© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 5: Describing Demand and Supply: Elasticities Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 2 Chapter Objectives 1. Use the terms price elasticity of demand and price elasticity of supply to describe the responsiveness of quantity demanded and quantity supplied to changes in price. 2. Calculate price elasticity of demand. 3. Interpret price elasticity of demand.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 3 Chapter Objectives 4. Explain the importance of substitution in determining price elasticity. 5. Relate price elasticity of demand to total revenue.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 4 Chapter Objectives 6a. Calculate and interpret income elasticity of demand, cross-price elasticity of demand, and price elasticity of supply. 6b. State how elasticity concepts are useful in describing the effect of shift factors on demand. 7. Calculate and interpret price elasticity of supply.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 5 Chapter Objectives 8. Explain how the concept of elasticity makes supply and demand analysis more useful.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 6 Concept of Elasticity Elasticity is a measure of the responsiveness of one variable to another. The greater the elasticity, the greater the responsiveness.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 7 Price Elasticity of Demand The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 8 What Information Price Elasticity Provides Price elasticity of demand gives the exact quantity response to a change in price.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 9 Things to Note About Elasticity Price elasticity of demand is always negative because price and quantity demanded are inversely related—when price rises, quantity demanded falls, and vice versa.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 10 Things to Note About Elasticity By the Law of Demand, as price rises, quantity demanded falls. Inverse relationship Elasticity tells us by how much quantity falls.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 11 Things to Note About Elasticity Economists therefore talk about price elasticity of demand as an absolute value of the number. Thus, price elasticity of demand is reported as a positive number.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 12 Classifying Demand as Elastic or Inelastic Demand is elastic if the percentage change in quantity is greater than the percentage change in price.  D > 1

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 13 Classifying Demand as Elastic or Inelastic Demand is inelastic if the percentage change in quantity is less than the percentage change in price.  D < 1

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 14 Elastic Demand Elastic demand means that quantity demanded changes by a greater percentage than the percentage change in price. Inelastic demand means that quantity doesn't change much with a change in price.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 15 Elasticity Is Independent of Units Elasticity is calculated as a ratio of percentages. Percentages allow us to have a measure of responsiveness that is independent of units.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 16 Elasticity Is Independent of Units Having a measure of responsiveness that is independent of units makes comparisons of responsiveness of different goods easier.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 17 Calculating Price Elasticity of Demand To determine price elasticity of demand, divide the percentage change in quantity demanded by the percentage change in price.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 18 End-Point Problem The end-point problem – the percentage change differs depending on whether you calculate the change as a rise or a decline in price.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 19 End-Point Problem Economists use the average of the end points to calculate the percentage change.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 20 Graph of Price Elasticity of Demand Price Quantity (in thousands) $ D B A 789 C (midpoint) Elasticity of demand between A and B =.96

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 21 Graph of Price Elasticity of Demand Price Quantity $ C D B A  D = 0.54  D =

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 22 Calculating Elasticity at a Point Let us now turn to a method of calculating the elasticity at a specific point, rather than over a range or an arc.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 23 Calculating Elasticity at a Point To calculate elasticity at a point, determine a range around that point and calculate the arc elasticity.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 24 Calculating Elasticity at a Point Price Quantity $ C B A

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 25 Calculating Elasticity at a Point Price Quantity $10 9 A B ε A = 2.33 ε B = 0.11 Demand

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 26 Elasticity and Demand Curves Two important points to consider:  Elasticity is related to, but is not the same as slope.  Elasticity changes along a straight-line demand curve.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 27 Elasticity Is Not the Same as Slope The steeper the curve at a given point, the less elastic is demand. There are two limiting examples of this.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 28 Elasticity Is Not the Same as Slope When the demand curve is flat, we call the demand perfectly elastic. Perfectly elastic demand is a horizontal line in which quantity changes enormously in response to any change in price (  D =  ).

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 29 Elasticity Is Not the Same as Slope When the demand curve is vertical, we call the demand perfectly inelastic. Perfectly inelastic demand is a vertical line in which quantity does not change at all in response to a change in price (  D = 0).

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 30 Perfectly inelastic demand curve Price 0 Quantity Perfectly Inelastic Demand Curve

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 31 Perfectly elastic demand curve Perfectly Elastic Demand Curve Price 0 Quantity

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 32 Elasticity Changes Along Straight-Line Curves Elasticity is not the same as slope. Elasticity changes along straight line demand curves – slope does not.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 33 Elasticity and Slope Price Quantity $ D1D2 Over the $3 to $4 price interval,  D (A to C on D1 ) = 0.47 while  D (A to G on D2 ) = 4.2 A G C

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 34 Elasticity Changes Along Straight-Line Curves A demand curve is perfectly elastic (  D =  ) at the vertical (price) intercept. Elasticity becomes smaller as you move down the demand curve until it becomes zero (  =  ) at the horizontal (quantity) intercept.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 35 Price $ Quantity Elasticity Along a Demand Curve Elasticity declines along demand curve as we move toward the quantity axis E d =  E d = 1 E d = 0 E d < 1 E d > 1

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 36 Interpret Price Elasticity of Demand We know by the law of demand that consumers buy less as price rises. Price elasticity of demand tells us if whether consumers reduce their purchases by a lot (elastic demand) or a little (inelastic demand).

