Chapter 20 elasticity of demand and supply

ELASTICITY OF DEMAND AND SUPPLY

CHAPTER 20

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INTRODUCTION

A. Elasticity of demand measures how much the quantity demanded changes with a given change in price of the item, change in consumer’s income, or change in price of a related product.

B. Price elasticity is a concept that also relates to supply.

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PRICE ELASTICITY OF DEMAND

A. The law of demand tell us that consumers will respond to a price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more.

B. The degree of responsiveness or sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand.

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PRICE ELASTICITY OF DEMAND

1. If consumers are relatively responsive to price changes, demand is said to be elastic.

2. If consumers are relatively unresponsive to price changes, demand is said to be inelastic.

3. Note that with both elastic and inelastic demand, consumers behave according to the law of demand; that is, they are responsive to price changes. The terms elastic or inelastic describe the degree of responsiveness.

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PRICE ELASTICITY FORMULA

The quantitative measure of elasticity can be found by using this formula:

Ed =

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1. Using the two price-quantity combinations of a demand schedule, calculate the percent 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.

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2. If we calculate the elasticity using the other original quantity and price, the resulting elasticity would be different. To eliminate this problem, economists use the mid-point formula, which uses the average of the quantities and the prices as denominators.

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3. Remember: what is being compared are the percentage changes not the absolute changes. That is because the absolute changes depend on the choice of units (a change in price of a $10,000 car by $1 is very different from a change in price of $10 shirt by $1.

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Percentages also make it possible to compare elasticities of demand for different products.

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4. Because of the inverse relationship between price and quantity demanded, the actual elasticity of demand will be a negative number. However, we will ignore the minus sign and use the absolute value of both percentage changes.

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5. The Coefficient of Elasticity: If the coefficient of elasticity of demand

is a number greater than one (Ed›1), we say demand is elastic.

In other words, the quantity demanded is “relative responsive” when Ed is greater than 1, and “relatively unresponsive” when Ed is les than 1.

A special case is if the coefficient equals one, it is called unit elasticity.

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NOTE: Inelastic demand does not mean that consumers are completely unresponsive. This extreme situation is called perfectly inelastic demand, and would be very rare. In this case, the demand curve would be vertical, as the quantity demanded would not change at all at any price.

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Likewise, an elastic demand does not mean that consumers are completely responsive to a price change. This extreme situation, in which a small reduction in price would cause buyers to increase their purchases to all that is possible to obtain, is perfectly elastic, and the demand curve would be horizontal.

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PRICE ELASTICITY FORMULASo, the best formula for elasticity is:

Ed =

orEd = =

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LET’S PRACTICE! PROBLEM # 1

Get your calculator out!On page 359, look at table 20.1. In your notebook, compute the elasticity between each two prices, using the midpoint formula. Did you get the same numbers from the table? Awesome! You’re ready to move on to the next problem…

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PROBLEM # 22. Complete the following table:

PRICEQUANTITY

DEMANDEDELASTICITY

COEFFICIENTCHARACTER OF DEMAND

$1.00 300 - -

.90 400

.80 500

.70 600

.60 700

.50 800

.40 900

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PROBLEM # 3a) Graph the demand schedule shown

below.b) Determine the Ed between the prices.

c) Where is elastic demand found?d) Where is the demand schedule inelastic?PRICE QUANTITY DEMANDED

$5 1

4 2

3 3

2 4

1 5

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PROBLEM # 3

e) What can you conclude about the relationship between the slope of the demand curve and its elasticity? How are they different?

f) Explain in a nontechnical way why demand is elastic in the northwest segment and inelastic in the southeast segment.

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GRAPHICAL ANALYSIS

A. Elasticity varies over a range of prices:1. Demand is more elastic in the upper left

portion of the curve because when the initial price is high and initial quantity is low, a unit change in price is a low percentage while the unit change in quantity is a high percentage change. The percent change in quantity exceeds the percent change in price, making demand elastic.

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GRAPHICAL ANALYSIS

2. Demand is more inelastic in the lower right portion of the curve because the initial price is low and the initial quantity is high, a unit change in price is a high percentage change while a unit change in quantity is a low percentage change. The percentage change in quantity is less than the percentage change in price, making demand inelastic.

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ELASTICITY AND SLOPE

It is impossible to judge the elasticity of a single demand curve by its steepness or flatness, since demand elasticity can measure both elastic and inelastic at different points on the same demand curve.

