ECN1A Week 2 Ch. 3 Supply and Demand Ch. 6 Elasticity.

ECN1A Week 2 Ch. 3 Supply and Demand Ch. 6 Elasticity

2 © 2015 Pearson Education, Inc. What Determines the Price of a Smartphone? Demand for smartphones How many smartphones do consumers want to buy? Affected by price of the smartphones Affected by other factors, including prices of other goods Supply of smartphones How many smartphones are producers willing to sell? Affected by price of the smartphones Affected by other factors, including prices of other goods We will analyze these in a perfectly competitive market: a market with (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market.

4 © 2015 Pearson Education, Inc. Demand Schedules and Quantity Demanded Demand schedule: A table that shows the relationship between the price of a product and the quantity of the product demanded. Quantity demanded: The amount of a good or service that a consumer is willing and able to purchase at a given price. A demand schedule and a demand curve Figure 3.1

5 © 2015 Pearson Education, Inc. Demand Curve and Market Demand Demand curve: A curve that shows the relationship between the price of a product and the quantity of the product demanded. Market demand: the demand by all the consumers of a given good or service. A demand schedule and a demand curve Figure 3.1

6 © 2015 Pearson Education, Inc. Ceteris Paribus When drawing the demand curve, we assume ceteris paribus. Ceteris paribus (“all else equal”) condition: The requirement that when analyzing the relationship between two variables—such as price and quantity demanded—other variables must be held constant. A demand schedule and a demand curve Figure 3.1

7 © 2015 Pearson Education, Inc. The Law of Demand Law of demand: The rule that, holding everything else constant, when the price of a product falls, the quantity demanded of the product will increase, and when the price of a product rises, the quantity demanded of the product will decrease. Implication: Demand curve slopes downward A demand schedule and a demand curve Figure 3.1

8 © 2015 Pearson Education, Inc. What Explains the Law of Demand? When the price of a product falls, two effects cause consumers to purchase more of it: The product has become cheaper relative to other goods, so consumers substitute toward it. This is the substitution effect. The consumer now has greater purchasing power, and elects to purchase more goods overall. This is income effect. Substitution effect: The change in the quantity demanded of a good that results from a change in price making the good more or less expensive relative to other goods that are substitutes. Income effect: The change in the quantity demanded of a good that results from the effect of a change in the good’s price on consumers’ purchasing power.

9 © 2015 Pearson Education, Inc. Increase and Decrease in Demand A change in something other than price that affects demand causes the entire demand curve to shift. A shift to the right (D 1 to D 2 ) is an increase in demand. A shift to the left (D 1 to D 3 ) is a decrease in demand. Shifting the demand curveFigure 3.2

10 © 2015 Pearson Education, Inc. Shifts of the Demand Curve As the demand curve shifts, the quantity demanded will change, even if the price doesn’t change. The quantity demanded changes at every possible price. Shifting the demand curveFigure 3.2 P1P1 Q 2 Q 1 Q 3

11 © 2015 Pearson Education, Inc. What Factors Influence Market Demand? Income of consumers Increase in income increases demand if product is normal, decreases demand if product is inferior. Prices of related goods Increase in price of related good increases demand if products are substitutes, decreases demand if products are complements Tastes Population and demographics Expected future prices We will discuss how each of these affects demand.

12 © 2015 Pearson Education, Inc. Change in Income of consumers Normal good: A good for which the demand increases as income rises, and decreases as income falls. Examples: Clothing Restaurant meals Vacations Inferior good: A good for which the demand decreases as income rises, and increases as income falls. Examples: Second-hand clothing Ramen noodles Are smartphones normal or inferior goods? Effect of increase in income, if good is normal Effect of increase in income, if good is inferior

13 © 2015 Pearson Education, Inc. Change in the Price of Related Goods Substitutes: Goods and services that can be used for the same purpose. Examples: Big Mac and Whopper Ford F-150 and Dodge Ram Jeans and Khakis Complements: Goods and services that are used together. Examples: Big Mac and McDonald’s fries Hot dogs and hot dog buns Left shoes and right shoes Effect on demand for Big Macs, if price of Whopper increases Effect on demand for Big Macs, if price of McDonald’s fries increases

