McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Describing Supply and Demand: Elasticities Chapter 6

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Laugher Curve Q. What’s the difference between an economist and a befuddled old man with Alzheimer’s? A. The economist is the one with a calculator.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Concept of Elasticity n Elasticity is a measure of the responsiveness of one variable to another. n The greater the elasticity, the greater the responsiveness.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Elasticity n The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Elasticity n The price elasticity of supply is the proportional change in quantity demanded relative to the proportional change in price.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. What Information Price Elasticity Provides n Price elasticity of demand and supply gives the exact quantity response to a change in price.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Classifying Demand and Supply as Elastic or Inelastic n Demand or supply is elastic if the percentage change in quantity is greater than the percentage change in price. E > 1

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Classifying Demand and Supply as Elastic or Inelastic n Demand or supply is inelastic if the percentage change in quantity is less than the percentage change in price. E < 1

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elastic Demand and Supply n Elastic supply means that quantity changes by a greater percentage than the percentage change in price. n The same holds true for demand.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Inelastic Demand and Supply n Inelastic supply means that quantity doesn't change much with a change in price. n The same holds true for demand.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity Is Independent of Units n Percentages allow us to have a measure of responsiveness that is independent of units. n This makes comparisons of responsiveness of different goods easier.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating Elasticities n To determine elasticity divide the percentage change in quantity by the percentage change in price.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The End-Point Problem n The end-point problem – the percentage change differs depending on whether you view the change as a rise or a decline in price.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The End-Point Problem n Economists use the average of the end points to calculate the percentage change.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphs of Elasticities Price Quantity of software (in hundred thousands) $ D B A C (midpoint) Elasticity of demand between A and B = 1.27

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphs of Elasticities Elasticity of supply between A and B = 0.18 Wage per hour Quantity of workers $ C B A 470 (midpoint)

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphs of Elasticities Price Quantity $ C D F E B A 515 E = 0.54 E = 0.67 E =

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating Elasticity at a Point n Let us now turn to a method of calculating the elasticity at a specific point, rather than over a range or an arc.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating Elasticity at a Point n To calculate elasticity at a point, determine a range around that point and calculate the arc elasticity.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating Elasticity at a Point Price Quantity $ C B A

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating Elasticity at a Point Price Quantity $10 9 A D B C Supply E A = 2.33 E B = 0.11 Demand E C = 0.75 E D = 0.86

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity and Supply and Demand Curves n Two important points to consider: l Elasticity is related (but is not the same as) slope. l Elasticity changes along straight-line demand and supply curves.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity Is Not the Same as Slope n The steeper the curve at a given point, the less elastic is supply or demand. n There are two limiting examples of this.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity Is Not the Same as Slope n When the curves are flat, we call the curves perfectly elastic. The quantity changes enormously in response to a proportional change in price (E =  ).

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity Is Not the Same as Slope n When the curves are vertical, we call the curves perfectly inelastic. n The quantity does not change at all in response to an enormous proportional change in price (E = 0).

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Perfectly inelastic demand curve Price 0 Quantity Perfectly Inelastic Demand Curve

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Perfectly elastic demand curve Perfectly Elastic Demand Curve Price 0 Quantity

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity Changes Along Straight-Line Curves n Elasticity is not the same as slope. n Elasticity changes along straight line supply and demand curves–slope does not.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity Changes Along Straight-Line Curves On a demand curve, elasticity is perfectly elastic (E =  ) at the price intercept. n It becomes smaller as you move down the demand curve until it becomes zero at the quantity intercept.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity Changes Along Straight-Line Curves Elasticity is perfectly elastic (E S =  ) where a straight line supply curve intercepts the price axis. n Points become less elastic as you move out along the supply curve.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity Changes Along Straight-Line Curves n Elasticity is perfectly inelastic (E S = 0) where a straight line supply curve intercepts the quantity axis. n Points become more elastic as you move out along the supply curve.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity Along a Supply Curve Price $ Quantity E s rises E s =  E s = 0 S1S1 S0S0 E s declines

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity Review Perfectly elastic – quantity responds enormously to price changes (E =  ). n Elastic – the percentage change in quantity exceeds the percentage change in price (E >1).

