Transcript Session 3 Elasticity of Supply and Demand

1.0 Elasticity of Demand and Supply
Real World Examples
SESSION 3:
CHAPTER 5
• SOFTWARE UPGRADES
•
•
Illustrates price elasticity of demand
and its determinants
CIGARETTE TAXATION
•
Illustrates price inelastic demand and
relation to revenue
Image Source WSJ
Tips for Navigation in the Video Lecture:
Chart Source WSJ
© Prof. Harmon
1 Begin 2 Demand Elas.
The table of contents in the left frame : has links to
each slide. The slide with the LECTURE
OUTLINE lists the main topic s. These topics begin
with a whole number (e.g. “2.0” ).
The bottom frame : has options to print each slide
and to display closed captioning of the audio.
The image of the house
appears on every
slide in the upper left and operates as a hyper
link to the slide “LECTURE OUTLINE”
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
1
End
1.1 Software Upgrades
Software Customers Reactions to Fees
for upgrades and maintenance
Since software doesn't wear out,software companies provide
upgrades free, generating additional revenue by selling users on
new add-ons or increasing maintenance fees. These fees have
crept up to as much as 22% or even 25% of the original license
fee, from about 15% a few years ago.
Some software companies now get the majority of their profits
from such recurring revenue, with original license fees serving as
an introductory loss leader.
Some customers are happy to upgrade. The recent versions of
most business applications, for example, allow better Web access
to company data than previously possible Elastic Demand
For some customers the pain of an upgrade is outweighed by the
value of the innovation. Many companies say the a business case
for the hassles of installing a new version or adding on the latest
bells and whistles.. Inelastic Demand
Adapted from : Software Customers
Force Change WSJ 1/2/2004
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
2
End
1.2a One Public Policy Issue Is…
If cigarette
smoking continues
at current rates…
Chart Source WSJ
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
3
End
1.2b Cigarette Taxes Raise Revenue: Low Demand Elasticity
A price rise of 10 percent on a pack of
cigarettes would be expected to reduce
demand for cigarettes in the short term:
• by about 4 percent in high-income countries
• by about 8 percent in low- and middle-income
countries, where lower incomes tend to make
people more responsive to price changes.
• In both cases sales revenue increases because the
percent increase in price is larger than the percent
decline in quantity. (Remember revenue = price x
quantity.)
• Long-run price responsiveness is estimated to be
twice as high.
• Source:
http://www.imf.org/external/pubs/ft/fandd/1999/
12/jha.htm
1 Begin 2 Demand Elas.
3 Supply Elas.
Chart Source WSJ
4 Income Elas. 5 Cross-Price Elas.
4
End
1.3 LECTURE OUTLINE
1. First Slide
2.0 Price Elasticity of Demand
3.0 Supply Elasticity
4.1 Income Elasticity
5.1 Cross Price Elasticity
Substitutes, Complements
6.0 Econ Lab
End
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
5
End
2.0 Price Elasticity of Demand
2.1 Price Elasticity Formula
2.2 Numerical Example
2.3 Three points about elasticity of demand
2.4 Categories of Elasticity
2.5 Demand Elasticity and Total Revenue
2.6 Constant Elasticity Cases
2.7 Determinants of Elasticity
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
6
End
2.1a Price Elasticity
Thus far we have talked about the
impact of changes in prices, incomes,
and costs, on demand and supply in
rather general terms
In fact, in the real world of policy
implementation, more precision is used
The Law of demand says that a higher
price will reduce quantity demanded,
BUT BY HOW MUCH  that is, will the
number sold decline by only a little or
by a lot?
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
7
End
2.1.b Formula for Price Elasticity of Demand
Price elasticity of demand measures in a
standardized way how responsive
consumers are to price change 
elasticity is another word for
responsiveness
In simplest terms, the price elasticity of
demand measures the percent change
in quantity demanded divided by the
percent change in price
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
8
End
2.1.c Price Elasticity of Demand Formula: In Words
Price elasticity of demand 
Percentage change in quantity demanded
Percentage change in price
To illustrate this process, let us write
out the algebraic formula and do an
example calculation.
