ECO 182 (Micro) Ch 05 Elasticity of Demand and Supply

ECO 182

Chapter 5

Elasticity of Demand and Supply

1Dr. Baban Hasnat, UB/SIM, ECO 182 Microeconomics, Ch. 5

Price Elasticity of Demand Elasticity

Responsiveness Price elasticity of demand

How responsive quantity demanded is to a price change

Formula: percentage change in quantity demanded divided by percentage change in price


Price Elasticity of Demand

• %Δq = percentage change in quantityΔq = change in quantity

• %Δp = percentage change in priceΔp = change in price

2/)'(2/)'(

%

%

pp

p

qq

qE

p

qE

D

D


Price Elasticity of Demand

• Price elasticity of demand, ED

Law of demandoPrice and quantity demanded are inversely

related

ED negative

Absolute value of ED positive


Exhibit 1Demand Curve for Tacos

D

10595 Thousands per day 0

0.90

Pric

e pe

r ta

co$1.10

b

a

If the price of tacos drops from $1.10 to $0.90, the quantity demanded increases from 95,000 to 105,000.


Categories of ED

Inelastic, Unit Elastic, Elastic• If %∆q < %∆p

A change in price has relatively little effect on quantity demanded

ED between 0 and 1

Inelastic demand• If %∆q = %∆p

ED = 1

Unit elastic demand


Categories of ED

• If %∆q > %∆p A change in price has a relatively large

effect on quantity demanded ED greater than 1

Elastic demand


Elasticity and Total Revenue• Total revenue = price * quantity

demanded at this price• TR= p ˣ q• As price decreases

If demand is elastic, TR increases If demand is inelastic, TR decreases If demand is unit elastic, TR constant


Price Elasticity and Linear D Curve• Linear demand curve

Straight line demand curve Constant slope Varying elasticity

Demand becomes less elastic as we move downward

Upper half: elastic Lower half: inelastic Midpoint: unit elastic


Exhibit 2Demand, Price Elasticity, and Total Revenue

D

90

60

10

70

Pric

e pe

r un

it

$100

80

50403020

b

a

de

800500200100 Quantity per period1,000 0 900

Tota

l rev

enue

$25,000

500 Quantity per period1,000 0

(a) Demand and price elasticity

(b) Total revenue

Total

revenue

Unit elastic, ED =1

Elastic, ED >1

Inelastic, ED <1

Where the demand curve is elastic, a lower price increases total revenue. Total revenue reaches a maximum at the rate of output where the demand curve is unit elastic.

c

Where the demand curve is inelastic, further decreases in price reduce total revenue.


Constant Elasticity Demand Curves• Perfectly elastic demand curve

Horizontal line Any price increase would reduce quantity

demanded to zero

ED = ∞

Consumers don’t tolerate price increases


Constant Elasticity Demand Curves• Perfectly inelastic demand curve

Vertical line Any price change has no effect on the

quantity demanded

ED = 0

‘Price is no object’


Constant Elasticity Demand Curves• Unit-elastic demand curve

Everywhere along the demand curve % Δp causes an equal but offsetting %Δq Total revenue remains the same

ED = 1

• Constant-elasticity demand curve Price elasticity is the same everywhere

along the curve Elasticity value is unchanged


Exhibit 3Constant-Elasticity Demand Curves

0 Quantity

per period

Pric

e pe

r un

it

pED = ∞

(a) Perfectly elastic

D P

rice

per

unit

ED’ = 0

(b) Perfectly inelastic

ED’’ = 1

(c) Unit elastic

D’

0 Quantity

per period

Q

Pric

e pe

r un

it

$10

6

0 Quantity

per period

60 100

D’’

a

b

The three panels show constant-elasticity demand curves, so named because the elasticity value does not change along the demand curve. Along the perfectly elastic, or horizontal, demand curve of panel (a), consumers demand all that is offered for sale at price p, but demand nothing at a price above p. Along the perfectly inelastic, or vertical, demand curve of panel (b), consumers demand amount Q regardless of price. Along the unit-elastic demand curve of panel (c), total revenue is the same for each price-quantity combination.


