Ch. 18 Elasticity of D and S

Elasticity and Its Applications
18
Copyright 2004 South-Western
Elasticity . . .
allows us to analyze supply and demand with greater precision. is a measure of how much buyers and sellers respond to changes in market conditions
Copyright 2004 South-Western/Thomson Learning
THE ELASTICITY OF DEMAND

Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.
Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.
The Price Elasticity of Demand and Its Determinants

Availability of Close Substitutes Necessities versus Luxuries Definition of the Market Time Horizon
The Price Elasticity of Demand and Its Determinants

Demand tends to be more elastic :
the larger the number of close substitutes. if the good is a luxury. the more narrowly defined the market. the longer the time period.
Computing the Price Elasticity of Demand

The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.
Percentage change in quantity demanded Percentage change in price
Price elasticity of demand =

Price elasticity of demand = Percentage change in quantity demanded Percentage change in price
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then elasticity of demand would be calculated as:
(10 8) 100 20% 10 2 (2.20 2.00) 100 10% 2.00

Price elasticity of demand = Percentage change in quantity demanded Percentage change in price
Example: If the price of an ice cream cone decreases from $2.20 to $2.00 and the amount you buy increases from 8 to 10 cones, then elasticity of demand would be calculated as: Calculate Price Elasticity of Demand ?
The Midpoint Method: Better Way to Calculate Elasticity

The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.
(Q 2 Q1 ) / [(Q 2 Q1 ) / 2] Price elasticity of demand = (P2 P1 ) / [(P2 P1 ) / 2]
The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticity
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then elasticity of demand, using the midpoint formula, would be calculated as: (10 8) 22% (10 8) / 2 2.32 (2.20 2.00) 9.5% (2.00 2.20) / 2
The Variety of Demand Curves

Inelastic Demand
Quantity demanded does not respond strongly to price changes. Price elasticity of demand is less than one.
Elastic Demand
Quantity demanded responds strongly to changes in price. Price elasticity of demand is greater than one.

(100 - 50)
Price
ED
(100 50)/2 (4.00 5.00)/2
(4.00 - 5.00)
$5
4
Demand 67 percent -3
- 22 percent
50
100 Quantity
Demand is price elastic


Perfectly Inelastic
Quantity demanded does not respond to price changes.
Perfectly Elastic
Quantity demanded changes infinitely with any change in price.
Unit Elastic
Quantity demanded changes by the same percentage as the price.

Because the price elasticity of demand measures how much quantity demanded responds to the changes in price, it is closely related to the slope of the demand curve.
Figure 1 Perfectly Elastic Demand
(a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand $5
4
1. An increase in price . . .
100
Quantity
2. . . . leaves the quantity demanded unchanged.
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Figure 2 Inelastic Demand
(b) Inelastic Demand: Elasticity Is Less Than 1

Price
$5 4 1. A 22% increase in price . . . Demand
90
100
Quantity
2. . . . leads to an 11% decrease in quantity demanded.
Figure 3 Unitary Elastic Demand
(c) Unit Elastic Demand: Elasticity Equals 1 Price
$5
4
1. A 22% increase in price . . . Demand
80
100
Quantity
2. . . . leads to a 22% decrease in quantity demanded.
Figure 4 Elastic Demand
(d) Elastic Demand: Elasticity Is Greater Than 1

Price
$5 4 1. A 22% increase in price . . . Demand
50
100
Quantity
2. . . . leads to a 67% decrease in quantity demanded.
Figure 5 Perfectly Elastic Demand
(e) Perfectly Elastic Demand: Elasticity Equals Infinity Price 1. At any price above $4, quantity demanded is zero. $4 2. At exactly $4, consumers will buy any quantity. Demand
0 3. At a price below $4, quantity demanded is infinite.
Quantity
Total Revenue and Price Elasticity of Demand

