Demand and Supply

Application
 Price Elasticity of Demand
• According to the law of demand, when price goes up,
consumers demand fewer quantities of a product. If the
price of a product falls, quantity demanded will rise.
• But when the price of a product changes, by how much
more (or less) will consumers buy?
• To help answer this question, we will use a measurement
called the Price Elasticity of Demand.
 Price Elasticity of Demand
• For some products, consumers are highly responsive
to price changes. Demand for such products is
relatively elastic or simply elastic.
• For other products, consumers’ responsiveness is only
slight, or in rare cases non-existent. Demand is said to
be relatively inelastic, or simply inelastic.
 The Price-Elasticity Coefficient
• Economist measure the degree of price elasticity or
inelasticity of demand with the coefficient Ed.

• Ed is defined as the percentage change in quantity

demanded of good X divided by the percentage
change in price of X.
 The Ed Formula
percentage change in quantity demanded of X
Ed =
percentage change in price of X

• Generally, when calculating percentage changes in the

equation, we divide the change in quantity demanded by the
original quantity demanded and the change in price by the
original price.
• However, because the resulting percentage change value
differs with the direction of the change, using averages as the
reference points ensures the same percentage change
regardless of the direction of the change.
 Elimination of the Minus Sign

Because the demand curve slopes downward, Ed will

always be a negative number. Therefore, we take the
absolute value and ignore the minus sign.
 Interpretations of Ed
The coefficient of price elasticity of demand can be
interpreted as follows:
• Elastic Demand: Product demand for which price
changes cause relatively larger changes in quantity
demanded; Ed > 1
• Inelastic Demand: Product demand for which price
changes cause relatively smaller changes in quantity
demanded; Ed < 1
• Unit Elasticity: Product demand for which price changes and
changes in quantity demanded are equal; Ed = 1
 Interpretations of Ed
Extreme Cases
• Perfectly Inelastic: Product demand for which
quantity demanded does not respond to a change in
price.
• Perfectly Elastic: Product demand for which quantity
demanded can be any amount at a particular price.
Interpretations of Ed
 The Total-Revenue Test
• Elasticity is important to firms because when the price
of their products change, so does their profit (total
revenue minus total costs).
Total revenue (TR) = price x quantity = P x Q

• This represents the total number of dollars received

by a firm from the sale of a product in a particular
period.
 The Total-Revenue Test
Total revenue and the price elasticity of
demand are related. The total-revenue
test can determine elasticity by
examining what happens to total
revenue when price changes.
 The Total-Revenue Test
• If demand is elastic, a decrease in price will increase
total revenue, and an increase in price will reduce
total revenue.
• If demand is inelastic, a price decrease will decrease
total revenue, while an increase in price will increase
total revenue.
• If demand is unit elastic, total revenue remains
constant when prices rise or fall.
The Total-Revenue Test
 Price Elasticity of Supply
• Price elasticity of supply measures the responsiveness
of sellers to changes in the price of a product.
✓ If producers are relatively responsive, supply
is elastic.
✓ If producers are relatively insensitive to
price changes, supply is inelastic.
 Price Elasticity of Supply
• The price elasticity of supply coefficient Es is defined
as:
percentage change in quantity supplied of X
Es = percentage change in price of X

• To calculate Es, we employ the midpoint approach to

determine the percentage changes.
 Price Elasticity of Supply
• If Es < 1, supply is inelastic.
• If Es > 1, supply is elastic.
• If Es = 1, supply is unit-elastic.

• Since price and quantity supplied are directly related,

Es is never negative.
 Price Elasticity of Supply
• The amount of time it takes producers to shift resources
between alternative uses to alter production of a good can
determine the degree of price elasticity of supply.
✓ The easier and more rapid the transfer of resources, the greater
is the price elasticity of supply.
✓ The longer a firm has to adjust to a price change, the greater
the elasticity of supply.
 Price Elasticity of Supply and
Time Periods
• The market period is a period in which producers of a
product are unable to change the quantity produced
in response to a change in price.
✓ During this time period, the supply of a product is fixed,
or supply is perfectly inelastic.
 Price Elasticity of Supply and
Time Periods
• In the short run, producers are able to change the
quantities of some but not all the resources they employ.
✓ This time period is too short to change plant capacity but long
enough to use fixed plant more or less intensively.
✓ The supply of a product is more elastic than the market
period.
 Price Elasticity of Supply and
Time Periods
• In the long run, producers are able to change all the
resources they employ.
✓ This time period is long enough for firms to adjust their plant
sizes and for new firms to enter (or existing firms to exit) the
industry.
✓ The supply of a product is more elastic than in the short run.
Price Elasticity of Supply and
Time Periods
 Income Elasticity of Demand
• Income elasticity of demand measures the responsiveness
of consumer purchases to changes in consumer income.
• The coefficient of income elasticity of demand Ei is
determined with the formula

