agri 2312 chapter 5 supplement

chapterchapternine:nine:

The Concept The Concept of Elasticityof Elasticity

part two: microeconomicspart two: microeconomics

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Agricultural Economics, 3th edition By H. Evan Drummond and John W. Goodwin

© 2011, 2004 Pearson Higher Education, Inc.© 2011, 2004 Pearson Higher Education, Inc.Pearson Prentice Hall - Upper Saddle River, NJ 07458Pearson Prentice Hall - Upper Saddle River, NJ 07458

The Concept of ElasticityThe Concept of Elasticity

• Consumers will accept an increase in the priceof a given product without too much reaction.– But an increase in the price of another good will be met

with stubborn resistance and a refusal to purchase.

• A strong price increase for some commodities will induce large numbers of producers to increase production.– And further interest of others in becoming producers.

• Still other products will absorb a price increasewith little reaction on the part of producers.

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• A third situation is that an increase in consumer income will be associated with a reduction in the use of one commodity, an increase in the use of another, and no change in the use of a third.

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• A measure of the sensitivity of consumers and producers to changes in prices and incomes is known as elasticity.– It deals with the sensitivity of the quantity demanded,

or quantity supplied to changes in some other factor.

• Through the use of elasticity estimates, managers can anticipate the probable magnitude of market impact of various sorts of changes.

• While the number of elasticities is almost limitless, four fundamental elasticity concepts—demand, supply, cross-price, and income—can be usedto characterize any given market.

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The Concept of ElasticityThe Concept of ElasticityELASTICITY OF DEMANDELASTICITY OF DEMAND

• We define elasticity of demand as responsiveness of the quantity demanded to a change in the price.– Degree of responsiveness is measured by an elasticity

coefficient—frequently called elasticities.

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• We define the elasticity coefficient to be:

If the rate of change of the quantity demanded is greater than the rate of change in price, we say the demand relationship is

elastic.

If the rate of change of quantity is less than the rate ofchange of price, the relationship is said to be inelastic.

If demand for a good is elastic, then we know that consumers are very responsive to price changes.

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• The concept of elasticity, and elasticity coefficients has a lot to do with rates of change.– As you move along a demand curve, both price & quantity

are changing simultaneously.

• We measure the elasticity of demand coefficient by dividing rate of change in the quantity demanded by rate of change in price for a small segment, or arc, along a given demand curve.

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Algebraically, the relationshipmay be expressed as:

The mathematical symbolΔ(delta) means “change in.”

This algebraic formulation isshown geometrically at left.

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The calculation of the elasticity of demand with respect to price for a move from point A to point B:

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Elasticity of demand coefficient for a move from point B to point A.

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We can modify our basic elasticity formulato eliminate the discrepancy arising from selecting either of the two endpoints of

the arc as the initial situation.

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The calculation for our example.

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If the value of the demand elasticity coefficientis between zero and -1 then demand is inelastic.

If the value of the coefficient is less than -1, orabsolute value is greater than 1), demand is elastic.

If the elasticity coefficient should be exactlyequal to -1 elasticity is said to be unitary.

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• Demand curves often exhibit all three rangesof elasticity in a single curve.– Always true when a

demand curve is astraight line.

Straight line demand curvesare elastic with respect to priceat relatively high prices, and inelastic at relatively low prices.

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• Both elastic & inelastic ranges can occur in a single demand curve.– As consumers pass from

the elastic to the inelastic range, they must pass through a point (or range) of unitary elasticity.

For a straight line demand curve, as shown, this always occurs atthe midpoint on the quantity axis, between the origin & where the demand curve hits the horizontal axis.

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The Concept of ElasticityThe Concept of ElasticityELASTICITY OF DEMAND - Some Special Cases ELASTICITY OF DEMAND - Some Special Cases

• Two extreme cases of elasticity of demand:– Cases in which the

elasticity coefficientis equal to zero (or perfectly inelastic)at all points on the function.

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The same quantity will be demanded no matter what the price happens to be.

The demand functionis perfectly vertical.

Largely theoretical, butthe demand for an item that normally representsa small part of the total budget and is an absolute necessity—such as table salt, or insulin—will approach this situation.

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• Two extreme cases of elasticity of demand:– Cases in which the

elasticity coefficientis infinite (or perfectly elastic) at all points of the function.