Exhibit 4Summary of Price Elasticity of Demand


Determinants of Price Elasticity of D

• ED is greater: The greater the availability of substitutes,

and the more similar the substitutes The more important the good as a share

of the consumer’s budget The longer the period of adjustment

(time)


Exhibit 5Demand Becomes More Elastic Over Time

Dw

Pric

e pe

r un

it

$1.25

1.00

Dm

Quantity per day95 10075500

Dy

e

Dw is the demand curve one week after a price increase from $1.00 to $1.25. Along this curve, quantity demanded per day falls from 100 to 95. One month after the price increase, quantity demanded has fallen to 75 along Dm. One year after the price increase, quantity demanded has fallen to 50 along Dy. At any given price, Dy is more elastic than Dm, which is more elastic than Dw.


Elasticity Estimates• Short run

Consumers have little time to adjust• Long run

Consumers can fully adjust to a price change

• Demand is more elastic in the long run


Exhibit 6Selected Price Elasticities of Demand (Absolute Values)


Deterring Young Smokers

• Health hazard–Kills 440,000 Americans a year

• 10 times more than traffic accidents• Lung cancer• Heart disease• Emphysema• Stroke



• Cost to society–More than $7 per pack sold in

• Higher health cost• Lost worker productivity

–Total: more than $150 billion a year• More than $3,400 per smoker per year



• About 80% of adult smokers–Began before the age of 18

• Each day–3,500 U.S. teens under 18 try smoking for

the first time–One third become regular smokers



• Discouraging smoking–Prohibit the sale of cigarettes to minors–Higher cigarette tax

• ED is higher for teens– Big share of budget– Less peer pressure– Not an addiction yet

• Reduces teen smoking–Change consumer tastes

• Health warnings


Price Elasticity of Supply• Elasticity

– Responsiveness• Price elasticity of supply

– Responsiveness of quantity supplied to a price change

– Percentage change in quantity supplied divided by percentage change in price


Price Elasticity of Supply

• Law of supply• ES positive

2/)'(2/)'(

%

%

pp

p

qq

qE

p

qE

S

S


Exhibit 7Price Elasticity of Supply

SP

rice

per

unit

p

p’

If the price increases from p to p’, the quantity supplied increases from q to q’.

Price and quantity supplied move in the same direction, so the price elasticity of supply is a positive number.

Quantity per periodq q’0


Categories of ES Inelastic, Unit Elastic, Elastic

• If %∆q < %∆p A change in price has relatively little

effect on quantity supplied ES between 0 and 1

Inelastic supply• If %∆q = %∆p

ES = 1

Unit elastic supply


Categories of ES

• If %∆q > %∆p A change in price has a relatively large

effect on quantity supplied ES greater than 1

Elastic supply


Constant Elasticity Supply Curves• Perfectly elastic supply curve

Horizontal line oAny price decrease drops the quantity

supplied to zero

ES = ∞

• Unit-elastic supply curve, ES=1 %∆p causes an identical %∆q Straight line from the origin


Constant Elasticity Supply Curves• Perfectly inelastic supply curve

Vertical lineoA price change has no effect on the quantity

supplied

ES = 0

Goods in fixed supply


Exhibit 8Constant-Elasticity Supply Curves

0 Quantity

per period

Pric

e pe

r un

it

pES = ∞

(a) Perfectly elastic

S P

rice

per

unit

ES’ = 0

(b) Perfectly inelastic

ES’’ = 1

(c) Unit elastic

S’

0 Quantity

per period

Q

Pric

e pe

r un

it

$10

5

0 Quantity

per period

10 20

In each of the three panels is a constant-elasticity supply curve, so named because the elasticity value does not change along the curve. Supply curve S in panel (a) is perfectly elastic, or horizontal. Along S, firms supply any amount of output demanded at price p, but supply none at prices below p. Supply curve S’ is perfectly inelastic, or vertical. S’ shows that the quantity supplied is independent of the price. In panel (c), S”, a straight line from the origin, is a unit-elastic supply curve. Any percentage change in price results in the same percentage change in quantity supplied.

