Chapter 4: Elasticity of Demand and Supply

1. Chapter 4: Elasticity of Demand and Supply

2. Price Elasticity of Demand • According to the law of demand, when price goes up, consumers demand fewer quantities of a product. If the price of a product falls, quantity demanded will rise. • But when the price of a product changes, by how much more (or less) will consumers buy? • To help answer this question, we will use a measurement called the Price Elasticity of Demand.

3. Price Elasticity of Demand • For some products, consumers are highly responsive to price changes. Demand for such products is relatively elastic or simply elastic. • For other products, consumers’ responsiveness is only slight, or in rare cases non-existent. Demand is said to be relatively inelastic, or simply inelastic.

4. The Price-Elasticity Coefficient • Economist measure the degree of price elasticity or inelasticity of demand with the coefficient Ed. • Ed is defined as the percentage change in quantity demanded of good X divided by the percentage change in price of X.

5. The Ed Formula percentage change in quantity demanded of X percentage change in price of X • Generally, when calculating percentage changes in the equation, we divide the change in quantity demanded by the original quantity demanded and the change in price by the original price. • However, because the resulting percentage change value differs with the direction of the change, using averages as the reference points ensures the same percentage change regardless of the direction of the change. Ed =

6. Using Averages: An Example • Consider the following example:Suppose that at a price of $10, quantity demanded is 200 units. When the price drops to $5, quantity demanded rises to 300 units. Price $10 Demand $5 200 300 Quantity

7. Using Averages: An Example • The percentage change in quantity demanded from 200 to 300 is a 50 percent (=100/200) increase, while the opposing change in quantity demanded from 300 to 200 is a 33 percent (=100/300) decrease. • Likewise, the percentage change in price from $10 to $5 is a 50 percent (=$5/$10) decrease, while the opposing change in price from $5 to $10 is a 100 percent (=$5/$5) increase.

8. Using Averages: An Example • Using averages eliminates the “up versus down” problem. change in quantity change in price sum of quantities/2 sum of prices/2 • For the quantity range 200-300, the quantity reference is 250 units [=(200+300)/2]. • For the same price range $5-$10, the price reference is $7.50 [=($5 + $10)/2] Ed =

9. Using Averages: An Example • The percentage change in quantity demanded is now 100/250, or a 40 percent increase, and the percentage change in price is now -$5/$7.50, or about a 67 percent decrease. • Ed= 0.4/-.67 = -0.597

10. Elimination of the Minus Sign Because the demand curve slopes downward, Ed will always be a negative number. Therefore, we take the absolute value and ignore the minus sign.

11. Interpretations of Ed The coefficient of price elasticity of demand can be interpreted as follows: • Elastic Demand: Product demand for which price changes cause relatively larger changes in quantity demanded; Ed > 1 • Inelastic Demand: Product demand for which price changes cause relatively smaller changes in quantity demanded; Ed < 1 • Unit Elasticity: Product demand for which price changes and changes in quantity demanded are equal; Ed = 1

12. Interpretations of Ed Extreme Cases • Perfectly Inelastic: Product demand for which quantity demanded does not respond to a change in price. • Perfectly Elastic: Product demand for which quantity demanded can be any amount at a particular price.

13. Interpretations of Ed

14. The Total-Revenue Test • Elasticity is important to firms because when the price of their products change, so does their profit (total revenue minus total costs). • This represents the total number of dollars received by a firm from the sale of a product in a particular period. Total revenue (TR) = price x quantity = P x Q

15. The Total-Revenue Test Total revenue and the price elasticity of demand are related. The total-revenue test can determine elasticity by examining what happens to total revenue when price changes.

16. The Total-Revenue Test • If demand is elastic, a decrease in price will increase total revenue, and an increase in price will reduce total revenue. • If demand is inelastic, a price decrease will decrease total revenue, while an increase in price will increase total revenue. • If demand is unit elastic, total revenue remains constant when prices rise or fall.

17. The Total-Revenue Test

18. Price Elasticity along a Linear Demand Curve • Along a linear demand curve, elasticity varies over the different price ranges. • Because elasticity involves relative or percentage changes in price and quantity, as you move along a demand curve, the percentage changes in price and quantity will vary.

19. Determinants of Price Elasticity of Demand • In general, there are four determinants that can affect the price elasticity of demand: • Substitutability • Proportion of Income • Luxuries versus Necessities • Time

20. Determinants of Price Elasticity of Demand • Price elasticity of demand is greater: • the larger the number of substitute goods that are available • the higher the price of a product relative to one’s income • the more that a good is considered to be a “luxury” rather than a “necessity” • the longer the time period under consideration

21. Price Elasticity of Supply • Price elasticity of supply measures the responsiveness of sellers to changes in the price of a product. • If producers are relatively responsive, supply is elastic. • If producers are relatively insensitive to price changes, supply is inelastic.

22. Price Elasticity of Supply • The price elasticity of supply coefficient Es is defined as: percentage change in quantity supplied of X percentage change in price of X • To calculate Es, we employ the midpoint approach to determine the percentage changes. Es =

23. Price Elasticity of Supply • If Es < 1, supply is inelastic. • If Es > 1, supply is elastic. • If Es = 1, supply is unit-elastic. • Since price and quantity supplied are directly related, Es is never negative.

24. Price Elasticity of Supply • The amount of time it takes producers to shift resources between alternative uses to alter production of a good can determine the degree of price elasticity of supply. • The easier and more rapid the transfer of resources, the greater is the price elasticity of supply. • The longer a firm has to adjust to a price change, the greater the elasticity of supply.

25. Price Elasticity of Supply and Time Periods • The market period is a period in which producers of a product are unable to change the quantity produced in response to a change in price. • During this time period, the supply of a product is fixed, or supply is perfectly inelastic.

26. Price Elasticity of Supply and Time Periods • In the short run, producers are able to change the quantities of some but not all the resources they employ. • This time period is too short to change plant capacity but long enough to use fixed plant more or less intensively. • The supply of a product is more elastic than the market period.

27. Price Elasticity of Supply and Time Periods • In the long run, producers are able to change all the resources they employ. • This time period is long enough for firms to adjust their plant sizes and for new firms to enter (or existing firms to exit) the industry. • The supply of a product is more elastic than in the short run.

28. Price Elasticity of Supply and Time Periods

29. Income Elasticity of Demand • Income elasticity of demand measures the responsiveness of consumer purchases to changes in consumer income. • The coefficient of income elasticity of demand Ei is determined with the formula percentage change in quantity demanded percentage change in income EI =

30. Income Elasticity of Demand • Normal Goods will have an income elasticity of demand that is positive. More of them are demanded as income increases. Ei > 0 • Inferior goods have a negative income elasticity of demand. As income rises, the demand for them falls. Ei < 0