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© 2006 McGraw-Hill Ryerson Li mited. All rights reserved. 1 Chapter 5: Describing Demand and Supply: Elasticities Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 5: Describing Demand and Supply: Elasticities Prepared by: Kevin Richter, Douglas College

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Page 1: © 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 5: Describing Demand and Supply: Elasticities Prepared by: Kevin Richter, Douglas College

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

1

Chapter 5:Describing Demand and Supply: ElasticitiesPrepared by:Kevin Richter, Douglas CollegeCharlene Richter,British Columbia Institute of Technology

Page 2: © 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 5: Describing Demand and Supply: Elasticities Prepared by: Kevin Richter, Douglas College

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

2

Chapter Objectives

1. Use the terms price elasticity of demand and price elasticity of supply to describe the responsiveness of quantity demanded and quantity supplied to changes in price.

2. Calculate price elasticity of demand.

3. Interpret price elasticity of demand.

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

3

Chapter Objectives

4. Explain the importance of substitution in determining price elasticity.

5. Relate price elasticity of demand to total revenue.

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

4

Chapter Objectives

6a. Calculate and interpret income elasticity of demand, cross-price elasticity of demand, and price elasticity of supply.

6b. State how elasticity concepts are useful in describing the effect of shift factors on demand.

7. Calculate and interpret price elasticity of supply.

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

5

Chapter Objectives

8. Explain how the concept of elasticity makes supply and demand analysis more useful.

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

6

Concept of Elasticity

Elasticity is a measure of the responsiveness of one variable to another.

The greater the elasticity, the greater the responsiveness.

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7

Price Elasticity of Demand

The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

8

What Information Price Elasticity Provides Price elasticity of demand gives the exact

quantity response to a change in price.

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

9

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.

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

10

Things to Note About Elasticity

By the Law of Demand, as price rises, quantity demanded falls.

Inverse relationship

Elasticity tells us by how much quantity falls.

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11

Things to Note About Elasticity

Economists therefore talk about price elasticity of demand as an absolute value of the number.

Thus, price elasticity of demand is reported as a positive number.

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12

Classifying Demand as Elastic or Inelastic

Demand is elastic if the percentage change in quantity is greater than the percentage change in price.

D > 1

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

13

Classifying Demand as Elastic or Inelastic

Demand is inelastic if the percentage change in quantity is less than the percentage change in price.

D < 1

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

14

Elastic Demand

Elastic demand means that quantity demanded changes by a greater percentage than the percentage change in price.

Inelastic demand means that quantity doesn't change much with a change in price.

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15

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.

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16

Elasticity Is Independent of Units Having a measure of responsiveness that is

independent of units makes comparisons of responsiveness of different goods easier.

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

17

Calculating Price Elasticity of Demand

To determine price elasticity of demand, divide the percentage change in quantity demanded by the percentage change in price.

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

18

End-Point Problem

The end-point problem – the percentage change differs depending on whether you calculate the change as a rise or a decline in price.

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

19

End-Point Problem

Economists use the average of the end points to calculate the percentage change.

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

20

Graph of Price Elasticity of Demand

Pric

e

Quantity (in thousands)

$26242220181614

0

D

B

A

7 8 9

C (midpoint)

Elasticity of demand between A and B = .96

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

21

Graph of Price Elasticity of Demand

Pric

e

Quantity

$10987654321

C

D

B

A

D = 0.54

D = 4

5 10 15 20 25 30 35 40 45 50 55

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

22

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 or an arc.

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23

Calculating Elasticity at a Point To calculate elasticity at a point, determine a

range around that point and calculate the arc elasticity.

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

24

Calculating Elasticity at a Point

Pric

e

Quantity

$10 9 8 7 6 5 4 3 2 1

C

BA

24 402820

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

25

Calculating Elasticity at a Point

6 12 18 30 36 42 48

Pric

e

Quantity

87654321

$109

A

24 6054

B

εA = 2.33

ε B = 0.11

Demand

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

26

Elasticity and Demand Curves Two important points to consider:

Elasticity is related to, but is not the same as slope.

Elasticity changes along a straight-line demand curve.

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

27

Elasticity Is Not the Same as Slope The steeper the curve at a given point, the

less elastic is demand.

There are two limiting examples of this.

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

28

Elasticity Is Not the Same as Slope When the demand curve is flat, we call the

demand perfectly elastic.

Perfectly elastic demand is a horizontal line in which quantity changes enormously in response to any change in price (D = ).

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29

Elasticity Is Not the Same as Slope

When the demand 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).

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30

Perfectly inelastic demand curve

Pric

e

0Quantity

Perfectly Inelastic Demand Curve

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31

Perfectly elastic demand curve

Perfectly Elastic Demand Curve

Pric

e

0Quantity

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32

Elasticity Changes Along Straight-Line Curves Elasticity is not the same as slope.

Elasticity changes along straight line demand curves – slope does not.

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33

Elasticity and SlopeP

rice

Quantity

$10987654321 10 20 30 40 50 60 70 80 90

D1 D2

Over the $3 to $4 price interval,

D (A to C on D1) = 0.47

while D (A to G on D2) = 4.2

AG C

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

34

Elasticity Changes Along Straight-Line Curves A demand curve is perfectly elastic ( D = ) at

the vertical (price) intercept.