14 © 2015 Pearson Education, Inc. Change in Tastes or Population/demographics Tastes If consumers’ tastes change, they may buy more or less of the product. Example: If consumers become more concerned about eating healthily, they might decrease their demand for fast food. Population and demographics Increases in the number of people buying something will increase the amount demanded. Example:An increase in the elderly population increases the demand for medical care. Effect on demand for fast food, if consumers want to eat healthy Effect on demand for medical care, as the population ages

15 © 2015 Pearson Education, Inc. Change in Expectations about Future Prices Consumers decide which products to buy and when to buy them. Future products are substitutes for current products An expected increase in the price tomorrow increases demand today. An expected decrease in the price tomorrow decreases demand today. Example: If you found out the price of gasoline would go up tomorrow, you would increase your demand today. Effect on today’s gasoline demand, if price will rise tomorrow

16 © 2015 Pearson Education, Inc. Change in Demand vs. Change in Quantity Demanded A change in the price of the product being examined causes a movement along the demand curve. This is a change in quantity demanded. Any other change affecting demand causes the entire demand curve to shift. This is a change in demand. A change in demand versus a change in quantity demanded Figure 3.3

17 © 2015 Pearson Education, Inc. Supply Schedules and Supply Curves Supply schedule: A table that shows the relationship between the price of a product and the quantity of the product supplied. Quantity supplied: The amount of a good or service that a firm is willing and able to supply at a given price. Supply curve: A curve that shows the relationship between the price of a product and the quantity of the product supplied. A supply schedule and a supply curve Figure 3.4

18 © 2015 Pearson Education, Inc. The Law of Supply The law of supply: The rule that, holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied. Implication: supply curves slope upward. A supply schedule and a supply curve Figure 3.4

19 © 2015 Pearson Education, Inc. Increase and Decrease in Supply A change in something other than price that affects supply causes the entire supply curve to shift. A shift to the right (S 1 to S 3 ) is an increase in supply. A shift to the left (S 1 to S 2 ) is a decrease in supply. Shifting the supply curveFigure 3.5

20 © 2015 Pearson Education, Inc. Shifts of the Supply Curve As the supply curve shifts, the quantity supplied will change, even if the price doesn’t change. The quantity supplied changes at every possible price. Shifting the supply curveFigure 3.5 P1P1 Q 2 Q 1 Q 3

21 © 2015 Pearson Education, Inc. Variables that Shift Market Supply Prices of inputs Technological change Prices of substitutes in production Number of firms in the market Expected future prices We will discuss how each of these affects supply.

22 © 2015 Pearson Education, Inc. Changes in Prices of Inputs Inputs are things used in the production of a good or service. Examples of inputs for smartphones: Computer processor Plastic housing Labor An increase in the price of an input decreases the profitability of selling the good, causing a decrease in supply. A decrease in the price of an input increases the profitability of selling the good, causing an increase in supply. Effect of an increase in the price of input goods Effect of a decrease in the price of input goods

23 © 2015 Pearson Education, Inc. Technological Change A firm may experience a positive or negative change in its ability to produce a given level of output with a given quantity of inputs. This is a technological change. Changes raise or lower firms’ costs, hence their supply of the good. Examples: A new, more productive variety of wheat would increase the supply of wheat. Governmental restrictions on land use for agriculture might decrease the supply of wheat. Effect of a positive change in technology Effect of a negative change in technology

24 © 2015 Pearson Education, Inc. Prices of Substitutes, and Number of Firms Many firms can produce and sell more than one product. Example: An Illinois farmer can plant corn or soybeans. If the price of soybeans rises, he will plant (supply) less corn. More firms in the market will result in more product available at a given price (greater supply). Fewer firms → supply decreases. Effect on the supply of corn, of an increase in the price of soybeans Effect of a increase in the number of firms

25 © 2015 Pearson Education, Inc. Change in Expected Future Prices If a firm anticipates that the price of its product will be higher in the future, it might decrease its supply today in order to increase it in the future. What types of products could be “stored” like this? Perishable products, or Non-perishable products Effect of an increase in future expected price of a good

