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Demand and Supply Elasticity

Should relatively substantial decreases in the prices of illicit drugs motivate concerns than consumption of these drugs may have risen dramatically?

In this chapter, you will find that the answer to this question depends on how responsive quantities demanded are to decreases in the market prices of these illicit drugs.

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Learning Objectives

• Express and calculate price elasticity of demand

• Understand the relationship between the price elasticity of demand and total revenues

• Discuss the factors that determine the price elasticity of demand

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Learning Objectives

• Describe the cross price elasticity of demand and how it may be used to indicate whether two goods are substitutes or complements

• Explain the income elasticity of demand

• Classify supply elasticities and explain how the length of time for adjustment affects the price elasticity of supply

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Did You Know That...

• A 10% reduction in the price of beer is associated with an increase in the incidence of campus violence of just over 3.5%?

• Consumers respond to changing prices in ways that influence total revenues that businesses receive?

• Economists have a special name for quantity responsiveness—elasticity, which is the subject of this chapter?

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Price Elasticity

• Price Elasticity of Demand (Ep)

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

Defined as the percentage change in quantity demanded divided by the percentage change in price

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Price Elasticity

• Price Elasticity of Demand (Ep)

Ep = Percentage change in quantity demanded

Percentage change in price

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Ep = –1%

+10%= –.1

Price Elasticity

• Example

Price of oil increases 10%

Quantity demanded decreases 1%

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Price Elasticity

• Question How would you interpret an elasticity

of –0.1?

• Answer A 10% increase in the price of oil will lead

to a 1% decrease in quantity demanded.

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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.

By convention, the minus sign is ignored.

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Calculating Elasticity

• Elasticity formula:

Change in Q

Sum of quantities/2Ep =

Change in P

Sum of quantities/2

or

in Q

(Q1 + Q2)/2Ep =

in P

(P1 + P2)/2

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Example: The Price Elasticity of Demand for Gasoline

• After Hurricane Katrina in 2005 the nationwide price of gasoline rose from $2.61 to $3.07.

• The total quantity of gasoline consumed in the United States declined from 9.42 to 9.04 million barrels.

• What is the price elasticity of demand?

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Example: The Price Elasticity of Demand for Gasoline

• Use the elasticity formula:

9.42 – 9.04 ÷ $3.07 – $2.61 (9.42 + 9.04)/2 ($3.07 +$2.61)/2

• The price elasticity of 0.25 means that a 1% increase in price generated a 0.25% decrease in the quantity of gasoline demanded.

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Price Elasticity Ranges

• Elastic Demand

Percentage change in quantity demanded is larger than the percentage change in price

Total expenditures and price are inversely related in the elastic region of the demand curve

Ep > 1

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Price Elasticity Ranges

• Unit Elasticity of Demand

Percentage change in quantity demanded is equal to the percentage change in price

Total expenditures are invariant to price changes in the unit-elastic region of the demand curve

Ep = 1

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Price Elasticity Ranges

• Inelastic Demand

Percentage change in quantity demanded is smaller than the percentage change in price

Total expenditures and price are directly related in the inelastic region of the demand curve

Ep < 1

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Price Elasticity Ranges

• Elastic demand

% change in Q > % change in P; Ep > 1

• Unit-elastic

% change in Q = % change in P; Ep = 1

• Inelastic demand

% change in Q < % change in P; Ep < 1

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Price Elasticity Ranges

• Extreme elasticities

Perfectly Inelastic DemandA 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.

A demand that exhibits zero responsiveness to price changes.

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Figure 21-1 Extreme Price Elasticities, Panel (a)

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Price Elasticity Ranges

• Extreme elasticities

Perfectly Elastic DemandA 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.

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Figure 21-1 Extreme Price Elasticities, Panel (b)

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Elasticity and Total Revenues

• When demand is elastic, a negative relationship exists between changes in price and changes in total revenues.

• When demand is unit-elastic, changes in price do not change total revenues.

• When demand is inelastic, a positive relationship exists between changes in price and total revenues.

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Figure 21-3 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service, Panel (a)

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Figure 21-3 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service, Panel (b)

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Figure 21-3 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service, Panel (c)

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Elasticity and Total Revenues

• Elasticity-revenue relationship

Total revenues are the product of price times units sold.

