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Chapter 20 - Demand and Supply Elasticity1 Learning Objectives Express and calculate price elasticity of demand Understand the relationship between the price elasticity of demand and total revenues Discuss the factors that determine the price elasticity of demand

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Chapter 20 - Demand and Supply Elasticity2 Learning Objectives Describe the cross price elasticity of demand and how it may be used to indicate whether two goods are substitutes or complements Explain the income elasticity of demand Classify supply elasticities and explain how the length of time for adjustment affects the price elasticity of supply

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Chapter 20 - Demand and Supply Elasticity3 Did You Know That... Consumers respond to changing prices in ways that influence total revenues that businesses receive? Economists have a special name for quantity responsiveness—elasticity, which is the subject of this chapter?

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Chapter 20 - Demand and Supply Elasticity4 Price Elasticity Price Elasticity of Demand (E p ) –The responsiveness of quantity demanded of a commodity to changes in its price –Defined as the percentage change in quantity demanded divided by the percentage change in price

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Chapter 20 - Demand and Supply Elasticity5 Price Elasticity Price Elasticity of Demand (E p ) E p = Percentage change in quantity demanded Percentage change in price

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Chapter 20 - Demand and Supply Elasticity6 E p = –1% +10% = –.1 Price Elasticity Example –Price of oil increases 10% –Quantity demanded decreases 1%

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Chapter 20 - Demand and Supply Elasticity7 Price Elasticity Question –How would you interpret an elasticity of –0.1? Answer –A 10% increase in the price of oil will lead to a 1% decrease in quantity demanded.

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Chapter 20 - Demand and Supply Elasticity8 Price Elasticity Relative quantities only –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. –By convention, the minus sign is ignored.

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Chapter 20 - Demand and Supply Elasticity9 Calculating Elasticity Elasticity formula: Change in Q Sum of quantities/2 Ep =Ep = Change in P Sum of quantities/2 or in Q (Q 1 + Q 2 )/2 Ep =Ep = in P (P 1 + P 2 )/2

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Chapter 20 - Demand and Supply Elasticity10 Price Elasticity Ranges Elastic Demand –Percentage change in quantity demanded is larger than the percentage change in price –Total expenditures and price are inversely related in the elastic region of the demand curve –E p > 1

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Chapter 20 - Demand and Supply Elasticity11 Price Elasticity Ranges Unit Elasticity of Demand –Percentage change in quantity demanded is equal to the percentage change in price –Total expenditures are invariant to price changes in the unit-elastic region of the demand curve –E p = 1

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Chapter 20 - Demand and Supply Elasticity12 Price Elasticity Ranges Inelastic Demand –Percentage change in quantity demanded is smaller than the percentage change in price –Total expenditures and price are directly related in the inelastic region of the demand curve –E p < 1

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Chapter 20 - Demand and Supply Elasticity13 Price Elasticity Ranges Elastic demand –% change in Q > % change in P; E p > 1 Unit-elastic –% change in Q = % change in P; E p = 1 Inelastic demand –% change in Q < % change in P; E p < 1

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Chapter 20 - Demand and Supply Elasticity14 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. A demand that exhibits zero responsiveness to price changes.

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Chapter 20 - Demand and Supply Elasticity15 Extreme Price Elasticities

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Chapter 20 - Demand and Supply Elasticity16 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.

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Chapter 20 - Demand and Supply Elasticity17 Extreme Price Elasticities

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Chapter 20 - Demand and Supply Elasticity18 Elasticity and Total Revenues When demand is elastic, a negative relationship exists between changes in price and changes in total revenues. When demand is unit-elastic, changes in price do not change total revenues. When demand is inelastic, a positive relationship exists between changes in price and total revenues.

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Chapter 20 - Demand and Supply Elasticity19 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service

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Chapter 20 - Demand and Supply Elasticity20 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service

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Chapter 20 - Demand and Supply Elasticity21 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service

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Chapter 20 - Demand and Supply Elasticity22 Elasticity and Total Revenues Elasticity-revenue relationship –Total revenues are the product of price times units sold. –The law of demand states along a given curve, price is inverse to quantity.

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Chapter 20 - Demand and Supply Elasticity23 Elasticity and Total Revenues What happens to the product of price times quantity depends on which of the opposing forces exerts a greater force on total revenues. This is what price elasticity of demand is designed to measure: responsiveness of quantity demanded to a change in price.

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Chapter 20 - Demand and Supply Elasticity24 Relationship Between Price Elasticity of Demand and Total Revenues Example

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Chapter 20 - Demand and Supply Elasticity25 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.

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Chapter 20 - Demand and Supply Elasticity26 Determinants of Price Elasticity of Demand The length of time allowed for adjustment –The longer any price change persists, the greater is the elasticity of demand. –Price elasticity is greater in the long run than in the short run.

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Chapter 20 - Demand and Supply Elasticity27 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.

