Transcript Interpreting Price Elasticity of Demand and other Elasticities

Interpreting Price Elasticity of
Demand and other Elasticities
Clarifying Price Elasticities
• Perfectly inelastic
▫ When quantity demanded
does not respond at all to
changes in price
 Demand curve is a vertical
line
 Price elasticity equals 0
• Perfectly elastic
▫ When any price increase will
cause the quantity demanded
to drop to zero.
 Demand curve is horizontal
 This implies an infinite price
elasticity of demand
• Elastic
▫ Price elasticity of demand is greater than 1
• Inelastic
▫ Price elasticity of demand is less than 1
• Unit elastic
▫ Price elasticity of demand is exactly 1
Why does it matter whether demand is
elastic, inelastic or unit elastic?
• It helps predict how changes in price will affect
total revenue, earned by producers from the sale
of that good.
▫ Total Revenue = P X Q
• Also two countervailing effects are present
▫ A price effect
 After a price increase, each unit sold sells at a higher
price, which tends to raise revenue
▫ A quantity effect
 After a price increase, fewer units are sold, which
tends to lower revenue
What factors determine Price Elasticity
of Demand?
• Whether close substitutes are available
▫ Price elasticity of demand tends to be high if there
are other goods that consumers regard as similar
and would be willing to consume instead
▫ Price elasticity of demand tends to be low if there
are no close substitutes
• Whether a good is a necessity or a luxury?
▫ Price elasticity tends to be low if it is something
you must have
▫ Price elasticity tends to be high if the good is a
luxury
• Share of income spent on the good
▫ Price elasticity of demand tends to be low when
spending on a good accounts for a small share of a
consumer’s income
 A significant change in price has little impact on
how much a consumer spends
▫ When the good accounts for a significant share of
consumer spending, consumer is less likely to be
responsive to a change in price thus price elasticity
of demand is high
• Time
▫ Price elasticity of demand tends to increase as
consumers have more time to adjust to a price
change
Long-run price elasticity of demand is higher than
short-run elasticity.
Other Elasticities
Cross-Price Elasticity of Demand
• Demand for a good is often affected by the prices
on other goods (substitutes and complements)
• A change in the price of related good shifts the
demand curve of the original good, reflecting a
change in the quantity demanded at any given
price.
• This can be measured by the cross-price
elasticity of demand
▫ It is a ratio of the percent change in the quantity
demanded of one good to the percent change in
the price of another.
• If two goods are substitutes (i.e. hot dogs/
hamburgers) cross-price elasticity of demand is
positive
▫ If they are close substitutes cross-price elasticity
will be positive and large
▫ If not cross-price elasticity will be positive and
small
• When two goods are complements (i.e. hot dogs/
hot dog buns) cross-price elasticity is negative
▫ If the cross-price elasticity is slightly below zero,
they are weak complements, if it is very negative,
they are strong complements
In the case of cross price elasticity the plus or
minus sign is very important: it indicates
whether the goods are substitutes or
complements
Income Elasticity of Demand
• Measures how changes in income affect the
demand for a good
• Income elasticity of demand can be both positive
and negative
▫ When the income elasticity of demand is positive,
the good is a normal good- the quantity demanded
at any given price increases as income increases
▫ When it is negative, the good is an inferior goodquantity demanded at any given price decreases as
income increases
• Economist use income-elasticity of demand to
predict which industries will grow most rapidly
as incomes of consumers grow over time.
• This helps make a useful distinctions among
normal goods
• Income elastic
▫ The income elasticity of demand for that good is
greater than 1
 When income rises, the demand for income-elastic
goods rise faster than income
 Example: second homes and international travel
• Income inelastic
▫ The income elasticity of demand for that good is
positive but less than 1
 When income rises, demand for income-inelastic
goods rises, but more slowly than income
 Example: food and clothing
Price Elasticity of Supply
• Definition: A measure of the responsiveness of
the quantity of a good supplied to the price of
that good. It is the ratio of the percent change in
quantity supplied to the percent change in the
price as we move along the supply curve.
• Formula
• Extreme Values
▫ Perfectly Inelastic Supply = 0
 Graphed Vertically
▫ Perfectly elastic Supply = infinite
 Graphed horizontally
Factors that determine Price Elasticity
of Supply
• Availability of Inputs
▫ Price elasticity of supply tends to be large when
inputs are readily available and can be shifted into
and out of production at a relatively low cost
▫ Price elasticity of supply tends to be small when
inputs are available only in a more-or-less fixed
quantity or can be shifted into and out of
production only at a relatively high cost
• Time
▫ Price elasticity of supply tends to grow larger as
producers have more time to respond to a price
change
 Long-run price elasticity of supply is often higher
than short run elasticity
• Short run = a few weeks or months
• Long run = several years