Total revenue is the amount received by a seller when he sells his product at a given price. Computed as the price of the good times the quantity sold. TR = P x Q
Figure 6
Price
Total Revenue
$4
P Q = $400 (revenue)
Demand
0 Q
100
Quantity
Elasticity and Total Revenue along a Linear Demand Curve (Inelastic Demand)
With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases.
Figure 7 How Total Revenue Changes when Price Changes: Inelastic Demand
Price An Increase in price from $1 to $3
Price leads to an Increase in total revenue from $100 to $240
$3
Revenue = $240 $1 Revenue = $100 0 100 Demand Quantity 0 80 Demand Quantity
Elasticity and Total Revenue along a Linear Demand Curve (Elastic Demand)
With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.
Figure 8 How Total Revenue Changes when Price Changes: Elastic Demand
Price
An Increase in price from $4 to $5
Price
leads to an decrease in total revenue from $200 to $100
$5
$4 Demand Revenue = $200 Revenue = $100 Demand
50
Quantity
20
Quantity
Elasticity of a Linear Demand Curve
Cross Price Elasticity of Demand

Cross price elasticity of demand measures how much the quantity demanded of a good X responds to a change in price of good Y. It is computed as the percentage change in the quantity demanded of product X divided by the percentage change in price of product Y.
Cross Price Elasticity of Demand

Types of Goods
Substitutes ..cross price elasticity is positive Complements..cross price elasticity is negative
If increase in price of a good raises the quantity demanded of another good, these are substitute goods If increase in price of a good decreases the quantity demanded of another good, these are complementary goods
Income Elasticity of Demand

Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income.
Computing Income Elasticity
Percentage change in quantity demanded Income elasticity of demand = Percentage change in income
Income Elasticity
Types of Goods
Normal Goods..income elasticity is positive Inferior Goods..income elasticity is negative
Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.
Income Elasticity
Goods consumers regard as necessities tend to be income inelastic
Examples include food, fuel, clothing, utilities, and medical services.
Goods consumers regard as luxuries tend to be income elastic.

Examples include sports cars, furs, and expensive foods.
ELASTICITY OF SUPPLY
Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good. Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price.
Figure 9
Price Elasticity of Supply
(a) Perfectly Inelastic Supply: Elasticity Equals 0 Price Supply $5 4 1. An increase in price . . .
100
Quantity
2. . . . leaves the quantity supplied unchanged.
Figure 10 Price Elasticity of Supply
(b) Inelastic Supply: Elasticity Is Less Than 1 Price Supply $5 4 1. A 22% increase in price . . .
100
110
Quantity
2. . . . leads to a 10% increase in quantity supplied.
(c) Unit Elastic Supply: Elasticity Equals 1

Price Supply $5 4 1. A 22% increase in price . . .
100
125
Quantity
(d) Elastic Supply: Elasticity Is Greater Than 1 Price Supply $5 4 1. A 22% increase in price . . .
100
200
Quantity
(e) Perfectly Elastic Supply: Elasticity Equals Infinity Price 1. At any price above $4, quantity supplied is infinite. $4 2. At exactly $4, producers will supply any quantity.
Supply
0 3. At a price below $4, quantity supplied is zero.
Quantity
Determinants of Elasticity of Supply

Ability of sellers to change the amount of the good they produce.
Beach-front land is inelastic. Books, cars, or manufactured goods are elastic.
Time period.
Supply is more elastic in the long run.
Computing the Price Elasticity of Supply

The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price.
Percentage change in quantity supplied Price elasticity of supply = Percentage change in price
THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITY

Can good news for farming be bad news for farmers? What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties?
THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITY

Examine whether the supply or demand curve shifts. Determine the direction of the shift of the curve. Use the supply-and-demand diagram to see how the market equilibrium changes.
Figure 14 An Increase in Supply in the Market for Wheat

Price of Wheat
2. . . . leads to a large fall in price . . . $3

2
1. When demand is inelastic, an increase in supply . . . S1
S2
Demand 0 100 110 Quantity of Wheat
3. . . . and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220.
Compute the Price Elasticity of Supply
100 110 (100 110) / 2 ED 3.00 2.00 (3.00 2.00) / 2 0.095 0.24 0.4 Supply is inelastic
Consumer Surplus
The difference between the price a consumer is willing to pay and what he actually pays
Measuring consumer well-being

consumer surplus (CS) from a good =
benefit a consumer gets from consuming it (in $'s) minus its price how much more you'd be willing to pay than you did pay for a good
demand curve contains this information demand curve reflects a consumer's marginal willingness to pay: amount a consumer will pay for an extra unit
Graph individual's CS
area under individual's demand curve and above market price up to quantity that consumer buys
Consumer Surplus
(a) David s Consumer Surplus p, $ per magazine 5 a
4 CS1 = $2 CS2 = $1 3
Price = $3
2
E 1 = $3 1 E2 = $3 E 3 = $3 Demand
5 q, Magazines per week