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity Review n Unit elastic – the percentage change in quantity is the same as the percentage change in price (E = 1).

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity Review n Inelastic – the percentage change in quantity is less than the percentage change in price (E <1). n Perfectly inelastic – quantity does not respond at all to price changes (E = 0).

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Substitution and Elasticity n As a general rule, the more substitutes a good has, the more elastic is its supply and demand.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Substitution and Demand n The larger the time interval considered, or the longer the run, the more elastic is the good’s demand curve. l There are more substitutes in the long run than in the short run. l The long run provides more options for change.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Substitution and Demand n The less a good is a necessity, the more elastic its demand curve. n Necessities tend to have fewer substitutes than do luxuries.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Substitution and Demand n Demand becomes more elastic as the definition of a good becomes more specific. l A broadly defined good like transportation does not have many substitutes so that demand will be inelastic. l A more narrowly defined good like bus transportation will have more substitutes.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Substitution and Demand n 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.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Substitution and Demand n 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. n It is worth spending a lot of time looking for substitutes for goods that take a large portion of one’s income.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Substitution and Supply n The longer the time period considered, the more elastic the supply. n The reasoning is the same as for demand. l In the long run there are more options for change so it is easier (less costly) for suppliers to change into the production of another good.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Substitution and Supply n Economists distinguish three time periods relevant to supply: l The instantaneous period. l The short run. l The long run.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Substitution and Supply n In the instantaneous period, quantity supplied is fixed – the elasticity of supply is perfectly inelastic. n This supply is sometimes called the momentary supply.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Substitution and Supply n In the short run, some substitution is possible – the short-run supply curve is somewhat elastic. n In the long run, significant substitution is possible – the supply curve becomes very elastic.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. How Substitution Factors Affect Specific Decisions n Suppose you’ve been asked to evaluate the potential impact of a 10¢ gas tax increase in Washington, D.C. and in the entire nation.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Evaluating the 10¢ Gas Tax Increase n We’d expect the short run the demand curve for gasoline to be less elastic than in the long run. n In the long run, motorists would switch to fuel efficient cars.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Evaluating the 10¢ Gas Tax Increase n Demand is probably inelastic for the entire U.S. l Gasoline is considered a necessity l It is only a small part of what it costs to drive.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Evaluating the 10¢ Gas Tax Increase n Demand for gasoline is very elastic in Washington, D.C. l Some may switch to an alternative form of transportation. l Others would go to neighboring states to buy gasoline.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Empirical Estimates of Elasticities n The following table provides short- and long-term estimates of elasticities for a number of goods.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Short-Run and Long-Run Elasticities of Demand

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity, Total Revenue, and Demand n The elasticity of demand tells suppliers how their total revenue will change if their price changes. n Total revenue equals total quantity sold multiplied by price of good.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity, Total Revenue, and Demand n If E D is elastic (E D > 1), a rise in price lowers total revenue. n Price and total revenue move in opposite directions.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity, Total Revenue, and Demand n If E D is unit elastic (E D = 1), a rise in price leaves total revenue unchanged.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity, Total Revenue, and Demand n If E D is inelastic (E D < 1), a rise in price increases total revenue. n Price and total revenue move in the same direction.