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The manager cannot affect price received, no matter how much is sold.

The market will absorb any quantity offered atthe prevailing price.

This approximates the conditions under which most farmers sell their products, thus, perfectly elastic demand is an important concept in thearea of agricultural microeconomics.

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The Concept of ElasticityThe Concept of ElasticityElasticity of Demand Related to Total RevenueElasticity of Demand Related to Total Revenue

• Elasticity of demand for a good & total revenuesof a firm producing it are very much interrelated.

• Movement along a demand curve, left to right,will result in an increase in quantity consumed.– And a decrease in the price per unit.

• As total revenue of the firm is equal to price times quantity, total revenue depends on whether quantity increases at a faster rate than price decreases.– The demand elasticity coefficient tells us what will

happen to total revenue as price & quantity change together.

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Price reductions in the elastic range of the demandcurve are associated with increases in the total revenue.

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Price reductions in the inelastic range areassociated with reductions in total revenue.

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When elasticity is unitary, total revenue is at its maximum, as shown here, graphically.

That portion of a straight line demand curve which lies to the left of the midpoint is elastic with respect to price.

The portion to the right of the midpoint is inelastic.

At the midpoint, demand is unitarily elastic.

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The Concept of ElasticityThe Concept of ElasticityFactors Affecting Demand ElasticityFactors Affecting Demand Elasticity

• What are the characteristics of goods that determine whether demand is elastic or inelastic?– In general, price elasticity of demand for any product will

be more elastic as the number of substitutes is greater.

– Demand elasticity is normally more elastic if expenditure on the product represents a large item in the consumer’s total budget.

– Demand is likely more elastic for luxuries as opposedto necessities, since consumers can do without luxuries.

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The Concept of ElasticityThe Concept of ElasticityFactors Affecting Elasticity - SubstitutesFactors Affecting Elasticity - Substitutes

• Demand for goods with lots of substitutes tendsto be elastic.– As the price of one good goes up, ceteris paribus,

the consumer will easily shift to substitute goods.• Consumption of the good with the price increase will

fall substantially.

• Demand for goods with few close substitutestends to be inelastic.– A good for which there are no viable substitutes is insulin,

and, as a result, the demand for insulin is very inelastic.• A good way to remember what is elastic and inelastic—

INsulin is INelastic.

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The Concept of ElasticityThe Concept of ElasticityFactors Affecting Elasticity - Budget ImportanceFactors Affecting Elasticity - Budget Importance

• Elasticity of demand for items very important inthe family budget—like a car or house—tendsto be very elastic, indicating consumers arevery price sensitive.– By comparison, demand for items that are a

small part of the budget is frequently inelastic.

• Goods in the latter category are frequently called impulse items as we buy then on the basis of a sudden impulse rather than on the basis of price.– These items—lip balm, comb, fingernail file, replacement

screws for eyeglasses—are usually located on displays by the checkout counter.

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The Concept of ElasticityThe Concept of ElasticityFactors Affecting Elasticity - Luxury vs. Necessity Factors Affecting Elasticity - Luxury vs. Necessity

• Elasticity of demand for luxury goods is very elastic while, that of necessities tends to be inelastic.– The family shopping for a summer vacation seeks

different transportation alternatives and hotel deals.• They are price sensitive, which means demand is elastic.

– The insulin consumer, or homeowner needing a drain unplugged are quite price insensitive or inelastic intheir demand.

• Both need something, as opposed to wanting something.

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The Concept of ElasticityThe Concept of ElasticityFactors Affecting Elasticity - Luxury vs. Necessity Factors Affecting Elasticity - Luxury vs. Necessity

• Numerous other factors affect demand elasticity:– Consumers are creatures of habit, only altering their

customary patterns of consumption in response toprice changes, over a period of time.

• Demand tends to be more elastic as the length ofthe time period in question is extended.

– Durability of some products will affect the elasticity of demand for them—repairing older durable goods canbe a good substitute for buying a new model.

– Culture and tradition can affect demand elasticity.• In late November, U.S. demand for turkey becomes highly

inelastic due to the Thanksgiving tradition, while the other 51 weeks of the year, demand may be quite elastic as there are numerous substitutes.

