1 elasticity of demand and supply topic 3. 2 topic objectives 1.explaining elasticity of demand, its...
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Elasticity of Demand and Supply
Topic 3
2
Topic Objectives
1. Explaining elasticity of demand, its measurement, categories and determinants.
2. Understand the relationship between elasticity and total revenue.
3. Explaining elasticity of supply, its measurement, categories and determinants.
4. Elasticity application on indirect tax.
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Price Elasticity of Demand
Price elasticity of demand measures how responsive consumers are to price change; elasticity is another word for responsiveness.
Price elasticity of demand = Percentage change in quantity demanded / Percentage change in price
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Demand Curve for Beef Burger
Price elasticity between a and b = 10% / - 20%
= - 0.5
0.90
0
b
Thousands per day
D
$1.10 a
95 105
Pri
ce
5
Price Elasticity of Demand
Price elasticity of demand formula
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Price Elasticity of Demand
Because price and quantity demanded are inversely related, the price elasticity of demand has a negative sign.
This tends to be cumbersome, thus it is commonplace to discuss the price elasticity of demand as an absolute value positive number.
For example, absolute value of the elasticity for beef burger computed earlier will be referred to as 0.5 rather than –0.5.
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Categories of Price Elasticity
Three general categories Demand is inelastic quantity demanded is
relatively unresponsive to a change in price Percent change in quantity demanded is smaller than the percent change in price. The price elasticity has an absolute value between 0 and 1.0 .
Unit-elastic demand Percent change in quantity demanded just equals the percent change in price. The price elasticity has an absolute value of 1.0.
Demand is elastic Percent change in quantity demanded exceeds the percent change in price, the price elasticity has an absolute value exceeding 1.0.
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Elasticity Demand CurvesP
rice
per
uni
t
Pri
ce p
er u
nit
Pri
ce p
er u
nit
p
0 Quantity per period
Quantity per period
Quantity per period
E = D
(a) Inelastic demand curve
$10
6
0 60 100
E = D
1
(c) Unit elastic demand curve
D
0
E =
0
D'
Q
D"
a
bD
(b) Elastic demand curve
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Elasticity Demand CurvesP
rice
per
uni
t
Pri
ce p
er u
nit
p
0 Quantity per period
Quantity per period
E = D
(d) Perfectly elastic demand curve
D
0
E = D 0
(e) Perfectly inelastic demand curve
D'
Q
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Elasticity and Total Revenue
Total revenue (TR) is the price (P) multiplied by the quantity demanded (Q) at that price TR = P x Q
What happens to TR when price decreases? Lower price producers get less for each unit sold
TR declines. Lower price increases quantity demanded TR
increases.Overall impact of lower price on total revenue
depends on the net result of these opposite effects.
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Elasticity and Total Revenue
When demand is elastic, the percent increase in quantity demanded exceeds the percent decrease in price TR increases!
When demand is unit elastic, the two are equal TR remains unchanged!
When demand is inelastic, the percent increase in quantity demanded is more than offset by the percent decrease in price TR decreases!
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(a) Demand and Price Elasticity$100
90
80
70
60
50
40
30
20
10 e
d
c
b
a
D
0
Quantity per period
100 200 500 800 900 1,000
Pri
ce p
er u
nit
Consider a movement from point a to point b on the demand curve. The 100-unit increase in quantity demanded is a percent change of 100/150 = 0.67% while the $10 drop in price is a percent change of 10/85 = 12% the price elasticity of demand here is 5.6 Between points d and e, the 100 quantity increase is a 12% change and the $10 price decrease is a 67% price decrease price elasticity of 0.2
Demand, Price Elasticity and Total Revenue
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(a) Demand and Price Elasticity$100 90 80 70 60 50 40 30 20 10 e
d
c
b
a
D
Inelastic ED < 1
Unit elastic ED = 1
Elastic ED > 1
0 Quantity
100 200 500 800 900 1,000
$25,000
Tota
l re
ven
ue
0
Total revenue
(b) Total Revenue
TR = P x Q
Pri
ce
Quantity1,000500
When demand is elastic, a decrease in price (from a to b) will increase total revenue because the gain in revenue from selling more units (blue box) exceeds the loss in revenue from selling all units at a lower price (red box)When demand is elastic, a price decrease (from d to e) reduces total revenue because the gain in revenue from selling more units (blue box) is less than the loss in revenue at the lower price (red box)
Demand, Price Elasticity and Total Revenue
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Determinants
1. Availability of Substitutes The greater the availability of substitutes for a
good and the closer the substitutes, the greater the good’s price elasticity of demand.
The number and similarity of substitutes depend on how we define the good the more broadly we define a good, the fewer the substitutes and the less elastic the demand.
