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Elasticity and Its Applications An increase in the price of a product decreases the quantity demanded while increasing the quantity supplied. The question is by how much they will change. Demand and supply elasticities measure how responsive quantity demanded and quantity supplied are to a change in price. More generally, elasticity measures the responsiveness of one variable when there is a change in another variable.

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Three topics: 1.

Elasticity of demand

2. Two other demand elasticities 3. Elasticity of supply

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5.1 The Elasticity of Demand After studying this section, you will be able to: 1.

Explain the responsiveness of quantity demanded to a price change depends on the steepness of the demand curve.

2. Understand the four determinants of the elasticity of demand. 3. Draw different shapes of demand curves. 4. Use the definition of the price elasticity of demand to calculate the percentage change in quantity demanded. 5. Explain the change in total revenue earned by producers due to a price change will depend on the elasticity of demand.

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

Follow the material in the lecture slides. You are not responsible for using the midpoint method to calculate the elasticity of demand in the text.

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1.

The elasticity of demand It measures how responsive quantity demanded for a product is to a change in its own price. Consider two demand curves which are downward sloping straight lines and they run through a common point.

Demand curve Demand responsiveness Description to a price change Steep

Less responsive

Demand is inelastic (less elastic)

Flat

More responsive

Demand is elastic

6

95 100

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2. Determinants of the Elasticity of Demand What makes one good has elastic demand while another good has inelastic demand? Four determinants: 1)

Availability of Substitutes

2) Necessities vs. Luxuries 3) Time Horizon 4) Share of Income Spent on the Good

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1)

Availability of Substitutes The fundamental determinant of the elasticity of demand is how easy it is to substitute one good for another good. The availability of substitutes strongly influences the sensitivity of quantity demanded to changes in price.

Goods which have few substitutes

Examples

Demand

Egg and milk

Inelastic

Goods which have many substitutes Coke

Elastic

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2) Necessities vs. Luxuries



For necessities such as food or something important like medicine, demand is inelastic.



Luxury goods such as sailboats, their demand is elastic because something you can do without.

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3) Time Horizon The time horizon considered influences demand elasticity. In the short run, demand tends to be inelastic whereas in the long run, demand tends to be elastic. 

Example: Gasoline Consider a price increase. Change in demand Demand elasticity Short Run (SR) A small decrease

Inelastic

Long Run (LR)

Elastic

A large decrease

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4) Share of Income Spent on the Good Good

Fraction of income spent Demand

Bread Small

Inelastic

Car

Elastic

Large

Consumers are less price sensitive to an increase price in bread. But they are more concerned and more price sensitive to a price increase in a car.

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In – Class Exercise Compare each pair of two goods and explain which good is more elastic. 1)

Breakfast cereal versus sunscreen

2) “Blue Jeans” versus “Clothing” 3) Insulin versus Caribbean Cruises

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3. Four Different Shapes of Demand Curves

Inelastic Demand

Perfectly Inelastic Demand

Goods with few substitutes

Goods like medicine tend to be

tend to be demand inelastic.

perfectly inelastic.

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Elastic Demand

Perfectly Elastic Demand

Goods with many substitutes

A competitive firm faces this type

tend to be demand elastic.

of demand curve because it is

a price taker.

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4. Calculating the Elasticity of Demand Elasticity of Demand = % change in quantity demanded for 1% change in the price of the product

=

% change in quantity demanded %∆𝑄 = % change in price %∆𝑃

Product

%∆𝑃

%∆𝑄

Demand elasticity

Chicken

10%

−6.5%

−0.65 (=

Coke

−20%

−6.5% ), 10%

inelastic demand

29.4% −1.47 (= 29.4% ), elastic demand −20%

In absolute terms 0.65 1.47

1% change in the price of chicken leads to 0.65% change in demand.

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

The following diagram may be useful to remember the names of demand elasticity for different values.

−1

Elastic

0

Inelastic

Unit price elastic

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In – Class Exercise: Use the elasticity of demand to calculate %∆𝑄

Product

%∆𝑃 Elasticity of demand

Chicken

1%

−0.65

%∆𝑄 1% (−0.65) = −0.65%

−20%

Product

%∆𝑃 Elasticity of demand

Coke

1% 10%

−1.47

%∆𝑄 1% (−1.47) = 1.47%

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5. Total Revenue and the Elasticity of Demand Total revenue is the money received from producing and selling a product. It is important for producers. The higher is the total revenue, the more likely they will make more money and earn a higher profit. What will happen to total revenue due to a price change?

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What is total revenue equal to?

Total Revenue = Price x quantity sold 𝑇𝑅 = 𝑃 x 𝑄

An area under the demand curve can be used to represent TR.

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Using a rectangular area under the demand curve to represent TR

P

TR = P x Q

Q

Demand curve

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In – Class Exercise: Use the elasticity of demand to calculate %∆𝑄

Product

%∆𝑃 Elasticity of demand

Chicken

1%

−0.65

%∆𝑄 1% (−0.65) = −0.65%

−20%

Product

%∆𝑃 Elasticity of demand

Coke

1% 10%

−1.47

%∆𝑄 1% (−1.47) = 1.47%

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5. Total Revenue and the Elasticity of Demand Total revenue is the money received from producing and selling a product. It is important for producers. The higher is the total revenue, the more likely they will make more money and earn a higher profit. What will happen to total revenue due to a price change?

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What is total revenue equal to?

Total Revenue = Price x quantity sold 𝑇𝑅 = 𝑃 x 𝑄

An area under the demand curve can be used to represent TR.