Elasticity becomes smaller as you move down the demand curve until it becomes zero ( = ) at the horizontal (quantity) intercept.

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35

Pric

e

$10987654321

0 1 2 3 4 5 6 7 8 9 10 Quantity

Elasticity Along a Demand Curve

Elasticity declines along demand curve as we move

toward the quantity axisEd =

Ed = 1

Ed = 0

Ed < 1

Ed > 1

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36

Interpret Price Elasticity of Demand

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).

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37

Price Elasticity of Demand: Review Perfectly elastic – quantity responds

enormously to price changes (D = ).

Elastic – the percentage change in quantity demanded exceeds the percentage change in price (D > 1).

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38

Unit elastic – the percentage change in quantity demanded is the same as the percentage change in price (D = 1).

Price Elasticity of Demand: Review

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39

Inelastic – the percentage change in quantity demanded is less than the percentage change in price (D < 1).

Perfectly inelastic – quantity does not respond at all to price changes (D = 0).

Price Elasticity of Demand: Review

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40

Interpret Price Elasticity of Demand

D Description of demand

Interpretation

D= Perfectly elastic Quantity responds enormously to changes in price

D>1 Elastic Consumers are responsive to price changes

D= Unit elastic Percent change in price and quantity are equal

D<1 Inelastic Consumers are unresponsive to price changes

D= Perfectly inelastic Consumers are completely unresponsive to price change

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41

As a general rule, the more substitutes a good has, the more elastic is its supply and demand.

Substitution and Price Elasticity of Demand

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42

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

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43

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.

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44

Luxuries versus Necessities

If a good is a necessity, the less elastic its demand curve.

Necessities tend to have fewer substitutes than do luxuries.

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45

Narrow or Broad Definition

Demand becomes more elastic as the definition of a good becomes more specific.

A broadly defined good like transportation does not have many substitutes so that demand will be inelastic.

A more narrowly defined good like bus transportation will have more substitutes.

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46

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.

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47

Goods that cost very little relative to your total expenditures are not worth spending a lot of time figuring out if there is a good substitute.

It is worth spending a lot of time looking for substitutes for goods that take a large portion of one’s income.

Budget Proportion

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48

Empirical Estimates of Elasticities The following table provides short- and long-

term estimates of price elasticities of demand for a number of goods.

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49

Short-Run and Long-Run Price Elasticities of Demand

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50

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.

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51

Price Elasticity of Demand and Total Revenue Knowing the price 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.

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52

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.

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53

Price Elasticity of Demand and Total Revenue If demand is unit elastic ( D = 1), a rise in

price leaves total revenue unchanged.

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54

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.

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55

A

(a) Unit Elastic DemandE = 1

Elasticity and Total Revenue

TR constant

C

0 6

Pric

e

Quantity

$10

8

6

4

2

1 2 3 4 5 7 8 9

B

ELost revenue

FGained revenue

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56

A

Pric

e

(b) Inelastic DemandE < 1

Quantity

$10

8

6

4

2

0 1 2 3 4 5 6 7 8 9

Elasticity and Total Revenue

TR rises

C

H

BG

Lost revenue

Gained revenue

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57

A

Pric

e

(c) Elastic DemandE > 1

Quantity

$10

8

6

4

2

0 1 2 3 4 5 6 7 8 9

Elasticity and Total Revenue

TR fallsC

B

KJ

Lost revenue

Gained revenue

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58

Total Revenue Along a Demand Curve With elastic demand – a rise in price lowers

total revenue.

With inelastic demand – a rise in price increases total revenue.

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Elastic range εD > 1

εD = 1

Inelastic range

εD < 1

Q0

Pri

ce

Quantity0

Total Revenue Changes Along a Demand Curve

Q0

0Quantity

To

tal r

eve

nu

e

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60

Elasticity of Individual and Market Demand Market demand elasticity is influenced both

by:

The number of people who totally drop out when price increases.

How much an existing consumer marginally changes his or her quantity demanded.

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61

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.

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62

Elasticity of Individual and Market Demand

Firms that price discriminate charge more to the individuals with inelastic demand and less to individuals with elastic demands.

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63

Elasticity of Individual and Market Demand Examples of price discrimination include:

Airlines’ Saturday stay-over specials. The phenomenon of selling new cars. The almost-continual-sale phenomenon.

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64

Other Elasticities of Demand

Two other demand elasticities are important in describing consumer behaviour:

Income elasticity of demand.

Cross-price elasticity of demand.

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65

Income Elasticity of Demand

Income elasticity of demand – the percentage change in demand divided by the percentage change in income.

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66

Income Elasticity of Demand

Income elasticity of demand tells us the responsiveness of demand to changes in income.

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67

Income Elasticity of Demand

An increase in income generally increases one’s consumption of almost all goods.

The increase may be greater for some goods than for others.

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68

Income Elasticity of Demand

Normal goods are those whose consumption increases with an increase in income.

