Chapter 20: Demand and Supply Elasticity ECON 152 – PRINCIPLES OF MICROECONOMICS Chapter 20: Demand and Supply Elasticity Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.

Price Elasticity Price Elasticity of Demand (Ep) The responsiveness of quantity demanded of a commodity to changes in its price Ep = percentage change in quantity demanded percentage change in price

Price Elasticity Example Price of oil increases 10 percent Quantity demanded decreases 1 percent Ep = -1% +10% = -.1

Price Elasticity Relative quantities only Always negative Elasticity is measuring the change in quantity relative to the change in price Always negative An increase in price decreases the quantity demanded, ceteris paribus

Calculating Elasticity Elasticity formula: change in Q sum of quantities/2 Ep = change in P or change in Q (Q1 + Q2)/2 Ep = change in P (P1 + P2)/2

Price Elasticity Ranges Elastic Demand Percentage change in quantity demanded is larger than the percentage change in price Ep > 1 Unit Elasticity of Demand Percentage change in quantity demanded is equal to the percentage change in price Ep = 1 Inelastic Demand Percentage change in quantity demanded is smaller than the percentage change in price Ep < 1

Price Elasticity Ranges Extreme elasticities Perfectly Inelastic Demand A demand curve that is a vertical line It has only one quantity demanded for each price No matter what the price, quantity demanded does not change

Extreme Price Elasticities D Perfect inelasticity, or zero elasticity Price 8 Quantity Demanded per Year (millions of units) Figure 21-1, Panel (a)

Price Elasticity Ranges Extreme elasticities Perfectly Elastic Demand A demand curve that is a horizontal line It has only one price for every quantity The slightest increase in price leads to zero quantity demanded

Extreme Price Elasticities 30 D Price (cents) Perfect elasticity, or infinite elasticity Quantity Demanded per Year (millions of units) Figure 21-1, Panel (b)

Policy Example: Who Pays Gasoline Taxes? State and federal governments impose gasoline taxes that are assessed as a flat amount per gallon. Who pays the tax depends on price elasticity of demand.

Policy Example: Who Pays Gasoline Taxes? Figure 21-2, Panels (a) and (b)

Policy Example: Who Pays Gasoline Taxes? D Figure 21-2, Panel (c)

Elasticity and Total Revenues When demand is elastic, a negative relationship exists between small changes in price and changes in total revenue. When demand is unit-elastic, changes in price do not change total revenue. When demand is inelastic, a positive relationship exists between changes in price and total revenues.

Determinants of Price Elasticity of Demand Existence of substitutes The closer the substitutes and the more substitutes there are, the more elastic is demand. Share of the budget The greater the share of the consumer’s total budget spent on a good, the greater is the price elasticity.

Determinants of Price Elasticity of Demand The length of time allowed for adjustment The longer any price change persists, the greater is the price elasticity of demand. Price elasticity is greater in the long-run than in the short-run.

Determinants of Price Elasticity of Demand How to define the short run and the long run The short run is a time period too short for consumers to fully adjust to a price change. The long run is a time period long enough for consumers to fully adjust to a change in price other things constant.

Short-Run and Long-Run Price Elasticity of Demand In the short run, quantity demanded falls slightly. However, with more time for adjustment the demand curve becomes more elastic and quantity demanded falls by a greater amount. P1 E Price per Unit Pe D2 D1 Q2 Q1 Qe Quantity Demanded per Period Figure 21-4

Short-Run and Long-Run Price Elasticity of Demand In the short run, quantity demanded falls slightly. However, with more time for adjustment the demand curve becomes more elastic and quantity demanded falls by a greater amount. P1 E Price per Unit Pe D3 D2 D1 Q3 Q2 Q1 Qe Quantity Demanded per Period Figure 21-4

Example: Real-World Elasticities of Demand Table 21-2

Cross Price Elasticity of Demand Cross Price Elasticity of Demand (Exy) The percentage change in the demand for one good (holding its price constant) divided by the percentage change in the price of a related good The responsiveness of change in demand of one good to the change in prices of related goods

Cross Price Elasticity of Demand Formula for computing cross elasticity of demand % change in demand for good X % change in price of good Y Exy =

Cross Price Elasticity of Demand Substitutes Exy would be positive An increase in the price of X would increase the quantity of Y demanded at each price. Complements Exy would be negative An increase in the price of X would decrease the quantity of Y demanded at each price.

Income Elasticity of Demand Income Elasticity of Demand (Ei) The percentage change in demand for any good, holding its price constant, divided by the percentage change in income The responsiveness of demand to changes in income, holding the good’s relative price constant refers to a horizontal shift in the demand curve in response to changes in income

Income Elasticity of Demand percentage change in demand percentage change in income Ei = Ei for a normal good is positive. Ei for an inferior good is negative.

Income Elasticity of Demand Formula: Change in Quantity ÷ Change in Income Average Quantity Average Income The income elasticity of demand can be either negative or positive. Remember that, in calculating the income elasticity of demand, the price of the good is assumed to be constant.

Elasticity of Supply Price Elasticity of Supply (Ei) The responsiveness of the quantity supplied of a commodity to a change in its price The percentage change in quantity supplied divided by the percentage change in price

Elasticity of Supply Formula for computing price elasticity of supply percentage change in quantity supplied percentage change in price ES =

Elasticity of Supply Classifying supply elasticities Perfectly Elastic Supply Quantity supplied falls to zero when there is any decrease in price. The supply curve is horizontal at a given price.

Elasticity of Supply Classifying supply elasticities Perfectly Inelastic Supply Quantity supplied is constant no matter what happens to price. The supply curve is vertical at a given price.

The Extremes in Supply Curves Perfect inelasticity P1 S Price per Unit Perfect elasticity Q1 Quantity Supplied per Period Figure 21-5

Elasticity of Supply Price elasticity of supply and length of time for adjustment The longer the time allowed for adjustment, the more elastic is supply. Firms can find ways to increase (or decrease) output. Resources can flow into (or out of) an industry through expansion (or contraction) of existing firms.

Short-Run and Long-Run Price Elasticity of Supply Pe Price per Unit E As time passes the supply curve rotates to S2 then to S3 and quantity supplied rises first to Q1 and then to Q2. Qe Q1 Q2 Quantity Supplied per Period Figure 21-6

Chapter 20: Demand and Supply Elasticity ECON 152 – PRINCIPLES OF MICROECONOMICS Chapter 20: Demand and Supply Elasticity Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.