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
9
End
2.1.d Price Elasticity of Demand Formula: Algebraic
Expression
Generalize the price elasticity formula
If the price drops from p to p’, other things
constant, the quantity demanded increases
from q to q’
The change in price can be represented as
Δp and the change in quantity as Δq
ED
1 Begin 2 Demand Elas.

q
(q  q) / 2
p
(p  p) / 2
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
10
End
11
2.2 Demand Curve for Cigarettes
For the price elasticity to be a useful
measure, we should come up with the
same result between points a and b as
we get between b and a. To do this we
must take the average of the initial
price and the new price and use that
as the base in computing the percent
change in price.
$1.10
0.90
The same process should be used for
changes in quantity demanded  the
average quantity demanded is
100,000 and the change in quantity
demanded is 10,000  10% change
1 Begin 2 Demand Elas.
b
Price per taco
 in our example the base used for
price is the average of $1.10 and
$0.90 = $1.00  the change in
price is -$0.20 divided by $1.00  20%
a
D
0 Thousands per day 95 105
Price elasticity between point “a” and “b” is:
= 10% / - 20% = - 0.5
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
End
2.3 .1 Three Points about Price Elasticity of
Demand: Point #1
Because the average quantity and
average price are used as a base for
computing percent change, the same
elasticity results whether going from
the higher price to the lower price or
the other way around
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
12
End
2.3.2 Point #2
Elasticity expresses a relationship
between two amounts
The percent change in quantity demanded
The percent change in price
Because the law of demand states that
price and quantity demanded are
inversely related, the change in price
and the change in quantity demanded
have opposite signs  the price
elasticity of demand has a negative sign
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
13
End
2.3.3 Point #3
Since constantly referring to elasticity
as a negative number gets cumbersome,
we will discuss the price elasticity of
demand as an absolute value  positive
number
For example, absolute value of the
elasticity for cigarettes computed
earlier will be referred to as 0.5 rather
than –0.5
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
14
End
2.4.1 Three Categories of Elasticity
The price elasticity of demand can be
divided into three general categories
depending on how responsive quantity
demanded is to a change in price
If the percent change in quantity demanded
is smaller than the percent change in price,
the resulting price elasticity has an absolute
value between 0 and 1.0  demand is
inelastic  quantity demanded is relatively
unresponsive to a change in price
If the percent change in quantity demanded
just equals the percent change in price  a
price elasticity with an absolute value of 1.0
 unit-elastic demand
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
15
End
2.4.2Numerical Ranges of the Categories
If the percent change in quantity demanded
exceeds the percent change in price, the
resulting price elasticity has an absolute
value exceeding 1.0  demand is said to be
elastic  quantity is responsive to changes
in price
Summary
Elastic  absolute value greater than 1.0 
responsive
Unit elastic  absolute value equal to 1.0
Inelastic  absolute value between 0 and
1.0  unresponsive
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
16
End
2.5.1 Elasticity and Total Revenue
Knowledge of price elasticity is
especially valuable because it indicates
the effect of a price change on 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 total revenue when
price decreases?
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
17
End
2.5.2 Elasticity and Total Revenue
A lower price means producers get less
for each unit sold which tends to
decrease total revenue
However, a lower price increases
quantity demanded which tends to
increase total revenue
Thus, the overall impact of a lower price
on total revenue depends on the net
result of these opposite effects
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
18
End
2.5.3Elasticity and Total Revenue
Specifically
When demand is elastic, the percent
increase in quantity demanded exceeds the
percent decrease in price  total revenue
increases
When demand is unit elastic, the two are
equal  total revenue remains unchanged
When demand is inelastic, the percent
increase in quantity demanded is more than
offset by the percent decrease in price 
total revenue decreases
The next slide presents these relationships
in a diagram
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
19
End
20
2.5.4 Diagram: Demand, Price Elasticity and Total Revenue
(a) Demand and Price Elasticity
Price per unit
Panel (a) shows the linear
demand curve and panel (b)
shows the total revenue
generated by each pricequantity combination along
the demand curve.
