Presentation on theme: "Elasticity of Demand and Supply"— Presentation transcript:
1 Elasticity of Demand and Supply Topic 3Elasticity of Demand and Supply
2 Topic ObjectivesExplaining elasticity of demand, its measurement, categories and determinants.Understand the relationship between elasticity and total revenue.Explaining elasticity of supply, its measurement, categories and determinants.Elasticity application on indirect tax.
3 Price Elasticity of Demand Price elasticity of demand measures how responsive consumers are to price change; elasticity is another word for responsiveness.Price elasticity of demand = Percentage change in quantity demanded / Percentage change in price
4 Demand Curve for Beef Burger $1.10aPrice0.90bPrice elasticity between a and b = 10% / - 20%= - 0.5D95105Thousands per day
5 Price Elasticity of Demand Price elasticity of demand formula
6 Price Elasticity of Demand Because price and quantity demanded are inversely related, the price elasticity of demand has a negative sign.This tends to be cumbersome, thus it is commonplace to discuss the price elasticity of demand as an absolute value positive number.For example, absolute value of the elasticity for beef burger computed earlier will be referred to as 0.5 rather than –0.5.
7 Categories of Price Elasticity Three general categoriesDemand is inelastic quantity demanded is relatively unresponsive to a change in price Percent change in quantity demanded is smaller than the percent change in price. The price elasticity has an absolute value between 0 and 1.0 .Unit-elastic demand Percent change in quantity demanded just equals the percent change in price. The price elasticity has an absolute value of 1.0.Demand is elastic Percent change in quantity demanded exceeds the percent change in price, the price elasticity has an absolute value exceeding 1.0.
10 Elasticity and Total Revenue Total revenue (TR) is the price (P) multiplied by the quantity demanded (Q) at that price TR = P x QWhat happens to TR when price decreases?Lower price producers get less for each unit sold TR declines.Lower price increases quantity demanded TR increases.Overall impact of lower price on total revenue depends on the net result of these opposite effects.
11 Elasticity and Total Revenue When demand is elastic, the percent increase in quantity demanded exceeds the percent decrease in price TR increases!When demand is unit elastic, the two are equal TR remains unchanged!When demand is inelastic, the percent increase in quantity demanded is more than offset by the percent decrease in price TR decreases!
12 Demand, Price Elasticity and Total Revenue Consider a movement from point a to point b on the demand curve. The 100-unit increase in quantity demanded is a percent change of 100/150 = 0.67% while the $10 drop in price is a percent change of 10/85 = 12% the price elasticity of demand here is 5.6Between points d and e, the 100 quantity increase is a 12% change and the $10 price decrease is a 67% price decrease price elasticity of 0.2(a) Demand and Price Elasticity$10090a80b706050c4030Price per unit20d10eD1002005008009001,000Quantity per period
13 Demand, Price Elasticity and Total Revenue (a) Demand and Price Elasticity$100When demand is elastic, a decrease in price (from a to b) will increase total revenue because the gain in revenue from selling more units (blue box) exceeds the loss in revenue from selling all units at a lower price (red box)When demand is elastic, a price decrease (from d to e) reduces total revenue because the gain in revenue from selling more units (blue box) is less than the loss in revenue at the lower price (red box)90aElastic ED > 180Priceb7060Unit elastic ED = 150c40Inelastic ED < 13020d10eD1002005008009001,000Quantity(b) Total RevenueTR = P x Q$25,000TotalrevnuTotalrevenue5001,000Quantity
14 Determinants 1. Availability of Substitutes The greater the availability of substitutes for a good and the closer the substitutes, the greater the good’s price elasticity of demand.The number and similarity of substitutes depend on how we define the good the more broadly we define a good, the fewer the substitutes and the less elastic the demand.
15 2. Proportion of Consumer’s Budget Because spending on some goods represents a large share of the consumer’s budget, a change in the price of such a good has a substantial impact on the amount consumers are able to purchase.Generally, the more important the item is as a share of the consumer’s budget, other things constant, the greater will be the income effect of a change in price, the more price elastic will be the demand for the item.
