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DESCRIBING SUPPLY AND DEMAND ELASTICITIES

- Chapter 6

Todays lecture

- Elasticity
- The Price Elasticity of Demand
- The Price Elasticity of Supply
- Calculate elasticity graphically and numerically.

The Concept of Elasticity

- Elasticity is a measure of the responsiveness of

one variable to another. - The greater the elasticity, the greater the

responsiveness. - In economics, elasticity is used to describe the

responsiveness of quantity supplied or quantity

demanded to price.

The Price Elasticity of Demand

- The price elasticity of demand measures how much

the quantity demanded responds to a change in

price.

Price elasticity of demand (ED)

Example

- Suppose that a 10-percent increase in the price

of an ice-cream cone causes the amount of ice

cream you buy to fall by 20 percent. - The related price elasticity of demand
- -20 percent / 10 percent 2

The Price Elasticity of Supply

- The price elasticity of supply measures how much

the quantity supplied responds to a change in

price.

Price elasticity of supply (ES)

Example

- Suppose a 10 percent increase in the price of an

ice-cream causes a 5 percent increase in the

supply of ice-cream. - The related price elasticity of supply
- 5 percent/ 10 percent 0.5

Classifying Demand and Supply as Elastic or

Inelastic

- Demand or supply is elastic if the percentage

change in quantity is greater than the percentage

change in price. - Egt1
- Demand or supply is inelastic if the percentage

change in quantity is less than the percentage

change in price. - Elt1

Unit Elastic Demand or Supply

- Demand or supply is unit elastic if the

percentage change in quantity is the same as the

percentage change in price. - E1

Elasticities and Supply and Demand Curves

Perfectly inelastic demand curve

P

Quantity

Elasticity is Not the Same as Slope, But

- The steeper the curve at a given point, the less

elastic is supply or demand. - Perfectly elastic supply or demand
- The curves are flat
- The quantity responds enormously to a change in

price (E 8) - Perfectly inelastic supply or demand
- The curves are vertical
- The quantity does not response to a change in

price (E0).

Example

- A diabetic, who will die without insulin, would

be willing to pay any price for the life-saving

quantity of insulin. - ----The diabetic has a perfectly inelastic demand

of insulin.

Example

- In agriculture individual producers generally

have no control over the price because she or he

will not be able to sell any of the crop if she

or he raise the price slightly above the market

price. - ---- The demand of crop is perfectly elastic.

Question

- The elasticity of demand is same along the demand

curve? - ----To find out the answer, we just calculate

them by ourselves.

Calculating Elasticity of Demand Between Two

Points

Elasticity of demand between A and B

26

B

24

22

midpoint

C

Price

20

A

18

16

Demand

14

0

10

12

14

Quantity of software (in hundred thousands)

Question

- A major cereal producer decides to lower price

from 3.60 to 3 per 15-ounce box. - Q If quantity demanded increases by 18 percent,

what is the price elasticity of demand?

Calculating Elasticity at a Point

To calculate elasticity at a point determine a

range around that point and calculate the arc

elasticity.

Calculating Elasticity along the Demand Curve

The elasticity at point C (16-24)/20/(6-4)/5

0.4/0.41

G

F

The elasticity at point F (16-0)/8/(6-10)/84

E

D

The elasticity at point A (28-20)/24/(3-5)/4

0.65

16

8

12

Elasticity Along a Demand Curve

Ed 8

Elasticity declines along demand curve as we move

toward the quantity axis

10

9

8

7

6

Ed 1

Price

5

4

3

2

1

0

1

2

3

4

5

6

7

8

9

10

Quantity

Question

- If a good have several substitutes, the demand of

this good is elastic or inelastic? - Substitutes are often pairs of goods that are

used in place of each other and an increase in

the price of one leads to an increase in the

demand for the other. - If a good is necessary, such as salt, the demand

of this good is elastic or inelastic?

Elasticity and Demand

- As a general rule, the more substitutes a good

has, the more elastic is its supply and demand. - The larger the time interval considered, the more

elastic is the demand curve. - The less a good is a necessity, the more elastic

is its demand curve. - Demand becomes more elastic as the definition of

the good becomes more specific. - Demand for goods that represent a large portion

of ones budget are more elastic.

Elasticity and Supply

- The longer the time period considered, the more

elastic the supply. - There are three time periods relevant to supply
- The instantaneous period supply is fixed,

perfectly inelastic. - The short run supply is somewhat elastic.
- The long run supply is very elastic.

Elasticity and Total Revenue

Unit Elastic Demand E 1

TRE 4x624 TRF 6x424

TR constant

C

E

O

A

B

Elasticity and Total Revenue

Elastic Demand E gt 1

10

9

C

TR falls if price increases. TR rises if price

decreases.

8

TRJ 8 x 2 16 TRK 9 x 1 9

6

A

Price

4

2

0

Quantity

1

2

3

4

5

6

7

8

9

Elasticity and Total Revenue

Inelastic Demand E lt 1

10

TR rises if price increases

8

TRG 1 x 9 9

TRH 2 x 8 16

6

Price

4

H

2

C

G

A

B

Quantity

0

1

2

3

4

5

6

7

8

9

Total Revenue Along a Demand Curve

A

Elastic ED gt 1

ED 1

C

Inelastic ED lt 1

B

Total revenue

0

Quantity

Question

- If you find that in California where vanity

plates cost 28.75, the elasticity of demand is

0.52. In Massachusetts where vanity plates cost

50, the elasticity of demand is 3.52. - Q What recommendation would you have for each

state to maximize revenue?

Question

- A newspaper recently lowered its price from 50

cents to 30 cents. As it did, the number of

newspapers sold increased from 240,000 to

280,000. - What was the newspapers elasticity of demand?
- Given that elasticity, did it make sense for the

newspaper to lower its price?

Question

- Comparing a rich person and a poor guy, for a

given good, which person has a more elastic

demand of the good? - If you can charge different price for different

person, you will charge a higher price or lower

price to the person who has a more elastic demand

of the good?

Elasticity of Individual and Market Demand

- Price discrimination occurs when a firm separates

the people with less elastic demand from those

with more elastic demand. - Firms charge more to the individuals with

inelastic demand and less to individuals with

elastic demand. - Examples of price discrimination
- Airlines Saturday stay-over specials
- Sales of new cars
- Almost-continual sales

Income Elasticity of Demand

- Income elasticity of demand measures the

responsiveness of demand to changes in income.

Income Elasticity of Demand

- Normal goods are those whose consumption

increases with an increase in income. - Normal goods can be luxuries or necessities
- Luxuries are goods that have an income elasticity

greater than one. - A necessity has an income elasticity less than 1.
- Inferior goods are those whose consumption

decreases when income increases. - Inferior goods have income elasticities less than

zero.

Cross-Price Elasticity of Demand

- Cross-price elasticity of demand measures the

responsiveness of demand to changes in prices of

other goods.

Complements and Substitutes

- Substitutes are goods that can be used in place

of another. - Substitutes have positive cross-price

elasticities. - Complements are goods that are used in

conjunction with one another. - Complements have negative cross-price

elasticities.