chapter 21 demand and supply elasticity. did you know that... the government predicted it would...

Chapter 21Demand and

Supply Elasticity

Did You Know That...

The government predicted it would raise $6 million per year in new revenues from a new 10 percent luxury tax on private airplane and yacht sales a few years ago

It actually collected only $53,000?

How can that be?

Price Elasticity

Price Elasticity of Demand (Ep)

– The responsiveness of quantity demanded of a commodity to changes in its price

Price Elasticity

Price Elasticity of Demand (Ep)

Ep = percentage change in quantity demanded

percentage change in price

Ep = %Qd

%P

Price Elasticity

Example– Price of oil increases 10%

– Quantity demanded decreases 1%

Ep = -1%

+10%= -.1

Price Elasticity

Question– How would you interpret an elasticity

of -0.1?

Answer– A one percent increase in the price of oil

will lead to a one percent decrease in quantity demanded

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

Calculating Elasticity

Calculating elasticity

% change in Qd = change in Qd

original Qd

% change in price = change in price

original price

Price Elasticity

The basics of measuring percentage changes– If price increases from $1 to $2

the percent change in price is:

%P = 11

= 100%

Price Elasticity

The basics of measuring percentage changes– If price falls from $2 to $1 the percent

change in price is:

%P = 12

= 50%

Price Elasticity

The basics of measuring percentage changes– The percentage is influenced

by the base of the original value.


Adjusting for the percent change biaschange in Q

sum of quantities/2Ep =

change in Psum of Prices/2

or change in Q(Q1 + Q2)/2

Ep =change in P(P1 + P2)/2

QAvg. Q

Ep =P

Avg. Por


Example– If the price increases from 1 to 2:

13/2

%P = = .67


Example– If the price decreases from 2 to 1:

13/2

%P = = .67

Price of Today was lowered 25 pence to 10 pence

Circulation increased from 590,000 to 1.05 million copies

International Example:The Price Elasticity of Demand for Newspapers


Q(Q1 + Q2)/2

Ep =P

(P1 + P2)/2

Ep =

1,050,000 - 590,000(590,000 + 1,050,000)/2

25 - 10(10 + 25)/2


Interpretation– A 60% decrease in price will increase

quantity demanded by .66 percent.

460,000820,000

Ep =15

17.5= .66

Price Elasticity Ranges

Elastic Demand– Percentage change in quantity demanded

is larger than the percentage change in price

– Ep > 1


Unit Elasticity of Demand– Percentage change in quantity demanded

is equal to the percentage change in price

– Ep = 1


Inelastic Demand– Percentage change in quantity demanded

is smaller than the percentage change in price

– Ep < 1


Elastic demand

Unit elastic

Inelastic demand

%Q > %P; Ep > 1

%Q = %P; Ep = 1

%Q < %P; Ep < 1

Real World Examples…analysis includes historic sales data, both public and private, and use of present-day surveys of customers' preferences. Data as of 3-9-2011

Airline travel (US)– -0.3 (First Class)

– -0.9 (Discount)

– -1.5 (for Pleasure Travelers)

Soft drinks -0.8 to -1.0 (general)-3.8 (Coca-Cola)-4.4 (Mountain Dew)

Car fuel– -0.25 (Short run)

– -0.64 (Long run)

Steel

-0.2 to -0.3

Eggs – 0.1 (US: Household only)– 0.35 (Canada)– 0.55 (South Africa)

Live Performing Arts (Theater, etc.)

–-0.4 to -0.9

Rice

– 0.47 (Austria)

– 0.80 (Bangladesh)

– 0.80 (China)

– 0.25 (Japan)

– 0.55 (US)

Cinema visits (US) – -0.87 (General)

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

• There can be NO close substitutes

Perfectly Inelastic Demand Example:

BUT WAIT ! Mine has treplobivium HG9

Perfectly Inelastic Demand Example:

Extreme Price Elasticities

Quantity Demanded per Year(millions of units)

Pric

e

0



Pric

eD

Perfect inelasticity, or zero elasticity

80

Figure 20-1, Panel (a)



Pric

eD

80

P0

P1

Perfect inelasticity, or zero elasticity

($4.79 – 1,000 Pack)

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

Burt’s Office Equipment Barry’s Office SpaceErnie’s Inc.