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Using a rectangular area under the demand curve to represent TR

P

TR = P x Q

Demand curve

Q

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

Question: How does a price change affect total revenue?

TR

TR

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Demand

Demand Responsiveness

Demand is inelastic; Quantity demanded steep demand curve is not responsive

The change in TR 1) 𝑃 ↑ → 𝑇𝑅 ↑ 2) 𝑃 ↓ → 𝑇𝑅 ↓ TR and P move together.

Demand is elastic; flat demand curve

Quantity demanded is responsive

1) 𝑃 ↑ → 𝑇𝑅 ↓ 2) 𝑃 ↓ → 𝑇𝑅 ↑ TR and P move in the opposite directions.

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

In – Class Exercise: Question 10 in pp.112 Food has an inelastic demand, and computers have an elastic demand. Assume the steepness of the supply curves is the same for both goods. Suppose that technological advance doubles the supply of both products. a.

What happens to the equilibrium price and quantity in

each market? b. Which product experiences a greater change in price? c.

Which product experiences a greater change in quantity?

d. What happens to total consumer spending and thus total revenue earned in each industry?

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Use this two – panel diagram to answer them.

Food

Computers

𝑃

𝑃

𝐸1

𝐸1

𝑄

𝑄

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Application: Technological advances in the farming sector

Question: Are farmers better off or worse off?

An increase in supply causes a decrease in the food price.

TR decreases because demand for food elastic.

Farmers are worse off.

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5.2 Other Demand Elasticities Demand also depends on income and the prices of related goods. The other two demand elasticities measure the percentage change in demand when there is a 1 percentage change in each of them. After studying this section, you will be able to 1.

Define the income elasticity of demand, and use it to determine whether a good is a normal good or an inferior good.

2. Define the cross – price elasticity of demand and use it to determine whether the two goods are substitutes or complements.

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1.

Income elasticity of demand Income elasticity of demand = % change in demand for 1 % change in income Product Cream

Income Elasticity of Demand 1.72

Peaches

1.43

Apples

1.32

Oranges

0.83

Eggs

0.44

Milk

0.5

Butter

0.37

Potatoes

0.15

Margarine

−0.20

Flour

−0.36

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Income elasticity of demand

Income elasticity of demand Normal goods

Positive

Inferior goods

Negative

Normal good

Income elasticity of demand

Coke

0.58

Pepsi

1.38

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2. Cross – price elasticity of demand Cross price elasticity of demand between demand for good 1 and the price of good 2 % change in demand for good 1

= % change in the price of good 2 1)

Good 1 and good 2 are substitutes: positive

2) Good 1 and good 2 are complements: negative Examples: Elasticity

Price of Coke Price of Pepsi

Demand for Coke

−1.47

0.52

Demand for Pepsi

0.64

−1.55

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Cross – price elasticities of demand for four automobiles Price of Sentra

Price of Escort

Demand for Sentra

−6.528

0.078

Demand for Escort

0.054

Demand for Lexus Demand for BMW

Price of Lexus LS400

Price of BMW 735i

0

0

−6.031

0.001

0

0

0.001

−3.085

0.093

0

0.001

0.032

−3.515

Are Sentra and Escort competing with each other? Are Sentra and Escort competing with Lexus and BMW?

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5.3 The Elasticity of Supply After studying this section, you will be able to:

1.

Explain the responsiveness of quantity supplied to a price change depends on the steepness of the supply curve as measured by the elasticity of supply,

2. List the main determinants of the elasticity of supply. 3. Draw the four different shapes of supply curves. 4. Define the elasticity of supply.

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A decrease in supply causes a large increase in P. But P will decrease to PLR over time. SR 𝑆′𝑆𝑅

LR 𝑆𝑆𝑅 𝑆′𝐿𝑅

𝑃𝑆𝑅

𝑆𝐿𝑅

𝑃𝑆𝑅 𝑃𝐿𝑅

𝑃1

𝑃1 𝐷𝑆𝑅

𝐷𝐿𝑅

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4. The elasticity of supply is defined as the percentage change in quantity supplied for 1% change in the price.

The elasticity of supply =

% change in quantity supplied % change in price

>0

It is usually positive because quantity supplied and the price moves in the same direction.

Is the following statement correct? The elasticity of supply in the SR is larger than the one in the LR.

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Summary 1.

The elasticity of demand measure how responsive quantity demanded is to a change in price.

Inelastic demand

Elastic demand

The steeper is a demand curve, The flatter is a demand curve, the less responsiveness is the more responsiveness is the quantity demanded to a price change the quantity demanded to a price change

2. Four determinants of elasticity of demand 1)

Availability of Substitutes

2) Necessities vs. Luxuries 3) Time Horizon 4) Share of Income spent on the Good

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3. TR and the elasticity of demand a.

Demand is inelastic: TR and P move in the same direction

b. Demand is elastic: TR and P move in the opposite directions

4. Elasticity of Demand = % change in quantity demanded for 1% change in the price of the product =

% change in quantity demanded % change in price

%∆𝑄

= %∆𝑃

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5. Income elasticity of demand and Cross – price elasticity of demand Income elasticity of demand Normal goods Positive Inferior goods Negative

Cross-price elasticity of demand Two goods are substitutes Positive Two goods are complements Negative

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6. The elasticity of supply measures how responsive quantity supplied is to a change in price Inelastic supply

Elastic supply

The steeper is a supply curve, the less responsiveness is the quantity supplied to a price change

The flatter is a supply curve, the more responsiveness is the quantity supplied to a price change



The type of the product and time horizon are the determinants of the elasticity of supply. Supply curve tends to be inelastic in the short run and elastic in the long run....