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 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

A Price (b) Inelastic Demand E < 1 Quantity $ Elasticity and Total Revenue TR rises C H B G Lost revenue Gained revenue McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

A Price (c) Elastic Demand E = 1 Quantity $ Elasticity and Total Revenue TR falls C B K J Lost revenue Gained revenue McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Total Revenue Along a Demand Curve n With elastic demand – a rise in price lowers total revenue. n With inelastic demand – a rise in price increases total revenue.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elastic range E D > 1 E D = 1 Inelastic range E D < 1 Q0Q0 (a) Price Quantity 0 (b) How Total Revenue Changes Along a Demand Curve Q0Q0 0 Quantity Total revenue

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity of Individual and Market Demand n Market demand elasticity is influenced both by: l The number of people who totally drop out when price increases. l How much an existing consumer marginally changes his or her quantity demanded.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity of Individual and Market Demand n Price discrimination occurs when a firm separates the people with less elastic demand from those with more elastic demand.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity of Individual and Market Demand n Firms that price discriminate charge more to the individuals with inelastic demand and less to individuals with elastic demands.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity of Individual and Market Demand n Examples of price discrimination include: l Airlines’ Saturday stay-over specials. l The phenomenon of selling new cars. l The almost-continual-sale phenomenon.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Other Elasticity Concepts n Other elasticities can be useful in specifying the effects of a shift factor of demand: l Income elasticity of demand. l Cross-price elasticity of demand.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Income Elasticity of Demand n Income elasticity of demand – the percentage change in demand divided by the percentage change in income.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Income Elasticity of Demand n Income elasticity of demand tells us the responsiveness of demand to changes in income.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Income Elasticity of Demand n An increase in income generally increases one’s consumption of almost all goods. n The increase may be greater for some goods than for others.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Income Elasticity of Demand n Normal goods are those whose consumption increases with an increase in income. n They have income elasticities greater than zero.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Income Elasticity of Demand n Normal goods are divided into luxuries and necessities.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Income Elasticity of Demand n Luxuries are goods that have an income elasticity greater than one. n Their percentage increase in demand is greater than the percentage increase in income.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Income Elasticity of Demand n A necessity has an income elasticity less than 1. n The consumption of a necessity rises by a smaller proportion than the rise in income.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Income Elasticity of Demand n Inferior goods are those whose consumption decreases when income increases. n Inferior goods have income elasticities less than zero.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Income Elasticities of Selected Goods

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Cross-Price Elasticity of Demand n Cross-price elasticity of demand – the percentage change in demand divided by the percentage change in the price of another good.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Cross-Price Elasticity of Demand n Cross-price elasticity of demand tells us the responsiveness of demand to changes in prices of other goods.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Complements and Substitutes n Substitutes are goods that can be used in place of another. n Substitutes have positive cross-price elasticities.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Complements and Substitutes n Complements are goods that are used in conjunction with other goods. n Complements have negative cross-price elasticities.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Cross-Price Elasticities

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. P0P0 D0D0 D1D1 P0P0 20Quantity26 Shift due to 20% rise in income Some Examples

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Some Examples S0S0 P0P0 S1S1 P0P0 104Quantity108 Shift due to 33% rise in price of pork

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. When Should a Supplier Raise Price? n The supplier should raise his price when it faces an inelastic demand. l Total revenue increases with a price increase because quantity drops proportionally less than price goes up. l Since costs also fall, profit rise.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. When Should a Supplier Raise Price? n When you have an elastic demand, you should hesitate to increase price.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity and Shifting Supply and Demand n Elasticity can tell us more precisely the effect of shifting supply and demand. n The more elastic the demand, the greater the effect of a supply shift on quantity, and the smaller effect on price.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity and Shifting Supply and Demand n Demand highly elastic, supply shifts out. l Price remains almost constant; quantity increases enormously. n Supply highly inelastic, demand shifts out. l Price rises significantly; quantity hardly changes at all.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity and Shifting Supply and Demand n Demand highly inelastic, supply shifts out. l Price falls significantly; quantity hardly changes at all.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Effects of Shifts in Supply on Price and Quantity Inelastic Supply and Inelastic Demand P0P0 P1P1 Demand Price Quantity S0S0 S1S1 Q0Q0 Q1Q1

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Effects of Shifts in Supply on Price and Quantity Inelastic Supply and Elastic Demand P0P0 P1P1 Demand Price Quantity S0S0 S1S1 Q0Q0 Q1Q1

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Describing Supply and Demand: Elasticities End of Chapter 6