Describing Supply and Demand: Elasticities
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1 CHAPTER 7 Describing Supply and Demand: Elasticities The master economist must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought. J. M. Keynes McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
2 What is Elasticity? Elasticity: shows how sensitive a change in quantity is to a change in price There are 4 types: 1. Elasticity of Demand 2. Elasticity of Supply 3. Cross-Price Elasticity (Substitutes or Complements) 4. Income Elasticity (Normal or Inferior McGraw-Hill/Irwin goods) Colander, Economics 2
3 ELASTICITY OF DEMAND McGraw-Hill/Irwin Colander, Economics 3
4 Price Elasticity of Demand: Elastic Demand It is a measurement of consumers responsiveness to a change in price What will happen if price increases? How much will it affect quantity demanded? Price elasticity of demand is always expressed as a positive number (E>1) McGraw-Hill/Irwin Colander, Economics 4
5 Price Elasticity of Demand: Elastic Demand Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price (independent of units) E D =% change in Quantity Demanded % change in Price 7-5
6 Price Elasticity of Demand: Elastic Demand Demand is elastic if the percentage change in quantity is greater than the percentage change in price Elastic demand =E D > 1 7-6
7 Characteristics of Elastic Goods Many substitutes Luxuries Large portion of income Plenty of time to decide Elasticity coefficient greater than 1 McGraw-Hill/Irwin Colander, Economics 7
8 Draw the Graph: Relatively Elastic Demand P D Q 7-8
9 Perfectly Elastic Demand This curve is perfectly elastic, meaning that Q responds enormously to changes in price, E D = P D Q McGraw-Hill/Irwin Colander, Economics 9
10 Elastic Demand Describing Supply and Demand: McGraw-Hill/Irwin Colander, Economics 10
11 Price Elasticity of Demand: Inelastic Demand When demand is inelastic, quantity demanded is insensitive to a change in price meaning there will be little change If price increases, quantity demanded will fall a little If price decreases, quantity demanded will increase a little In other words, people will continue to buy it McGraw-Hill/Irwin Colander, Economics 11
12 Price Elasticity of Demand: Inelastic Demand Demand is inelastic if the percentage change in quantity is less than the percentage change in price Inelastic demand=e D < 1 McGraw-Hill/Irwin Colander, Economics 12
13 Characteristics of Inelastic Goods Few substitutes Necessities Small portion of income Required now, rather than later Elasticity coefficient less than 1 McGraw-Hill/Irwin Colander, Economics 13
14 Draw the Graph: Inelastic Demand P D Q 7-14
15 Perfectly Inelastic Demand This curve is perfectly inelastic, meaning that Q does not respond at all to changes in price, E D = 0. Q is insensitive to changes in P. P D Q McGraw-Hill/Irwin Colander, Economics 15
16 Elasticity Along a Demand Curve P E D = Perfectly elastic (where intersects P) E D > 1 Elastic Elasticity declines along this straight-line demand curve as we move towards the Q axis E D = 1 Unit elastic (at midpoint) E D < 1 Inelastic Elastic Inelastic Q E D = 0 Perfectly inelastic (where intersects Q) 7-16
17 Inelastic Demand McGraw-Hill/Irwin Colander, Economics 17
18 Calculating Elasticity: Using the Midpoint Formula One way to calculate elasticity is to use the midpoint formula E D = %ΔQ %ΔP = Q2 Q1 ½(Q2+Q1) P2 P1 ½(P2+P1) When given price and quantity for two points on a line, we can use the above formula (this is the way the textbook teaches it) 7-18
19 Calculating Elasticity: Using the Midpoint Formula $20 $16 $12 P B 20 C 22 What is the price elasticity of demand between A and B? 24 Midpoint A D E D = = Q %ΔQ %ΔP ½(24+20) ½(12+20) = Q2 Q1 ½(Q2+Q1) P2 P1 ½(P2+P1) -.36 = = Relatively inelastic 7-19
20 Calculating Elasticity: Using the Midpoint Formula Let s simplify the formula: %ΔQ midpoint / %ΔP midpoint 8 / =-0.72 I prefer to do the midpoint part in my head and write it like this McGraw-Hill/Irwin Colander, Economics 20
21 Calculating Elasticity: Using the % Δ Formula Another way to calculate elasticity (when given two sets of points) is to use the percent change formula: Q2 Q1 Q1 (New) Q 2 minus (old) Q 1 divided by (old) Q 1 P2 P1 P1 (New) P 2 minus (old) P 1, divided by (old) P 2 McGraw-Hill/Irwin Colander, Economics 21
