Describing Demand and Supply: Elasticities

1. Describing Demand and Supply: Elasticities Chapter 6

2. 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.

3. Price Elasticity • The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

4. 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.

5. 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.

6. Classifying Demand as Elastic or Inelastic • It is helpful to classify demand by relative responsiveness as elastic or inelastic.

7. 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

8. 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.

9. 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

10. 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.

11. 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.

12. Elasticity Is Independent of Units • Having a measure of responsiveness that is independent of units makes comparisons of responsiveness of different goods easier.

13. Calculating Elasticities • To determine elasticity, divide the percentage change in quantity by the percentage change in price.

14. The Mid-point Formula • Using the mid-point formula, the average of the two end points are used when calculating percentage change.

15. Graph of Price Elasticity of Demand,Fig.6-1a, p 136 B $26 C (midpoint) 23 A 20 Price D 0 5 7 9 Quantity of software (in thousands) Elasticity of demand = 1.3

16. D = 4 D = 0.54 Graph of Price Elasticity of Demand, Fig.6-1b, p 136 $10 B 9 8 A 7 6 C Price 5 4 3 D 2 1 5 10 15 20 25 30 35 40 45 50 55 Quantity b) Some examples

17. 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.

18. 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.

19. $10 9 8 7 6 C Price 5 A 4 B 3 2 1 24 40 Quantity 20 28 Calculating Elasticity at a Point, Fig a) p 138

20. A B Calculating Elasticity at a Point Fig b) p 138 $10 Demand 9 D= 2.33 8 7 6 5 Price 4 D = 0.11 3 2 1 6 12 18 30 36 42 48 54 60 24 Quantity

21. 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 and Demand Curves

22. 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

23. When the curve is horizontal, it is perfectly elastic. Elasticity Is Not the Same as Slope • Perfectly elastic demand is a horizontal line in which quantity changes enormously in response to any change in price (D =¥).

24. 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). Elasticity Is Not the Same as Slope

25. Perfectly inelastic demand curve 0 Quantity Perfectly Inelastic Demand Curve, Fig 6-2a, p 139 Price

26. Perfectly elastic demand curve 0 Quantity Perfectly Elastic Demand Curve Fig 6-2b, p 139 Price

27. Elasticity and slope, Fig.6-3, p 140 $10 Over the$3 to $4 price interval, D (D1) = 0.47 while D (D2)= 4.2 9 8 7 6 Price 5 C G 4 A 3 2 D1 D2 1 10 20 30 40 50 60 70 80 90 Quantity

28. 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

29. A demand curve is perfectly elastic (D = ¥) at the vertical (price) intercept. Elasticity Changes Along Straight-Line Curves • Elasticity becomes smaller as you move down the demand curve until it becomes zero ( = 0) at the horizontal (quantity) intercept.

30. D =   D > 1  D = 1  D < 1  D = 0 Elasticity Along a Straight Line Demand Curve Fig 6-4, p 141 Elasticity declines along demand curve as we move toward the quantity axis $10 9 8 7 6 5 Price 4 3 2 1 0 1 2 3 4 5 6 7 8 9 10 Quantity

31. 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).

32. Interpreting Price Elasticity of Demand, Table 6-1, p 141

33. Substitution and Price Elasticity of Demand • As a general rule, the more substitutes a good has, the more elastic is its demand.

34. 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

35. 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.

36. 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.

37. 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.

38. 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.

39. 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.

40. 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.

41. Empirical Estimates of Elasticities • The following table provides short- and long-term estimates of elasticities for a number of goods.

42. Empirical Estimates of Elasticities, Table 6-2, p 143

43. 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.

44. 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.

45. Price Elasticity of Demand and Total Revenue • If demand is unit elastic (D= 1), a rise in price leaves total revenue unchanged.

46. 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.

47. C A Gained revenue E F Lost revenue B Elasticity and Total Revenue Fig. 6-5a, p 144 Elastic Demand D> 1 $10 8 6 Price 4 2 0 1 2 3 4 5 6 7 8 9 Quantity

48. Gained revenue Lost revenue H G C A B Elasticity and Total Revenue Fig. 6-5b, p 144 Inelastic Demand D< 1 $10 8 6 Price 4 2 0 1 2 3 4 5 6 7 8 9 Quantity

49. $10 8 K Gained revenue 6 C Price J Lost revenue 4 B A 2 0 1 2 3 4 5 6 7 8 9 Quantity Elasticity and Total Revenue Fig. 6-5c, p 144 Unit Elastic Demand D= 1

50. 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.