16 3. Length of Time Demand Becomes More Elastic over Time Suppose the price increases from the initial price of RM1.00 to RM 1.25.Dw shows that one week after the price increase, the quantity demanded has not changed much, from 100 to 95After one month, Dm, it has declined to 75, and after one year, Dy, to 50The longer the time period the larger the response to a given price change$1.251.00Price per unitDyDmDw507595100Quantity per period
17 Price Elasticity of Supply The price elasticity of supply measures how responsive producers are to a price change.Equals the percent change in quantity supplied divided by the percent change in price.Since the higher price usually results in an increased quantity supplied, the percent change in price and the percent change in quantity supplied move in the same direction the price elasticity of supply is usually a positive number.
19 Price Elasticity of Supply If the price increases from p1 to p2, the quantity supplied increases from q1 to q2The price elasticity of Es isWhere q is the change in quantity supplied and p is the change in price.
20 Categories of Supply Elasticity The terminology for supply elasticity is the same as for demand elasticityIf supply elasticity is less than 1.0, supply is inelasticIf it equals 1.0, supply is unit elasticIf it exceeds 1.0, supply is elastic
22 Elasticity Supply Curves nnuurreE =epSpepSeE =cSicrirPPQuantity per periodQuantity per periodQ(d) Perfectly elastic(e) Perfectly inelastic
23 Determinants1. The responsiveness of sellers depends on how easy it is to alter output when price changesIf the cost of supplying additional units rises sharply as output expands, then a higher price will elicit little increase in quantity suppliedBut if the marginal cost rises slowly as output expands, the lure of a higher price will prompt a large increase in output
24 Length of Time 2. Length of Time Supply also becomes more elastic over time as producers adjust to price changesThe longer the time period under consideration, the more able producers are to adjust to changes in relative prices
25 Supply Becomes More Elastic over Time Sw is the supply curve when the period of adjustment is a week.Sm is the supply curve when the adjustment period is one month; supply more elastic and quantity supplied increases to 140After one year the supply curve becomes Sy and the quantity supplied increases to 200Quantity per periodSwSmSy100110140200$1.25Price1.00
26 Other Types of Elasticity 1. Income Elasticity of DemandMeasures how responsive demand is to a change in income.Equals the percent change in demand divided by the percent change in income.CategoriesGoods with income elasticities less than zero are called inferior goods demand declines when income increases.Normal goods have income elasticities greater than zero demand increases when income increases.
27 2. Cross-Price Elasticity of Demand The responsiveness of the demand for one good to changes in the price of another good is called the cross-price elasticity of demand.Defined as the percent change in the quantity demanded of one good divided by the percent change in the price of another good.If an increase in the price of one good leads to an increase in the demand for another good, their cross-price elasticity is positive the two goods are substitutes.If an increase in the price of one good leads to a decrease in the demand for another, their cross-price elasticity is negative the two goods are complements.
28 Elasticity on Tax Incidence When the government impose a tax, someone will be liable to pay the tax.Normally the tax burden will be borne entirely by consumers or producers or will be distributed between consumers and producers in the market.The degree of tax burden – who pay more or less tax is depends on the elasticity of demand and supply in the market which the tax is imposed.
29 Effect of Different Demand Elasticities on ExciseTax Incidence
30 Demand Elasticity and Tax Incidence The more elastic the demandthe more the tax is paid by producers.the less it’s passed on to consumers as a higher price.The less elastic the demandthe more the tax is paid by consumers as a higher price.the less it’s paid by producers.Tax revenues is lower when the tax is levied on goods or services with demand that is elastic.
31 Effects of Different Supply Elasticities on ExciseTax Incidence
32 Supply Elasticity and Tax Incidence The more elastic the supply, the less the tax is paid by producers as a lower net-of-tax receipt and the more is passed on to consumers as a higher price.The less elastic the supply, the more the tax is paid by producers as a lower net-of-tax receipt and the less is passed on to consumers as a higher price.