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## Elasticity of Demand & Supply

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**20**C H A P T E 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.**Price Elasticity of Demand**- The degree of responsivenessor sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand. • If consumers are relatively responsive to price changes, demand is said to be elastic.**If consumers are relatively unresponsive to price changes,**demand is said to be inelastic. • 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 ) Qd1 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 The percentage change in quantity P The percentage change in price .01 .02 P2 P1 Elasticity is .5 D Q Q2 Q1****Q % d % P PRICE ELASTICITY OF DEMAND Commonly Expressed as… The percentage change in quantity P The percentage change in price P2 P1 Elasticity is .5 D Q Q2 Q1**Percentage change in quantity**demanded of product X εd= Percentage change in price of product X Percentage change in quantity demanded of X εd= Original quantity demanded of X Change in price of X Original price of X PRICE ELASTICITY OF DEMAND The Price-Elasticity Coefficient and Formula Or equivalently… Elimination of the Minus Sign**Elastic Demand**.02 .04 .01 = 1 = .5 = 2 εd= εd= εd= .02 .02 .02 Inelastic Demand Unit Elasticity PRICE ELASTICITY OF DEMAND Interpretations of Ed**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.**P**D • Perfectly inelastic demand Po Q Q***P**D • Perfectly inelastic demand P1 Po Q Q***P**Changes in P will no affect Qd D • Perfectly inelastic demand P1 Po Q Q***P**Changes in P will no affect Qd D • Perfectly inelastic demand 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.**P**Any Change in P will cause a huge change in Qd • Perfectly elastic demand ε d = ∞ Q**Consider the following example:**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:**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**If P1 is 5:**• This is a problem since demand is elastic and inelastic! P D 5 4 4 5**Then D is elastic**• This is a problem since demand is elastic and inelastic! P D 5 4 4 5**If P1 is 4:**• This is a problem since demand is elastic and inelastic! P D 4 5**Then D is inelastic**• This is a problem since demand is elastic and 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 ) (Qd2+ Qd1)/2 ( P2-P1 )/2 ÷**To solve this problem, we use the average, or “the**midpoint formula” for elasticity: εd = (Qd2- Qd1) ( P2-P1 ) (Qd2+ Qd1)/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 ) (Qd2+ Qd1)/2 ( P2+P1 )/2 Applying to our example: εd = (5-4)/(4.5) (4-5)/(4.5) εd = |-1| = 1 ÷ Demand is Unitary Elastic! ÷**Change in**quantity Change in price ε d = Sum of Quantities/2 Sum of prices/2 PRICE ELASTICITY OF DEMAND Refinement – The Midpoint Formula**Elasticity varies over range of prices.**• 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.**• 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**So is total revenue When prices are low, P TR D Q Q Quantity Demanded**PRICE ELASTICITY & TOTAL REVENUE**Total revenue rises with price to a point... P TR D Q Q Quantity Demanded**PRICE ELASTICITY & TOTAL REVENUE**Total revenue rises with price to a point... then declines P TR D Q Q Quantity Demanded**PRICE ELASTICITY & TOTAL REVENUE**Total revenue rises with price to a point... then declines P TR D Q Q Quantity Demanded**PRICE ELASTICITY & TOTAL REVENUE**Total Revenue Test Total revenue rises with price to a point... then declines P TR D Q Quantity Demanded**PRICE ELASTICITY & TOTAL REVENUE**Total revenue rises with price to a point... then declines P TR Inelastic Demand D Inelastic Demand Q Quantity Demanded**PRICE ELASTICITY & TOTAL REVENUE**Total revenue rises with price to a point... then declines P TR Elastic Demand Inelastic Demand D Elastic Demand Inelastic Demand Q Quantity Demanded**PRICE ELASTICITY & TOTAL REVENUE**Total revenue rises with price to a point... then declines P TR Unit Elastic Elastic Demand Inelastic Demand D Elastic Demand Inelastic Demand Q 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. • Inelastic demand for agricultural products helps to explain why bumper crops depress the prices and total revenues for farmers. • 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. • 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.