Transcript Price elasticity of supply

CHAPTER
3
Elasticity: A Measure
of Responsiveness
Prepared by: Jamal Husein
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
The Concept of Elasticity

Elasticity is a measure of the
responsiveness of people to changes in
economic variables.

How large is the response of producers and
consumers to changes in price? Before
business firms and the government decide
to change prices and taxes, they must
anticipate the magnitude of response by
those affected.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
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Popular Elasticity Measures
Popular measures of elasticity include:
Price elasticity of demand ( Ed )
 Price elasticity of supply ( Es )



Income elasticity of demand
Cross elasticity of demand for
related goods
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Survey of Economics, 2/e
O’Sullivan & Sheffrin
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Price Elasticity of Demand
 Price
elasticity of demand
( Ed ) measures the response of
consumers to changes in price.
Elasticity
of Demand = Ed =
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% Change in
quantity demanded
Survey of Economics, 2/e
% Change in Price
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4
Computing Price Elasticity of Demand
Elasticity
of Demand = Ed =
% Change in
quantity demanded
% Change in Price
85  100 15
% Q 

 015
. or 15%
100
100
$2.20  $2.00 $0.20
% P 

 10%
$2.00
$2.00
%  Q 15%

 150
.
%  P 10%
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Survey of Economics, 2/e
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Using the Midpoint Formula to Compute
Price Elasticity (Appendix )

The midpoint formula is a more accurate
measure of percentage changes.
absolute value
percentage change =
average value
85  100
15
% Q 

 16.22%
(100  85) / 2 92.5
$2.20  $2.00
$0.20
% P 

 9.52%
($2.00  $2.20) / 2 $2.10
%  Q 16.22%

 170
.
%  P 9.52%
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Survey of Economics, 2/e
O’Sullivan & Sheffrin
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Interpreting the Value of Elasticity
Value of
Elasticity
Demand
Elasticity
Ed > 1
Elastic
%QD > %P
Responsive
Ed < 1
Inelastic
%QD < %P
Unresponsive
Ed = 1
Unitary elastic
%QD = %P
Proportional
Type of
Elasticity
Substitutes
Available
Elastic
Many
Inelastic
Few
Magnitudes of Response to
Change
Price Changes
The main determinant
of demand elasticity is
the availability of
substitutes for the
good in question.
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Interpreting the Value of Elasticity
Estimated price elasticities of
demand for selected products
Product
Price elasticity
of demand
Salt
0.1
Water
0.2
Coffee
0.3
Cigarettes
0.3
Shoes and footwear
0.7
Housing
1.0
Automobiles
1.2
Foreign travel
1.8
Restaurant meals
2.3
Air travel
2.4
Motion pictures
3.7
Specific brands of
coffee
5.6
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
Survey of Economics, 2/e

The price elasticity for
water (0.20) suggests that a
10% increase in the price of
water would decrease the
quantity demanded by only
2%.
The elasticity for specific
brands of coffee (5.6)
suggests that a 10% increase
in the price of a specific
brand would decrease its
quantity demanded by 56%.
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Using the Price Elasticity of demand
Applications: College Education

Suppose a university increases tuition
from $4,000 to $4,400 (a 10% increase in
price) and wants to predict how many
fewer students will enroll as a result of
the high price. The Ed of higher education
is 1.4.
percentage change in quantity
demanded = 1.4 × 10% = 14%
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Using the Price Elasticity of demand
Predicting Changes in Quantity demanded

Suppose you run a campus film series,
and you know that Ed is 2.0. If you decide
to increase price by 15%, you can use the
following rearranged formula to predict
Changes in Quantity demanded
percentage change in quantity
demanded = 2 × 15% = 30%
© 2005 Prentice Hall Business Publishing
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Using the Price Elasticity of demand
Predicting Changes in Quantity demanded

How would a tax on beer affect highway
deaths? The Ed for beer among adults is
1.3. If a state imposes a beer tax that
increases beer price by 20%, what would
happen to the number of highway deaths
among young adults?
percentage change in quantity
demanded = 1.3 × 20% = 26%
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Elasticity and Total Revenue (TR)

Elasticity of demand determines if an
increase in price will cause the firm’s
revenue to increase or decrease.
Total Revenue = Price x Quantity sold

An increase in the price have two opposing effects
 The good news about an increase in price is that a
higher price will increase the revenue obtained
from each unit sold.
 The bad news is that at a higher price, fewer units
are sold. Elasticity of demand tells us whether
the good news dominates over the bad news.
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Predicting Changes in Total Revenue
This graph shows the relationship
between elasticity along a linear
demand curve and total revenue.
Note the following:
 Revenue is maximum when Ed=1.
© 2005 Prentice Hall Business Publishing

Along the elastic range of the
demand curve, an increase in price
leads to a decrease in total revenue.

Along the inelastic range, an
increase in price leads to an
increase in total revenue.
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Predicting Changes in TR
Elasticity and Total Revenue (TR)
Type of
demand Value of Ed
Change in quantity
versus change in price
Effect of an
increase in
price on total
revenue
Elastic
Greater than
1.0
Larger percentage
change in quantity
Total revenue
decreases
Total revenue
increases
Inelastic
Less than 1.0
Smaller percentage
change in quantity
Total revenue
increases
Total revenue
decreases
Unitary
elastic
Equal to 1.0
Same percentage change
in quantity and price
Total revenue
does not change
Total revenue does
not change
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
Effect of a
decrease in price
on total revenue
14
Price Elasticity of Supply

Price elasticity of supply is a measure
of the responsiveness in quantity
supplied to changes in price.
Elasticity
of Supply = Es =
© 2005 Prentice Hall Business Publishing
% Change in
quantity supplied
% Change in Price
Survey of Economics, 2/e
O’Sullivan & Sheffrin
15
Computing Price Elasticity of Supply
Elasticity
of Supply = Es =
% Change in
quantity supplied
% Change in Price
120  100
20
% Qs 

 20%
100
100
$2.20  $2.00 $0.20
% P 

 10%
$2.00
$2.00
%  Qs 20%
Es 

 2.0
%  P 10%
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
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Supply Elasticity and Time

Supply becomes more
elastic over time.
The increase in quantity
supplied as a response to
an increase in price is
greater when supply is
more elastic.
Higher market prices give business firms an incentive to expand
production and output. As time goes by, the ability of firms to expand
productive capacity is greater, and supply becomes more elastic.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
17
Predicting Price Changes Using
Elasticities

The price-change formula can be used to
predict the change in price resulting from a
change in demand.
percentage change in demand
percentage change in price =
E s  Ed

For changes in price resulting from a change in
supply:
percentage change in supply
percentage change in price =
E s  Ed
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
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Predicting Price Changes Using
Elasticities: an Example

Assume that Ed=1.5 and
Es=2.0, a rightward
shift in demand by
35%, will increase price
by the following
percentage:
% demand
%P =
E s  Ed
35%
% P =
 10%
2.0  15
.
© 2005 Prentice Hall Business Publishing
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O’Sullivan & Sheffrin
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