($4.79 – 1,000 Pack) ($5.79 – 1,000 Pack)($4.79 – 1,000 Pack)



Pric

e (c

ents

)

0



Pric

e (c

ents

)

30

0

Perfect elasticity, or infinite elasticity

D

Figure 20-1, Panel (b)



Pric

e (c

ents

)

30

P1

0

P1 never touches the demand curve

Perfect elasticity, or infinite elasticity

D

Policy Example:Who Pays Higher Cigarette Taxes?

In recent years Congress and state legislatures have increased cigarette taxes.– These taxes are a flat

amount per pack

– Sellers pay the tax but supply the same quantity only at the old price plus the tax

– Supply decreases

Who pays the tax depends on price elasticity of demand

Price Elasticity: A Cigarette Tax

Figure 20.2, Panels (a) and (b)

Policy Example: Who Pays Higher Cigarette Taxes?

Figure 20.2, Panel (c)

The Relationship Between Price Elasticity of Demand and Total Revenues

for Cellular Phone Service

Quantity per period (billions of minutes)

Pric

e pe

r Min

ute

($)

0

.10

.20

.30

.40

.50

.60

.70

.80

.90

1.00

1.10

1 2 3 4 5 6 7 8 9 10 11



Pric

e pe

r Min

ute

($)



Quantity per period (billions of minutes)0

.10

.20

.30

.40

.50

.60

.70

.80

.90

1.00

1.10

1 2 3 4 5 6 7 8 9 10 11

D

Demand, or average revenue curve

Elastic (Ep > 1)

Unit-Elastic (Ep = 1)

Inelastic (Ep < 1)

Figure 20-3, Panel (b)


Tota

l Rev

enue

($ b

illio

ns)

0

0.5

1.0

1.5

2.0

2.5

1 2 3 4 5 6 7 8 9 10 11



3.0


Tota

l Rev

enue

($ b

illio

ns)

0

0.5

1.0

1.5

2.0

2.5

1 2 3 4 5 6 7 8 9 10 11



D

Total revenue curve

Elastic

Unit-Elastic

Inelastic

3.0

Figure 20-3, Panel (c)

Elasticity and Total Revenues

Elastic Demand– A negative relationship exists between

small changes in price and changes in total revenue


Unit-Elastic Demand– Changes in price do not change total

revenue


Inelastic Demand– A positive relationship exists between

changes in price and total revenues

Inelastic (Ep < 1) TR TR

Unit-elastic (Ep = 1) No change in TR No change in TR

Elastic (Ep > 1) TR TR

Price Elasticity Effect of Price Changeof Demand on Total revenues (TR)

Price PriceDecrease Increase

Relationship Between Price Elasticity of Demand and Total Revenues

1995– Prices were lowered from 250 francs

to 195 francs

– Quantity demanded increased by 700,000

– Total revenue increase by 22%

Was the demand elastic or inelastic?

International Example:A Pricing Decision at Disneyland Paris

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.


The length of time allowed for adjustment– The longer any price change persists, the

greater is the price elasticity of demand.• Price elasticity is greater in the long-run

than in the short-run.


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.

Short-Run and Long-RunPrice Elasticity of Demand

In the short run, quantitydemanded falls slightly.However, with more timefor adjustment the demand curve becomesmore elastic and quantitydemanded falls by a greater amount.

D1

Pe

Q2

E

D2

Q1 Qe

P1

Pric

e pe

r Uni

t

Quantity Demanded per Period

Short-Run and Long-RunPrice Elasticity of Demand

In the short run, quantitydemanded falls slightly.However, with more timefor adjustment the demand curve becomesmore elastic and quantitydemanded falls by a greater amount.

D1

Pe

Q2

E

D2

Q1 Qe

P1

Q2

D3

Pric

e pe

r Uni

t

Quantity Demanded per PeriodFigure 20-4

Demand Elasticityfor Selected Goods

Category Short Run Long RunEstimated Elasticity

Lamb 2.75 —— Bread .2 ——Tires and related items .8 1.2Auto repair and related services 1.4 2.4Radio and television repair .5 3.8Legitimate theater and opera .2 .3Motion pictures .9 3.7Foreign travel by U.S. residents .1 1.8Taxicabs .6 ——Local public transportation .6 1.2Intercity bus .2 2.2Electricity .1 1.8Jewelry and watches .4 .6

Cross PriceElasticity of Demand

Cross Price Elasticity of Demand (Exy)– 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

– The responsiveness of change in demand of one good to the change in prices of related goods


Formula for computing cross elasticity of demand

% in demand for good X% in price of good Y

Exy =


Substitutes– Exy would be positive

• An increase in the price of X would increase the quantity of Y demanded at each price.

