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

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. 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

8. 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

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

14. 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.

15. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphs of Elasticities Price Quantity of software (in hundred thousands) $26 24 22 20 18 16 14 0 D B A 101214 C (midpoint) Elasticity of demand between A and B = 1.27

16. 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 $6.00 5.50 5.00 4.50 4.00 3.50 3.00 0 C B A 470 (midpoint) 480 490

17. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphs of Elasticities Price Quantity $10 9 8 7 6 5 4 3 2 1 C D F E B A 515 E = 0.54 E = 0.67 E = 4 3540455025302010

18. 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.

19. 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.

20. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating Elasticity at a Point Price Quantity $10 9 8 7 6 5 4 3 2 1 C B A 2440 2820

21. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating Elasticity at a Point 612183036 4248 Price Quantity 8 7 6 5 4 3 2 1 $10 9 A 24 6054 D B C Supply E A = 2.33 E B = 0.11 Demand E C = 0.75 E D = 0.86

22. 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.

23. 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.

24. 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 =  ).

25. 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).

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

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

28. 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.

29. 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.

30. 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.

31. 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.

32. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Price $10 9 8 7 6 5 4 3 2 1 012345678910Quantity 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

33. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity Along a Supply Curve Price $10 9 8 7 6 5 4 3 2 1 0012345678910Quantity E s rises E s =  E s = 0 S1S1 S0S0 E s declines

34. 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).

35. 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).

36. 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).

37. 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.

38. 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.

39. 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.

40. 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.

41. 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.

42. 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.

43. 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.

44. 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.

45. 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.

46. 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.

47. 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.

48. 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.

49. 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.

50. 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.

51. 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.

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

53. 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.

54. 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.

55. 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.

56. 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.

57. A (a) Unit Elastic Demand E = 1 Elasticity and Total Revenue TR constant C 0 6 Price Quantity $10 8 6 4 2 12345789 B E Lost revenue F Gained revenue McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

58. A Price (b) Inelastic Demand E < 1 Quantity $10 8 6 4 2 0 123456789 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.

59. A Price (c) Elastic Demand E = 1 Quantity $10 8 6 4 2 0 123456789 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.

60. 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.

61. 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

62. 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.

63. 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.

64. 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.

65. 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.

66. 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.

67. 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.

68. 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.

69. 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.

70. 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.

71. 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.

72. 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.

73. 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.

74. 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.

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

76. 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.

77. 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.

78. 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.

79. 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.

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

81. 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

82. 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

83. 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.

84. 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.

85. 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.

86. 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.

87. 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.

88. 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

89. 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

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