Econ 201

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Econ 201 MicroeconomicsChapter 5 Elasticity
of Demand and Supply

• Big Ideas
• Elasticity in Economics refers to the
  responsiveness of demand or supply to changes in
  price.
• Determining elasticity shows the affect of
  price changes on demand and supply and, thus, the
  influence of price change on total revenue.
• We calculate elasticity using simple formulae
  to arrive at a finite number that measures
  elasticity.
• An elasticity value less than one is inelastic
  and relatively unresponsive to price changes,
  while an elasticity value greater than one is
  elastic and relatively responsive to price
  changes.

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Chapter 5 Elasticity of Demand and Supply

• Elasticity
• Elasticity a ratio measuring the
  change in a dependent variable (Effect) as it
  responds to a change in an independent variable
  (Cause)
• Example
• If Quantity Demanded of pizza the Dependent
  Variable
• And if Price of pizza the Independent
  Variable
• Then, Ceteris Paribus, we find the Price
  Elasticity of Demand (ED) for pizza as follows
• ED Change in Quantity Demanded / Change in
  Price
• Economists express this mathematically as
  follows
• q___ __p___
• ED (qq1)/2 / (pp1)/2

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Chapter 5 Elasticity of Demand and Supply

• Elasticity
• Elasticity gauges responsiveness of the
  Dependent Variable as it reacts to a proportional
  change in the Independent Variable. Economists
  always express Elasticity as an Absolute Value -
  a Positive Number.
• Example
• If ED for pizza 2.0, then a 10 drop in price
  results in a 20 increase in Quantity Demanded
  (QD), cetaris paribus.
• The ED 2.0 means Quantity Demanded is very
  sensitive to a Price Change, since the QD
  response is double the price change.
• Two lessons
• We love pizza.
• Elasticity values gt 1 mean the dependent
  variable is very responsive to
  price changes.

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Chapter 5 Elasticity of Demand and Supply

• Elasticity
• Lets examine the business value of
  understanding Elasticity.
• Example
• If ED for pizza 2.0, then a 10 drop in price
  results in a 20 increase in Quantity Demanded
  (QD), cetaris paribus.
• If the Cenex sells 20 pizzas a night at a price
  of 10 per pizza, would Brad Rosa come out ahead,
  if he follows Kaylas advice to offer a sale of
  10 off pizzas?
• Two lessons
• We love pizza.
• Elasticity values gt 1 mean the dependent
  variable is responsive to price
  changes and revenues will
  climb if you drop the price.

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Chapter 5 Elasticity of Demand and Supply
Price Elasticity General Concepts

• Economists use the Average Quantity Demanded
  and Average Price in the Elasticity Formulas.
  This ensures the formula will accurate calculate
  elasticity whether the price is increasing or
  decreasing.
• Elasticity measures percentage change, so we
  dont have to worry about how price or output is
  measured.
• Economists treat elasticity as an absolute
  value, so we always portray it as a positive
  number.

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Chapter 5 Elasticity of Demand and Supply

• Price Elasticity of Demand
• The Law of Demand - a product price decrease will
  increase the quantity demanded of that product,
  ceteris paribus.
• Price Elasticity of Demand measures consumer
  responsiveness to a price change. We used the
  formula for calculating ED as our example earlier
  when we explored the general concept of
  Elasticity.
• q p___
  
• ED (qq1)/2 / (pp1)/2
• ED Change in Quantity Demanded / Change in
  Price
• Notice we use the Avg Quantity Demanded and Avg
  Price.
• Calculating Price Elasticity of Demand helps
  businesses decide whether dropping a price would
  be profitable.
• Prof. Toland uses the terms Arc Elasticity of
  Demand and Ep to express the same concept and
  formula.

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Chapter 5 Elasticity of Demand and Supply
Price Elasticity of Demand - Example

• Movement from Point A to Point B on the Demand
  Curve represents the Change in Quantity Demanded
  based on the price change.
• Formula for Price Elasticity of Demand
• q__ p__
• ED (qq1)/2 / (pp1)/2
• ED
• ED

Price
A
1.10
B
.90
D
95
105
Quantity Thousands/Day
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Chapter 5 Elasticity of Demand and Supply
Categories of Price Elasticity of Demand

• Elastic Demand ED gt 1
• The good or service is highly price sensitive
  or responsive.
• Consumers decrease the quantity demanded more
  than the increase in price or,
• Consumers increase the quantity demanded more
  than the decrease in price.
• Examples goods with many possible substitutes
  such as name brand candy or athletic shoes

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Chapter 5 Elasticity of Demand and Supply
Categories of Price Elasticity of Demand

• Unit or Unitary Elastic Demand ED 1
• The good or service is equally price sensitive
  or responsive.
• Consumers decrease the quantity demanded by
  an amount equal to the increase in price or,
• Consumers increase the quantity demanded by
  an amount equal to the decrease in price.
• Examples Goods/services that are
  approximately unitary elastic include public
  transportation in metro areas.