$100
90
80
70
60
50
40
30
20
10
Slope = rise/run
Unit elastic ED = 1
Inelastic ED < 1
D
100 200
500
1 Begin 2 Demand Elas.
800 900 1,000
Quality per period
(b) Total Revenue
TR = p x q
Total revenue
Since the demand curve is
linear, its slope is constant 
a given decrease in price
0
always causes the same unit
increase in quantity
demanded.
$25,000
The price elasticity of
demand is greater on the
higher-price end of the
demand curve than on the
lower-price end.
(Hint: the same price change at a high
price level translates into a smaller
denominator
0
Elastic ED > 1
Total
revenue
Quantity per period
3 Supply Elas.
500
1,000
4 Income Elas. 5 Cross-Price Elas.
End
21
2.5.5 Diagram: Demand, Price Elasticity and Total Revenue
(a) Demand and Price Elasticity
a
b
Price per unit
Consider a movement from
point a to point b on the
demand curve.
$100
90
12%
80
70
60
50
40
30
20
67%
10
The 100-unit increase in
quantity demanded is a
percent change of 100/150 =
67%
while the $10 drop in price is a
percent change of 10/85 = 12%
 the price elasticity of demand
here is 5.6 = (67%/12%)
0
c
d
e
100 200
67%
500
D
800 900 1,000
12%Quality per period
(b) Total Revenue
TR = p x q
Between points d and e on the
lower end, the 100-unit quantity
increase is a percent change of
100/850 = 12% and the $10 price
decrease is a percent decline of
10/15 = 67%  a price elasticity
of 0.2 = (12%/67%)
1 Begin 2 Demand Elas.
Total revenue
$25,000
0
Total
revenue
Quantity per period
3 Supply Elas.
500
1,000
4 Income Elas. 5 Cross-Price Elas.
End
22
2.5.6 Summary: Demand, Price Elasticity and Total Revenue
Price per unit
Demand becomes less elastic as we
move down the curve. Halfway
down, the elasticity equals 1.0.
Since we have a linear demand
curve, the slope is constant but the
elasticity varies  slope is not the
same thing as elasticity.
Where demand is elastic, a
decrease in price will increase
total revenue because the gain in
revenue from selling more units
exceeds the loss in revenue from
selling at the lower price.
$100
90
80
70
60
50
40
30
20
10
0
Where demand is inelastic, a price
decrease reduces total revenue
because the gain in revenue from
selling more units is less than the loss
in revenue at the lower price.
When Elasticity is unitary Total
Elastic ED > 1
a
b
Unit elastic ED = 1
c
Inelastic ED < 1
d
e
100 200
TR = p x q
Total
revenue
Elastic ED > 1
0
D
800 900 1,000
Quality per period
(b) Total Revenue
Unit elastic ED = 1
Revenue is at its peak
1 Begin 2 Demand Elas.
500
Total revenue
$25,000
(a) Demand and Price Elasticity
Quantity per period
3 Supply Elas.
Inelastic ED < 1
500
1,000
4 Income Elas. 5 Cross-Price Elas.
End
2.5.7 Example of Pricing & Inelastic Demand
When Elmo Live arrives in stores on
Tuesday, it will cost $60 -- about a third
more than last year's model, and above
the $50 tag that once was the high-water
mark for most toys. Elmo Live hits stores
as economic uncertainty is gripping
consumers and prompting retailers such
as Wal-Mart Stores Inc. and KB Toys Inc.
to pitch low-cost toys to lure customers.
