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DESCRIBING SUPPLY AND
DEMAND: ELASTICITIES
Chapter 6Chapter 6
Today’s lecture
• Elasticity
• The Price Elasticity of Demand
• The Price Elasticity of Supply
• Calculate elasticity graphically and numerically.
The Concept of Elasticity
• Elasticity is a measure of the responsiveness of one variable to another.
• The greater the elasticity, the greater the responsiveness.
• In economics, elasticity is used to describe the responsiveness of quantity supplied or quantity demanded to price.
The Price Elasticity of Demand
price in change Percentage
demanded quantity in change Percentage ED
Price elasticity of demand (ED)
• The price elasticity of demand measures how much the quantity demanded responds to a change in price.
Example
• Suppose that a 10-percent increase in the price of an ice-cream cone causes the amount of ice cream you buy to fall by 20 percent.
The related price elasticity of demand:
-20 percent / 10 percent = 2
The Price Elasticity of Supply
Price elasticity of supply (ES)
• The price elasticity of supply measures how much the quantity supplied responds to a change in price.
price in change Percentage
supplied quantity in change Percentage ES
Example
• Suppose a 10 percent increase in the price of an ice-cream causes a 5 percent increase in the supply of ice-cream.
The related price elasticity of supply:
5 percent/ 10 percent = 0.5
Classifying Demand and Supply as Elastic or Inelastic
• Demand or supply is elastic if the percentage change in quantity is greater than the percentage change in price.
E>1• Demand or supply is inelastic if the
percentage change in quantity is less than the percentage change in price.
E<1
Unit Elastic Demand or Supply
• Demand or supply is unit elastic if the percentage change in quantity is the same as the percentage change in price.
E=1
Elasticities and Supply and Demand Curves
Perfectly inelastic demand curve
Pri
ce
0Quantity
Perfectly elastic demand curve
Pri
ce
0Quantity
P
Elasticity is Not the Same as Slope, But
• The steeper the curve at a given point, the less elastic is supply or demand.
• Perfectly elastic supply or demand– The curves are flat– The quantity responds enormously to a change
in price (E = ∞)
• Perfectly inelastic supply or demand– The curves are vertical– The quantity does not response to a change in
price (E=0).
Example
• A diabetic, who will die without insulin, would be willing to pay any price for the life-saving quantity of insulin.
----The diabetic has a perfectly inelastic demand of insulin.
Example
• In agriculture individual producers generally have no control over the price because she or he will not be able to sell any of the crop if she or he raise the price slightly above the market price.
---- The demand of crop is perfectly elastic.
Question
• The elasticity of demand is same along the demand curve?
----To find out the answer, we just calculate them by ourselves.
Calculating Elasticity of Demand Between Two Points
27.126.
33.
236
124
)2026(2026
)1014(1410
E
21
21
D
Pri
ce
Quantity of software (in hundred thousands)
$26
24
22
20
18
16
14
0
Demand
B
A
10 12 14
Cmidpoint
Elasticity of demand between A and B: P%
Q% E
Question
• A major cereal producer decides to lower price from $3.60 to $3 per 15-ounce box.
Q: If quantity demanded increases by 18 percent, what is the price elasticity of demand?
Calculating Elasticity at a PointP
rice
Quantity
$10 9 8 7 6 5 4 3 2 1
C
BA
24 402820
To calculate elasticity at a point determine a range around that point and calculate the arc elasticity.
66.5.
33.
42
248
)35(35
)2028(2028
E
21
21
Aat
Calculating Elasticity along the Demand Curve
Pri
ce
Quantity
$10 9 8 7 6 5 4 3 2 1
C
BA
24 402820168
D
F
12
E
The elasticity at point C:[(16-24)/20]/[(6-4)/5]=0.4/0.4=1
The elasticity at point A:[(28-20)/24]/[(3-5)/4]=0.65
The elasticity at point F:[(16-0)/8]/[(6-10)/8]=4
G
Elasticity Along a Demand CurveP
rice
$10987654321
0 1 2 3 4 5 6 7 8 9 10 Quantity
Elasticity declines along demand curve as we move
toward the quantity axis
Ed = 1
Ed = 0
Ed < 1
Ed > 1
Ed = ∞
Question
• If a good have several substitutes, the demand of this good is elastic or inelastic?
