.
How much more or less will they buy?

The amount varies from product to product
and over different price ranges for the
same product and it can vary over time.
2
A BUSINESS CONTEMPLATING A
PRICE HIKE, WILL WANT TO
KNOW
How will consumers respond


Will they remain loyal and thus increase
the revenue of a business
Will they “defect en masse” to other sellers
and thus revenue will decrease
3
PRICE ELASTICITY OF
DEMAND
Responsiveness of consumers to a price change

Examples:
 Restaurants
 Toothpaste
Extent (Degree) to which changes in price cause
changes in the quantity demanded
Two types:


Elastic
Inelastic
Can help businesses determine pricing policies to
increase revenues
4
ELASTICITY
ELASTIC





Change in price
causes a relatively
large change in the
quantity demanded
Things that are
luxuries
Things that have
substitutes
Large amount of
income
Ex: Mercedes or
Lexus
INELASTIC




Change in price
causes a relatively
small change in the
quantity demanded
Things that are
necessities
Small amount of
income
Ex: Salt or Soap
5
Price-Elasticity Coefficient and
Formula
Measure degree of price elasticity or
inelasticity of demand with

Coefficient = Ed
Ed =
Percentage Change in Quantity
Demanded of Product X
Percentage Change in Price
of Product X
6
Restated Price Elasticy Coefficient
Ed =
Change in Quantity Demanded of X
Original Quantity Demanded of X
÷
Change in Price of X
Original Price of X
7
Average Midpoint Formula
Ed =
Change in Quantity
Sum of Quantities/2
÷
Change in Price
Sum of Prices/2
8
Why use percentages?
Two reasons
1.
The choice of units will arbitrarily affect our
impression of buyer responsiveness
Ex:
If a bag of popcorn at a game is reduced from $3 to $2
and consumers increase their purchases from 60 to 100
bags, it will tell us that consumers are quite sensitive to
price changes and therefore that demand is elastic
2.
We can compare consumer responsiveness to
changes in the prices of different products
9
Interpretation of Ed
Elastic Demand

Percentage change in price results in a larger percentage change in quantity
demanded
 Ed > 1
Inelastic Demand

Percentage change in price produces a smaller percentage change in
quantity demanded
 Ed < 1
Unit Elasticity

Percentage change in price and percentage change in quantity demanded
are the same
 Ed = 1
Perfectly Inelastic

Price change results in no changer in the quantity demanded
 Ed is zero
Perfectly Elastic

Small price reduction causes buyers to increase their purchases from zero to
all they can obtain
 Ed is infinite
10
Price Elasticity of Demand
Extreme Cases
Perfectly Inelastic Demand
P
D1
Perfectly
Inelastic
Demand
(Ed = 0)
0
Q
Perfectly Elastic Demand
P
0
Perfectly
Elastic
Demand
(Ed = ∞)
D2
Q 11
TOTAL REVENUE TEST
Total revenue is also called total receipts test
To calculate Total Revenue


Price X Quantity Sold
See Page 344--Chart at bottom of page
Changes in Total Receipts can determine
elasticity



If TR changes in the opposite direction of the
price, demand is elastic
If TR changes in the same direction as price,
demand is inelastic
If TR does not change when price changes,
demand is unit-elastic
12
Elastic Demand and TR
If demand is elastic, a decrease in price
will increase total revenue
If demand is elastic, a price increase
will reduce total revenue
See graph on Page 343 in book
13
Inelastic Demand and TR
If demand is inelastic, a price decrease
will reduce total revenue
If demand is inelastic, a price increase
will increase total revenue
See graph on Page 343 in book
14
ELASTIC DEMAND REVENUE

Elastic Demand—amount consumers will buy
will go up when the price is lowered causing an
increase in sales at the lower price and a large
increase in total receipts. Higher prices will
mean lower total receipts because the quantity
demanded goes down sharply.
15
INELASTIC DEMAND REVENUE

Inelastic Demand—lower prices will mean a
smaller increase in the quantity demanded and
increased sales would not be enough for total
receipts to rise. Total revenue will actually
increase when prices are raised.
16
DETERMINANTS OF DEMAND
ELASTICITY
Can the purchase be delayed?


