Elasticity Of Demand And Supply

1. 1
Elasticity of Demand and
Supply
Chapter 5
© 2006 Thomson/South-Western

2. 2
Price Elasticity of Demand
Price elasticity of demand measures how
responsive consumers are to price
change; elasticity is another word for
responsiveness
Price elasticity of demand = Percentage
change in quantity demanded /
Percentage change in price

3. 3
Exhibit 1: Demand Curve for Tacos
For the price
elasticity to be a
useful measure, we
should come up with
the same result
between points a and
b as we get between b
and a.
To do this we must
take the average of
the initial price and
the new price and
use that as the base
in computing the
percent change in
price
Price elasticity between a and b =
10% / - 20% = - 0.5
0.90
0
b
Thousands per day
D
$1.10 a
95105
Price

4. 4
Price Elasticity of Demand
Generalize the price elasticity formula
2/)pp(
p
2/)qq(
q
D
E
¢+
D
¢+
D
=

5. 5
Price Elasticity of Demand
Because the average quantity and average price
are used as a base for computing percent
change, the same elasticity results whether
going from the higher price to the lower price
or the other way around
Since the focus is on the percent change, we
need not be concerned with how output or price
is measured

6. 6
Price Elasticity of Demand
Because price and quantity demanded are
inversely related, the price elasticity of demand
has a negative sign
This tends to be cumbersome, thus it is
commonplace to discuss the price elasticity of
demand as an absolute value  positive
number
For example, absolute value of the elasticity for
tacos computed earlier will be referred to as 0.5
rather than –0.5

7. 7
Categories of Price Elasticity
Three general categories
Percent change in quantity demanded is smaller than the
percent change in price, the price elasticity has an absolute
value between 0 and 1.0  demand is inelastic  quantity
demanded is relatively unresponsive to a change in price
Percent change in quantity demanded just equals the percent
change in price  a price elasticity with an absolute value of
1.0  unit-elastic demand
Percent change in quantity demanded exceeds the percent
change in price, the price elasticity has an absolute value
exceeding 1.0  demand is said to be elastic  quantity is
responsive to changes in price

8. 8
Elasticity and Total Revenue
Total revenue (TR) is the price (p) multiplied by
the quantity demanded (q) at that price  TR = p
x q
What happens to total revenue when price
decreases?
Lower price  producers get less for each unit sold
 total revenue declines
Lower price  increases quantity demanded 
total revenue increases
Overall impact of lower price on total revenue
depends on the net result of these opposite effects

9. 9
Elasticity and Total Revenue
When demand is elastic, the percent increase in
quantity demanded exceeds the percent
decrease in price  total revenue increases
When demand is unit elastic, the two are equal
 total revenue remains unchanged
When demand is inelastic, the percent increase
in quantity demanded is more than offset by
the percent decrease in price  total revenue
decreases

10. 10
Exhibit 2: Demand, Price Elasticity and Total
Revenue

11. 11

(a) Demand and Price Elasticity
Exhibit 2: Demand, Price Elasticity and Total Revenue
Panel (a) shows the
linear demand curve
and panel (b) shows the
total revenue generated
by each price-quantity
combination along the
demand curve
Because the demand
curve is linear, its slope
is constant: a given
decrease in price
always causes the same
unit increase in price
However, the price
elasticity of demand is
larger on the high end
of the demand curve
than it is on the low
price end
$100
90
80
70
60
50
40
30
20
10
D
0
Quantity per period
100200 500 8009001,000
$25,000
T
o
t
a
l

r
e
v
e
n
u
e

0
Total
revenue
(b) Total Revenue
TR = p x q
Price per unit
Quantity per period
1,000500

12. 12

(a) Demand and Price Elasticity
$100
90
80
70
60
50
40
30
20
10
e
d
c
b
a
D
0
Quantity per period
100200 500 8009001,000
Price per unit
Consider a movement
from point a to point b
on the demand curve.
The 100-unit increase in
quantity demanded is a
percent change of
100/150 = 0.67% while
the $10 drop in price is a
percent change of 10/85
= 12%  the price
elasticity of demand here
is 5.6
Between points d and
e, the 100 quantity
increase is a 12% change
and the $10 price
decrease is a 67% price
decrease  price
elasticity of 0.2
Exhibit 2: Demand, Price Elasticity and Total Revenue