Consumer Surplus
p, $ per trading card
Consumer surplus, CS
p1
Expenditure, E
Demand Marginal willingness to pay for the last unit of output q1 q , Trading cards per year
Effect of a price change on CS

price increase reduces CS could be caused by
leftward shift of supply curve new government tax
Producer Surplus
The difference between the price a Producer is willing to accept and what he actually receives
Producer surplus
1. supplier's gain from participating in a market 2. difference between amount for which good sells and minimum amount necessary for seller to produce good 3. minimum amount a seller must receive to be willing to produce is firm's avoidable production cost (shut-down rule)
Measuring PS using supply curve

producer surplus for a competitive firm or market: area above supply curve (MC curve), below price line, up to quantity sold
Summary
Price elasticity of demand measures how much the quantity demanded responds to changes in the price. Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. If a demand curve is elastic, total revenue falls when the price rises. If it is inelastic, total revenue rises as the price rises.
Summary
The income elasticity of demand measures how much the quantity demanded responds to changes in consumers income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good. The price elasticity of supply measures how much the quantity supplied responds to changes in the price. .
Summary
In most markets, supply is more elastic in the long run than in the short run. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. The tools of supply and demand can be applied in many different types of markets.

Ch. 18 Elasticity of D and S

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Ch. 18 Elasticity of D and S

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Elasticity and Its Applications

Copyright 2004 South-Western

Copyright 2004 South-Western/Thomson Learning

THE ELASTICITY OF DEMAND

Copyright 2004 South-Western/Thomson Learning

The Price Elasticity of Demand and Its Determinants

Copyright 2004 South-Western/Thomson Learning

The Price Elasticity of Demand and Its Determinants

Copyright 2004 South-Western/Thomson Learning

Computing the Price Elasticity of Demand

Price elasticity of demand =

Copyright 2004 South-Western/Thomson Learning

Computing the Price Elasticity of Demand

Copyright 2004 South-Western/Thomson Learning

Computing the Price Elasticity of Demand

The Midpoint Method: Better Way to Calculate Elasticity

Copyright 2004 South-Western/Thomson Learning

The Variety of Demand Curves

Copyright 2004 South-Western/Thomson Learning

Computing the Price Elasticity of Demand

(100 50)/2 (4.00 5.00)/2

Demand is price elastic

The Variety of Demand Curves

The Variety of Demand Curves

Copyright 2004 South-Western/Thomson Learning

Figure 1 Perfectly Elastic Demand

(a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand $5

2. . . . leaves the quantity demanded unchanged.

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Figure 2 Inelastic Demand

(b) Inelastic Demand: Elasticity Is Less Than 1

$5 4 1. A 22% increase in price . . . Demand

2. . . . leads to an 11% decrease in quantity demanded.

Figure 3 Unitary Elastic Demand

(c) Unit Elastic Demand: Elasticity Equals 1 Price

2. . . . leads to a 22% decrease in quantity demanded.

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Figure 4 Elastic Demand

(d) Elastic Demand: Elasticity Is Greater Than 1

$5 4 1. A 22% increase in price . . . Demand

2. . . . leads to a 67% decrease in quantity demanded.

Figure 5 Perfectly Elastic Demand

0 3. At a price below $4, quantity demanded is infinite.

Total Revenue and Price Elasticity of Demand

Copyright 2004 South-Western/Thomson Learning

Copyright2003 Southwestern/Thomson Learning

Copyright 2004 South-Western/Thomson Learning

Price An Increase in price from $1 to $3

Price leads to an Increase in total revenue from $100 to $240

Revenue = $240 $1 Revenue = $100 0 100 Demand Quantity 0 80 Demand Quantity

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Copyright 2004 South-Western/Thomson Learning

Copyright2003 Southwestern/Thomson Learning

Elasticity of a Linear Demand Curve

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Cross Price Elasticity of Demand

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Cross Price Elasticity of Demand

Income Elasticity of Demand

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Computing Income Elasticity

Copyright 2004 South-Western/Thomson Learning

Copyright 2004 South-Western/Thomson Learning