Elasticity of Demand & Supply & its Real-World Situation

This presentation material discusses the elasticity of demand and supply and its application real world situation. It also discusses the concept of shortage, surplus and inefficiencies or deadweight loss.

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BASIC
MICROECONOMICS

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ECON 012
Cross Elasticity and Income
Elasticity of Demand
The Price Elasticity of Demand
and the Total Revenue Test
The Price Elasticity of Supply
Elasticity and Real-World
Applications
Consumer and Producer’s Surplus

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The Price Elasticity of Demand and the Total
Revenue Test
Price Elasticity of Demand
➢A measure of the responsiveness of buyers to a change in
the price of a product or resource
Formula:
Calculating a Percentage
Formula:percentage change in quantity demanded of product X
original quantity demanded of product X
%∆Qd= x100

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The Price Elasticity of Demand and the Total
Revenue Test
Example:
If the quantity demanded increases from 4 to 5 units, the percentage
change in quantity demanded would be calculated as1
4
25%%∆Qd = x 100 =
To calculate the change in price between 2 points, we would divide the
change in price by the original price1
5
%∆P = x 100 = 20%
For example if the price dropped from 5 to 4, the percentage change
would bechange in price of product X
original price of product X
%∆P = x 100

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The Price Elasticity of Demand and the Total
Revenue Test

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The Price Elasticity of Demand and the Total
Revenue Test
Using Averages: Mid pricing formulas
Formula:change in quantity change in price
sum of quantities/2 sum of prices/2E
d =
÷
In symbol, the formula becomes:∆Q ∆P
(Q
0+Q
1)/2 (P
0+P
1)/2E
d =
÷

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The Price Elasticity of Demand and the Total
Revenue Test
Using Averages: Mid pricing formulas
For example price range of $5-$4, the price reference is 4.5, (that
is (5+4)/2)
Quantity demanded range of 10-20, the quantity reference is
15, (that is (10+20/2)1.0 10
4.5 15Ed =
÷
÷0.22 0.67= 33.3%
=

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The Price Elasticity of Demand and the Total
Revenue Test
Elasticity
➢is an economic concept used to measure the change in
the aggregate quantity demanded of a good or service
in relation to price movements of that good or service
Elastic demand
➢Product demand whose price elasticity or coefficient is
greater than one
For example: Supposed that a 2 percent decline in price of
cut flowers results in a 4 percent increase in quantity
demanded.
E
D = 0.04/0.02 = 2, demand for flower is elastic

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The Price Elasticity of Demand and the Total
Revenue Test
Inelastic demand
➢Product or resource demand for which the price elasticity
coefficient is less than 1.
For example: Supposed that a 2 percent decline in price of
coffee leads to only 1 percent increase in quantity demanded
ED = 0.01/0.02 = .5, demand for coffee is inelastic

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The Price Elasticity of Demand and the Total
Revenue Test
Unit elastic
➢Demand or supply for which the elasticity coefficient are the
same or equal to 1.
For example: Supposed that a 2 percent decline in price of
chocolate causes 2 percent increase in quantity demanded
E
D = 0.02/0.02 = 1, demand for chocolate is unit elastic

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The Price Elasticity of Demand and the Total
Revenue Test
Please note that in interpreting elasticity, we ignore the minus sign
and simply present the absolute value of the elasticity to avoid an
ambiguity that might arise.
Total revenue
➢The total number of dollars(pesos) receive by a firm from the sale
of product in a particular period.
➢It is calculated by multiplying the product price by the quantity
demanded or sold
TR = P x Q
Where:
TR is the Total Revenue
P is the product Price
Q is the Quantity demanded/sold

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The Price Elasticity of Demand and the Total
Revenue Test
Total Revenue Test
➢A test to determine the elasticity of demand between two
prices

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The Price Elasticity of Demand and the Total
Revenue Test
Figure A, price declines from $2 to $1, and total revenue increases
from $20 to $40. So demand is elastic. The gain in revenue (blue
area) exceeds the loss of revenue (orange area).
Figure B, price declined from $4 to $1, and total revenue falls from
$40 to $20. So demand is inelastic. The gain in revenue (blue
area) is less than the loss of revenue in orange area.
Figure C, price declined from $3 to $1, and total revenue falls
from $40 to $20 and total revenue did not change. Demand is
unit elastic. The gain in revenue (blue area) equals the loss of
revenue in orange area.

