# Bryan Becher

2/3/10 Chapter 5: Elasticity of Demand and Supply

EC 111

- In a market economy, prices tell producers and consumers about the relative scarcity of products and resources - A firm’s success or failure often depends on how much it knows about the demand for its product - The price elasticity of demand measures, in a standardized way, how responsive consumers are to a change in price - Measures the percentage change in quantity demanded divided by the percentage change in price - = Percentage change in quantity demanded / Percentage change in price - Price elasticity formula – Percentage change in quantity demanded divided by the percentage change in price; the average quantity and the average price are used as bases for computing percentage changes in quantity and in price - ED = (Δq / ((q + q1) / 2)) / (Δp / ((p + p1) / 2)) - Elasticity expresses a relationship between two amounts: the percentage change in quantity demanded and the percentage change in price - In the elasticity formula, the numerator and the denominator have opposite signs, leaving the price elasticity of demand with a negative sign - Inelastic demand – A change in price has relatively little effect on quantity demanded; the percentage change in quantity demanded is less than the percentage change in price; the resulting price elasticity has an absolute value less than 1.0 - Unit-elastic demand – The percentage change in quantity demanded equals the percentage change in price; the resulting price elasticity has an absolute value of 1.0 - Elastic demand – A change in price has a relatively large effect on quantity demanded; the percentage change in quantity demanded exceeds the percentage change in price; the resulting price elasticity has an absolute value exceeding 1.0 - Knowledge of price elasticity of demand is especially valuable to producers - Indicates the effect of a price change on total revenue - Total revenue (TR) – Price multiplied by the quantity demanded at that price - TR = p x q - If the positive effect of a greater quantity demanded more than offsets the negative effect of a lower price, then total revenue rises - If demand is elastic, the percentage increase in quantity demanded exceeds the percentage decrease in price, so total revenue increases - If demand is unit elastic, the percentage increase in quantity demanded just equals the percentage decrease in price, so total revenue remains unchanged - If demand is inelastic, the percentage increase in quantity demanded is more than offset by the percentage decrease in price, so total revenue decrease - Linear demand curve – A straight-line demand curve; such a demand curve has a constant slope but usually has a varying price elasticity - A given decrease in price always causes the same unit increase in quantity demanded - If the demand curve is linear, consumers are more responsive to a given price change when the initial price is high than when it’s low - Demand becomes less elastic as one moves down the curve - A point halfway down the linear demand curve divides a linear demand curve into an elastic upper half and an inelastic lower half

Bryan Becher

2/3/10

EC 111

- A price decline increases total revenue if demand is elastic, has no effect on total revenue if demand is unit elastic, and decreases total revenue if demand is inelastic - The slope of a demand curve is not the same as the price elasticity of demand - Perfectly elastic demand curve – A horizontal line reflecting a situation in which any price increase would reduce quantity demanded to zero; the elasticity has an absolute value of infinity - Perfectly inelastic demand curve – A vertical line reflecting a situation in which any price change has no effect on the quantity demanded; the elasticity value is zero - Unit-elastic demand curve – Everywhere along the demand curve, the percentage change in price causes an equal but offsetting percentage change in quantity demanded, so total revenue remains the same; the elasticity has an absolute value of 1.0 - Constant-elasticity demand curve – The type of demand that exists when price elasticity is the same everywhere along the curve; the elasticity value is unchanged - The greater the availability of substitutes and the more similar these substitutes are to the good in question, the greater that good’s price elasticity of demand - The more narrow the definition, the more substitutes, and, thus, the more elastic the demand - The more important the item is as a share of the consumer’s budget, other things constant the greater is the income effect of a change in price, so the more price elastic is the demand for the item - The longer the period of adjustment, the more responsive the change in quantity demanded is to a given change in price - When estimating price elasticity, economists often distinguish between a period during which consumers have little time to adjust, the short run, and a period during which consumers can more fully adjust to a price change, the long run - The price elasticity of demand is greater in the long run because consumers have more time to adjust - Price elasticity of supply – A measure of the responsiveness of quantity supplied to a price change; the percentage change in quantity supplied divided by the percentage change in price - The percentage change in price and the percentage change in quantity supplied move in the same direction, so the price elasticity of supply is usually a positive number - ES = (Δq / ((q + q1) / 2)) / (Δp / ((p + p1) / 2)) - Inelastic supply – A change in price has relatively little effect on quantity supplied; the percentage change in quantity supplied is less than the percentage change in price; the price elasticity of supply has a value less than 1.0 - Unit-elastic supply – The percentage change in quantity supplied equals the percentage change in price; the price elasticity of supply equals 1.0 - Elastic supply – A change in price has a relatively large effect on quantity supplied; the percentage change in quantity supplied exceeds the percentage change in price; the price elasticity of supply exceeds 1.0 - Constant-elasticity supply curves – Supply curves whose elasticity does not change along the curves - Perfectly elastic supply curve – A horizontal line reflecting a situation in which any price decrease drops the quantity supplied to zero; the elasticity value is infinity - Perfectly inelastic supply curve – A vertical line reflecting a situation in which a price change has no effect on the quantity supplied; the elasticity value is zero - Unit-elastic supply curve – A percentage change in price causes an identical percentage change in quantity supplied; depicted by a supply curve that is a straight line from the origin; the elasticity value equals 1.0 - The elasticity of supply indicates how responsive producers are to a change in price

Bryan Becher

2/3/10

EC 111

- Their response depends on how easy it is to alter quantity supplied when the price changes - Just as demand becomes more elastic over time as consumers adjust to price changes, supply also becomes more elastic over time as producers adjust to price changes - The longer the adjustment period under consideration, the more able producers are to adapt to a price change - The elasticity of supply is typically greater the longer the period of adjustment - The ability to increase quantity supplied in response to a higher price differs across industries - Income elasticity of demand – The percentage change in demand divided by the percentage change in consumer income; the value is positive for normal goods and negative for inferior goods - Normal goods with income elasticities less than 1 are called income inelastic - Necessities often have income elasticities greater than 1 - Luxuries – Have income inelasticities greater than 1 - Because demand is price inelastic, total revenue falls when the price falls - Cross-price elasticity of demand – The percentage change in demand of one good divided by the percentage change in the price of another good; it’s negative for substitutes, positive for complements, and zero for unrelated goods - The responsiveness of the demand for one good to 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 goods are complements - Most pairs of goods selected at random are unrelated, so their cross-price elasticity is zero - Elasticity measures the willingness and ability of buyers and sellers to alter their behavior in response to changes in their economic circumstances - Firms try to estimate the price elasticity of demand for their products - Governments also have an ongoing interest in various elasticities