13. 13

(a) Demand and Price Elasticity$100
90
80
70
60
50
40
30
20
10
e
d
c
b
a
D
Inelastic E
D
< 1
Unit elastic E
D
= 1
Elastic E
D
> 1
0
Quantity per period
100200 500 8009001,000
$25,000
T
o
t
a
l

r
e
v
e
n
u
e

0
Total
revenue
(b) Total Revenue
TR = p x q
Price per unit
Quantity per period
1,000500
When demand is
elastic, a decrease in price
(from a to b) will increase
total revenue because the
gain in revenue from
selling more units (blue
box) exceeds the loss in
revenue from selling all
units at a lower price (red
box)
When demand is
elastic, a price decrease
(from d to e) reduces total
revenue because the gain
in revenue from selling
more units (blue box) is
less than the loss in
revenue at the lower price
(red box)
Exhibit 2: Demand, Price Elasticity and Total Revenue

14. 14
Exhibit 3: Constant Elasticity Demand Curves
P
r
i
c
e

p
e
r

u
n
i
t
P
r
i
c
e

p
e
r

u
n
it
P
r
i
c
e

p
e
r

u
n
it
p
0 Quantity
per period
Quantity
per period
Quantity
per period
E =
D ¥
(a) Perfectly elastic
demand curve
$10


6
0 60 100
E = D 1
(c) Unit elastic
demand curve
D
0
E =
D 0
(b) Perfectly inelastic
demand curve
D'
Q
D"
a
b
This demand curve
indicates consumers will
demand all that is offered
at the given price, p. If the
price rises above p,
quantity demanded drops
to zero.
This demand curve
indicates that quantity
demanded does not vary
when the price changes; no
matter how high the price,
consumers will purchase the
same quantity.
This demand curve is
unit-elastic everywhere:
any percent change in
price results in an
identical offsetting
percent change in
quantity demanded.

15. 15
Availability of Substitutes
The greater the availability of substitutes for a
good and the closer the substitutes, the greater
the good’s price elasticity of demand
The number and similarity of substitutes
depend on how we define the good  the more
broadly we define a good, the fewer the
substitutes and the less elastic the demand

16. 16
Proportion of Consumer’s Budget
Because spending on some goods represents a large
share of the consumer’s budget, a change in the
price of such a good has a substantial impact on
the amount consumers are able to purchase
Generally, the more important the item is as a
share of the consumer’s budget, other things
constant, the greater will be the income effect of a
change in price, the more price elastic will be the
demand for the item

17. 17
Exhibit 5: Demand Becomes More Elastic over Time
$1.25
Suppose the price
increases from the initial
price of $1.00 to $1.25.
D
w
shows that one week
after the price increase, the
quantity demanded has not
changed much, from 100 to
95
After one month, D
m
, it
has declined to 75, and
after one year, D
y
, to 50
The longer the time
period the larger the
response to a given price
change
Quantity per period
1.00
0
D
w
1007550 95
D
m
D
yPrice per unit

18. 18
Price Elasticity of Supply
The price elasticity of supply measures how
responsive producers are to a price change
Equals the percent change in quantity supplied
divided by the percent change in price
Since the higher price usually results in an
increased quantity supplied, the percent change
in price and the percent change in quantity
supplied move in the same direction  the
price elasticity of supply is usually a positive
number

19. 19
Exhibit 7: Price Elasticity of Supply

20. 20
Exhibit 7: Price Elasticity of Supply
If the price increases from p to p', the
quantity supplied increases from q to q‘
The price elasticity of E
s
is
Where D q is the change in quantity
supplied and D p is the change in price.
2/)pp(
p
2/)qq(
q
s
E
+¢
D
+¢
D
=