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Chapter 5 Elasticity of Demand and Supply
Categories of Price Elasticity of Demand

• Inelastic Demand ED lt 1
• The good or service is very price insensitive
  or unresponsive.
• Consumers decrease the quantity demanded less
  than the increase in price or,
• Consumers increase the quantity demanded less
  than the decrease in price.
• Examples household electricity prescription
  drugs, the category of food in general.

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Chapter 5 Elasticity of Demand and Supply
Elasticity and Total Revenue

• Total Revenue (TR) is the price (p) multiplied
  by the quantity demanded (q). TR p x q
• Elasticity reveals the affect of price changes
  on total revenue.
• If the positive effect of a greater quantity
  demanded more than offsets the negative effect
  of a lower price, then total revenue rises.
• Elastic Demand - a price decrease total
  revenue increase, and
• - a price increase total revenue decrease
• Unitary Elastic - a price decrease/increase
  revenue neutral
• Inelastic Demand - a price decrease revenue
  decrease, and
• - a price increase revenue increase

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Chapter 5 Elasticity of Demand and Supply
Price Elasticity and the Linear Demand Curve

• A linear demand curve reveals that consumers
  are more responsive to a given price change when
  the initial price is high.
• The midpoint in a linear demand curve divides
  an elastic upper half and an inelastic lower half.

Price
Elastic ED gt 1
Unit Elastic ED lt 1
Inelastic ED lt 1
D
Quantity
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Chapter 5 Elasticity of Demand and Supply
Price Elasticity and the Linear Demand Curve

• The graph of total revenue generated by a
  linear demand curve shows
• an elastic upper portion generating greater
  revenue
• a mid-point marking maximum revenue and
• an inelastic lower half generating decreasing
  revenue.

Demand Curve
TR
Total Revenue
Mid-Point Quantity
Quantity
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Chapter 5 Elasticity of Demand and Supply
Determinants of Price Elasticity of Demand

• ED tends to be elastic (ED gt 1) when
• Substitutes are readily available (Substitution
  effect)
• The good takes up a large share of the
  consumers budget (Income effect)
• A longer consumer adjustment period
  (Substitution effect)
• Consumer access to transportation and
  communications (Substitution effect)
• ED tends to be inelastic (ED lt 1) when
• Substitutes are less readily available (No
  Substitution effect)
• The good takes up a small share of the
  consumers budget
• The good is an essential or cheap component of a
  final product
• Examples Gasoline, a new luxury car, KFC
  chicken, feeder calves

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Chapter 5 Elasticity of Demand and Supply

• Price Elasticity of Supply
• The Law of Supply - a product price decrease will
  decrease the quantity supplied of that product,
  ceteris paribus.
• Price Elasticity of Supply measures producer
  responsiveness to a price change. The formula
  for calculating Es is essentially the same as for
  ED except the q now represents quantity supplied.
• q p___
  
• Es (qq1)/2 /
  (pp1)/2
• ES Change in Quantity Supplied / Change in
  Price
• Notice we again use the Avg Quantity Supplied and
  Avg Price.
• Calculating Price Elasticity of Supply helps
  businesses decide whether dropping a price would
  be profitable.
• Prof. Toland uses the terms Arc Elasticity of
  Supply to express the same concept and formula.

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Chapter 5 Elasticity of Demand and Supply
Price Elasticity of Supply - Example

• Movement from Point A to Point B on the Supply
  Curve represents the Change in Quantity Supplied
  based on the price change.
• Formula for Price Elasticity of Supply
• _ q__ p___
• ED (qq1)/2 / (pp1)/2
• ED
• ED

S
Price
1.10
B
.90
A
95
105
Quantity Thousands/Day
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Chapter 5 Elasticity of Demand and Supply
Categories of Price Elasticity of Supply

• Elastic Supply Es gt 1
• The good or service is highly price sensitive
  or responsive.
• Producers increase the quantity supplied more
  than the increase in price or,
• Producers decrease the quantity supplied more
  than the decrease in price.
• Examples low marginal cost of increasing
  production, so producers increase profits by
  increasing production