Substitutes are often pairs of goods that are used in place of each other and an increase in the price of one leads to an increase in the demand for the other.
• If a good is necessary, such as salt, the demand of this good is elastic or inelastic?
Elasticity and Demand• As a general rule, the more substitutes a good has,
the more elastic is its supply and demand.• The larger the time interval considered, the more
elastic is the demand curve.• The less a good is a necessity, the more elastic is
its demand curve.• Demand becomes more elastic as the definition of
the good becomes more specific.• Demand for goods that represent a large portion of
one’s budget are more elastic.
Elasticity and Supply
• The longer the time period considered, the more elastic the supply.
• There are three time periods relevant to supply:– The instantaneous period – supply is fixed,
perfectly inelastic.– The short run – supply is somewhat elastic.– The long run – supply is very elastic.
Elasticity and Total Revenue
A
Unit Elastic DemandE = 1
TR constant
C
0 6
Pri
ce
Quantity
$10
8
6
4
2
1 2 3 4 5 7 8 9
B
ELost revenueEO46 (B)
FGained revenue:FO46(C)
TRE= $4x6=$24TRF= $6x4=$24
O
C
B
Elasticity and Total Revenue
A
Pri
ce
Elastic DemandE > 1
Quantity
$10
8
6
4
2
0 1 2 3 4 5 6 7 8 9
TR falls if price increases.TR rises if price decreases.
KJ
TRJ = $8 x 2 = $16TRK = $9 x 1 = $9
9
Elasticity and Total Revenue
A
Pri
ce
Inelastic DemandE < 1
Quantity
$10
8
6
4
2
0 1 2 3 4 5 6 7 8 9
TR rises if price increases
C
H
G
TRG = $1 x 9 = $9
TRH = $2 x 8 = $16
B
Total Revenue Along a Demand
Curve
Elastic ED > 1
ED = 1
Inelastic ED < 1
Pri
ce
Quantity0
0Quantity
To
tal r
eve
nu
e
Q0
Q0
C
A
B
Question
• If you find that in California where vanity plates cost $28.75, the elasticity of demand is 0.52. In Massachusetts where vanity plates cost $50, the elasticity of demand is 3.52.
Q: What recommendation would you have for each state to maximize revenue?
Question
• A newspaper recently lowered its price from 50 cents to 30 cents. As it did, the number of newspapers sold increased from 240,000 to 280,000.
a. What was the newspaper’s elasticity of demand?
b. Given that elasticity, did it make sense for the newspaper to lower its price?
Question
• Comparing a rich person and a poor guy, for a given good, which person has a more elastic demand of the good?
• If you can charge different price for different person, you will charge a higher price or lower price to the person who has a more elastic demand of the good?
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.
• Firms charge more to the individuals with inelastic demand and less to individuals with elastic demand.
• Examples of price discrimination:– Airlines’ Saturday stay-over specials– Sales of new cars– Almost-continual sales
Income Elasticity of Demand
• Income elasticity of demand measures the responsiveness of demand to changes in income.
income in change Percentage
demand in change Percentage Eincome
Income Elasticity of Demand
• Normal goods are those whose consumption increases with an increase in income.
• Normal goods can be luxuries or necessities:– Luxuries are goods that have an income elasticity greater
than one.– A necessity has an income elasticity less than 1.
• Inferior goods are those whose consumption decreases when income increases. – Inferior goods have income elasticities less than zero.
Cross-Price Elasticity of Demand
• Cross-price elasticity of demand measures the responsiveness of demand to changes in prices of other goods.
good related a of
price in change Percentage
demand in change Percentage E pricecross
Complements and Substitutes
• Substitutes are goods that can be used in place of another.– Substitutes have positive cross-price
elasticities.
• Complements are goods that are used in conjunction with one another.– Complements have negative cross-price
elasticities.