26 © 2015 Pearson Education, Inc. Change in Supply vs. Change in Quantity Supplied A change in the price of the product being examined causes a movement along the supply curve. This is a change in quantity supplied. Any other change affecting supply causes the entire supply curve to shift. This is a change in supply. A change in supply versus a change in quantity supplied Figure 3.6

28 © 2015 Pearson Education, Inc. Market Equilibrium At a price of $200, consumers want to buy 10 million smartphones, and producers want to sell 10 million smartphones. This is a market equilibrium: a situation in which quantity demanded equals quantity supplied. A market equilibrium with many buyers and sellers is a competitive market equilibrium. Market equilibriumFigure 3.7

29 © 2015 Pearson Education, Inc. Market Equilibrium Price and Quantity In this market: The equilibrium price of a smartphone is $200, and The equilibrium quantity of a smartphone is 10 million smartphones per week. Since buyers and sellers want to trade the same quantity at the price of $200, we do not expect the price to change. Market equilibriumFigure 3.7

30 © 2015 Pearson Education, Inc. A Surplus in the Market for Smartphones At a price of $250, consumers want to buy 9 million smartphones, while producers want to sell 11 million. This gives a surplus of 2 million smartphones: a situation in which quantity supplied is greater than quantity demanded. Prediction: sellers will compete amongst themselves, driving the price down. The effect of surpluses and shortages on the market price Figure 3.8

31 © 2015 Pearson Education, Inc. A Shortage in the Market for Smartphones At a price of $100, consumers want to buy 12 million smartphones, while producers want to sell 8 million. This gives a shortage of 4 million smartphones: a situation in which quantity demanded is greater than quantity supplied. Prediction: sellers will realize they can increase the price and still sell as many smartphones, so the price will rise. The effect of surpluses and shortages on the market price Figure 3.8

32 © 2015 Pearson Education, Inc. Demand and Supply Both Count Price is determined by the interaction of buyers and sellers. Neither group can dictate price in a competitive market (i.e. one with many buyers and sellers). However changes in supply and/or demand will affect the price and quantity traded.

34 © 2015 Pearson Education, Inc. The Usefulness of the Demand and Supply Model Predictions about price and quantity in our model require us to know supply and demand curves. Typically, we know price and quantity, but do not know the curves that generate them. The power of the demand and supply model is in its ability to predict directional changes in price and quantity traded.

35 © 2015 Pearson Education, Inc. The Effect of Shifts in Supply on Equilibrium Suppose Amazon enters the smartphone market: More smartphones are supplied at any given price—an increase in supply from S 1 to S 2. Equilibrium price falls from P 1 to P 2. Equilibrium quantity rises from Q 1 to. Q2 Q2 The effect of an increase in supply on equilibrium Figure 3.9

36 © 2015 Pearson Education, Inc. How Much Will Price and Quantity Change? By how much will price fall? By how much will quantity rise? We cannot say, without knowing more information. For now, we can only predict that price will fall and quantity traded will rise. The effect of an increase in supply on equilibrium Figure 3.9

37 © 2015 Pearson Education, Inc. The Effect of Shifts in Demand on Equilibrium Suppose incomes increase. What happens to the equilibrium in the smartphone market? Smartphones are a normal good, so as income rises, demand shifts to the right (D 1 to D 2 ). Equilibrium price rises (P 1 to P 2 ). Equilibrium quantity rises (Q 1 to Q 2 ). The effect of an increase in demand on equilibrium Figure 3.10

38 © 2015 Pearson Education, Inc. Shifts in Demand and Supply over Time Over time, it is likely that both demand and supply will change. For example, as new firms enter the market for smartphones and incomes increase, we expect The supply of smartphones will shift to the right, and The demand for smartphones will shift to the right. Shifts in demand and supply over time: demand shifting more than supply Figure 3.11a

39 © 2015 Pearson Education, Inc. Demand Shifting More Than Supply What does our model predict? S↑  ( P↓ and Q↑ ) D↑  ( P↑ and Q↑ ) So we can be sure equilibrium quantity will rise; but the effect on equilibrium price is not clear. This panel shows demand shifting more than supply: equilibrium price and quantity both rise. Shifts in demand and supply over time: demand shifting more than supply Figure 3.11a