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Chapter 20 - Demand and Supply Elasticity28 In the short run, quantity demanded falls slightly Short-Run and Long-Run Price Elasticity of Demand With more time for adjustment the demand curve becomes more elastic and quantity demanded falls by a greater amount

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Chapter 20 - Demand and Supply Elasticity29 Price Elasticities of Demand for Selected Goods

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Chapter 20 - Demand and Supply Elasticity30 Cross Price Elasticity of Demand Cross Price Elasticity of Demand (E xy ) –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

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Chapter 20 - Demand and Supply Elasticity31 Cross Price Elasticity of Demand Formula for computing cross price elasticity of demand between good X and good Y % Change in demand for good X % Change in price of good Y E xy =

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Chapter 20 - Demand and Supply Elasticity32 Cross Price Elasticity of Demand Substitutes –E xy would be positive An increase in the price of X would increase the quantity of Y demanded at each price. Complements –E xy would be negative An increase in the price of X would decrease the quantity of Y demanded at each price.

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Chapter 20 - Demand and Supply Elasticity33 Income Elasticity of Demand Income Elasticity of Demand (E i ) –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

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Chapter 20 - Demand and Supply Elasticity34 Income Elasticity of Demand Percentage change in demand Percentage change in income Ei =Ei =

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Chapter 20 - Demand and Supply Elasticity35 How Income Affects Quantity of DVDs Demanded

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Chapter 20 - Demand and Supply Elasticity36 Income Elasticity of Demand Income Elasticity of Demand –Refers to a horizontal shift in the demand curve in response to changes in income Price Elasticity of Demand –Refers to a movement along the curve in response to price changes

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Chapter 20 - Demand and Supply Elasticity37 Income Elasticity of Demand Calculating the income elasticity of demand E i = 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.

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Chapter 20 - Demand and Supply Elasticity38 Price Elasticity of Supply Price Elasticity of Supply (E s ) –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

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Chapter 20 - Demand and Supply Elasticity39 Percentage change in quantity supplied Percentage change in price ES =ES = Price Elasticity of Supply Formula for computing price elasticity of supply

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Chapter 20 - Demand and Supply Elasticity40 Price Elasticity of Supply Classifying supply elasticities –Perfectly Elastic Supply Quantity supplied falls to zero when there is the slightest decrease in price The supply curve is horizontal at a given price

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Chapter 20 - Demand and Supply Elasticity41 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

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Chapter 20 - Demand and Supply Elasticity42 The Extremes in Supply Curves

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Chapter 20 - Demand and Supply Elasticity43 Price Elasticity of Supply Price elasticity of supply and length of time for adjustment 1.The longer the time allowed for adjustment, the more resources can flow into (out of) an industry through expansion (contraction) of existing firms. 2.The longer the time allowed for adjustment, the entry (exit) of firms increases (decreases) production in an industry.

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Chapter 20 - Demand and Supply Elasticity44 Short-Run and Long-Run Price Elasticity of Supply As time passes the supply curve rotates from S 1 to S 2 and quantity supplied rises to Q 1 As more time passes the supply curve rotates from S 2 to S 3 and quantity supplied rises from Q 1 to Q 2

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Chapter 20 - Demand and Supply Elasticity45 Estimated Price Elasticities of Demand for Selected Illicit Drugs

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Chapter 20 - Demand and Supply Elasticity46 Summary Discussion of Learning Objectives Expressing and calculating the price elasticity of demand –Percentage change in quantity demanded divided by the percentage change in price

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Chapter 20 - Demand and Supply Elasticity47 Summary Discussion of Learning Objectives The relationship between the price elasticity of demand and total revenues –When demand is elastic, price and total revenue are inversely related. –When demand is inelastic, price and total revenue are positively related. –When demand is unit-elastic, total revenue does not change when price changes.

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Chapter 20 - Demand and Supply Elasticity48 Summary Discussion of Learning Objectives Factors that determine price elasticity of demand –Availability of substitutes –Percentage of a person’s budget spent on the good –The length of time allowed for adjustment to a price change

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Chapter 20 - Demand and Supply Elasticity49 Summary Discussion of Learning Objectives The cross price elasticity of demand and using it to determine whether two goods are substitutes or complements –Percentage change in the demand for one good divided by the percentage change in the price of a related good –If cross elasticity is positive, the goods are substitutes. –If cross elasticity is negative, the goods are complements.

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Chapter 20 - Demand and Supply Elasticity50 Summary Discussion of Learning Objectives Income elasticity of demand –Responsiveness of the demand for the good to a change in income –Percentage change in the demand for a good divided by the percentage change in income.

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Chapter 20 - Demand and Supply Elasticity51 Summary Discussion of Learning Objectives Classifying supply elasticities and how the length of time for adjustment affects price elasticity of supply –Elastic supply: price elasticity of supply is greater than 1 –Inelastic supply: price elasticity of supply is less than 1 –Unit-elastic supply: price elasticity of supply is equal to 1 –The longer the time period for adjustment, the more elastic is supply.

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