They have income elasticities greater than zero.

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69

Income Elasticity of Demand

Normal goods are usually divided into two categories:

Income elastic normal goods

Income inelastic normal goods

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70

Income Elasticity of Demand

Income elastic normal goods are goods that have an income elasticity greater than one.

Their percentage increase in demand is greater than the percentage increase in income. Luxuries tend to be income elastic.

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71

Income Elasticity of Demand

An income inelastic normal good has an income elasticity less than 1.

The consumption of these goods rises by a smaller proportion than the rise in income. Necessities tend to be income inelastic.

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72

Income Elasticity of Demand

Inferior goods are those whose consumption decreases when income increases.

Inferior goods have income elasticities less than zero (negative). Generic (store-brand) cereals tend to be inferior

goods.

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73

Income Elasticities of Selected Goods

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74 

Coefficient

Interpretation

Description

Normal good

I Qd

Two cases of normal good:

Income inelastic normal good (“necessity”)

Income elastic normal good (“superior” good)

Inferior good

I Qd

0

10

1

Interpret Income Elasticity of Demand

0

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Cross-Price Elasticity of Demand Cross-price elasticity of demand is

computed by dividing the percentage change in quantity demanded by the percentage change in the price of another good.

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Cross-Price Elasticity of Demand Cross-price elasticity of demand tells us the

responsiveness of demand to changes in prices of other goods.

Cross-price elasticity measures both how and how strongly consumers respond to changes in the price of related products.

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Cross-Price Elasticity of Demand Depending on how consumers respond to

changes in the price of related products, goods can be classified as

Substitutes

Complements

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Complements and Substitutes Substitutes are goods that can be used in

place of one another.

When the price of a good goes up, the demand for the substitute good also goes up.

Cross-price elasticity of substitutes is positive

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Complements and Substitutes Complements are goods that are used in

conjunction with other goods.

A rise in the price of a good will decrease the demand for a good, and for its complement.

Complements have negative cross-price elasticities.

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Interpret Cross-Price Elasticity of Demand

Coefficient Interpretation Ratio

XY > 0 Substitute

Goods

PYQX

XY < 0 Complementary

Goods

PY QX

XY = 0 Unrelated Goods PY QX=0

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P0

D0 D1

P0

18 Quantity25

Shift due to increase in

income

Calculating Income and Cross-Price Elasticities

Price=6.5

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Calculating Income and Cross-Price Elasticities

P0 P0

3 Quantity of ketchup4

Shift due to rise in priceof hot dogs

D1

D0

Price of ketchup

XY= - 0.7

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Commodities Cross-Price

Elasticity

Beef in response to price change in pork 0.11 Beef in response to price change in chicken 0.02 U.S. automobiles in response to price changes

in European and Asian automobiles

0.28 European automobiles in response to price

changes in U.S. and Asian automobiles

0.61 Beer in response to changes in wine 0.23 Hard liquor in response to price changes in

beer

- 0.11

Cross-Price Elasticities

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Price Elasticity of Supply

Price elasticity of supply measures the responsiveness of firms to a change in the price of their product.

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Price Elasticity of Supply

The price elasticity of supply is calculated as the percent change in quantity supplied over the percent change in price.

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Inelastic Supply

Common sense tells us that an inelastic supply means that the percent change in quantity is less than the percentage change in price.

An elastic supply means that quantity supplied changes by a larger percent than the percent change in price.

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Substitution and Supply

The longer the time period considered, the more elastic the supply.

In the long run there are more alternatives so it is easier (less costly) for suppliers to change and produce other goods.

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Substitution and Supply

Economists distinguish three time periods relevant to supply:

The instantaneous period. The short run. The long run.

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Substitution and Supply

In the instantaneous period, quantity supplied is fixed so supply is perfectly inelastic.

This supply is sometimes called the momentary supply.

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Substitution and Supply

In the short run, some substitution is possible – the short-run supply curve is somewhat elastic.

In the long run, significant substitution is possible – the supply curve becomes very elastic.

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Substitution and Supply

An additional factor to consider in determining elasticity of supply:

How easy or difficult is it to produce more of the good?

The easier it is to produce additional units, the more elastic the supply.

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Elasticity and Shifting Supply and Demand Elasticity can tell us more precisely the effect

of shifting supply and demand.

The more elastic the demand, the greater the effect of a supply shift on quantity, and the smaller effect on price.

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Effects of Shifts in Supply on Price and Quantity

An example of the importance of elasticities of demand and supply can be illustrated by the example of the world market for oil

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Effects of Shifts in Supply on Price and Quantity

If oil supply decreases, the world prices will rise sharply if the demand for oil is inelastic.

Oil prices will not be affected a lot if demand is elastic.

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Effects of Shifts in Supply on Price and Quantity

Inelastic Supply and Inelastic Demand

P0

P1

DemandPrice

Quantity

S0S1

Q0Q1

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Effects of Shifts in Supply on Price and Quantity

Inelastic Supply and Elastic Demand

P1

P0 Demand

Price

Quantity

S1 S0

Q1 Q0

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Describing Demand and Supply: Elasticities

End of Chapter 5