S’’


Determinants of Supply Elasticity

• ES is greater: If the marginal cost rises slowly as output

expands The longer the period of adjustment

(time)


Exhibit 9Supply Becomes More Elastic Over Time

SwP

rice

per

unit

1.00

$1.25

Quantity per day110 2000 100 140

Sm

Sy

The supply curve one week after a price increase, Sw, is less elastic, at a given price, than the supply curve one month later, Sm, which is less elastic than the supply curve one year later, Sy. Given a price increase from $1.00 to $1.25, quantity supplied per day increases to 110 units after one week, to 140 units after one month, and to 200 units after one year.


Income Elasticity of Demand• Income elasticity of demand

Demand responsiveness to a change in consumer income

Percentage change in demand divided by the percentage change in income that caused it


Income Elasticity of Demand• Inferior goods

Negative income elasticity• Normal goods

Positive income elasticity Income inelastic, necessities

oElasticity between 0 and 1 Income elastic, luxuries

oElasticity > 1


Exhibit 10Selected Income Elasticities of Demand


Market for Food & the “Farm Problem”

• 1950: 10 millions family farms• Today: less than 3 millions• Demand

Price inelasticoTotal revenue falls when P falls

Income inelastic: D increases• Supply

Technological improvements: S increases


Exhibit 11The Demand for Grain

D

5 10 11 Billions of bushels per year0

Pric

e pe

r bu

shel

$5

4

3

2

1

The demand for grain tends to be price inelastic. As the market price falls, so does total revenue.


Exhibit 12The Effect of Increases in Demand and Supply on Farm Revenue

S’

D’

D

5 10 14 Billions of bushels per year0

Pric

e pe

r bu

shel

$8

4

S Over time, technological advances in farming have sharply increased the supply of grain. In addition, increases in consumer income over time have increased the demand for farm products. But because increases in the supply of grain exceed increases in demand, the combined effect is a drop in the market price and a fall in total farm revenue.


Cross-Price Elasticity of Demand• Cross-price elasticity of demand

The percentage change in the demand of one good, divided by the percentage change in the price of another good

Positive for substitutes Negative for complements Zero for unrelated goods


Price Elasticity and Tax Incidence

• Tax Decrease in supply by the amount of tax

• Tax incidence Consumers : high price Producers: lower net-of-tax receipt


Price Elasticity and Tax Incidence

• The more price elastic the demand: The more tax producers pay The less tax consumers pay

• The more elastic the supply: The less tax producers pay The more tax consumers pay


Exhibit 13Effects of Price Elasticity of Demand on Tax Incidence

St

S

D’

St

S

D

$0.20 Tax

Pric

e pe

r ou

nce

$1.15

1.000.95

Millions of

ounces per day1090

$0.20 Tax

Pric

e pe

r ou

nce

$1.051.00

0.85

(a) Less elastic demand (b) More elastic demand

The imposition of a $0.20-per-ounce tax on tea shifts the supply curve leftward from S to S t. In panel (a), which has a less elastic demand curve, the market price rises from $1.00 to $1.15 per ounce and the market quantity falls from 10 million to 9 million ounces. In panel (b), which has a more elastic demand curve, the same tax leads to an increase in price from $1.00 to $1.05; market quantity falls from 10 million to 7 million ounces. The more elastic the demand curve, the more the tax is paid by producers in the form of a lower net-of-tax receipt.

107 Millions of

ounces per day


Exhibit 14Effects of Price Elasticity of Supply on Tax Incidence

St’

S’

D’’

$0.20 Tax

Pric

e pe

r ou

nce

$1.15

1.000.95

(a) More elastic supply

St” S”

D’’

$0.20 Tax

109P

rice

per

ounc

e

$1.051.00

0.85

(b) Less elastic supply

Millions of ounces per day1080

The imposition of a $0.20-per-ounce tax on tea shifts the supply curve leftward from S to S t. In panel (a), which has a less elastic demand curve, the market price rises from $1.00 to $1.15 per ounce and the market quantity falls from 10 million to 9 million ounces. In panel (b), which has a more elastic demand curve, the same tax leads to an increase in price from $1.00 to $1.05; market quantity falls from 10 million to 7 million ounces. The more elastic the demand curve, the more the tax is paid by producers in the form of a lower net-of-tax receipt.


ECO 182 (Micro) Ch 05 Elasticity of Demand and Supply

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