Source: Mattel Gambles on Pricey Elmo
for Holidays (WSK 10/9/08)
To be increasing prices, sellers of Elmo
must be of the view that demand is
inelastic and hence the price increases
will increase revenue
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
23
End
24
2.6 Constant Elasticity Demand Curves
(a) Perfectly elastic
(b) Perfectly inelastic
(c) Unit elastic
p

D
E D= 0
Price per unit
E D=
Price per unit
Price per unit
D'
E D=
$10
a
b
6
0
Quantity
per period
Demand curve in (a)
indicates consumers will
demand all that is offered
at the given price, p. If the
price rises above p,
quantity demanded drops
to zero  perfectly elastic
demand curve.
1 Begin 2 Demand Elas.
0
Q
Quantity
per period
Demand curve in (b) is
vertical, quantity demanded
does not vary when the price
changes  no matter how
high the price, consumers
will purchase the same
quantity  perfectly inelastic
demand curve.
3 Supply Elas.
0
1
D"
60
100
Quantity
per period
(c) shows a unit-elastic
demand curve where
any percent change in
price results in an
identical offsetting
percent change in
quantity demanded.
4 Income Elas. 5 Cross-Price Elas.
End
2.7 Determinants
Time to turn to the issue of why price
elasticities of demand vary for different
goods
Three basic determinants
Availability of substitutes
Proportion of the consumer’s budget spent
on the good
A matter of time
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
25
End
2.7.1 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
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
26
End
2.7.2 Proportion of Consumer’s
Budget
Because 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
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
27
End
2.7.3a A Matter of Time
The process of finding substitutes takes
time
Thus, the longer the adjustment period,
the greater the consumers’ ability to
substitute away from relatively higherpriced products toward lower-priced
substitutes  the more responsive the
change in quantity demanded is to a
given change in price
The next slide demonstrates this
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
28
End
29
2.7.3b Demand Becomes More Elastic over Time
Initial price = $1.00
Dw = the demand curve one week
after the price change
Dm = one month after
Dy, = one year after.
Suppose the price now increases
to $1.25. The more time for
consumers to respond to price
increase, the greater will become
the reduction in quantity
demanded.
$1.25
Dw shows that one week after the
price increase, the quantity
demanded has not changed much –
in this case from 100 to 95 per day.
However, after one month, the
curve Dm shows quantity
demanded has declined to 75, and
1.00
Dy
Dw
0
50
Dm
75 95 100 Quantity per period
Note that among these demand curves and over the range
starting from the point where the demand curves intersect, the
flatter the demand curve, the more price elastic the demand.
Dw shows after one year to 50 per
day.
1 Begin 2 Demand Elas. 3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
End
2.8.1 Elasticity Estimates
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.
Exhibit 6 provides some short-run and
long-run price elasticity estimates for
selected products
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
30
End
2.8.2 Selected Price Elasticities of Demand
Product
Cigarettes (among adults)
Electricity (residential)
Air travel
Medical care and hospitalization
Gasoline
Milk
Fish (cod)
Wine
Movies
Natural gas (residential)
Automobiles
Chevrolets
1 Begin 2 Demand Elas.
3 Supply Elas.
Short Run
Long Run
—
0.1
0.1
0.3
0.4
0.4
0.5
0.7
0.9
1.4
1.9
—
0.4
1.9
2.4
0.9
1.5
—
—
1.2
3.7
2.1
2.2
4.0
4 Income Elas. 5 Cross-Price Elas.
31
End
3.0 Price Elasticity of Supply
3.1
3.2
3.3
3.4
3.5
Definition
Graph
Categories
Polar Cases
Determinants
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
32
of
x
End
3.1 Price Elasticity of Supply
The price elasticity of supply 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
Exhibit 7 depicts a typical upwardsloping supply curve
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
33
End
34
3.2 Price Elasticity of Supply
S
If the price increases
from p to p', the
quantity supplied
increases from q to q'
p'
p
Price per unit
The price elasticity of Es, is
Where  q is the change in
quantity supplied and  p is the
change in price.