Delayed: elastic
Cannot be Delayed: inelastic
Are adequate substitutes available?


Many substitutes: elastic
Few substitutes: inelastic
17
DETERMINANTS CONTINUED
Does the purchase use a large portion
of income?


Large portion of income: elastic
Small portion of income: inelastic
Specific vs. General Market?

Gas a particular gas station sells or gas in
general
18
UNIT ELASTIC


Unit Elastic--Total revenues neither increase
nor decrease
See graph on Page 345 in book
DEMAND SCHEDULE
Price per
Pound
$.80
.70
.60
.50
.40
.30
.20
.10
Number of Pounds
Demanded
1,250
1,500
2,000
2,500
3,000
4,000
5,000
6,000
Total Receipts
$1,000
1,050
1,200
1,250
1,200
1,200
1,000
600
19
Price Elasticity of Supply
If producers are relatively responsive to
price changes, supply is elastic.
If producers are relatively insensitive to
price changes, supply is inelastic.
20
ELASTICITY OF SUPPLY
The degree to which price changes
affect the quantity supplied
A product’s supply can be either


Elastic
Inelastic
21
ELASTIC SUPPLY
Exists when a small change in price causes a
major change in the quantity supplied
Products with elastic supply usually can be
made: quickly, inexpensively, and using a
few, readily available resources
Suppliers can change the production rates of
such goods easily in order to meet changing
consumer demand

Examples: Sports teams’ souvenirs, such as
T-shirts, posters, and hats
22
INELASTIC SUPPLY
Exists when a change in a good’s price
has little impact on the quantity supplied.
A product usually has an inelastic supply if
production requires a great deal of time,
money, and resources that are not readily
available.
SUPPLIERS cannot easily change the
production rates of such goods in order to
meet changing consumer demand.

Examples: Gold, fine art, or space shuttles.
23
Measure the Degree of Price
Elasticity or Inelasticity
Es
Equation
Es =
Percentage Change in Quantity
Supplied of Product X
Percentage Change in Price
of Product X
24
Price Elasticity of Supply
Depends on how easily and therefore
quickly producers can shift resources
between alternative uses.
The longer the time, the greater the
resource “shiftability.”

The longer a firm has to adjust to a price
change, the greater elasticity of supply
25
Market Period
Period that occurs when the time immediately
after a change in market price is too short for
producers to respond with a change in
quantity supplied
Ex.

Truckload of tomatoes need a full growing season
Producers of goods that can be inexpensively
stored, there may be no market period at all.
26
Short Run
A period of time too short to change plant
capacity, but long enough to use fixed plant
more or less intensively
Result is a somewhat greater output in
response to a presumed increase in demand

Greater output is reflected in a more elastic supply
of tomatoes
Equilibrium price is therefore lower in the
short run than in the market period
27
Long Run
A time period long enough for firms to adjust
their plant sizes and for new firms to enter
(or existing firms to leave) the industry.
There is not a total revenue test for supply
Supply shows a positive or direct relationship
between price and amount supplied
Supply curve is upsloping
Regardless of the degree of elasticity or
inelasticity, price and total revenue always
move together
28
Examples of Price Elasticity of
Supply
Antiques (inelastic)
Reproductions (elastic)
Gold (inelastic)
29
Cross Elasticity of Demand
Measures how sensitive consumer
purchases of one product (X) are to a
change in price of some other product
(Y)
Exy
Equation
Percentage Change in Quantity
Demanded of Product X
Exy =
Percentage Change in Price
of Product Y
30
Cross Elasticity
Helps us to more fully understand substitutes and
complementary goods
Substitute Goods



Cross elasticity is positive
Sales of X move in the same direction as a change in the price of Y,
then X and Y are substitute goods
Ex:
 Evian and Dasani

The larger the positive cross-elasticity coefficient, the greater is the
substitutability between the two products
Complementary Goods




Cross elasticity is negative
X and Y go together
Increase in the price of one decreases the demand for the other
The larger the negative cross-elasticity coefficient, the greater is
the complementarity between the two goods
31
Independent Goods
A zero or near-zero cross elasticity
suggests that the two products being
considered are unrelated or
independent goods.

