Chapter Twenty: Elasticity of Demand and Supply

I. Price Elasticity of Demand A. The responsiveness of consumers to a price change is measured by a product’s price elasticity of demand. 1. When modest price changes cause very large changes in the quantity purchased, this demand is seen as elastic. 2. When substantial price changes only cause small changes in the amount purchased, this demand is seen as inelastic. B. The Price-Elasticity Coefficient and Formula 1. The degree of price elasticity or inelasticity of demand (Ed ) is defined as: Ed =
% ∆ in quantity demanded of product X % ∆ in price of product X % ∆ quantity demanded original quantity demanded

a. Percent change in quantity demanded = b. Percent change in price =
% ∆ price original price

2. There are two main reasons for using percentages rather than absolute amounts: a. Choice of units will arbitrarily effect impressions of buyer responsiveness. b. Percentages allow correct comparison of consumer responsiveness to different products. 3. Because the demand curve is downsloping, Ed will always be a negative number. This is ignored by economists in order to demonstrate the true dominance of larger values of Ed . C. Interpretations of Ed 1. Demand is elastic if Ed is greater than 1. a. This occurs when
% ∆ quantity demanded original quantity demanded

is greater than

% ∆ price original price .

2. Demand is inelastic if Ed is less than one. a. This occurs when
% ∆ quantity demanded original quantity demanded

is less than than

% ∆ price original price .

3. Unit elasticity occurs when Ed is equal to one.(

% ∆ quantity demanded % ∆ price original quantity demanded = original price )

4. Extreme cases occur when something is perfectly inelastic or elastic. a. Perfect inelasticity occurs when there is no response to a change in price. (Ed = 0) b. Perfect elasticity occurs when a small price reduction causes buyers to increase their purchases from 0 to all they can obtain. (Ed = ∞) D. Midpoint Formula 1. In order to even out the variance when choosing intervals, economists use the averages of price and quantity pairs to calculate Ed . a. Percent change in quantity demanded = b. Percent change in price =
1 Σ 2 1 Σ 2

∆ quantity demanded quantity demanded

∆ price price

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E. Graphical Analysis 1. For all downsloping straight-line and most other demand curves, demand is more price-elastic toward the upper left than toward the lower right. This is the consequences of the arithssssssssssssmetic properties of the elasticity measure. a. For quantities in the upper left segment of the demand curve, the original reference quantity is small and the original reference price is large. These lead to a large percentage change in quantity and a small percentage change in price. F. The Total-Revenue Test 1. The importance of elasticity relates to the effect of price changes on total revenue. a. Total revenue is the total amount the seller receives from the sale of a product in a particular time period. (T R = P ∗ Q) b. One of the easiest ways to infer whether demand is elastic or inelastic is to observe the total revenue when the product price for the given good changes. 2. Elastic demand : Demand is elastic if a price change causes total revenue to change in the opposite direction. 3. Inelastic demand : Demand is inelastic if a price change causes total revenue to change in the same direction. 4. Unit elasticity: There is unit elasticity when increase or decrease in price leaves total revenue unchanged.

Table 1. Summary of Price Elasticity of Demand Ed Ed > 1 Ed = 1 Demand Is: Elastic or relatively elastic Unit or Unitary elastic Description Price Increase Price Decrease % ∆ quantity > % ∆ demand TR ↓ TR ↑ % ∆ quantity = % ∆ demand No change TR ↑ No change TR ↓

Ed < 1 Inelastic or relatively elastic % ∆ quantity < % ∆ demand

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G. Determinants of Price Elasticity of Demand 1. Substitutability: The larger number of substitute goods that are available, the greater the price elasticity of demand. a. The elasticity of demand for a product depends on how narrowly the product is defined. i. In a purely competitive market, where there are many perfect substitutes for the product of any specific seller, the demand curve seen by a single seller is perfectly elastic. ii. A highly inelastic good will indicate that it has no close substitutes. 2. Proportion of Income: The higher the price of a good relative to consumers’ incomes, the greater the price elasticity of demand. 3. Luxuries versus Necessities: The more that a good is considered to be a “luxury,” rather than a “necessity,” the greater is the price elasticity of demand. 4. Time: Product demand is more elastic the longer the time period under consideration. a. Consumers often need time to adjust to changes in prices. If the price of a product rises, it takes time to find an experiment with other products to see if they are acceptable. b. Another consideration is product durability. H. Applications of Price Elasticity of Demand 1. Large Crop Yields a. The demand for most farm products is highly inelastic. i. Increases in the output of farm products tends to depress the prices of farm products as well as the total revenues of the farmers. It therefore is undesirable to overproduce. It also means that achieving the goal of higher total farm income requires the restriction of farm output. 2. Excise Taxes a. Government pays attention to elasticity of demand when it selects goods and services on which to levy excise taxes. A higher tax on a product with elastic demand will bring in less tax revenue. As a result, it is advantageous to tax those things with inelastic demand. 3. Decriminalization of Illegal Drugs a. It has been proposed to make drugs legal for adults, regulated, and then be able to tax. Doing so, proponents say, would reduce crime, increase the safety of use, and bring in a lot of money for the state. Opponents say that drugs are fare more elastic than believed as well as increase public use and therefore possibly endanger more people. 4. Minimum Wage (this one talks in circles... I’m not going to bother to type it out.)

