Elasticities of demand and supply

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Elasticities of demand and supply
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The price responsiveness of demand

• The price elasticity of demand is the
  percentage change in the quantity demanded
  divided by the corresponding percentage change in
  its price.

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• Although we later introduce other demand
  elasticities - the cross-price elasticity and
  the income elasticity - the (own)-price
  elasticity is the most often used of the three.
  If economists speak of the demand elasticity they
  mean the price elasticity of demand, as defined
  above.
• If a 1 per cent price rise reduces the quantity
  demanded by 2 per cent, the demand elasticity is
  2. The minus sign tells us quantity falls when
  price rises. If a price fall of 4 per cent
  increases the quantity demanded by 2 per cent,
  the demand elasticity is 1/2 since the quantity
  change (2 per cent) is divided by the price
  change (-4 per cent). Since demand curves slope
  down, price and quantity changes always have
  opposite signs. The price elasticity of demand
  tells us about movements along a demand curve.
  The demand elasticity is a negative number.

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Determinants of price elasticity

• Consider two extreme cases. Suppose the price
  of all cigarettes rises by 1 per cent. The
  quantity of cigarettes demanded will hardly
  respond. People who can easily quit smoking have
  already done so. In contrast, suppose the price
  of a particular brand of cigarettes rises by 1
  per cent, all other brand prices remaining
  unchanged. We expect a much larger quantity
  response. Consumers switch from the dearer brand
  to other brands that also satisfy the nicotine
  habit. For a particular cigarette brand the
  demand elasticity is quite high.
• Our example suggests a general rule. The more
  narrowly we define a commodity (a particular
  brand of cigarette rather than cigarettes in
  general), the higher will be the price elasticity
  of demand

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Table 4-1 The demand for football tickets
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• The price elasticity of demand for football
  tickets is shown in column (3) of Table 4-1.
  Examining the effect of price cuts of 2.50, we
  calculate the price elasticity of demand at each
  price. Beginning at 10 and 20 000 tickets
  demanded, consider a price cut to 7.50. The
  price change is 25 per cent, from 10 to 7.50,
  the change in quantity demanded is 100 per cent,
  from 20000 to 40000 tickets. The demand
  elasticity at 10 is (100/25) 4. Other
  elasticities are calculated in the same way,
  dividing the percentage change in quantity by the
  corresponding percentage change in price. When we
  begin from the price of 12.50 the demand
  elasticity is minus infinity. The percentage
  change in quantity demanded is 20/0. Any
  positive number divided by zero is infinity.
  Dividing by the 20 per cent change in price,
  from 12.50 to 10.00, the demand elasticity is
  minus infinity at this price.

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• We say that the demand elasticity is high if it
  is a large negative number. The quantity demanded
  is sensitive to the price. The demand elasticity
  is low if it is a small negative number and the
  quantity demanded is insensitive to the price.
  'High' or 'low refer to the size of the
  elasticity ignoring the minus sign. The demand
  elasticity falls when it becomes a smaller
  negative number and quantity demanded becomes
  less sensitive to the price.

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Figure 4-1 The demand for football tickets

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• The demand curve for football tickets is a
  straight line with constant slope along its
  entire length a 1 cut in price always leads to
  8000 extra ticket sales. Yet Table 4-1 shows the
  demand elasticity falls as we move down the
  demand curve from higher prices to lower prices.
  At high prices, 1 is a small percentage change
  in the price but 8000 tickets is a large
  percentage change in the quantity demanded.
  Conversely, at low prices 1 is a large
  percentage change in the price but 8000 is a
  small percentage change in the quantity. When the
  demand curve is a straight line, the price
  elasticity falls steadily as we move down the
  demand curve.

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• Demand is elastic if the price elasticity is
  more negative than 1. Demand is inelastic if
  the price elasticity lies between 1 and 0. If
  the demand elasticity is exactly 1, demand is
  unelastic.

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Measuring price elasticities
Table 4-2 UK price elasticities of demand
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• Table 4-2 confirms that the demand for broad
  categories of basic commodities, such as fuel,
  food, or even household durable goods, is
  inelastic. As a category, only services such as
  haircuts, the theatre, and sauna baths, have an
  elastic demand. Households simply do not have
  much scope to alter the broad pattern of their
  purchases.
• In contrast, there is a much wider variation in
  the demand elasticities for narrower definitions
  of commodities. Even then, the demand for some
  commodities, such as dairy produce, is very
  inelastic. However, particular kinds of services
  such as entertainment and catering have much
  more elastic demand.