40 © 2015 Pearson Education, Inc. Supply Shifting More Than Demand This panel shows supply shifting more than demand: quantity rises, but equilibrium price falls. Without knowing the relative size of the changes, the effect on equilibrium price is ambiguous. It is possible, but unlikely, that the equilibrium price will remain unchanged. Shifts in demand and supply over time: supply shifting more than demand Figure 3.11b

41 © 2015 Pearson Education, Inc. Effect of Changes in Demand or Supply—redux We can now fill in the rest of Table 3.3. The cell in red is the example that we just did. How shifts in demand and supply affect equilibrium price (P) and quantity (Q) Table 3.3 Supply Curve Unchanged Supply Curve Shifts to the Right Supply Curve Shifts to the Left Demand Curve UnchangedQ unchanged P unchanged Q increases P decreases Q decreases P increases Demand Curve Shifts to the Right Q increases P increases Q increases P increases or decreases Q increases or decreases P increases Demand Curve Shifts to the Left Q decreases P decreases Q increases or decreases P decreases Q decreases P increases or decreases

42 © 2015 Pearson Education, Inc. Making the Connection The Falling Price of Blu-ray Players From 2006 to 2013, the price of Blu-ray players fell from about $800 to about $95, while the number of Blu-ray players traded increased dramatically. What best explains this change? A.Increase in demand B.Decrease in demand C.Increase in supply D.Decrease in supply Can you show this change on a supply-and-demand diagram?

44 © 2015 Pearson Education, Inc. Shifts of a Curve vs. Movements along a Curve Suppose an increase in supply occurs. We now know: Equilibrium quantity will increase, and Equilibrium price will decrease It is tempting to believe the decrease in price will cause an increase in demand. But this is incorrect. The decrease in price will cause a movement along with demand curve, but not an increase in demand. Why? The demand curve already describes how much of the good consumers want to buy, at any given price. When the price change occurs, we just look at the demand curve to see what happens to how much consumers want to buy.

45 © 2015 Pearson Education, Inc. Do People Respond to Changes in the Price of Gasoline? Some argue that people don’t vary the quantity of gasoline they buy as the price changes. Do you think this is correct? From September 2011 to September 2012, the price of gasoline rose by about 7% ($3.66 per gallon to $3.91 per gallon). Gasoline consumption fell by about 5%. People do respond to incentives, changing their behavior as prices, incomes, and prices of related goods change. This chapter explores these behavioral changes.

47 © 2015 Pearson Education, Inc. Measuring Responsiveness to Price Changes Although we saw consumers did change the amount of gasoline they bought, they didn’t appear to change it by very much. How can we come up with a sensible way to measure how much quantity changes when price changes? One idea is to look at the slope of the demand curve. But this won’t work, since the value of the slope depends on the units used to measure on the axes.

48 © 2015 Pearson Education, Inc. Price Elasticity of Demand A better way to measure responsiveness of quantity demanded is to think in terms of percentage changes. This avoids the problem with units of measurement. Although the slope and price elasticity of demand are related, they are not the same thing. Since price and quantity change in opposite directions on the demand curve, the price elasticity of demand is a negative number. However we often refer to “more negative” elasticities as being “larger” or “higher”.

49 © 2015 Pearson Education, Inc. Price Elasticity of Demand Terminology A “large” value for the price elasticity of demand means that quantity demanded changes a lot in response to a price change. Formally, we say demand is price elastic if its price elasticity of demand is larger (in absolute value) than 1. So a 10% increase in price would result in a greater than 10% decrease in quantity demanded. Demand is price inelastic if its price elasticity of demand is smaller (in absolute value) than 1. That is, close to zero, indicating that quantity demanded changes little in response to a price change. Demand is unit price elastic if the price elasticity of demand is exactly equal to (negative) 1.