22 Calculating Elasticity: Using the % Δ Formula Example: Price is $20, quantity is 20. Then, it changes to $12 and quantity of 24. %ΔQ %ΔP = McGraw-Hill/Irwin Colander, Economics 22
23 Calculating Elasticity: Using the % Δ Formula Example: Price is $20, quantity is 20. Then, it changes to $12 and quantity of 24. = = 4 20 X Demand is relatively inelastic -0.5 This would be the way to show your work if asked by the College Board McGraw-Hill/Irwin Colander, Economics 23
24 Calculating Elasticity: Total Revenue Test You can also use the total revenue test to show how changes in price will affect total revenue (TR) Total Revenue = Price x Quantity McGraw-Hill/Irwin Colander, Economics 24
25 Calculating Elasticity: Total Revenue Test Elastic Demand: If E D > 1 Price increase causes TR to decrease Price decrease causes TR to increase Inelastic Demand: If E D < 1 Price increase causes TR to increase Price decrease causes TR to decrease Unit Elastic: If E D = 1 A change in price changes leaves TR unchanged McGraw-Hill/Irwin Colander, Economics 25
26 Calculating Elasticity: Total Revenue Test Let s use the same example: Price is $20, quantity is 20. Then, it changes to $12 and quantity of 24. Total Revenue = Price x Quantity $20 (20)= $400 (old P and Q) $12 (24) =$288 (new P and Q) As price decreased, so did TR. Demand is relatively inelastic. McGraw-Hill/Irwin Colander, Economics 26
27 Figuring Out Elasticity You can use the midpoint formula, the percent change formula, or the total revenue test to figure out elasticity Know all three ways A lot of the book stuff requires us to use the midpoint formula If asked to show your work on an FRQ, set-up the math and go from there using one of the methods (unless specially asked to do it a certain way) McGraw-Hill/Irwiaaan Colander, Economics 27
28 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 that price discriminate charge more to the individuals with inelastic demand and less to individuals with elastic demand Examples of price discrimination Last minute purchase of airfare New cars 7-28
29 Substitution and Elasticity What makes demand (or supply) more or less elastic? Substitution A general rule is: The more substitutes a good has, the more elastic its supply or demand If a good has substitutes, a rise in the price of that good will cause the consumer to shift consumption to those substitute goods 7-29
30 Substitution and Demand The number of substitutes a good has is affected by several factors Four of the most important factors: 1. The time period being considered 2. The degree to which a good is a luxury 3. The market definition 4. The importance of the good in one s budget 7-30
31 Income Elasticity of Demand Income elasticity of demand measures the responsiveness of demand to changes in income E Income = % change in Demand % change in Income 7-31
32 Income Elasticity of Demand Normal goods are those whose consumption increases with an increase in income For normal goods: E income > 0 Necessity: 0 < E income < 1 (greater than 0 and less than 1) Luxury: E Income > 1 McGraw-Hill/Irwin Colander, Economics 32
33 Income Elasticity of Demand Inferior goods are those whose consumption decreases with an increase in income E Income < 0 (negative number) McGraw-Hill/Irwin Colander, Economics 33
34 Cross Price Elasticity of Demand Cross price elasticity of demand measures the responsiveness of demand to changes in prices of other goods E cross-price = % change in Demand % change in P of related good 7-34
35 Cross Price Elasticity of Demand Cross-price elasticity tells us if goods are substitutes or complements Here, positive and negative matters Positive change indicates a substitute Negative change indicates a complement McGraw-Hill/Irwin Colander, Economics 35
36 Cross Price Elasticity of Demand Substitutes are goods that can be used in place of another (when the price of a good goes up, the demand for the substitute goes up) E cross-price > 0 (positive number) McGraw-Hill/Irwin Colander, Economics 36
37 Cross Price Elasticity of Demand Complements are goods that are used conjunction with other goods (a decrease in the price of a good will increase the demand for its complement) E cross-price < 0 (negative number) McGraw-Hill/Irwin Colander, Economics 37
38 ELASTICITY OF SUPPLY McGraw-Hill/Irwin Colander, Economics 38