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Chapter 5 Elasticity of Demand and Supply
Categories of Price Elasticity of Supply

• Unit or Unitary Elastic Supply ES 1
• The good or service is equally price sensitive
  or responsive.
• Producers decrease the quantity supplied by
  an amount equal to the decrease in price or,
• Producers increase the quantity supplied by
  an amount equal to the increase in price.
• Examples marginal costs match marginal
  increases in revenue

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Chapter 5 Elasticity of Demand and Supply
Categories of Price Elasticity of Supply

• Inelastic Supply ES lt 1
• The good or service is very price insensitive
  or unresponsive.
• Producers increase the quantity supplied less
  than the increase in price or,
• Producers decrease the quantity supplied less
  than the decrease in price.
• Examples goods where one or more factors of
  production are particularly scarce or goods in
  limited supply

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Chapter 5 Elasticity of Demand and Supply
Determinants of Price Elasticity of Supply

• ES tends to be elastic (ES gt 1) when
• Producers can readily ramp up or cut back
  production in response to
  price changes
• A longer producer adjustment period
  (Substitution effect)
• ES tends to be inelastic (ES lt 1) when
• Factors of production are scarce or unavailable
• Decreasing production incurs excessive costs
• The good is in limited supply
• Examples soda production, flu vaccine, oil
  extraction, deep mines

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Chapter 5 Elasticity of Demand and Supply
Price Elasticity of Supply - Time
Sw
Price
Sm
Sy
1.10

• Elasticity of Supply tends to grow the longer
  the period for producers to adjust to price
  changes.
• The long term enables producers to arrange
  suppliers hire and train workers buy new
  machinery and open new production.

.90
50
100
55
75
Quantity
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Chapter 5 Elasticity of Demand and Supply

• Income Elasticity of Demand
• Income Elasticity of Supply measures how
  responsive demand is to change in consumer
  income.
• EI Change in Quantity Demanded / Change in
  Income
• We again use the Avg Quantity Demanded and Avg
  Income.
• Calculating Income Elasticity of Demand helps
  businesses predict the effect of changing incomes
  on quantity demanded and total revenue.
• Because demand for some goods actually declines
  as income increases, income elasticity of demand
  can actually be negative number

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Chapter 5 Elasticity of Demand and Supply

• Income Elasticity of Demand
• Classifying Income Elasticity Values
• EI lt 0 Inferior Goods (Demand decreases
  as income increases)
• EI gt 0 Normal Goods
• EI gt 0 and lt 1 Income Inelastic (necessities
  like food, housing, and clothing)
• EI gt 0 and gt 1 Income Elastic (superior goods
  such as quality wines, fine dining, and expensive
  cars)

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Chapter 5 Elasticity of Demand and Supply

• Cross-Price Elasticity of Demand
• Cross-Price Elasticity of Demand measures
  responsiveness of demand for one good to changes
  in the price of another good.
• EX Change in Quantity Demanded for one good /
  Change in Price of another good
• We again use the Avg Quantity Demanded and Avg
  Price.
• Calculating Cross-Price Elasticity of Demand
  helps businesses predict the effect of price
  changes in one product on quantity demanded and
  total revenue of another product.
• The numerical value of Cross-Price Elasticity of
  Demand can be positive, negative, or zero,
  depending on whether the two goods are
  substitutes, complements, or unrelated.

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Chapter 5 Elasticity of Demand and Supply

• Cross-Price Elasticity of Demand
• Classifying Cross- Price Elasticity Values
• EX lt 0 - the two goods are Complements
  (Price for one and Demand for the
  other are
  inversely related)
• EX gt 0 - the two goods are Substitutes (Price for
  one and Demand for the other
  are directly related)
• EX 0 the two goods are Unrelated (price for
  one has no relation to demand for the other)

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Chapter 5 Elasticity of Demand and Supply

• Summary
• Elasticity in Economics refers to the
  responsiveness of demand or supply to changes in
  price or changes in income.
• Determining elasticity shows the affect of price
  changes on demand and supply and, thus, the
  influence of price change on total revenue.
• We calculate elasticity using simple formulae to
  arrive at a finite number that measures
  elasticity.
• A price elasticity value less than one is
  inelastic and relatively unresponsive to price
  changes, while an elasticity value greater than
  one is elastic and relatively responsive to price
  changes.