50 © 2015 Pearson Education, Inc. Elastic and Inelastic Demand Along D 1, cutting the price from $4.00 to $3.70 increases the number of gallons sold from 1,000 per day to 1,200 per day, so demand is elastic between point A and point B. Along D 2, cutting the price from $4.00 to $3.70 increases the number of gallons sold from 1,000 per day only to 1,050 per day, so demand is inelastic between point A and point C. Elastic and inelastic demand Figure 6.1

51 © 2015 Pearson Education, Inc. Percentage Changes and the Midpoint formula Percentage changes have the unfortunate characteristic that the percentage change from A to B is not the negative of the percentage change from B to A. Example: On the previous slide, from point A to point B, quantity increased from 1000 to 1200, an increase of 20%. However from B to A, quantity decreases by 16.7%. This would mean the elasticity from A to B was different from the elasticity from B to A, an undesirable characteristic. To avoid this, we calculate percentage changes using the midpoint formula:

52 © 2015 Pearson Education, Inc. The Midpoint Formula The midpoint formula avoids the confusion of whether we are going from A to B or from B to A: we use the average of A and B in the denominator instead of choosing one of them. Price elasticity of demand becomes: The first term is the percentage change in quantity, using the midpoint formula. The second term is the percentage change in price, using the midpoint formula.

53 © 2015 Pearson Education, Inc. Calculating Price Elasticity of Demand—part 1 At your gas station, you cut price from $3.50 per gallon to $3.30 per gallon. Gasoline sales went up from 2000 to 2500 gallons per day. To calculate this price elasticity, we first need the average quantity and price:

54 © 2015 Pearson Education, Inc. Calculating Price Elasticity of Demand—part 2 Now calculate the percentage change in quantity and price: Then price elasticity of demand is the ratio of these two: This is greater in absolute value than –1, so we say that demand in this range is price elastic.

55 © 2015 Pearson Education, Inc. Calculating Price Elasticity of Demand—part 3 What if the quantity had only increased to 2100? Percentage change in price remains the same (-5.9%). Percentage change in quantity is now: So price elasticity of demand is now… This is smaller (in absolute value) than -1, so demand is inelastic.

56 © 2015 Pearson Education, Inc. Observations About Elasticity While slope and elasticity are not the same, they are related: If two demand curves go through the same point, the one with the higher slope also has the higher (more negative) elasticity. A vertical demand curve means that quantity demanded does not change as price changes. So elasticity is zero. A vertical demand curve is perfectly inelastic. A horizontal demand curve means quantity demanded is infinitely responsive to price changes. Elasticity is infinite. A horizontal demand curve is perfectly elastic.

60 © 2015 Pearson Education, Inc. Do People Respond to Changes in the Price of Gasoline? We can now use our knowledge to answer this question in economic terms. Gasoline demand is inelastic: the quantity demanded does not change much as the price of gasoline changes. It is not perfectly inelastic: it is somewhat responsive to price. Which panel shows this?

62 © 2015 Pearson Education, Inc. What Determines the Price Elasticity of Demand? Why do some goods have a high price elasticity of demand, while others have a low price elasticity of demand? There are several characteristics of the good, of the market, etc. that determine this. 1.The availability of close substitutes If a product has more substitutes available, it will have more elastic demand. Example: There are few substitutes for gasoline, so its price elasticity of demand is low. Example: There are many substitutes for Nikes (Reeboks, Adidas, etc.), so their price elasticity of demand is high.

63 © 2015 Pearson Education, Inc. More Determinants of the Price Elasticity of Demand 2.The passage of time Over time, people can adjust their buying habits more easily. Elasticity is higher in the long run than the short run. Example: If the price of gasoline rises, it takes a while for people to adjust their gasoline consumption. How might they do that? Buying a more fuel-efficient car Moving closer to work 3.Whether the good is a luxury or a necessity People are more flexible with luxuries than necessities, so price elasticity of demand is higher for luxuries. Example: Many people consider milk and bread necessities; they will buy them every week almost regardless of the price. And if the price goes down, they won’t drastically increase their consumption of bread or milk.

