Chapter 18 The Elasticities of Demand and Supply 18-1 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives The elasticity of demand The determinants of elasticity Elasticity and total revenue The elasticity of supply Tax incidence 18-2 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

18-3 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Elasticity of Demand The elasticity of demand for a good or service measures the change in quantity demanded in response to a change in price –In other words, elasticity measures the sensitivity (measured in percentage change) of quantity demanded because of a change (percentage) in price –When price goes up, we know that quantity demanded declines. But we don’t know by how much? –Elasticity provides us a way of measuring this response Elasticity answers the “how much” question

18-4 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Measuring Elasticity Calculate the coefficient of price elasticity (Ep) E p = Percentage change in quantity demanded Percentage change in price E p = Q 2 - Q 1 P 2 + P 1 X Q 2 + Q 1 P 2 - P 1 P 1 is the initial price; P 2 is the new price Q 1 is the initial quantity sold; Q 2 is the new quantity sold

18-5 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. A firm has been selling 100 chairs a week. It runs a sale, charging $8 instead of the usual $10. Sales go up to 140 chairs. E p = Q 2 - Q 1 P 2 + P 1 Q 2 + Q 1 P 2 - P 1 X E p = X E p = X = E p = 1.5 So the negative sign is ignored Note: the answer is always negative

18-6 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Price is raised from $40 to $41, and quantity sold declines from 15 to 12 E p = Q 2 - Q 1 P 2 + P 1 Q 2 + Q 1 P 2 - P 1 X E p = X E p = X 81 1 = E p = 9.0 So the negative sign is ignored Note: the answer is always negative

18-7 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Meaning of Elasticity Elasticity is many things –First, elasticity is a number An Ep greater than 1 is elastic This means that demand is relatively sensitive to price changes The larger the number, the greater will be the sensitivity to price changes –This number represents the percent change in quantity demanded resulting from each 1% change in a goods price An Ep of 10 means that for every 1% change in price there will be a 10% change in QD

18-8 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Meaning of Elasticity An E p less than 1 is inelastic This means that demand is relatively less sensitive to price changes The smaller the number, the greater the insensitivity to price changes An E p of.1 means that for every 1% change in price there will be a.1% change in quantity demanded

18-9 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Meaning of Elasticity –An E p that is exactly 1 is unit elastic This means that demand is neither elastic nor inelastic An E p of 1 means that for every 1% change in price there will be a 1% change in QD

18-10 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Perfectly Elastic Demand Curve The elasticity of a perfectly elastic demand curve is infinity

18-11 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Perfectly Inelastic Demand Curve The elasticity of a perfectly inelastic demand curve is 0

18-12 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Relativity Elasticity of Demand Curves

18-13 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Straight Line Demand Curve

18-14 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Elasticity of Straight Line Demand Curve

Relatively Inelastic Demand Curve Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Relatively Elastic Demand Curve Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Determinants of the Degree of Elasticity of Demand The availability of substitutes is the most important influence on the elasticity of demand The question of necessity versus luxury The product’s cost relative to the buyer’s income The passage of time The number of uses Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Advertising Purpose –To make the demand for a product greater –To make the demand for a product more inelastic D D Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Elasticity and Total Revenue Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Prices were raised from $10 to $12 and quantity demanded fell from 20 to 12 Elastic Demand and Total Revenue Solution: P 1 = 10; P 2 = 12; Q 1 = 20; Q 2 = = =.25 X 11 = 2.75 PriceQDTR $10 20 $ Calculate E p When demand is elastic, a price increase will lead to a fall in total revenue!

Elasticity and Total Revenue Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Prices were raised from $10 to $12 and quantity demanded fell from 20 to 12 Elastic Demand and Total Revenue Solution: P 1 = 10; P 2 = 12; Q 1 = 20; Q 2 = = =.25 X 11 = 2.75 PriceQDTR $10 20 $ Calculate E p When demand is elastic, a price decrease will lead to a rise in total revenue!

Elasticity and Total Revenue Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Prices were raised from $2 to $3 and quantity demanded fell from 9 to 8 Inelastic Demand and Total Revenue Solution: P 1 = 2; P 2 = 3; Q 1 = 9; Q 2 = = = X 5 = 0.29 PriceQDTR $2 9 $18 $3 8 $24 Calculate E p When demand is inelastic, a price increase will lead to a rise in total revenue! - - -

Elasticity and Total Revenue Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Prices were raised from $2 to $3 and quantity demanded fell from 9 to 8 Inelastic Demand and Total Revenue Solution: P 1 = 2; P 2 = 3; Q 1 = 9; Q 2 = = = X 5 = 0.29 PriceQDTR $2 9 $18 $3 8 $24 Calculate E p When demand is inelastic, a price decrease will lead to a fall in total revenue!

Elasticity of Supply Elasticity of supply is the responsiveness of quantity to changes in price –Elasticity of supply parallels the elasticity of demand –Elasticity of supply measures the responsiveness of quantity supplied to changes in price An elasticity of 10 means a 1% change in price brings about a 10% change in quantity supplied An elasticity of 0.2 means a 10% change in price gives rise to just a.2% change in quantity supplied Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

18-24 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Perfectly Elastic Supply Curve Perfectly Inelastic Supply Curve

18-25 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Relative Elasticities of Supply

Elasticity over Time Remember, supply grows more elastic over time, especially when enough time has passed for new firms to enter the industry and for existing firms to increase their output Economists have identified three distinct time periods –The market period –The short run –The long run Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Market Period The market period is the time immediately after a change in market price during which the sellers can’t respond by changing the quantity supplied –During this period the supply curve may be perfectly inelastic or with some positive slope because firms have limited ability to increase output Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Short Run In the short run a firm has an essentially fixed productive capacity –A firm has some ability to increase output A firm could go from two 8-hour shifts to three 8-hour shifts Store hours could probably be extended And so, an increase in demand will result in more output Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Long Run In the long run there is sufficient time for a firm to alter its productive capacity –The firm can leave the industry –New firms can enter the industry –When a rise in demand is considered to be long lasting, some existing firms will add to their plant and equipment –If demand falls, some or all firms will cut back on their plant and equipment, while others may leave the industry Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

18-30 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Tax Incidence (tells us who really pays the tax) D S1S1 S2S $10 Output Price A tax increase lowers the supply How much is the tax?? (hint... measure it vertically) Answer: $3

18-31 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Tax Incidence (tells us who really pays the tax) D S1S1 S2S $10 Output Price A tax increase lowers the supply Who pays the tax? S 1 /D P=$6; QD=6 S 2 /D P=$7; QD=4 The Customer pays an additional $1 The Supplier absorbed the rest ($2)

18-32 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Tax Incidence (tells us who really pays the tax) D S1S1 S2S $10 Output Price Who pays the tax? S 1 /D P=$6; QD=6 S 2 /D P=$9; QD= 6 The demand curve is perfectly inelastic The buyer pays and additional $3 Seller absorbs ($0) The burden falls entirely on the buyer

Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Tax Incidence (tells us who really pays the tax) S1S1 S2S $10 Output Price Who pays the tax? S 1 /D P=$6; QD=6 S 2 /D P=$8.30 QD=2 The supply curve is more elastic than the demand curve The buyer pays and additional $2.30 Seller absorbs $.70 D The burden falls mainly on the buyer 18-33

Summary When the supply is perfectly inelastic, the seller bears the entire tax burden When supply is perfectly elastic, the buyer bears entire tax burden As the elasticity of demand rises, the tax burden is shifted from the buyer to the seller As the elasticity of supply rises, the tax burden is shifted from the seller to the buyer Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.