1. Elasticity and Demand and Supply Applications

2. Review: Comparative Statics
Changes in quantity demand and supplied or movements along the curves
Changes in demand and supply or shifts of the curve
Comparative Statics
Changes in demand
Increase in demand: price increases, quantity increases
Decrease in demand: price decreases, quantity decreases
Changes in supply
Increase in supply: price decreases, quantity increases
Decrease in supply: price increases, quantity decreases

3. Changes in both
Increase in
Demand
Decrease in
Increase in Supply
P ambiguous
Q increases
P decreases
Q ambiguous
Decrease in Supply
P increases
Q decreases

4. Dynamics Shifts in demand or supply create surpluses or shortages
Surpluses cause price to fall and shortages cause price to rise
Increases in prices cause quantity demanded to decrease (law of demand) and quantity supplied to increase (law of supply)
Decreases in prices cause quantity demanded to increase (law of demand) and quantity supplied to decrease (law of supply)
These price changes occur until surpluses or shortages are eliminated at the new equilibrium price and quantity

5. Using Demand and Supply
Step 1: Determine if the change in the determinant affects the demand or supply curve.
Step 2: Determine which way it shifts the curve
Step 3: Determine how the equilibrium price and quantity change (dynamic adjustment)

6. Elasticity: Responsiveness versus Directions
Demand and Supply analysis allows us to see the direction of changes in the equilibrium price and quantity
We need another concept to see how responsive demand and supply are to change in their determinants
The concept that helps us measure that sensitivity is elasticity

7. Price Elasticity of Demand
The concept of elasticity helps understand how responsive demand is to price changes
Intuitively, if we are a businessperson and we want to increase revenues, one important question is whether we increase price or decrease price
Increases in price decreases the quantity demanded, but we get more for each unit we sell
Decreases in price increases the quantity demanded, but we get less for each unit we sell
How can we tell whether the price or the quantity effect wins out to increase our revenues
The answer is the concept of elasticity

8. Definition of Elasticity
Price elasticity of demand =
%change in quantity demanded/
% change in price
Or using symbols: Ep = %ΔQd /%ΔP
For example, if the %ΔQd = 10% and the %ΔP = 2%, the price elasticity of demand = 5, OR for every 1% change in price the quantity demand changes by 5%.

9. Ep > 1 Responsive or elastic Ep < 1 Not responsive or inelastic
%ΔQd > %ΔP
Ep < 1 Not responsive or inelastic
%ΔQd < %ΔP
Ep = 1 unit elastic
%ΔQd = %ΔP

10. BUT I Hate Percentages!!! OK, but they come in mighty handy. Why?
They always measure the change relative to a starting point. (e.g. a $1 increase in your hourly wage is different if you make $5/hr. or $100/hr.)
Absolute changes are affected by changes in the units with which they are measured ( 100 boxes of apples = 5,000 apples, but the later looks like a bigger change)
Percentages are everywhere!!!! (Stores usually use percentage discounts during sales, increases in pay are generally in percentages, batting averages are in percentages, grades are given in percentages)

11. The Farmer’s Dilemma
For many crops, a strange situation arises a bad crop year results in a good year for farm incomes, and a good crop year results in a bad year for farm incomes. How can this be?
Price elasticity gives us the answer:
Bad crop year: supply decreases, prices for farm products rise, but quantity demanded doesn’t fall very much. The quantity demanded of farm products is not very responsive to changes in prices
Good crop year: supply increases, prices for farm products fall, but quantity demanded doesn’t increase very much. The quantity demanded of farm products is not very responsive to changes in prices
It is easy to show this with a graph. But first we need yet another concept: Total Revenue = Price x Quantity

12. Elasticity and Total Revenue
TR = P x Q
If P goes down Q goes up, but what happens to TR?
If P goes up Q goes down, but what happens to TR?
Elasticity can answer the question….

13. Elasticity to the Rescue….
Ep > 1 Responsive or elastic
%ΔQd (10%) > %ΔP (5%) if P goes down (up) total revenue goes up (down)
Ep < 1 Not responsive or inelastic
%ΔQd (5%) < %ΔP (10%) if P goes down (up) total revenue goes down (up)
Ep = 1 unit elastic
%ΔQd (5%)= %ΔP (5%) if P goes down (up) total revenue stays the same

14. The Farm Example
During bad crop years, prices rise and quantity falls (but not that much) so total revenue to farmers goes up.
During good crop years, prices fall and quantity increases (but not that much) so total revenue to farmers goes down.
The graphs….

15. Figure 8 An Increase in Supply in the Market for Wheat
Price of
Wheat
1. When demand is inelastic,
an increase in supply
. . .
leads
to a large fall
in price . . . S1 S2
Demand $3
100 2
110
Quantity of
and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
Wheat
Copyright©2003 Southwestern/Thomson Learning

16. Can Elasticity Tell Us More?
What a minute, first we need to talk about what increases or decreases the price elasticity of demand.
Determinants of Price Elasticity
Availability of close substitutes
Necessity versus luxury
Definition of the market
Time horizon
Percentage of consumer budget

17. Price elasticity of demand
Estimated price elasticities of demand
elasticity coefficient
item short run long run
Airline travel
Medical care
Natural gas
Auto tires
Stationery
Gasoline
Housing
Automobiles
Movies
Jewelry & watches
Radio & TV repair
Foreign travel
Glass, china, etc

18. Elasticity of Supply
How how about the price elasticity of supply? How responsive are suppliers to changes in price?
Price elasticity of supply = %change in quantity supplied/% change in price
Determinants of elasticity of supply:
Flexibility in altering the amount of a good produced.
Time period

19. Price elasticity of supply
Estimated price elasticities of supply
Price elasticity
Vegetable short run long run
Lima beans
Cabbage
Carrots
Cucumbers
Onions
Green peas
Green peppers
Tomatoes
Cauliflower
Celery
Spinach

20. Further Examples of Elasticity
Inelastic demand and addictive drugs:
Supply side prevention
Demand side prevention
Luxury Taxes
Who pays a tax? But with elasticity we find out…
Who really pays the tax? (tax incidence or burden).