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 37 Price Elasticity of Demand: Review Perfectly elastic – quantity responds enormously to price changes (  D =  ). Elastic – the percentage change in quantity demanded exceeds the percentage change in price (  D > 1).

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 38 Unit elastic – the percentage change in quantity demanded is the same as the percentage change in price (  D = 1). Price Elasticity of Demand: Review

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 39 Inelastic – the percentage change in quantity demanded is less than the percentage change in price (  D < 1). Perfectly inelastic – quantity does not respond at all to price changes (  D = 0). Price Elasticity of Demand: Review

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 40 Interpret Price Elasticity of Demand  D Description of demand Interpretation D=D= Perfectly elasticQuantity responds enormously to changes in price  D >1 ElasticConsumers are responsive to price changes D=D= Unit elasticPercent change in price and quantity are equal  D <1 InelasticConsumers are unresponsive to price changes D=D= Perfectly inelasticConsumers are completely unresponsive to price change

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 41 As a general rule, the more substitutes a good has, the more elastic is its supply and demand. Substitution and Price Elasticity of Demand

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 42 Substitution and Price Elasticity of Demand How many substitutes a good has is affected by many factors:  Time to Adjust  Luxuries versus Necessities  Narrow or Broad Definition  Budget Proportion

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 43 Time to Adjust The larger the time interval considered, or the longer the run, the more elastic is the good’s demand curve.  There are more substitutes in the long run than in the short run.  The long run provides more options for change.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 44 Luxuries versus Necessities If a good is a necessity, the less elastic its demand curve. Necessities tend to have fewer substitutes than do luxuries.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 45 Narrow or Broad Definition Demand becomes more elastic as the definition of a good becomes more specific.  A broadly defined good like transportation does not have many substitutes so that demand will be inelastic.  A more narrowly defined good like bus transportation will have more substitutes.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 46 Budget Proportion Demand for goods that represent a large proportion of one's budget are more elastic than demand for goods that represent a small proportion of one's budget.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 47 Goods that cost very little relative to your total expenditures are not worth spending a lot of time figuring out if there is a good substitute. It is worth spending a lot of time looking for substitutes for goods that take a large portion of one’s income. Budget Proportion

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 48 Empirical Estimates of Elasticities The following table provides short- and long- term estimates of price elasticities of demand for a number of goods.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 49 Short-Run and Long-Run Price Elasticities of Demand

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 50 Price Elasticity of Demand and Total Revenue Total revenue is the total amount of money a firm receives from selling its product.  Revenue equals total quantity sold multiplied by the price of good.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 51 Price Elasticity of Demand and Total Revenue Knowing the price elasticity of demand is useful to firms because from it they can tell what happens to total revenue when they raise or lower their prices.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 52 Price Elasticity of Demand and Total Revenue If demand is elastic (  D > 1), a rise in price lowers total revenue. Price and total revenue move in opposite directions.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 53 Price Elasticity of Demand and Total Revenue If demand is unit elastic (  D = 1), a rise in price leaves total revenue unchanged.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 54 Price Elasticity of Demand and Total Revenue If demand is inelastic (  D < 1), a rise in price increases total revenue. Price and total revenue move in the same direction.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 55 A (a) Unit Elastic Demand E = 1 Elasticity and Total Revenue TR constant C 0 6 Price Quantity $ B E Lost revenue F Gained revenue

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 56 A Price (b) Inelastic Demand E < 1 Quantity $ Elasticity and Total Revenue TR rises C H B G Lost revenue Gained revenue

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 57 A Price (c) Elastic Demand E > 1 Quantity $ Elasticity and Total Revenue TR falls C B K J Lost revenue Gained revenue

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 58 Total Revenue Along a Demand Curve With elastic demand – a rise in price lowers total revenue. With inelastic demand – a rise in price increases total revenue.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 59 Elastic range ε D > 1 ε D = 1 Inelastic range ε D < 1 Q0Q0 Price Quantity 0 Total Revenue Changes Along a Demand Curve Q0Q0 0 Quantity Total revenue

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 60 Elasticity of Individual and Market Demand Market demand elasticity is influenced both by:  The number of people who totally drop out when price increases.  How much an existing consumer marginally changes his or her quantity demanded.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 61 Elasticity of Individual and Market Demand Price discrimination occurs when a firm separates the people with less elastic demand from those with more elastic demand.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 62 Elasticity of Individual and Market Demand Firms that price discriminate charge more to the individuals with inelastic demand and less to individuals with elastic demands.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 63 Elasticity of Individual and Market Demand Examples of price discrimination include:  Airlines’ Saturday stay-over specials.  The phenomenon of selling new cars.  The almost-continual-sale phenomenon.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 64 Other Elasticities of Demand Two other demand elasticities are important in describing consumer behaviour: Income elasticity of demand. Cross-price elasticity of demand.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 65 Income Elasticity of Demand Income elasticity of demand – the percentage change in demand divided by the percentage change in income.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 66 Income Elasticity of Demand Income elasticity of demand tells us the responsiveness of demand to changes in income.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 67 Income Elasticity of Demand An increase in income generally increases one’s consumption of almost all goods. The increase may be greater for some goods than for others.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 68 Income Elasticity of Demand Normal goods are those whose consumption increases with an increase in income. They have income elasticities greater than zero.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 69 Income Elasticity of Demand Normal goods are usually divided into two categories: Income elastic normal goods Income inelastic normal goods