Ex: walnuts and plums
 A change in the price of walnuts does not have
an effect on purchases of plums
32
Application of Cross Elasticity
Degree of substitutability of products
measured by cross-elasticity co-efficient
is important to businesses and
government
Used to test the sale of one product a
company makes against another
product
Governments use this for proposed
mergers and whether or not they
violate anti-trust laws
33
Income Elasticity of Demand
Measures the degree to which
consumers respond to a change in their
incomes by buying more or less of a
particular good
Explains the expansion and contraction
(recession) of the economy
Ei
Percentage Change in Quantity
Demanded
Equation E =
i
Percentage Change in Income
34
Normal Goods versus
Inferior Goods
Normal Goods




Income elasticity co-efficient is positive
More of them are demanded as income
rises
Also called superior goods
Value of Ei varies greatly among normal
goods
Inferior Goods


Income elasticity co-efficient is negative
Less of them are demanded as income
rises
35
Cross and Income Elasticity of
Demand
Cross Elasticity

Positive
 Ewz > 0
 Quantity demanded of W changes in the same direction as change in price of Z
 Substitutes

Negative
 Exy < 0
 Quantity demanded of X changes in opposite direction as change in price of Y
 Complements
Income Elasticity

Positive
 Ei > 0
 Quantity demanded of the product changes in the same direction as change in
income
 Normal Good

Negative
 Ei < 0
 Quantity demanded of the product changes in opposite direction as change in
income
 Inferior
36
Consumer Surplus
The difference between maximum price a consumer
is willing to pay for a product and actual price
The utility surplus arises because all consumers pay
the equilibrium price even though many would be
willing to pay more than that price for the product
Demand Curve
Consumer surplus and price are inversely related
(negative)

Higher prices reduce consumer surplus and lower prices
increase consumer surplus
37
Consumer Surplus
Price (Per Bag)
Consumer
Surplus
Equilibrium
Price = $8
P1
Q1
Quantity (Bags)
D
38
Producer Surplus
The difference between the actual price a producer
receives and the minimum acceptable price
Sellers receive a producer surplus in most markets
because most sellers are willing to accept a lower
than equilibrium price in order to sell the product
Supply Curve
Equilibrium price and amount of producer surplus are
directly related (positive)

Lower prices reduce producer surplus and higher prices
increase producer surplus
39
Producer Surplus
Price (Per Bag)
S
Equilibrium
Price = $8
P1
Producer
Surplus
Quantity (Bags)
40
Efficiency
Bring supply and demand together
Bring consumer surplus and producer surplus
together
Productive efficiency is achieved because competition
forces producers to use the best techniques and
combinations of resources in growing and selling
products
Allocative efficiency is achieved because the correct
quantity of output is produced relative to other
goods and services



MB=MC or marginal benefit equals marginal cost
Maximum willingness to pay=minimum acceptable price
Combined consumer and producer surplus is at a maximum
41
Efficiency
S
Price (Per Bag)
Consumer
Surplus
Equilibrium
Price = $8
P1
Producer
Surplus
D
Q1
Quantity (Bags)
42
Efficiency Losses or
Deadweight Losses
Reductions of combined consumer and
producer surplus associated with
underproduction or overproduction of a
product
43
Dead Weight Losses
S
Price (Per Bag)
Efficiency
Losses
P1
D
Q2
Q1
Q3
Quantity (Bags)
44