39 Price Elasticity of Supply: Elastic Supply Elasticity of supply shows how sensitive producers are to a change in price Elasticity of supply is based on time limitations Producers need time to produce more McGraw-Hill/Irwin Colander, Economics 39
40 Price Elasticity of Supply: Elastic Supply Price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price E S = % change in Quantity Supplied % change in Price This tells us exactly how quantity supplied responds to a change in price (elasticity is independent of units) 7-40
41 Elasticity of Supply Supply is elastic if the percentage change in quantity is greater than the percentage change in price Elastic supply=e S > 1 Supply is inelastic if the percentage change in quantity is less than the percentage change in price Inelastic supply =E S <
42 Drawing the Graph: Relatively Elastic Supply P S Q McGraw-Hill/Irwin Colander, Economics 42
43 Drawing the Graph: Inelastic Supply P S Q McGraw-Hill/Irwin Colander, Economics 43
44 Elasticity Along a Supply Curve At the point on the supply curve that intercepts the price axis, supply is perfectly elastic E s = Points become less elastic as you move out along the supply curve At the point on the supply curve that intercepts the quantity axis, supply is perfectly inelastic E s = 0 Points become more elastic as you move along the supply curve Supply is unit elastic if it intercepts the origin McGraw-Hill/Irwin Colander, Economics 44
45 Elasticity Along a Supply Curve P $10 $8 $6 E s = (perfectly elastic) $4 $2 E s = 1 2 Unit elastic (intercepts origin) E s = 0 Perfectly inelastic Q McGraw-Hill/Irwin Colander, Economics 45
46 Calculating Elasticity: Midpoint Formula P What is the price elasticity of supply between A and B? $5.00 $4.75 $4.50 Midpoint A C B S = E S = ½( ) ½(5+4.50) %ΔQ %ΔP = Q2 Q1 ½(Q2+Q1) P2 P1 ½(P2+P1) = = Q 7-46
47 Calculating Elasticity: Using the Midpoint Formula Let s simplify the formula: %ΔQ midpoint / %ΔP midpoint 9 / =0.18 McGraw-Hill/Irwin Colander, Economics 47
48 Substitution and Elasticity What makes supply (or demand) more or less elastic? Substitution A general rule is: The more substitutes a good has, the more elastic its supply or demand If a good has substitutes, a rise in the price of that good will cause the consumer to shift consumption to those substitute goods 7-48
49 Substitution and Supply The longer the time period considered, the more elastic the supply There are three time periods relevant to supply: 1. The instantaneous period where supply is fixed and is perfectly inelastic 2. The short run where some substitution is possible and supply is somewhat elastic 3. The long run where significant substitution is possible and supply is most elastic 7-49
50 Shifting Supply and Demand and Elasticity The more elastic the demand (or supply), the greater the effect of a supply (or demand) shift on quantity and the smaller the effect on price % change in P = % change in P = % change in D E D + E S % change in S E D + E S 7-50
51 Chapter Summary Elasticity is percentage change in quantity divided by percentage change in some variable that affects demand (supply). The most common elasticity is price. E D = E S = % change in Quantity Demanded % change in Price % change in Quantity Supplied % change in Price 7-51
52 Chapter Summary Five price elasticity of demand or supply terms are: Elastic E>1 Inelastic E<1 Unit elastic E=1 Perfectly inelastic E=0 Perfectly elastic E= Demand becomes less elastic as we move down along a demand curve The most important factor affecting the number of substitutes in supply is time. The longer the time interval, the more elastic is supply 7-52
53 Chapter Summary Factors affecting the number of substitutes in demand are: Time period Degree to which the good is a luxury Market definition Importance of the good in one s budget The more substitutes a good has, the greater its elasticity 7-53
54 Chapter Summary When a supplier raises price: If demand is inelastic, total revenue increases If demand is elastic, total revenue decreases If demand is unit elastic, total revenue remains constant Other important elasticities are: Income elasticity is the percentage change in demand divided by the percentage change in income Cross-price elasticity is the percentage change in demand divided by the percentage change in the price of a related good 7-54
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