1 Begin 2 Demand Elas.
0
3 Supply Elas.
q
q'
Quantity per period
4 Income Elas. 5 Cross-Price Elas.
End
3.3 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
Exhibit 8 illustrates some special cases
of supply elasticity to consider
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
35
End
36
3.4 Constant-Elasticity Supply Curves
(b) Perfectly inelastic
(a) Perfectly elastic
(c) Unit elastic
p

S
ES= 0
Price per unit
ES=
Price per unit
Price per unit
S'
S"
ES= 1
$10
5
0
Quantity per period 0
At one extreme is the
horizontal supply curve.
Here producers will
supply none of the good at
a price below p, but will
supply any amount at a
price of p, as in (a).
Q
Quantity per period 0
The most unresponsive
relationship is where there
is no change in the quantity
supplied regardless of the
price, as shown in (b)
where the supply curve is
perfectly vertical.
1 Begin 2 Demand Elas.
3 Supply Elas.
10
20Quantity per period
Any supply curve that
is a straight line from
the origin such as
shown in (c) is a
unit-elastic supply
curve.
4 Income Elas. 5 Cross-Price Elas.
End
3.5 Determinants
The elasticity of supply indicates how
responsive producers are to a change in price
Their responsiveness 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
• When overtime and hiring additional workers MC can be
steep
But if the marginal cost rises slowly as output
expands, the lure of a higher price will prompt a
large increase in output
• Marginal cost of producing additional copies of software
is essentially zero
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
37
End
3.5.1 Length of Time
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 time period under
consideration, the more able producers
are to adjust to changes in relative
prices
The next slide illustrates this
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
38
End
3.5.1a Supply Becomes More Elastic over Time
Sw
Sm
Sy
$1.25
Sm is the supply curve when
the adjustment period is one
month. Here the firms have a
greater ability to vary output
 supply is more elastic
1.00
Price per unit
Sw is the supply curve when
the period of adjustment is a
week. In this situation, the
higher price does not elicit
much of a response in
quantity supplied because
firms have little time to
adjust  supply curve is
inelastic if the price increases
from $1.00 to $1.25
39
0
100
140
200
Quantity per period
110
Supply is even more elastic when the adjustment period is a year as shown by Sy
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
End
3.5.1b Supply Becomes More Elastic over Time
Mall Glut to Clog Market for Years
Scarce Shoppers, Lack of Tenants
Cause: a decade of overbuilding
For retailers, the glut can have an
upside: cheaper rents, shorter lease
terms and fatter allowances from
landlords for outfitting stores. This
year, the rents in new lease signings
are 10.4% lower on average than the $1.25
asking price, down from the 9.3%
1.00
discount of two years ago
WSJ 9/10/08
40
Images Source WSJ
Sw
Sm
Price per unit
Sy
D1
D2
0
100
140
200
Quantity per period
110
In the short run the decline in Demand will lead to sharp falls in rent, but in the
longer run the rent adjustment will not be as large.
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
End
4.0 Income Elasticity of Demand
4.1
4.2
4.3
4.4
4.5
Definition
Formula
Categories
Selected Cases
Agricultural Producers
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
41
End
4.1 Income Elasticity of Demand
The income elasticity of demand
measures how responsive demand is
to a change in income
Measures 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
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
42
End
4.2 Income Elasticity of Demand
Formula: Algebraic Expression
The income elasticity formula
If the income rises from I to I’, other things
constant, the demand increases from q to q’
