chapter 4: elasticity of demand and supply. copyright 2007 by the mcgraw-hill companies, inc. all...
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Chapter 4: Elasticity of Demand and Supply
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Price Elasticity of Demand
According to the law of demand, when price goes up, consumers demand fewer quantities of a product. If the price of a product falls, quantity demanded will rise.
But when the price of a product changes, by how much more (or less) will consumers buy?
To help answer this question, we will use a measurement called the Price Elasticity of Demand.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Price Elasticity of Demand
For some products, consumers are highly responsive to price changes. Demand for such products is relatively elastic or simply elastic.
For other products, consumers’ responsiveness is only slight, or in rare cases non-existent. Demand is said to be relatively inelastic, or simply inelastic.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
The Price-Elasticity Coefficient
Economist measure the degree of price elasticity or inelasticity of demand with the coefficient Ed.
Ed is defined as the percentage change in quantity demanded of good X divided by the percentage change in price of X.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
The Ed Formula
percentage change in quantity demanded of X
percentage change in price of X Generally, when calculating percentage changes in the
equation, we divide the change in quantity demanded by the original quantity demanded and the change in price by the original price.
However, because the resulting percentage change value differs with the direction of the change, using averages as the reference points ensures the same percentage change regardless of the direction of the change.
Ed =
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Using Averages: An Example
Consider the following example:Suppose that at a price of $10, quantity demanded is 200 units. When the price drops to $5, quantity demanded rises to 300 units. Price
Quantity
$10
$5
200 300
Demand
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Using Averages: An Example
The percentage change in quantity demanded from 200 to 300 is a 50 percent (=100/200) increase, while the opposing change in quantity demanded from 300 to 200 is a 33 percent (=100/300) decrease.
Likewise, the percentage change in price from $10 to $5 is a 50 percent (=$5/$10) decrease, while the opposing change in price from $5 to $10 is a 100 percent (=$5/$5) increase.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Using Averages: An Example
Using averages eliminates the “up versus down” problem.
change in quantity change in price
sum of quantities/2 sum of prices/2 For the quantity range 200-300, the quantity
reference is 250 units [=(200+300)/2]. For the same price range $5-$10, the price
reference is $7.50 [=($5 + $10)/2]
Ed =
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Using Averages: An Example
The percentage change in quantity demanded is now 100/250, or a 40 percent increase, and the percentage change in price is now -$5/$7.50, or about a 67 percent decrease.
Ed = 0.4/-.67 = -0.597
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Elimination of the Minus Sign
Because the demand curve slopes downward, Ed will always be a negative number. Therefore, we take the absolute value and ignore the minus sign.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Interpretations of Ed
The coefficient of price elasticity of demand can be interpreted as follows:
Elastic Demand: Product demand for which price changes cause relatively larger changes in quantity demanded; Ed > 1
Inelastic Demand: Product demand for which price changes cause relatively smaller changes in quantity demanded; Ed < 1
Unit Elasticity: Product demand for which price changes and changes in quantity demanded are equal; Ed = 1
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Interpretations of Ed
Extreme Cases Perfectly Inelastic: Product demand for which
quantity demanded does not respond to a change in price.
Perfectly Elastic: Product demand for which quantity demanded can be any amount at a particular price.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Interpretations of Ed
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
The Total-Revenue Test
Elasticity is important to firms because when the price of their products change, so does their profit (total revenue minus total costs).
This represents the total number of dollars
received by a firm from the sale of a product in a particular period.
Total revenue (TR) = price x quantity = P x Q
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
The Total-Revenue Test
Total revenue and the price elasticity of demand are related. The total-revenue test can determine elasticity by examining what happens to total revenue when price changes.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
The Total-Revenue Test
If demand is elastic, a decrease in price will increase total revenue, and an increase in price will reduce total revenue.
If demand is inelastic, a price decrease will decrease total revenue, while an increase in price will increase total revenue.
If demand is unit elastic, total revenue remains constant when prices rise or fall.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
The Total-Revenue Test
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Price Elasticity along a Linear Demand Curve
Along a linear demand curve, elasticity varies over the different price ranges.
Because elasticity involves relative or percentage changes in price and quantity, as you move along a demand curve, the percentage changes in price and quantity will vary.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Determinants of Price Elasticity of Demand
In general, there are four determinants that can affect the price elasticity of demand:
Substitutability Proportion of Income Luxuries versus Necessities Time
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Determinants of Price Elasticity of Demand
Price elasticity of demand is greater: the larger the number of substitute goods that
are available the higher the price of a product relative to
one’s income the more that a good is considered to be a
“luxury” rather than a “necessity” the longer the time period under consideration
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Price Elasticity of Supply
Price elasticity of supply measures the responsiveness of sellers to changes in the price of a product. If producers are relatively responsive, supply
is elastic. If producers are relatively insensitive to price
changes, supply is inelastic.
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Price Elasticity of Supply
The price elasticity of supply coefficient Es is defined as:
percentage change in quantity supplied of Xpercentage change in price of X
To calculate Es, we employ the midpoint approach to determine the percentage changes.
Es =
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Price Elasticity of Supply
If Es < 1, supply is inelastic.
If Es > 1, supply is elastic.
If Es = 1, supply is unit-elastic.
Since price and quantity supplied are directly related, Es is never negative.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Price Elasticity of Supply
The amount of time it takes producers to shift resources between alternative uses to alter production of a good can determine the degree of price elasticity of supply. The easier and more rapid the transfer of
resources, the greater is the price elasticity of supply.
The longer a firm has to adjust to a price change, the greater the elasticity of supply.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Price Elasticity of Supply and Time Periods
The market period is a period in which producers of a product are unable to change the quantity produced in response to a change in price. During this time period, the supply of a
product is fixed, or supply is perfectly inelastic.
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Price Elasticity of Supply and Time Periods
In the short run, producers are able to change the quantities of some but not all the resources they employ. This time period is too short to change plant
capacity but long enough to use fixed plant more or less intensively.
The supply of a product is more elastic than the market period.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Price Elasticity of Supply and Time Periods
In the long run, producers are able to change all the resources they employ. This time period is long enough for firms to
adjust their plant sizes and for new firms to enter (or existing firms to exit) the industry.
The supply of a product is more elastic than in the short run.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Price Elasticity of Supply and Time Periods
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Income Elasticity of Demand
Income elasticity of demand measures the responsiveness of consumer purchases to changes in consumer income.
The coefficient of income elasticity of demand Ei is determined with the formula
percentage change in quantity demanded
percentage change in incomeEI =
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Income Elasticity of Demand
Normal Goods will have an income elasticity of demand that is positive. More of them are demanded as income increases. Ei > 0
Inferior goods have a negative income elasticity of demand. As income rises, the demand for them falls. Ei < 0