Complements– Exy would be negative

• An increase in the price of X would decrease the quantity of Y demanded at each price.

Income Elasticity of Demand

Income Elasticity of Demand (Ei)

– 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


percentage change in demandpercentage change in income

Ei =


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

How Income Affects Quantity of CDs Demanded

Number of CDsPeriod Demanded per Month Income per Month

1 6 $400

2 8 600


Income increases from $400to $600/month

(8 - 6)/6(600 - 400)/400

Ei = =1/31/2

23

= = .667


Income decreases from $600 to $400/month

(6 - 8)/8(400 - 600)/600

Ei = =-1/4-1/3

34

= = .75


Eliminating the bias of the base

Quantitysum of quantities/2

Ei =Income

sum of income/2


Demand and elasticities– Accurate estimates of Ep and Ei can yield

accurate forecasts of the demand for goods and services.

Elasticity of Supply

Price Elasticity of Supply (Ei)

– 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


Formula for computing price elasticity of supply

percentage change in quantity suppliedpercentage change in price

ES =


Classifying supply elasticities– Perfectly Elastic Supply

• Quantity supplied falls to 0 when there as any decrease in price.

• The supply curve is horizontal at a given price.


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.

The Extremes in Supply CurvesP

rice

per U

nit

Quantity Supplied per PeriodQ1

S’

Perfect inelasticity

The Extremes in Supply Curves

Q1

Pric

e pe

r Uni

t

Quantity Supplied per Period

P1 S

S’

Perfect elasticity

Perfect inelasticity

Figure 20-5


Price elasticity of supply and length of time for adjustment– The longer the time allowed for

adjustment, the more elastic is supply.• Firms can find ways to increase

(or decrease) output.• Resources can flow into (or out of) an industry

through expansion (or contraction) of existing firms.

The Extremes in Supply CurvesP

rice

per U

nit


The Extremes in Supply Curves

Qe

Pric

e pe

r Uni

t


S1

In the short run the supply curve, S1, is vertical with price Pe and quantity supplied of Qe.

Pe E

Short-Run and Long-Run Price Elasticity of Supply

Pe

Qe

Pric

e pe

r Uni

t


P1

S1

If price increases to S3 quantity stays unchanged

E


Pe

Qe

Pric

e pe

r Uni

t


S1

S2

P1

Q1

As time passes the supply curve rotates to S1 then to S2 and quantity supplied rises first to Q1.

E


Pe

Qe

Pric

e pe

r Uni

t

Quantity Supplied per PeriodQ1

S1

S2

P1

As time passes the supply curve rotates to S2 then to S3 and quantity supplied rises first to Q1 and then to Q2.

E

S3

Figure 20-6

Q2

Chinese competition caused the price of French truffles to fall 30 percent in 1996.

Accordingly French production decreased by 25%.

Short-run ES = .83

International Example:French Truffle Production Takes a Nosedive

Issues and Applications:Discovering the Value of Garbage

Charlottesville, Virginia recently experimented with a per-unit price for trash collection– Previously trash collection was financed

from property taxes

– Per unit cost was zero

– The cost of trash disposal became high for the city

Issues and Applications:Discovering the Value of Garbage

Consequences of the $0.80 charge per 32 gallon bag of garbage– The quantity of trash-collection services

declined by 37 percent

– The town’s revenues increased

– Some illegal dumping occurred

– Revenues from the program did not cover costs

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


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 elastic total revenue

does not change when price changes


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


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 another

– If cross elasticity is positive, the goods are substitutes

– If cross elasticity is negative, the goods are complements


Income elasticity of demand– Percentage change in the demand for a

good divided by the percentage in income


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

chapter 21 demand and supply elasticity. did you know that... the government predicted it would...

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