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The Price Elasticity of Demand and the Total
Revenue TestPrice IncreasePrice Decrease
Greater than 1 (Ed >1)
Elastic or
relatively elastic
Quantity demanded
changes by a larger
percentage than price
Total revenue
decreases
Total revenue
increases
Equal to 1 (Ed = 1)
Unit or unitary
elastic
Quantity demanded
changes by the same
percentage with price
Total revenue
is unchanged
Total revenue
is unchanged
Less than 1 (Ed < 1)
Inelastic or
relatively
inelastic
Quantity demanded
changes by a smaller
percentage than price
Total revenue
increases
Total revenue
decreases
Absolute Value of
Elasticity Coefficient
Demand is Description
Impact on Total Revenue
Summary of Price Elasticity of Demand

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The Price Elasticity of Demand and the Total
Revenue Test
Determinants of Price Elasticity of Demand
➢Substitutability – generally, the larger the number of
substitute goods that are available, the greater the price
elasticity of a demand
➢Proportion of income – other things equal, the greater
proportion of income spent on a good, the greater the
price elasticity of demand for it
➢Luxuries versus necessities – in general, the more that a good
is considered luxury, the greater is the price elasticity
➢Time -generally, product demand is more elastic the longer
the period under consideration. Studies shows that short-run
demand for gasoline is more inelastic than in the long run
demand.

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The Price Elasticity of Supply
Price Elasticity of Supply
➢percentage change in quantity supplied of a product or
resource to the percentage change in its price.
Formula:percentage change in quantity supplied of product X
percentage change in price of product XEs=

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The Price Elasticity of Supply
Market Period
➢A period in which producers of a product are unable to
change the quantity produced in response to a change in its
price.
Short run
➢A period of time in which producers are able to change the
quantities of some but not all of the resources they employ.
Long run
➢A period of time long enough to enable the producers of a
product to change the quantities of all of the resources they
employ

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Cross Elasticity and Income Elasticity of Demand
Cross Elasticity of Demand
➢The ratio of the percentage change in quantity demanded
of one good to the percentage change in the price of some
other good.
Formulapercentage change in quantity demanded of product X
percentage change in price of product YExy=

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Cross Elasticity and Income Elasticity of Demand
Substitute Goods - If cross elasticity is positive, meaning that the sale
of X move the same direction as a change in the price of Y, then X
and Y are substitute goods, For example is photo paper for ink jet
printers, such as Kodak photo paper (X) and Canon photo paper
(Y), An increase in the price of Kodak photo paper causes
consumers to buy more Canon photo paper, resulting in a positive
cross elasticity. The larger the cross- elasticity coefficient the
greater the substitutability between the two products.
Complementary Goods – When cross elasticity is negative, we
know that X and Y ”go together” , an increase in the price of one
decreases the demand for the other. They are complementary
goods. For example, an increase in the price of digital camera will
decrease the amount of photo paper purchase. The larger the
negative cross elasticity coefficient, the greater is the
complementary between the two goods.