21. 21
Categories of Supply Elasticity
The terminology for supply elasticity is the
same as for demand elasticity
If supply elasticity is less than 1.0, supply is inelastic
If it equals 1.0, supply is unit elastic
If it exceeds 1.0, supply is elastic
Exhibit 8 illustrates some special cases of
supply elasticity to consider

22. 22
Exhibit 8: Constant-Elasticity Supply Curves
P
r
i
c
e

p
e
r

u
n
i
t
P
r
i
c
e

p
e
r

u
n
i
t
P
r
i
c
e

p
e
r

u
n
i
t
p
0
E =
S
¥
(a) Perfectly elastic
$10



5
0 10 20
E =
S
1
(c) Unit elastic
S
0
E =
S
0
(b) Perfectly inelastic
S'
Q
S"
Quantity
per period
Quantity per periodQuantity per period
At one extreme is the
horizontal supply curve.
Here producers will
supply none of the good at
a price below p, but will
supply any amount at a
price of p
The most unresponsive
relationship is where there
is no change in the quantity
supplied regardless of the
price where the supply
curve is perfectly vertical.
Any supply curve that
is a straight line from
the origin such as
shown above is a
unit-elastic supply
curve.

23. 23
Determinants
The responsiveness of sellers depends on how
easy it is to alter output when price changes
If the cost of supplying additional units rises
sharply as output expands, then a higher price
will elicit little increase in quantity supplied
But if the marginal cost rises slowly as output
expands, the lure of a higher price will prompt a
large increase in output

24. 24
Length of Time
Supply also becomes more elastic over time as
producers adjust to price changes
The longer the time period under
consideration, the more able producers are to
adjust to changes in relative prices

25. 25
Exhibit 9: Supply Becomes More Elastic over
Time
1.00
S
w
is the supply
curve when the period
of adjustment is a
week.
S
m
is the supply
curve when the
adjustment period is
one month; supply
more elastic and
quantity supplied
increases to 140
After one year the
supply curve becomes
S
y
and the quantity
supplied increases to
200
0

Quantity per period
S
w S
m
S
y
100
110
140 200
$1.25
Price

26. 26
Income Elasticity of Demand
Measures how responsive demand is to a
change in income
Equals the percent change in demand divided
by the percent change in income
Categories
Goods with income elasticities less than zero are
called inferior goods  demand declines when
income increases

27. 27
Income Elasticity of Demand
Normal goods have income elasticities greater
than zero  demand increases when income
increases
Normal goods with income elasticities greater than
zero but less than 1 are called income inelastic goods
 demand increases but not as much as does
income
Goods with income elasticity greater than 1 are
called income elastic  demand not only increases
when income increases but increases by more than
does income

28. 28
Exhibit 11: The Demand for Grain

29. 29
Exhibit 12: Effect of Increases in Supply and
Demand on Farm Revenue


$8

Billions of bushels per year
D
S
0
4
14
D'
S'
10
Over time, technological
advances in farming have
sharply increased the
supply of grain
In addition, increases in
household income over time
have increased the demand
for farm products
But because increases in
the supply of grain have
exceeded increases in
demand, the combined
effect has been a drop in the
market price and a fall in
total farm revenue
Price per bushel

30. 30
Cross-Price Elasticity of Demand
Since firms often produce an entire line of
products, it has a special interest in how a
change in the price of one product will affect
the demand for another
The responsiveness of the demand for one good
to changes in the price of another good is called
the cross-price elasticity of demand

31. 31
Cross-Price Elasticity of Demand
Defined as the percent change in the demand of
one good divided by the percent change in the
price of another good
If an increase in the price of one good leads to an
increase in the demand for another good, their
cross-price elasticity is positive  the two goods are
substitutes
If an increase in the price of one good leads to a
decrease in the demand for another, their cross-
price elasticity is negative  the two goods are
complements