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2. Proportion of Consumer’s BudgetBecause spending on some goods represents a large
share of the consumer’s budget, a change in the price of such a good has a substantial impact on the amount consumers are able to purchase.
Generally, the more important the item is as a share of the consumer’s budget, other things constant, the greater will be the income effect of a change in price, the more price elastic will be the demand for the item.
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$1.25 Suppose the price increases from the initial price of RM1.00 to RM 1.25.
Dw shows that one week after the price increase, the quantity demanded has not changed much, from 100 to 95
After one month, Dm, it has declined to 75, and after one year, Dy, to 50
The longer the time period the larger the response to a given price change
Quantity per period
1.00
0
Dw
1007550 95
Dm
DyPri
ce p
er u
nit
Demand Becomes More Elastic over Time
3. Length of Time
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Price Elasticity of Supply
The price elasticity of supply measures how responsive producers are to a price change.
Equals the percent change in quantity supplied divided by the percent change in price.
Since the higher price usually results in an increased quantity supplied, the percent change in price and the percent change in quantity supplied move in the same direction the price elasticity of supply is usually a positive number.
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Price Elasticity of Supply
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Price Elasticity of Supply
If the price increases from p1 to p2, the quantity supplied increases from q1 to q2
The price elasticity of Es is
Where q is the change in quantity supplied and p is the change in price.
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Categories of Supply Elasticity
The terminology for supply elasticity is the same as for demand elasticity If supply elasticity is less than 1.0, supply is inelastic If it equals 1.0, supply is unit elastic If it exceeds 1.0, supply is elastic
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Elasticity Supply CurvesP
rice
per
uni
t
Pri
ce p
er u
nit
Pri
ce p
er u
nit
p
0 Quantity per period
Quantity per period
Quantity per period
E = S
(a) Inelastic supply curve
$10
6
0 60 100
E = S
1
(c) Unit elastic supply curve
S
0
E =
S
Q
D"
a
S
(b) Elastic supply curve
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Elasticity Supply CurvesP
rice
per
un
it
Pri
ce p
er
un
it
p
0
E = S
(d) Perfectly elastic
S
0
E = S 0
(e) Perfectly inelastic
S'
QQuantity per periodQuantity per period
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Determinants
1. The responsiveness of sellers depends on how easy it is to alter output when price changes If the cost of supplying additional units rises
sharply as output expands, then a higher price will elicit little increase in quantity supplied
But if the marginal cost rises slowly as output expands, the lure of a higher price will prompt a large increase in output
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Length of Time
2. Length of TimeSupply also becomes more elastic over time as
producers adjust to price changes
The longer the time period under consideration, the more able producers are to adjust to changes in relative prices
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Supply Becomes More Elastic over Time
1.00
Sw is the supply curve when the period of adjustment is a week. Sm is the supply curve when the adjustment period is one month; supply more elastic and quantity supplied increases to 140After one year the supply curve becomes Sy and the quantity supplied increases to 200
0 Quantity per period
Sw Sm
Sy
100110
140 200
$1.25P
rice
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Other Types of Elasticity
1. Income Elasticity of DemandMeasures how responsive demand is to a change
in income.Equals the percent change in demand divided by
the percent change in income.Categories
Goods with income elasticities less than zero are called inferior goods demand declines when income increases.
Normal goods have income elasticities greater than zero demand increases when income increases.
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2. Cross-Price Elasticity of Demand The responsiveness of the demand for one good to changes
in the price of another good is called the cross-price elasticity of demand.
Defined as the percent change in the quantity demanded of one good divided by the percent 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 two goods are complements.
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Elasticity on Tax Incidence
When the government impose a tax, someone will be liable to pay the tax.
Normally the tax burden will be borne entirely by consumers or producers or will be distributed between consumers and producers in the market.
The degree of tax burden – who pay more or less tax is depends on the elasticity of demand and supply in the market which the tax is imposed.
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Effect of Different Demand Elasticities on ExciseTax Incidence
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Demand Elasticity and Tax Incidence
The more elastic the demandthe more the tax is paid by producers. the less it’s passed on to consumers as a higher
price.The less elastic the demand
the more the tax is paid by consumers as a higher price.
the less it’s paid by producers.Tax revenues is lower when the tax is levied on
goods or services with demand that is elastic.
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Effects of Different Supply Elasticities on ExciseTax Incidence
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Supply Elasticity and Tax Incidence
The more elastic the supply, the less the tax is paid by producers as a lower net-of-tax receipt and the more is passed on to consumers as a higher price.
The less elastic the supply, the more the tax is paid by producers as a lower net-of-tax receipt and the less is passed on to consumers as a higher price.