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 70 Income Elasticity of Demand Income elastic normal goods are goods that have an income elasticity greater than one. Their percentage increase in demand is greater than the percentage increase in income.  Luxuries tend to be income elastic.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 71 Income Elasticity of Demand An income inelastic normal good has an income elasticity less than 1. The consumption of these goods rises by a smaller proportion than the rise in income.  Necessities tend to be income inelastic.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 72 Income Elasticity of Demand Inferior goods are those whose consumption decreases when income increases. Inferior goods have income elasticities less than zero (negative).  Generic (store-brand) cereals tend to be inferior goods.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 73 Income Elasticities of Selected Goods

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 74 Coefficient Interpretation Description Normal good  I   Qd Two cases of normal good: Income inelastic normal good (“necessity”) Income elastic normal good (“superior” good) Inferior good  I   Qd Interpret Income Elasticity of Demand

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 75 Cross-Price Elasticity of Demand Cross-price elasticity of demand is computed by dividing the percentage change in quantity demanded by the percentage change in the price of another good.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 76 Cross-Price Elasticity of Demand Cross-price elasticity of demand tells us the responsiveness of demand to changes in prices of other goods. Cross-price elasticity measures both how and how strongly consumers respond to changes in the price of related products.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 77 Cross-Price Elasticity of Demand Depending on how consumers respond to changes in the price of related products, goods can be classified as Substitutes Complements

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 78 Complements and Substitutes Substitutes are goods that can be used in place of one another. When the price of a good goes up, the demand for the substitute good also goes up. Cross-price elasticity of substitutes is positive

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 79 Complements and Substitutes Complements are goods that are used in conjunction with other goods. A rise in the price of a good will decrease the demand for a good, and for its complement. Complements have negative cross-price elasticities.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 80 Interpret Cross-Price Elasticity of Demand CoefficientInterpretationRatio  XY > 0 Substitute Goods  P Y  Q X  XY < 0 Complementary Goods  P Y  Q X  XY = 0 Unrelated Goods  P Y   Q X =0

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 81 P0P0 D0D0 D1D1 P0P0 18 Quantity 25 Shift due to increase in income Calculating Income and Cross-Price Elasticities Price  =6.5

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 82 Calculating Income and Cross-Price Elasticities P0P0 P0P0 3 Quantity of ketchup 4 Shift due to rise in price of hot dogs D1D1 D0D0 Price of ketchup  XY = - 0.7

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 83 Cross-Price Elasticities

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 84 Price Elasticity of Supply Price elasticity of supply measures the responsiveness of firms to a change in the price of their product.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 85 Price Elasticity of Supply The price elasticity of supply is calculated as the percent change in quantity supplied over the percent change in price.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 86 Inelastic Supply Common sense tells us that an inelastic supply means that the percent change in quantity is less than the percentage change in price. An elastic supply means that quantity supplied changes by a larger percent than the percent change in price.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 87 Substitution and Supply The longer the time period considered, the more elastic the supply.  In the long run there are more alternatives so it is easier (less costly) for suppliers to change and produce other goods.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 88 Substitution and Supply Economists distinguish three time periods relevant to supply:  The instantaneous period.  The short run.  The long run.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 89 Substitution and Supply In the instantaneous period, quantity supplied is fixed so supply is perfectly inelastic. This supply is sometimes called the momentary supply.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 90 Substitution and Supply In the short run, some substitution is possible – the short-run supply curve is somewhat elastic. In the long run, significant substitution is possible – the supply curve becomes very elastic.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 91 Substitution and Supply An additional factor to consider in determining elasticity of supply: How easy or difficult is it to produce more of the good? The easier it is to produce additional units, the more elastic the supply.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 92 Elasticity and Shifting Supply and Demand Elasticity can tell us more precisely the effect of shifting supply and demand. The more elastic the demand, the greater the effect of a supply shift on quantity, and the smaller effect on price.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 93 Effects of Shifts in Supply on Price and Quantity An example of the importance of elasticities of demand and supply can be illustrated by the example of the world market for oil

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 94 Effects of Shifts in Supply on Price and Quantity If oil supply decreases, the world prices will rise sharply if the demand for oil is inelastic. Oil prices will not be affected a lot if demand is elastic.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 95 Effects of Shifts in Supply on Price and Quantity Inelastic Supply and Inelastic Demand P0P0 P1P1 Demand Price Quantity S0S0 S1S1 Q0Q0 Q1Q1

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 96 Effects of Shifts in Supply on Price and Quantity Inelastic Supply and Elastic Demand P1P1 P0P0 Demand Price Quantity S1S1 S0S0 Q1Q1 Q0Q0

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.97 Describing Demand and Supply: Elasticities End of Chapter 5