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The Concept of ElasticityThe Concept of ElasticityCROSS-PRICE ELASTICITYCROSS-PRICE ELASTICITY

• The Cross-price elasticity coefficient measures adjustments consumers make in their consumptionof one product in response to a change in the price of another.– It measures the extent to which the demands for various

commodities are related.

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Shown here is the relationshipof quantities of sausage that consumers will consume and alternative prices for sausage, ceteris paribus.

An important ceteris paribus condition for the sausage market is the price of bacon.

The sausage demand curve shown in black is drawn for a bacon price of $2.00/lb, and labeled B = 2.

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What would happen in the sausage market if the priceof bacon rose to $3.00/lb?

Consumers would substitute sausage for bacon in their morning diet, consuming a larger quantity of sausageat every sausage price.

This would result in a demand shift in the sausage market, caused by the price changein bacon.

The new demand curveis shown in blue and is

labeled B = 3

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For any given sausage price of sausage, such as Ps, the sausage quantity demanded has increased from Q2 to Q3.

The amount of increased sausage consumptions associated with an increase in the price of bacon is

measured with a cross-price elasticity coefficient.

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To examine consumption of beef as the priceof pork is changed, divide the rate of changein the quantity of beef purchased by the rate

of change in the price of pork:

…which may be modified into an operational form, using midpoints:

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• When two commodities are substitutes for each other, the algebraic sign of the cross-priceelasticity coefficient will be positive.– If the price of one increases, the quantity of the

other commodity purchased will also increase.

• Commodities that are complementary to each other have negative cross-price elasticity coefficients.– Dress shirts and neckties serve as an illustration.

• The cross-price elasticity between the price of one product and the consumption of another may be quite different when the direction is reversed.

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The Concept of ElasticityThe Concept of ElasticityINCOME ELASTICITYINCOME ELASTICITY

• An income elasticity coefficient shows the extent to which consumers alter their purchases of any good as a result of changes in income.– With slight alterations, our basic elasticity formula can

be used to define an income elasticity coefficient:

…modified intothe standard

midpoint formula:

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• Normally, we expect the algebraic sign of the income elasticity coefficient to be positive.– As a consumer has more income, his consumption

of the good in question will increase.• Such goods are called normal goods.

• There are a limited number of goods—lard, for example—that exhibit negative income elasticities.– As consumers’ incomes rise, they tend to reduce their

consumption of these inferior goods.• If they can afford to substitute vegetable shortening

for hog lard, they will do so.

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• If the income elasticity of demand for a particular good is 0.0, demand for that good is not affectedby changes in income.– Normally the case for items such as salt and other

condiments that are an insignificant part of the budget.

• If income elasticity of demand is greater than 1.0, an increasing proportion of consumer income is spent on the good, as income increases.– Examples are protein sources among the poor in

developing countries.• Numerous studies have found the income elasticity

of demand for milk among the poor to be well above 1.0.

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• Most goods have an income elasticity of less than 1.0, meaning that the proportion of income spenton the good falls as the consumer becomes richer.– Most foods in developed countries fall into this category.

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The Concept of ElasticityThe Concept of ElasticityELASTICITY OF SUPPLYELASTICITY OF SUPPLY

• The idea of elasticity of supply is almost identical with the concept of elasticity of demand.– The formula is identical, but where the algebraic sign

of the elasticity of demand coefficient is normally negative, that of the elasticity of supply coefficientis generally positive.

• Since quantity supplied increases as price increases, the supply function slopes upward,to the right, with a positive slope.– Hence the positive elasticity of supply coefficient

with respect to price.

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The Concept of ElasticityThe Concept of ElasticityPRICE DISCRIMINATIONPRICE DISCRIMINATION

• When a firm produces a product sold in two different markets, with different demand elasticities, the firm can probably increase revenues by engaging in price discrimination.– Charging different prices in the two different markets.

• An example in the food industry is a vegetable packer that can sell vegetables in either the fresh market (inelastic demand) or the frozen market (elastic demand).

• Another example is a producer of tomato saucesells it either as a branded product (inelastic demand) or as a generic (elastic demand).

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agri 2312 chapter 5 supplement

Business

demand elasticity coefficient

elastic demand

demand function

demand iselastic

concept of elasticity

ranges of elasticity

elasticity coefficients

given demand curve