64 © 2015 Pearson Education, Inc. Yet More Determinants of the Price Elasticity of Demand 4.The definition of the market The more narrowly defined the market, the more substitutes are available, and hence the more elastic is demand. Example: You might believe there is no good substitute for jeans, so your demand for jeans is very inelastic. But if you consider different brands of jeans, you might be more sensitive to the price of a particular brand. 5.The share of a good in a consumer’s budget If a good is a small portion of your budget, you will likely not be very sensitive to its price. Example: You might buy table salt once a year or less; changes in its price will not affect very much how much you buy. Example: Changes in the price of housing do affect where people choose to live.

65 © 2015 Pearson Education, Inc. Some Real-World Price Elasticities of Demand Estimated real-world price elasticities of demand Table 6.2 Product Estimated ElasticityProduct Estimated Elasticity Books (Barnes & Noble)–4.00Bread–0.40 Books (Amazon)–0.60Water (residential use)–0.38 DVDs (Amazon)–3.10Chicken–0.37 Post Raisin Bran–2.50Cocaine–0.28 Automobiles–1.95Cigarettes–0.25 Tide (liquid detergent) –3.92 Beer –0.29 Coca-Cola –1.22 Catholic school attendance –0.19 Grapes–1.18Residential natural gas–0.09 Restaurant meals–0.67Gasoline–0.06 Health insurance (low-income households) –0.65Milk–0.04 Sugar–0.04

66 © 2015 Pearson Education, Inc. Making the Connection Price Elasticity of Demand for Breakfast Cereal What is the price elasticity of demand for breakfast cereal? The answer depends on whether you mean: A particular brand of a particular breakfast cereal A particular category of breakfast cereal Breakfast cereal in general The further down the list we go, the more broadly the market is defined, and hence the fewer close substitutes are available. So we would expect the price elasticity of demand to become smaller as we move down the list. And so it does: Cereal Price elasticity of demand Post Raisin Bran–2.5 All family breakfast cereals–1.8 All types of breakfast cereal–0.9

LEARNING OBJECTIVE 67 © 2015 Pearson Education, Inc. The Relationship between Price Elasticity of Demand and Total Revenue 6.3 Understand the relationship between the price elasticity of demand and total revenue.

68 © 2015 Pearson Education, Inc. Elasticity and the Pricing Decision If you are a business owner, you need to decide how to price your product. “How many customers will I gain if I cut my price?” “What will happen to my total revenue if I cut my price?” Total revenue: The total amount of funds received by a seller of a good or service, calculated by multiplying the price per unit by the number of units sold. Knowing the price elasticity of demand for your product can help to answer these questions.

69 © 2015 Pearson Education, Inc. Effect of Cutting Price with Different Elasticities Suppose demand for your product is relatively price inelastic. Customers are not very sensitive to the price of your product. As you decrease the price, you expect to gain few additional customers. The few additional customers do not compensate for the lost revenue, so overall revenue goes down. Suppose demand for your product is relatively price elastic. Customers are very sensitive to the price of your product. As you decrease the price, you expect to gain many additional customers. The many additional customers more than compensate for the lost revenue, so overall revenue goes up.

70 © 2015 Pearson Education, Inc. Cutting Price When Demand Is Inelastic Revenue before price cut (at A): 1,000 x $4.00 = $4,000 Revenue after price cut (at B): 1,050 x $3.70 = $3,885 The decrease in price does not generate enough extra customers (area E) to offset revenue loss (area C). The relationship between price elasticity and total revenue Figure 6.2a

71 © 2015 Pearson Education, Inc. Cutting Price When Demand Is Elastic Revenue before price cut (at A): 1,000 x $4.00 = $4,000 Revenue after price cut (at B): 1,200 x $3.70 = $4,440 The decrease in price generates enough extra customers (area E) to more than offset revenue loss (area C). The relationship between price elasticity and total revenue Figure 6.2b

72 © 2015 Pearson Education, Inc. Why Are Elasticity and Total Revenue Related? The formula for price elasticity of demand is: So if this is greater than 1 (in absolute terms) then quantity demanded goes up by a higher percentage than price, raising the revenue. A special case occurs when price elasticity of demand is -1: the percentage change in quantity demanded equals the percentage change in price, so revenue does not change.