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Cross Elasticity and Income Elasticity of Demand
Independent Goods – A zero or near zero elasticity tell us that the
two products being considered are unrelated or independent
goods. An example is walnut and photo paper. We would not
expect a change in the price of walnuts to have any effect on
purchase f photo paper and vice versa.
Income Elasticity of Demand
➢Measures the responsiveness of consumer purchases to
income changes
Formula:

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Cross Elasticity and Income Elasticity of Demand
Normal goods – the income elasticity coefficient is positive, meaning
that more of them, are demand as income rise. For example income
elasticity for automobiles is about +3 while income elasticity for most
farm products in only about +0.20.
Inferior goods - A negative income elasticity coefficient designates an
inferior good. Retread tires, cabbage, long distance bus tickets and
used clothing are likely candidates. Consumers decrease their
purchases of inferior goods an income rises.Value of
Coefficient
Description Type of Good(s)
Positive (Ewz > 0)
Quantity demanded of W changes in same directon as
change in price of Z
Substitutes
Negative (E
xy < 0)
Quantity demanded of X changes in opposite directon as
change in price of Y
Complements
Positive (Ei > 0)
Quantity demanded of the product chnanges in same
direction as change in income
Normal
Negative (Ei < 0)
Quantity demanded of the product chnanges in opposite
direction as change in income
Inferior
Cross and Income Elasticities of Demand
Cross Elasticity
Income Elasticity

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Elasticity and Real-World Applications
Incidence of tax
➢refers to the extent to which an individual or organisation
suffers from the imposition of a tax – it may fall on the
consumer, the producer, or both. The incidence is also called
the ‘burden’ of taxation.
➢How the incidence falls depends upon the price elasticity of
demand.

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Elasticity and Real-World Applications
The figure below shows where tax incidence resides depending on the
elasticity of demand and supply
In panel A, if the demand is inelastic, the price to the buyer will increase
substantially (P to P1) and most of the tax will be shifted to consumers.
In panel B, if the demand is elastic in the relevant price range, price rises
modestly from (P to P1) when the tax is levied. Hence the producer
bears most of the tax burden.

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Elasticity and Real-World Applications
https://thismatter.com/economics/images/tax-incidence-supply-demand-diagrams.png
Supply Elasticity and the Incidence of Tax
In panel A, if the supply is inelastic, the price rise is small t(P to P1) and
sellers will have to bear most of the tax.
In panel B, with an elastic supply, the sales tax results in a large price
increase (P to P1) and the tax is therefore paid mainly by the consumers.

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Consumer and Producer’s Surplus
Consumer Surplus
➢The difference between the maximum price consumers are
willing to pay for a product and the actual pricePerson
Maximum Price
Willing to Pay
Actual Price
(Equilibrium Price)
Consumer Surplus
A $13 $8 $5
B 12 8 4
C 11 8 3
D 10 8 2
E 9 8 1
F 8 8 0
Consumer Surplus
Consumer surplus and price are inversely (negatively related).
Given the demand curve, higher prices reduce consumera surplus
lower prices increase it.

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Consumer and Producer’s Surplus
Producers Surplus
➢The difference between the maximum price consumers are
willing to pay for a product and the actual price.Person
Minimum
Acceptable Price
Actual Price
(Equilibrium Price)
Producer Surplus
A $3 $8 $5
B 4 8 4
C 5 8 3
D 6 8 2
E 7 8 1
F 8 8 0
Producers Surplus
There is a direct (positive) relationship between equilibrium price
and the amount of producer surplus. Given the supply curve,
lower prices reduce producer surplus higher prices increase it.

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Consumer and Producer’s Surplus
Productive Efficiency
➢The production of a good in a least cost way
Efficiency Losses or Deadweight Losses
➢Reductions of combined consumer and producer surplus
associated with underproduction and overproduction of a
product.
Instances where there is inefficiencies:
oUnderproduction reduces both consumer and producer
surplus, and efficiency is lost because both buyers and sellers
would be willing to exchange for a higher quantity.

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Consumer and Producer’s Surplus
Instances where there is inefficiencies:
oOverproduction causes inefficiency because the equilibrium
quantity, it cost society more to produce the good than it is
worth to the consumer in terms of willingness to pay.
oA deadweight loss occurs when the combined consumer and
producer surplus is not maximized. This occurs when something
such as price control causes wether over production or under
production of a good or service.

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Consumer and Producer’s Surplus

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