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ECON 1023 SPRING 2012
Instructor: Gibson Nene
Lecture Notes: Elasticity of Demand and Supply
Source: Microeconomics Brief Edition, First Edition by McConnell, Brue and Flynn.
This handout has 15printed pages.
By the end of Chapter 4 you should be able to understand:
•The Price Elasticity of Demand and How It Can Be Applied
•The Usefulness of the Total Revenue Test for Price Elasticity of Demand
•Price Elasticity of Supply and How It Can Be Applied
•Cross Elasticity of Demand and Income Elasticity of Demand
The law of demand tells us that consumers will respond to a price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more.
•The concept of price elasticity of demand fills this gap.
What is the Price elasticity of Demand?
•A measure of the responsiveness of the ______demanded of a good to a change in its _____ when all other influences on buyers’ plans remain the same.
•To determine the price elasticity of demand, we compare the percentage change in the ______demanded with the percentage change in ______.
Elastic demand
•For some products, consumers are highly responsive to price changes.
• Demand for such products is relatively _____or simply ______.
•In other words for these products, a small change in price leads to a large change in the quantity of products bought by the consumer.
Inelastic demand
•For other products, consumers’ responsiveness is only slight, or in rare cases non-existent.
•Demand is said to be relatively ______, or simply ______.
•In other words for these products, a large change in price leads to a small change in the quantity of products bought by the consumer.
•It is important to note that with both elastic and inelastic demand, consumers behave according to the law of demand; that is, they are responsive to price changes.
•The terms elastic or inelastic describe the ______of responsiveness.
Price-elasticity coefficient and formula
•The formula on the previous slide can be restated as follows:
When calculating the price elasticity of demand the starting point matters.
• Using traditional calculations (The formulas from the previous two slides ), the measured elasticity over a given range of prices is ______to whether one starts at the ______price and goes down, or the ______price and goes up.
Example
•Suppose the price of Cheese changes from $4 to $5 per pound. This change yields:
•______.
•Suppose the price of a pound of Cheese changes from $5 to $4. This change yields:
•______.
•Which one of the above percentage changes in price should we use to calculate price elasticity coefficient?
How about quantity changes?
•A quantity change from 10 to 20 yields.
•______
•A quantity changes from 20 to 10 yields.
•______.
•Which one of the above percentage changes in quantity should we use to calculate price elasticity coefficient?
How do we deal with this problem?
•A way to deal with this problem is to use the average of the two quantities and the average of the two prices.
•Price changes
•1st compute the ______of the two prices
•______
•Price change from $4 to $5 yieldsa
•______
•A price change from $5 to $4 yields a
•______
•Quantity changes
•1st compute the ______of the two quantities
•______
•Quantity change from 10 to 20 yields a
•______
•Quantity change from 20 to 10 yields
•______
Price Elasticity of Demand: The Midpoint approach
•The Midpoint formula
•We use the average of the two quantities and the average of the two prices as the denominators in the calculation of price elasticity.
Interpretations of Elasticity
•Because of the inverse relationship between price and quantity demanded, the actual elasticity of demand will be a negative number. However, we ignore the minus sign and use absolute value of both percentage changes.
•If the coefficient of elasticity of demand is a number greater than one, we say demand is ______.
•If the coefficient is less than one, we say demand is ______
•A special case is if the coefficient equals one; this is called ______
Extreme cases of price elasticity of demand
•______demand
•The demand curve would be vertical.
•Consumers are completely unresponsive in to change price.
•______demand
• The demand curve would be horizontal.
• Product demand for which quantity demanded can be any amount at a particular price.
•Why use percentages when calculating the price elasticity of demand?
•______measure
•Compare responsiveness ______products
The Total Revenue Test
•Total Revenue (TR) = Price (P) x Quantity (Q)
•Total-revenue test is the easiest way to judge whether demand is elastic or inelastic. This test can be used in place of elasticity formula, unless there is a need to determine the elasticity coefficient.
•Inelastic demand: Price and Total Revenue change in the ______direction.
•Elastic demand: Price and Total Revenue change in ______directions.
•______elasticity: Demand has unit elasticity if Total Revenuedoes not change when the price changes.
This is summarized in the table below:
If Demand is / Response to an increase in price / Response to a decrease in priceElastic
Unit Elastic
Inelastic
Inelastic Demand and Total Revenue
- Total revenue changes in the same direction as price.
- If price increases, revenue ______, and when price ______, revenue falls.
•When price falls from $4 to $1
•The loss is ______ than the gain
•TR falls when price falls, i.e. TR falls from ______.
•Therefore demand is inelastic (Ed < 1).