73 © 2015 Pearson Education, Inc. Total Revenue Along a Linear Demand Curve Suppose we have a linear demand curve. What happens to total revenue as price increases? Initially, total revenue rises, suggesting demand is inelastic. But then total revenue starts to fall, suggesting demand is elastic! Elasticity is not constant along a linear demand curve Figure 6.3

74 © 2015 Pearson Education, Inc. Total Revenue Along a Linear Demand Curve—cont. The data from the table are plotted in the graphs. As price decreases from $8, revenue rises—hence demand is elastic. As price continues to fall, revenue eventually flattens out—demand is unit elastic. Then as price falls even further, revenue begins to fall—demand is inelastic. Elasticity is not constant along a linear demand curve Figure 6.3

75 © 2015 Pearson Education, Inc. Price Elasticity of Demand and Revenue The relationship between price elasticity and revenue Table 6.3 If demand is…then...because... elastican increase in price reduces revenue the decrease in quantity demanded is proportionally greater than the increase in price. elastica decrease in price increases revenue the increase in quantity demanded is proportionally greater than the decrease in price. inelastican increase in price increases revenue the decrease in quantity demanded is proportionally smaller than the increase in price. inelastica decrease in price reduces revenue the increase in quantity demanded is proportionally smaller than the decrease in price. unit elastican increase in price does not affect revenue the decrease in quantity demanded is proportionally the same as than the increase in price. unit elastica decrease in price does not affect revenue the increase in quantity demanded is proportionally the same as than the decrease in price.

76 © 2015 Pearson Education, Inc. Estimating Price Elasticity of Demand We can see that knowing the price elasticity of demand would be very useful for a firm. But how can a firm know this information? For a well-established product, economists can use historical data to estimate the demand curve. To calculate the price elasticity of demand for a new product, firms often rely on market experiments. With market experiments, firms try different prices and observe the change in quantity demanded that results.

LEARNING OBJECTIVE 77 © 2015 Pearson Education, Inc. Other Demand Elasticities 6.4 Define cross-price elasticity of demand and income elasticity of demand and understand their determinants and how they are measured.

78 © 2015 Pearson Education, Inc. Cross-Price Elasticity of Demand When we examined demand in Chapter 3, we discussed substitutes and complements. Substitutes: Goods and services that can be used for the same purpose. Complements: Goods and services that are used together. Cross-price elasticity of demand measures the strength of substitute or complement relationships between goods:

79 © 2015 Pearson Education, Inc. Summary of the Cross-Price Elasticity of Demand Summary of cross-price elasticity of demand Table 6.4 If the products are… then the cross- price elasticity of demand will be…Example substitutespositiveTwo brands of tablet computers complementsnegativeTablet computers and applications downloaded from online stores unrelatedzeroTablet computers and peanut butter

80 © 2015 Pearson Education, Inc. Income Elasticity of Demand When we examined demand in Chapter 3, we discussed normal and inferior goods. Normal goods: Goods and services for which the quantity demanded increases as income increases Inferior goods: Goods and services for which the quantity demanded falls as income increases Income elasticity of demand measures the strength of the effect of income on quantity demanded:

81 © 2015 Pearson Education, Inc. Summary of Income Elasticity of Demand Summary of income elasticity of demand Table 6.5 If the income elasticity of demand is…then the good is…Example positive but less than 1normal and a necessityBread positive and greater than 1normal and a luxuryCaviar negativeinferior Ramen noodles Necessity: A normal good with a quantity demanded that responds less than proportionally to a price change. Luxury: A normal good with a quantity demanded that responds more than proportionally to a price change.

82 © 2015 Pearson Education, Inc. Making the Connection Elasticities of Alcoholic Beverages Christopher Ruhm of the University of Virginia and colleagues estimated elasticities for various alcoholic beverages. According to their study: Demand for beer is price inelastic. Beer and wine are complements. Beer and spirits are also complements, but the relationship is not as strong. Beer is a normal good; a necessity. Price elasticity of demand for beer −0.30 Cross-price elasticity of demand between beer and wine −0.83 Cross-price elasticity of demand between beer and spirits −0.50 Income elasticity of demand for beer 0.09 Are any of these results surprising to you? Why or why not?