percentage change in quantity demanded

EI =
percentage change in income
 Income Elasticity of Demand
• Normal goods will have an income elasticity of
demand that is positive. More of them are demanded
as income increases. Ei > 0
• Necessity Good 0 < Ei < 1
• Luxury Good Ei > 1
• Inferior goods have a negative income elasticity of
demand. As income rises, the demand for them falls.
Ei < 0
Cross-Price Elasticity of Demand
• The cross price elasticity of demand measures the
responsiveness of demand for one good with respect to a
change in the price of another good.
• The coefficient of cross price elasticity of demand Exy is
determined with the formula
percentage change in quantity demanded of Y
Exy =
percentage change in price of X
• the percentage change in the demand of one good given a
one percent change in a related good’s price, ceteris paribus.
Cross-Price Elasticity of Demand
• Substitutes will have a positive cross price elasticity of
demand, since consumers will decrease purchases of
the good that has the price increase, and buy more
substitute goods.
• The opposite is true on complementary goods.
• Substitutes: Edxy = %ΔQdy /%ΔPx > 0
Complements: Edxy = %ΔQdy /%ΔPx < 0
Unrelated Goods: Edxy = %ΔQdy /%ΔPx = 0
 Household or Family Size Elasticity of Demand
• the percentage change in the expenditure or quantity
demanded divided by the percentage change in family
size, ceteris paribus
• The opposite is true on complementary goods.
• Substitutes: Edxy = %ΔQdy /%ΔPx > 0
Complements: Edxy = %ΔQdy /%ΔPx < 0
Unrelated Goods: Edxy = %ΔQdy /%ΔPx = 0
 Household or Family Size Elasticity of Demand
• the percentage change in the expenditure or quantity
demanded divided by the percentage change in family size,
ceteris paribus
• The coefficient of household or family size elasticity Ehh is
determined with the formula
percentage change in expenditure/quantity demanded
Ehh =
percentage change in family size
 Price Flexibility
• percentage change in price given a percentage change in
quantity
• approximated by the inverse of the elasticity of demand
• inelastic demand characterizes more flexible prices via a larger
price flexibility coefficient
percentage change in price = 1/Ed
F=
percentage change in quantity demanded
 Factors Affecting Elasticity of Demand
A. Given Demand Curve
• Price: Elasticity is highest at high prices, declines as prices go
down, and is lowest at low prices
• Substitution effect: When prices are high, many other products can
be used as substitutes
• Uses: The more uses a commodity has, the more elastic is its
demand
B. Different Demand Curves
• The number of characteristics of the product, the consumers and
the marketing system lead to different demand curves and different
degrees of price elasticity
C. Product Characteristics
• Availability of substitutes: The demand for a good is more
elastic if it has more substitutes
• Uses of the commodity: The larger the number of alternative
uses of a commodity, the more elastic the demand
• Length of time product has been marketed: A new product
that has just entered the market is relatively more price
elastic than the products that have been marketed for a long
time
• Quality: High-quality products are relatively more price
elastic than low-quality products.
•Necessary to life: Products which are
essential or thought to be essential are
generally price inelastic
•Perishability: Highly perishable products are
more price elastic than the relatively non-
perishable goods
•Price: If price is high relative to income,
products will become more costly, thus
making them more price elastic than when
price is low relative to income.
D. Consumer Characteristics
• Income: High-income consumers are considerably more
income and price inelastic than lower ones.
• Age: Young consumers are relatively price elastic as they
are price conscious and substitute foods for each other on
the basis of price; Older consumers buy more uniformly
regardless of price, hence are really price inelastic but
income elastic since they have fewer fixed commitments
for their income (spending more on foods)
E. Characteristics of the Marketing System
•Products that have been processed, packaged
and stored are more price elastic than those
products that are not
•Retail prices are more elastic than wholesale
prices, and wholesale prices are more elastic
than farm prices
•This results in demand being more price
inelastic as one moves backward through
the marketing system
 Importance of Elasticity
1. Price elasticity of demand indicates the consumers’
response to changing price conditions
✓ A price increase will cause consumers to spend less
money than before for items with elastic demand and
more for those with price inelastic demand
2.Income elasticity is necessary in evaluating the effect of
changing consumer incomes
✓ Products with a relatively high degree of income elasticity
benefit most when income increases, those with low
income elasticity benefit least of all
3.Determining what products may be most profitably
advertised, graded, packaged or may have other additional
marketing services
✓ The more price elastic the demand for a product, the
greater the opportunity for profitably adding marketing
services
4. Government farm policies whose aim is to raise farm prices
✓ Higher prices result in higher gross incomes for farmers
because the demands for most farm products are inelastic
5. Economic policies directed to increasing exports
✓ If the demand for a country’s exports in inelastic, lowering the
prices of its exports (as by devaluation of its currency) will
result in smaller money receipts.
 Demand and Supply Application
A. The Instability of Farm Prices
• Farm prices are more volatile than non-food prices
• Because of the inelastic demand for farm products, shifts in
either demand or supply will result in proportionately larger
price changes
B. Incentives to Restrict Farm Output
• Inelastic demand provides farmers with a profit incentive to restrict
output and raise gross farm income
• It has been difficult for farmers to achieve, independently, the levels of
supply control necessary to raise total return
C. Who Benefits from a Larger than Expected Crop?
• An unexpected yield increase shifts supply rightward -> this shift
lowers farm prices -> the movement along the inelastic demand
curve reduces gross farm income
• The farmer is penalized from an unexpected large crop
D. Who Benefits from Cost-Reducing Technology?
• New farming technologies shift the supply curve rightward, as prices
fall along the inelastic demand curve, gross farm sales also fall
• The benefits from cost-reducing agricultural technology are passed
on to the consumer in the form of lower relative food prices in the
long run
E. How do Export Affect Food Prices
• In the short run, supplies could not be expanded, and any
increase in demand will push prices up an inelastic supply curve
• These high prices induce farm production in the following years
and prices fall as the supply curve becomes more elastic
F. What is the Effect of Food Price Ceilings and Floors?
• A price floor generates a surplus: this may be stored, dumped or sold
in non-competing markets
• Price ceilings result in black markets, rationing and out-of-stock
problems
Thank you!