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ELASTICITY AND SLOPE

It is impossible to judge the elasticity of a single demand curve by its steepness or flatness, since demand elasticity can measure both elastic and inelastic at different points on the same demand curve.

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PART 2:TOTAL REVENUE AND ELASTICITY

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THE TOTAL-REVENUE TESTThe total-revenue test is the easiest way to judge whether demand is inelastic or elastic. This test can be used in place of the elasticity formula, unless there is a need to determine the elasticity coefficient. 1. 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 different directions-indirectly related).

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THE TOTAL-REVENUE TEST

2. Inelastic demand and the total-revenue test: Demand is inelastic if a decrease in price results in a fall in total revenue, or if an increase in price results in a rise in total revenue (price and revenue move in the same direction-directly related).

3. Unit elasticity and the total revenue test: Demand has unit elasticity if total revenue does not change when the price changes.

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THE TOTAL-REVENUE TEST

4. See the graphical representation of the relationship between the relationship between total revenue and price elasticity shown in the data from the table on page 359 and the Figure 20.2 on page 360.

5. Table 20.2 on page 362 shows the summary of the rules and concepts related to elasticity of demand.

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DETERMINANTS OF ELASTICITY

There are several determinants of the price elasticity of demand.1. Substitutes for the product: Generally,

the more substitutes for the products, the more elastic the demand.

2. The proportion of price relative to income: Generally, the larger the expenditure is relative to one’s budget, the more elastic the demand, because buyers notice the change in price more.

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3. Whether the product is a necessity or a luxury: Generally, the less necessary the item, the more elastic the demand.

4. The amount of time involved: Generally, the longer the time period involved, the more elastic the demand becomes.

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See the table 20.3 from page 363, which presents some real-world elasticities. Use the determinants and to see if the actual elasticities are equivalent to what you would predict, based on the characteristics of the good. Discuss your thoughts with your neighbors.

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APPLICATIONS OF ELASTICITY

There are many practical applications of elasticity:1. Inelastic demand for agricultural

products help explain why bumper crops depress the prices and total revenues for farmers.

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1. Government looks at elasticity of demand when levying excise taxes. Excise taxes on products with inelastic demand will raise the most revenue (in taxes) and have the least impact on quantity demanded for those products.

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3. 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.

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1. Opponents of legalization think that occasional users or “dabblers” have a more elastic demand and would increase their use at lower, legal prices.

2. Removal of the legal prohibitions might make drug use more socially acceptable and shift demand to the right.

3. The impact of minimum-wage laws will be less harmful to employment if the demand for minimum-wage workers is inelastic.

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PART 3:PRICE ELASTICITY

OF SUPPLY

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PRICE ELASTICITY OF SUPPLY

A. The concept of price elasticity also applies to supply. The elasticity formula is the same as that for demand, but you must substitute the word “supplied “ for the word “demanded” everywhere in the formula.

Es =

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B. The time period involved is very important in price elasticity of supply because it will determine how much flexibility a product has to adjust his/her resources to a change in the price. The degree of flexibility, and therefore the time period, will be different in different industries.

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PRICE ELASTICITY OF SUPPLY1. The market period is so short that

elasticity of supply is inelastic; it could be almost perfectly inelastic or vertical. In this situation, it is virtually impossible for producers to adjust their resources and change the quantity supplied (for example, think of adjustments on a farm once the crop has been planted).

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2. The short-run supply elasticity is more elastic than the market period and will depend on the ability of producers to respond to price change. Industrial producers are able to make some output changes by having workers work overtime or by bringing on an extra shift.

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3. The long-run supply elasticity is the most elastic, because more adjustments can be made over time and quantity can be changes more relative to a small change in price. The producer has time to build a new plant.

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CROSS ELASTICITY OF DEMAND

A. Cross elasticity of demand refers to the effect of a change in a product’s price on the quantity demanded for another product. Numerically this is the formula:

EXY =

1. If EXY is positive, then X and Y are substitutes.

2. If EXY is negative, then X and Y are complements.

3. Note: If EXY is zero, then X and Y are unrelated, independent goods.

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INCOME ELASTICITY OF DEMAND

1. Income elasticity of demand refers to the percentage change in quantity demanded that results from some percentage change in consumer incomes.

Ei=

If Ei is positive, then the good is normal. If Ei is negative, then the good is inferior. The goods that are income elastic will expand at

a higher rate as the economy grows.

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Chapter 20 elasticity of demand and supply