DESCRIBING SUPPLY AND DEMAND: ELASTICITIES

1. DESCRIBING SUPPLY AND DEMAND: ELASTICITIES Chapter 6

2. Today’s lecture • Elasticity • The Price Elasticity of Demand • The Price Elasticity of Supply • Calculate elasticity graphically and numerically.

3. 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.

4. 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)

5. 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

6. 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)

7. 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

8. 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

9. Unit Elastic Demand or Supply • Demand or supply is unitelastic if the percentage change in quantity is the same as the percentage change in price. E=1

10. Price Price Perfectly elastic demand curve 0 0 Quantity Elasticities and Supply and Demand Curves Perfectly inelastic demand curve P Quantity

11. 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 inelasticsupply or demand • The curves are vertical • The quantity does not response to a change in price (E=0).

12. 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 perfectlyinelastic demand of insulin.

13. 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.

14. Question • The elasticity of demand is same along the demand curve? ----To find out the answer, we just calculate them by ourselves.

15. Calculating Elasticity of Demand Between Two Points Elasticity of demand between A and B: $26 B 24 22 midpoint C Price 20 A 18 16 Demand 14 0 10 12 14 Quantity of software (in hundred thousands)

16. 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?

17. $10 9 8 7 6 Price C 5 A 4 B 3 2 1 24 40 20 28 Quantity Calculating Elasticity at a Point To calculate elasticity at a point determine a range around that point and calculate the arc elasticity.

18. $10 9 8 7 6 Price C 5 A 4 B 3 2 1 24 40 20 28 Quantity Calculating Elasticity along the Demand Curve 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 The elasticity at point A: [(28-20)/24]/[(3-5)/4]=0.65 8 12 16

19. Ed > 1 Ed < 1 Ed = 0 Elasticity Along a Demand Curve Ed =∞ Elasticity declines along demand curve as we move toward the quantity axis $10 9 8 7 6 Ed = 1 Price 5 4 3 2 1 0 1 2 3 4 5 6 7 8 9 10 Quantity

20. 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?

21. 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.

22. 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.

23. $10 8 F Gained revenue:FO46(C) 6 Price Lost revenueEO46 (B) 4 2 0 1 2 3 4 5 6 7 8 9 Quantity Elasticity and Total Revenue Unit Elastic Demand E = 1 TRE= $4x6=$24 TRF= $6x4=$24 TR constant C E O A B

24. J K B Elasticity and Total Revenue Elastic Demand E > 1 $10 9 C TR falls if price increases. TR rises if price decreases. 8 TRJ = $8 x 2 = $16 TRK = $9 x 1 = $9 6 A Price 4 2 0 1 2 3 4 5 6 7 8 9 Quantity

25. Elasticity and Total Revenue Inelastic Demand E < 1 $10 TR rises if price increases 8 TRG = $1 x 9 = $9 TRH = $2 x 8 = $16 6 Price 4 H 2 G C A B 0 8 1 2 3 4 5 6 7 9 Quantity

26. Q0 Price 0 Quantity Q0 Total Revenue Along a Demand Curve A Elastic ED > 1 ED = 1 C Inelastic ED< 1 B Total revenue 0 Quantity

27. 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?

28. 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. • What was the newspaper’s elasticity of demand? • Given that elasticity, did it make sense for the newspaper to lower its price?

29. 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?

30. 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

31. Income Elasticity of Demand • Income elasticity of demand measures the responsiveness of demand to changes in income.

32. 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.

33. Cross-Price Elasticity of Demand • Cross-price elasticity of demand measures the responsiveness of demand to changes in prices of other goods.

34. 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.