The change in income can be represented as
ΔI and the change in quantity as Δq
EI
1 Begin 2 Demand Elas.

q
(q  q) / 2
I
(I  I ' ) / 2
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
43
End
4.3 Categories
Normal goods have income elasticities
greater than zero  demand increases
when income increases
• Normal goods with income elasticities greater
than zero but less than 1 are called income
inelastic goods  demand increases but not as
much as does income
• Goods with income elasticity greater than 1 are
called income elastic  demand not only
increases when income increases but increases by
more than does income
The next slide presents some income
elasticity estimates for various goods
and services
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
A “fine”
cup of
coffee
44
End
45
4.4 Selected Income Elasticities of Demand
Product
Private education
Automobiles
Wine
Owner-occupied housing
Furniture
Dental service
Restaurant meals
Shoes
Chicken
Spirits (“hard” liquor)
Clothing
1 Begin 2 Demand Elas.
Income
Elasticity
2.46
2.45
2.45
1.49
1.48
1.42
1.40
1.10
1.06
1.02
0.92
3 Supply Elas.
Product
Physicians’ services
Coca-Cola
Beef
Food
Coffee
Cigarettes
Gasoline and oil
Rental housing
Beer
Pork
Flour
Income
Elasticity
0.75
0.68
0.62
0.51
0.51
0.50
0.48
0.43
0.27
0.18
–0.36
4 Income Elas. 5 Cross-Price Elas.
End
Price per bushel
4.5a The Case of Agricultural Producers: The Demand for
Grain
46
$5
4
3
2
1
D
0
5
1 Begin 2 Demand Elas.
10 11
3 Supply Elas.
Billions of bushels per year
4 Income Elas. 5 Cross-Price Elas.
End
4.5b The swings in Supply Dominate Demand47
Shifts: Greatly Changing Farm Revenue
S
Price per bushel
S'
$8
Hence the
case for
stabilizing
farmer’s
incomes by
price
controls
4
D D'
0
5
Return1 to
Outline
Begin
2 Demand Elas.
10
3 Supply Elas.
14 Billions of bushels per year
4 Income Elas. 5 Cross-Price Elas.
End
5.0 Cross Price Elasticity
5.1
5.2
5.3
5.4
Definition
Formula
Substitutes and Complements
Diagram It
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
48
End
5.1 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 demand
of one good divided by the percent change in
the price of another good
Its numerical value can be positive, negative,
or zero depending on whether the goods are
substitutes, complements, or unrelated,
respectively
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
49
End
5.2 Cross Price Elasticity of Demand
Formula: Algebraic Expression
The cross price elasticity formula
The price of X changes from Px to Px’, other
things constant, the demand for good Y
changes from Qy to Qy’.
The change in the price of X can be
represented as ΔPx and the change in
quantity of good Y as ΔQy
EDx, y
1 Begin 2 Demand Elas.

Qy
(Qy  Qy' ) / 2
Px
( Px  Px' ) / 2
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
50
End
51
5.3 Substitutes and Complements
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
Pepsi
v
Coke
For some people, though, they
are not substitutes! (click the
link for a YouTube video that
illustrates.)
In case the link doesn’t work
here it is:
http://www.youtube.com/wat
ch?v=48WLoJcvdGM
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
Qy
(Qy  Qy' ) / 2

Dx, y
Px
( Px  Px' ) / 2
Retooling the Economy,
US Cuts its thirst for Oil
(WSJ 8/12/08)
Bananas
& Cereal
E
Return1 to
Outline
Begin
2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
49
End
52
5.4 Diagram Substitutes and Complements
LHS Graph:
The space is for a graphing tool, which
appears in the PowerPoint version, but not
in the Video Lecture file format. , but it
not
Represent
equilibrium
and an
increase in
supply
RHS Graph:
Assume the
LHS good is a
substitute to
the good in
the RHS
graph,
represent the
effect on
equilibrium of
the change
shown in the
LHS
1 Begin 2 Demand Elas.
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
End
END OF PRESENTATION
Clic a pic for review
ED

q
(q  q) / 2
p
(p  p) / 2
EDx, y
EI

q
(q  q) / 2
I
(I  I ' ) / 2
1 Begin 2 Demand Elas.

Qy
(Qy  Qy' ) / 2
Px
( Px  Px' ) / 2
3 Supply Elas.
4 Income Elas. 5 Cross-Price Elas.
53
End