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Using price elasticities

• Price elasticities of demand are useful in
  calculating the price rise required to eliminate
  a shortage (excess demand) or the price fall to
  eliminate a surplus (excess supply). One
  important source of surpluses and shortages is
  shifts in the supply curve. Harvest failures (and
  bumper crops) are a feature of agricultural
  markets. Because the demand elasticity for many
  agricultural products is very low, harvest
  failures produce large increases in the price of
  food. Conversely, bumper crops induce very large
  falls in food prices. When demand is very
  inelastic, shifts in the supply curve lead to
  large fluctuations in price but have little
  effect on equilibrium quantities

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Price, quantity demanded, and total expenditure

• Other things equal, the demand curve shows how
  much consumers of a good wish to purchase at each
  price. At each price, total spending by consumers
  is the price multiplied by the quantity demanded.
  We now discuss the relation between total
  spending and price, and show the relevance of the
  price elasticity of demand.

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Short run and long run

• The price elasticity of demand varies with time
  in which consumers can adjust their spending
  patterns when prices change. The most dramatic
  price change of the last 50 years, the oil price
  rise of 1973-74, caught many households with a
  new but fuel-inefficient car. At first, they may
  not have expected the higher oil price to last.
  Then they may have planned to buy a smaller car
  with greater fuel economy. But in countries like
  the US few small cars were yet available. In the
  short run, households were stuck. Unless they
  could rearrange their lifestyles to reduce car
  use, they had to pay the higher petrol prices.
  Demand for petrol was inelastic.

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• Over a longer period, consumers had time to
  sell their big cars and buy cars with better fuel
  economy, or to move from the distant suburbs
  closer to their place of work. Over this longer
  period, they could reduce the quantity of petrol
  demanded much more than initially.
• The price elasticity of demand is lower in the
  short run than in the long run when there is more
  scope to substitute other goods. This result is
  very general. Even if addicted smokers can't
  adjust to a rise in the price of cigarettes,
  fewer young people start smoking and gradually
  the number of smokers falls.

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• How long is the long run?
• The short run is the period after prices change
  but before quantity adjustment can occur. The
  long run is the period needed for complete
  adjustment to a price change. Its length depends
  on the type of adjustments consumers wish to make.

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The cross-price elasticity of demand

• The cross-price elasticity of demand for good i
  with respect to changes in the price of good j is
  the percentage change in the quantity of good i
  demanded, divided by the corresponding percentage
  change in the price of good j.

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Table 4-6 Cross-price and own-price
elasticities of demand in the UK
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• Table 4-6 shows estimates for the UK. Own-price
  elasticities for food, clothing, and travel are
  given down the diagonal of the table, from top
  left (the own-price elasticity of demand for
  food) to bottom right (the own-price elasticity
  of demand for travel). Off-diagonal entries in
  the table show cross-price elasticities of
  demand. Thus, 0.1 is the cross-price elasticity
  of demand for food with respect to travel. A 1
  per cent increase in the price of travel
  increases the quantity of food demanded by 0.1
  per cent.
• The own-price elasticities for the three goods
  lie between 0.4 and 0.5. For all three goods
  the quantity demanded is more sensitive to
  changes in its own price than to changes in the
  price of any other good.

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The effect of income on demand

• Finally, holding constant the own price of a
  good and the prices of related goods, we examine
  the response of the quantity demanded to changes
  in consumer incomes. For the moment we neglect
  the possibility of saving. Thus a rise in the
  income of consumers will typically be matched by
  an equivalent increase in total consumer spending.

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• The budget share of a good is its price times
  the quantity demanded, divided by total consumer
  spending or income
• The income elasticity of demand for a good is
  the percentage change in quantity demanded
  divided by the corresponding percentage change in
  income.

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Normal, inferior, and luxury goods

• The income elasticity of demand measures how
  far the demand curve shifts horizontally when
  incomes change. Figure 4-5 shows two possible
  shifts caused by a given percentage increase in
  income. The income elasticity is larger if the
  given rise in income shifts the demand curve from
  DD to D"D" than if the same income rise shifts
  the demand curve only from DD to D'D'. When an
  income rise shifts the demand curve to the left,
  the income elasticity of demand is a negative
  number, indicating that higher incomes are
  associated with smaller quantities demanded at
  any given prices.

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• A normal good has a positive income elasticity
  of demand. An inferior good has a negative income
  elasticity of demand.
• We also distinguish luxury goods and necessities.
• A luxury good has an income elasticity above
  unity. A necessity has an income elasticity below
  unity.
• All inferior goods are necessities, since their
  income elasticities of demand are negative.
  However, necessities also include normal goods
  whose income elasticity of demand lies between
  zero and one.

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Inflation and demand

• Elasticities measure the response of quantity
  demanded to separate variations in three factors
  -the own price, the price of related goods, and
  income. Chapter 2 distinguished nominal
  variables, measured in the prices of the day, and
  real variables, which adjust for inflation when
  comparing measurements at different dates. We end
  this chapter by examining the effect of inflation
  on demand behaviour.