LEARNING OBJECTIVE 83 © 2015 Pearson Education, Inc. The Price Elasticity of Supply and Its Measurement 6.6 Define price elasticity of supply and understand its main determinants and how it is measured.

84 © 2015 Pearson Education, Inc. Price Elasticity of Supply Price elasticity of supply is very much analogous to price elasticity of demand: So the same sort of calculation methods apply (midpoint formula, etc.)

85 © 2015 Pearson Education, Inc. Determinants of the Price Elasticity of Supply Price elasticity of supply depends on the ability and willingness of firms to alter the quantity they produce as price increases. The time period in question is critically important for determining the price elasticity of supply. Suppose the wholesale price of grapes doubled overnight: Farmers could do little to increase their quantity immediately; the initial price elasticity of supply would be close to 0. Over time, farmers could plant more fields in grapes; so over the course of several years, the price elasticity of supply would rise.

86 © 2015 Pearson Education, Inc. Making the Connection Why Are Oil Prices So Unstable? Oil producers cannot change output very quickly. When demand increases suddenly, price rises, acting as a rationing mechanism for the increased demand. On the other hand, during a recession, demand for oil falls. Oil producers cannot adjust their output quickly, so the price falls dramatically.

87 © 2015 Pearson Education, Inc. Terminology for Price Elasticity of Supply—part 1 Much the same terminology applies to price elasticity of supply as to price elasticity of demand: elastic, inelastic, unit-elastic, perfectly elastic, and perfectly inelastic all have similar meanings. Summary of the price elasticity of supply Table 6.6 If supply is… then the value of price elasticity is…

90 © 2015 Pearson Education, Inc. Why Is Knowing Price Elasticity of Supply Useful? Knowing the price elasticity of supply can help us to predict the effect that a change in demand will have. When demand increases, we know equilibrium price and quantity will increase. But if supply is inelastic, quantity supplied cannot change much in response to the demand change; so price will rise a lot. If supply is elastic, price will rise much less. The next two slides illustrate these statements.

91 © 2015 Pearson Education, Inc. Parking on the 4 th of July—Inelastic Supply Demand Typical represents the typical demand for parking spaces on a summer weekend at a beach resort. Demand July 4 represents demand on the 4 th of July. When supply is inelastic, the price increase will be large. Changes in price depend on the price elasticity of supply Figure 6.5a

92 © 2015 Pearson Education, Inc. Parking on the 4 th of July—Elastic Supply If supply is elastic instead, then the resulting price change will be much smaller. Changes in price depend on the price elasticity of supply Figure 6.5b

93 © 2015 Pearson Education, Inc. Summary of Elasticities—part 1 Summary of elasticitiesTable 6.7 Price Elasticity of Demand Absolute Value of Price Elasticity Effect on Total Revenue of an Increase in Price ElasticGreater than 1Total revenue falls InelasticLess than 1Total revenue rises Unit elasticEqual to 1Total revenue unchanged

94 © 2015 Pearson Education, Inc. Summary of Elasticities—part 2 Summary of elasticitiesTable 6.7 Cross-Price Elasticity of Demand Types of ProductsValue of Cross-Price Elasticity SubstitutesPositive ComplementsNegative UnrelatedZero Income Elasticity of Demand Types of ProductsValue of Income Elasticity Normal and a necessityPositive but less than 1 Normal and a luxuryPositive and greater than 1 InferiorNegative

95 © 2015 Pearson Education, Inc. Summary of Elasticities—part 3 Summary of elasticitiesTable 6.7 Price Elasticity of Supply Value of Price Elasticity ElasticGreater than 1 InelasticLess than 1 Unit elasticEqual to 1

ECN1A Week 2 Ch. 3 Supply and Demand Ch. 6 Elasticity.

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ECN1A Week 2 Ch. 3 Supply and Demand Ch. 6 Elasticity.

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Presentation on theme: "ECN1A Week 2 Ch. 3 Supply and Demand Ch. 6 Elasticity."— Presentation transcript:

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