Elastic Demand and Total Revenue
Response of Total revenue when price changes
- Revenue changes in the opposite direction from price.
- If price increases, revenue falls, and when price falls, revenue increases.
•Price falls from $2 to $1
•Loss is s______than gain
•TR rises when price falls i.e. TR increases from ______
•Therefore demand is elastic (Ed > 1)
Total revenue and unit elastic demand
Total revenue remains the same when price changes.
Elasticity on a Linear Demand Curve
Elasticity and the TR Curve
•Substitutes for the product
–Generally, themore substitutes, the more elastic the demand.
•The proportion of price relative to income
–Generally, the larger the expenditure relative to one’s budget, the more elastic the demand, because buyers notice the change in price more.
•Whether the product is a luxury or a necessity
– Generally, the less necessary the item, the more ______the demand.
Applications of Elasticity
- Governments look at elasticity of demand when levying excise taxes. Excise taxes on products with ______demand will raise the most revenue and have the least impact on quantity demanded for those products.
Cross Elasticity of Demand
•Cross Elasticity of Demand: A measure of the responsiveness of the demand for a good to a change in the price of a substitute or complement when other things remain the same.
•Numerically, the formula is shown for products X and Y:
Exy = (percentage change in quantity of X) / (percentage change in price of Y)
- If cross elasticity is ______, then X and Y are substitutes.
- If cross elasticity is ______, then X and Y are complements.
- Note: if cross elasticity is zero, then X and Y are unrelated, independent products.
Cross Elasticity of Demand: Examples
Substitutes
Suppose that when the price of a burger falls by 10 %, the quantity of pizza demanded decreases by 5%. The cross elasticity of demand for pizza with respect to the price of a burger is
The cross elasticity of demand for a substitute is positive: The quantity demanded of a good and the price of one of its substitutes change in the same direction.
Complements
Suppose that when the price of soda falls by 10%, the quantity of pizza demanded increases by 2%. The cross elasticity of demand for pizza with respect to the price of a burger is
The cross elasticity of demand for a complement is negative: The quantity demanded of a good and the price of one of its complements change in ______directions.
Income Elasticity of Demand
•Income Elasticity of Demand: A measure of the responsiveness of the demand for a good to a change in income when other things remain the same.
•It is calculated by using the following formula:
Ei = (percentage change in quantity demanded) / (percentage change in income)
•The income elasticity of demand falls into three ranges:
Greater than 1: ______good, income elastic
Between 0 and 1: ______good, income inelastic
Less than 0(negative): ______good
Price Elasticity of Supply
•Price elasticity of Supply: A measure of the responsiveness of the ______ supplied of a good to a change in its ______when all other influences on sellers’ plans remain the same.
•To determine the price elasticity of supply, we compare the percentage change in the quantity supplied with the percentage change in price.
Elastic and Inelastic Supply
•Elastic supply: When the percentage change in the quantity suppliedexceeds the percentage change in price.
•Unit elastic supply: When the percentage change in the quantity supplied equals the percentage change in price.
•Inelastic supply: When the percentage change in the quantity supplied is less than the percentage change in price.
•Perfectly inelastic supply: When the percentage change in the quantity supplied iszero for any percentage change in the price.
•Perfectly elastic supply: When the quantity supplied changes by a very large percentage in response to an almost zero percentage change in price.
Computing the Price Elasticity of Supply
To determine whether the supply of a good is elastic, unit
elastic, or inelastic, we compute a numerical value for the
price elasticity of supply in a way similar to that used to
calculate the price elasticity of demand. We use the formula:
Es = percentage change in quantity supplied / percentage change in price
As with price elasticity of demand, the ______ is more accurate.
•If the price elasticity of supply is greater than 1, supply is elastic
•If the price elasticity of supply equals 1, supply is unit elastic
•If the price elasticity of supply is less than 1, supply is inelastic
Price Elasticity of Supply and Time Periods
•The Immediate market period
–Producers are unable to adjust the quantity produced in response to price changes.
–It is virtually impossible for producers to adjust their resources and change the quantity supplied.
–Period is so short that elasticity of supply is ______; it could be almost perfectly inelastic or vertical.
•Shortrun
–Pant size is fixed but production can be varied.
•Industrial producers are able to make some output changes by having workers work overtime or by bringing on an extra shift.
–Elasticity of supply depends on the ability of producers to respond to price change.
Supply elasticity is more elastic in the short-run than in the market period
•The longrun
–More adjustments such as plant size can be made over time.
–Quantity can be changed more relative to a small change in price.
–Supply elasticity is more ______than market period and short run.
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