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Elasticity of supply

• Whereas the analysis of demand elasticities is
  quite tricky, the analysis of supply elasticities
  is refreshingly simple. We really need only keep
  track of the supply response to an increase in
  the own price of a good or service. The
  elasticity of supply measures the responsiveness
  of the quantity supplied to a change in the price
  of that commodity.
• Supply change in quantity supplied
• elasticity change in price

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Who realty pays the tax?

• By spending and taxing, the government affects
  resource allocation in the economy. By taxing
• cigarettes, the government can reduce the amount
  of cigarettes smoked and thereby improve health.
  By taxing fuel it can discourage pollution,
  though it may incur the wrath of lorry drivers
  and motorists. By taxing income earned from work,
  the government affects the amount of time people
  want to work. Taxes loom large in the workings of
  a mixed economy and have a profound effect on the
  way society allocates its scarce resources.

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Consumer choice and demand decisions
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Demand by a single consumer

• The budget constraint
• A consumer's income and the market prices of
  goods define her budget constraint.
• The budget constraint describes the different
  bundles that the consumer can afford.
• Consider a student with a weekly budget
  (income, allowance, or grant) of 50 to be spent
  on meals or films. Each meal costs 5 and each
  film 10. What combination of meals and films can
  she afford? Going without films, she can spend
  50 on 10 meals at 5 each. Going without meals,
  she can buy 5 cinema tickets at 10 each. Between
  these two extremes lie many combinations of meals
  and films that together cost exactly 50. These
  combinations are called the budget constraint.

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• The budget constraint shows the maximum
  affordable quantity of one good given the
  quantity of the other good being purchased.

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• The marginal rate of substitution of meals for
  films is the quantity of films the consumer must
  sacrifice to increase the quantity of meals by
  one unit without changing total utility.
• Consumers prefer more to less. An extra meal
  increases utility. To hold utility constant when
  a meal is added, the consumer must sacrifice some
  of the other good (films). The marginal rate of
  substitution tells us how many films the consumer
  could exchange for an additional meal without
  changing total utility.

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• Suppose the student has 5 films and no meals.
  Having already seen 4 films, she does not enjoy
  the fifth film much. With no meals, she is very
  hungry. The utility of this bundle is low being
  so hungry, she cannot enjoy films anyway. For the
  same low amount of utility she could give up a
  lot of films for a little food.

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• This common-sense reasoning about tastes or
  preferences is very robust. It can become a
  general principle, the third assumption we need
  to make about consumer tastes. It is the
  assumption of a diminishing marginal rate of
  substitution.
• Consumer tastes exhibit a diminishing marginal
  rate of substitution when, to hold utility
  constant, diminishing quantities of one good will
  be sacrificed to obtain successive equal
  increases in the quantity of the other good.

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Utility maximization and choice

• The budget line shows affordable bundles given
  a consumer's market environment (his budget and
  the price of different goods). The indifference
  map shows his tastes. To complete the model, we
  assume the consumer chooses the affordable bundle
  that maximizes his utility.
• To find which point on the budget line
  maximizes utility we examine the consumer's
  tastes. Our glutton should pick a point with more
  meals and less films than the point our film buff
  selects. We first show how to use indifference
  curves to find the bundle the consumer chooses.
  Then we confirm that our model of consumer choice
  captures the different behaviour of the glutton
  and the film buff.

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Adjustment to price changes

• The substitution effect of a price change is
  the adjustment of demand to the relative price
  change alone. The income effect of a price change
  is the adjustment of demand to the change in real
  income alone.

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The market demand curve

• The market demand curve is the sum of the
• demand curves of all individuals in that market.
• At each price, we find out how much each
  consumer demands. Adding the quantities demanded
  by all consumers at that price, we get the total
  quantity demanded at each price, the market
  demand curve. Since, as price is reduced, each
  person increases the quantity demanded, the total
  quantity demanded must also increase as price
  falls. The market demand curve also slopes
  downwards.
• The market demand curve is the horizontal
  addition of individual demand curves. With prices
  on the vertical axis and quantities on the
  horizontal axis, we must add together individual
  quantities demanded at the same price.

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Complements and substitutes

• Income and substitution effects are used to
  understand the effects of a price change.
  Whatever the direction of the income effect, with
  only two goods the substitution effect is always
  negative. The pure relative price effect leads
  the consumer to substitute away from the good
  whose relative price has risen towards the good
  whose relative price has fallen. Abstracting from
  income effects, goods are necessarily substitutes
  for one another in a two-good world.

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• Even with many goods, there is always a
  substitution effect away from goods whose
  relative price has risen. However, substitution
  may not be towards all other goods. Consumers
  substitute away from goods consumed jointly with
  the good whose price has risen.

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Transfers in kind

• A transfer is a payment, usually by the
  government, for which no corresponding service
  is provided by the recipient. A transfer in kind
  is the gift of a good or service.

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• THE END
• for today..