The law of demand states along a given curve, price is inverse to quantity.

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Elasticity and Total Revenues

• What happens to the product of price times quantity depends on which of the opposing forces exerts a greater force on total revenues.

• This is what price elasticity of demand is designed to measure: responsiveness of quantity demanded to a change in price.

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Table 21-1 Relationship Between Price Elasticity of Demand and Total Revenues Example

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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.

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Determinants of Price Elasticity of Demand

• The length of time allowed for adjustment

The longer any price change persists, the greater is the elasticity of demand.

Price elasticity is greater in the long run than in the short run.

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Determinants of Price Elasticity of Demand

• 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.

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In the short run, quantity demanded falls slightly

Figure 21-4 Short-Run and Long-Run Price Elasticity of Demand

With more time for adjustment the demand curve becomes more elastic and quantity demanded falls by a greater amount

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Example: What Do Real-World Price Elasticities of Demand Look Like?

• Economists have found that estimated elasticities of demand are greater in the long run than in the short run.

• Remember that even though we are leaving off the negative sign, there is an inverse relationship between price and quantity demanded.

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Table 21-2 Price Elasticities of Demand for Selected Goods

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Cross Price Elasticity 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

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Cross Price Elasticity of Demand (cont'd)

• Formula for computing cross price elasticity of demand between good X and good Y

% Change in demand for good X

% Change in price of good YExy =

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Cross Price Elasticity of Demand

• Substitutes

Exy would be positiveAn increase in the price of X would increase

the quantity of Y demanded at each price.

• Complements

Exy would be negativeAn increase in the price of X would decrease

the quantity of Y demanded at each price.

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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

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Income Elasticity of Demand

Percentage change in demand

Percentage change in incomeEi =

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Table 21-3 How Income Affects Quantity of DVDs Demanded

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Income Elasticity of Demand

• 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

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Income Elasticity of Demand

• Calculating the income elasticity of demand

Ei = Change in quantity ÷ Change in income Average quantity Average income

The income elasticity of demand can be either negative or positive.

Remember that in calculating the income elasticity of demand, the price of the good is assumed to be constant.

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Price Elasticity of Supply

• Price Elasticity of Supply (Es)

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

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Percentage change in quantity supplied

Percentage change in priceES =

Price Elasticity of Supply (cont'd)

• Formula for computing price elasticity of supply

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Price Elasticity of Supply (cont'd)

• Classifying supply elasticities

Perfectly Elastic Supply Quantity supplied falls to zero when there is

the slightest decrease in price

The supply curve is horizontal at a given price

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Price Elasticity of Supply (cont'd)

• Classifying supply elasticities

Perfectly Inelastic SupplyQuantity supplied is constant no matter what

happens to price

The supply curve is vertical at a given price

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Figure 21-5 The Extremes in Supply Curves

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Price Elasticity of Supply

• Price elasticity of supply and length of time for adjustment

1. The longer the time allowed for adjustment, the more resources can flow into (out of) an industry through expansion (contraction) of existing firms.

2. The longer the time allowed for adjustment, the entry (exit) of firms increases (decreases) production in an industry.

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Figure 21-6 Short-Run and Long-Run Price Elasticity of Supply

As time passes the supply

curve rotates from S1 to S2 and quantity supplied rises to Q1

As more time passes the

supply curve rotates from S2 to S3 and quantity supplied rises from Q1 to Q2

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Table 21-4 Estimated Price Elasticities of Demand for Selected Illicit Drugs

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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

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Summary Discussion of Learning Objectives

• 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 unit-elastic, total revenue does not change when price changes.

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Summary Discussion of Learning Objectives

• 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

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Summary Discussion of Learning Objectives

• 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 a related good

If cross elasticity is positive, the goods are substitutes.

If cross elasticity is negative, the goods are complements.

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Summary Discussion of Learning Objectives

• Income elasticity of demand

Responsiveness of the demand for the good to a change in income

Percentage change in the demand for a good divided by the percentage change in income.

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Summary Discussion of Learning Objectives

• 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.