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II. Price Elasticity of Supply A. If producers are relatively responsive to price changes, supply is elastic. If producers are relatively insentitive to price changes, supply is inelastic. B. The degree of price elasticity or inelasticity of supply(Es ) is defined as: Es =
% ∆ in quantity supplied of product X % ∆ in price of product X

1. The degree of price elasticity of supply depends upon how easily—and therefore quickly—producers can shift resources between alternative uses. a. The easier and more rapidly producers can shift resources between alternative uses, the greater the price elasticity of supply. i. The greater amount of time that producers have to adjust to a change in demand, the greater their output response. C. Price Elasticity of Supply: The Market Period 1. The market period is the period that occurs when the time immediately after a change in the market is too short for producers to respond with a change in quantity supplied. a. In the case of time sensitive goods, during the market period, a producer is forced to sell regardless of the costs of production and supply is fixed. Quantity, therefore, is shown as a vertical line. b. Not all supply curves will be completely inelastic after a price change as goods can be stored away or put in inventory. The supply curve in these cases will be able to maintain some positive slope. If storage is inexpensive, there may be no market period whatsoever. D. Price Elasticity of Supply: The Short Run 1. The short run in microeconomics is a period of time too short to exchange plant capacity but long enough o use fixed plant more or less intensively. a. The result of this is a small but noticeable response to the increase or decrease in demand. a. Change in demand is therefore being met by a similar change in quantity. As a result, the equilibrium price is lower in the short un than in the market period. E. Price of Elasticity of Supply: The Long Run 1. The long run in microeconomics is a time period long enough for firms to readjust their plant sizes and for new firms to enter (or existing firms to leave) the industry. F. There is no total-revenue test for elasticity of supply. Regardless of the degree of elasticity or inelasticity, price and total revenue always move together. G. Applications of Price Elasticity of Supply 1. Antiques and Reproductions a. The high price of an antique results from strong demand and limited, highly inelastic supply.

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2. Volatile Gold Prices a. The price of gold is quite volatile mainly due to shifts in demand and highly inelastic supply. Because the supply is so inelastic, even relatively small changes in demand can change price dramatically. III. Cross Elasticity and Income Elasticity of Demand. A. The consumption of a good is effected not only by changes in price, but changes in prices of related products or a change in income. 1. Cross elasticity of demand measures how sensitive consumer purchases of one product are to a change in the price of some other product. a. The coefficient of cross elasticity of demand(Exy ) is defined as: Exy =
% ∆ in quantity demanded of product X % ∆ in price of product Y

i. If this value is positive, X and Y are substitute goods. ii. If this value is negative, X and Y are complementary. iii. If this value is zero or near zero, X and Y are unrelated or independent goods. b.. Applications i. The degree of substitutability is important to business and government. With these numbers, it is easy to see how lowering prices for one thing will effect another brand of a company. Government uses these numbers to observe the constitutionality of mergers and how they affect competition. 2. Income elasticity of eemand measures the degree to which consumers respond to change in incomes by buying more or less of a particular good. a. The coefficient of income elasticity of demand(Exy ) is defined as: Ei =
% ∆ in quantity demanded of product X % ∆ in income

i. If this value is positive, the good is a normal good. ii. If this value is negative, the good is an inferior good. 3. Exy and Ei help provide insights into the economy. a. Ei helps explain the expansion and contraction of the economy.

Table 2. Cross and Income Elasticities of Demand Value of Coefficient Ewz > 0 Exy < 0 Ei > 0 Ei < 0 Description Qw changes in same direction as ∆ Pz Qx changes in direction opposite of ∆ Py Q changes in same direction as ∆ income Q changes in direction opposite of ∆ income Type of goods Substitutes Complements Normal or superior Inferior

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