Transcript Elasticity and Demand and Supply Applications

Elasticity and Demand and
Supply Applications
• Review:
– Changes in quantity demand and supplied or
movements along the curves
– Changes in demand and supply or shifts of the curve
• Comparative Statics
– Changes in demand
• Increase in demand: price increases, quantity increases
• Decrease in demand: price decreases, quantity decreases
– Changes in supply
• Increase in supply: price decreases, quantity increases
• Decrease in supply: price increases, quantity decreases
– Changes in both
Increase in
Demand
Decrease in
Demand
Increase in
Supply
P ambiguous
Q increases
P decreases
Q ambiguous
Decrease in
Supply
P increases
P ambiguous
Q ambiguous Q decreases
Dynamics
• Shifts in demand or supply create surpluses or shortages
• Surpluses cause price to fall and shortages cause price to
rise
• Increases in prices cause quantity demanded to decrease
(law of demand) and quantity supplied to increase (law of
supply)
• Decreases in prices cause quantity demanded to increase
(law of demand) and quantity supplied to decrease (law of
supply)
• These price changes occur until surpluses or shortages are
eliminated at the new equilibrium price and quantity
Using Demand and Supply
• Step 1: Determine if the change in the
determinant affects the demand or supply
curve.
• Step 2: Determine which way it shifts the
curve
• Step 3: Determine how the equilibrium
price and quantity change (dynamic
adjustment)
Elasticity: Responsiveness versus
Directions
• Demand and Supply analysis allows us to
see the direction of changes in the
equilibrium price and quantity
• We need another concept to see how
responsive demand and supply are to
change in their determinants
• The concept that helps us measure that
sensitivity is elasticity
Price Elasticity of Demand
• The concept of elasticity helps understand how
responsive demand is to price changes
• Intuitively, if we are a businessperson and we
want to increase revenues, one important question
is whether we increase price or decrease price
• Increases in price decreases the quantity demanded, but we get
more for each unit we sell
• Decreases in price increases the quantity demanded, but we get
less for each unit we sell
• How can we tell whether the price or the quantity effect wins
out to increase our revenues
• The answer is the concept of elasticity
Definition of Elasticity
• Price elasticity of demand =
%change in quantity demanded/
% change in price
• Or using symbols: Ep = %ΔQd /%ΔP
• For example, if the %ΔQd = 10% and the
%ΔP = 2%, the price elasticity of demand =
5, OR for every 1% change in price the
quantity demand changes by 5%.
• Ep > 1 Responsive or elastic
– %ΔQd > %ΔP
• Ep < 1 Not responsive or inelastic
– %ΔQd < %ΔP
• Ep = 1 unit elastic
– %ΔQd = %ΔP
BUT I Hate Percentages!!!
• OK, but they come in mighty handy.
Why?
– They always measure the change relative to a starting
point. (e.g. a $1 increase in your hourly wage is
different if you make $5/hr. or $100/hr.)
– Absolute changes are affected by changes in the units
with which they are measured ( 100 boxes of apples =
5,000 apples, but the later looks like a bigger change)
– Percentages are everywhere!!!! (Stores usually use
percentage discounts during sales, increases in pay are
generally in percentages, batting averages are in
percentages, grades are given in percentages)
The Farmer’s Dilemma
• For many crops, a strange situation arises a bad crop year
results in a good year for farm incomes, and a good crop
year results in a bad year for farm incomes. How can this
be?
• Price elasticity gives us the answer:
– Bad crop year: supply decreases, prices for farm products rise, but
quantity demanded doesn’t fall very much. The quantity
demanded of farm products is not very responsive to changes in
prices
– Good crop year: supply increases, prices for farm products fall, but
quantity demanded doesn’t increase very much. The quantity
demanded of farm products is not very responsive to changes in
prices
• It is easy to show this with a graph. But first we need yet
another concept: Total Revenue = Price x Quantity
Elasticity and Total Revenue
• TR = P x Q
• If P goes down Q goes up, but what happens
to TR?
• If P goes up Q goes down, but what happens
to TR?
• Elasticity can answer the question….
Elasticity to the Rescue….
• Ep > 1 Responsive or elastic
– %ΔQd (10%) > %ΔP (5%) if P goes down (up) total
revenue goes up (down)
• Ep < 1 Not responsive or inelastic
– %ΔQd (5%) < %ΔP (10%) if P goes down (up) total
revenue goes down (up)
• Ep = 1 unit elastic
– %ΔQd (5%)= %ΔP (5%) if P goes down (up) total
revenue stays the same
The Farm Example
• During bad crop years, prices rise and
quantity falls (but not that much) so total
revenue to farmers goes up.
• During good crop years, prices fall and
quantity increases (but not that much) so
total revenue to farmers goes down.
• The graphs….
Figure 8 An Increase in Supply in the Market for Wheat
Price of
Wheat
2. . . . leads
to a large fall
in price . . .
1. When demand is inelastic,
an increase in supply . . .
S1
S2
$3
2
Demand
0
100
110
Quantity of
Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
Copyright©2003 Southwestern/Thomson Learning
Can Elasticity Tell Us More?
• What a minute, first we need to talk about what
increases or decreases the price elasticity of
demand.
• Determinants of Price Elasticity
–
–
–
–
–
Availability of close substitutes
Necessity versus luxury
Definition of the market
Time horizon
Percentage of consumer budget
Elasticity of Demand
Price elasticity of demand
Estimated price elasticities of demand
item
Percentage Change in
Quantity Demanded
E 
d Percentage Change in Price
elasticity coefficient
short run
long run
Airline travel
Medical care
Natural gas
Auto tires
Stationery
Gasoline
Housing
Automobiles
Movies
Jewelry & watches
Radio & TV repair
Foreign travel
Glass, china, etc.
0.1
0.3
1.4
0.9
0.5
0.2
0.3
1.9
0.9
0.4
0.5
0.1
1.5
2.4
0.9
2.1
1.2
0.6
0.7
1.9
2.2
3.7
0.7
3.8
1.8
2.5
Elasticity of Supply
• How how about the price elasticity of supply?
How responsive are suppliers to changes in price?
• Price elasticity of supply = %change in quantity
supplied/% change in price
• Determinants of elasticity of supply:
– Flexibility in altering the amount of a good produced.
– Time period
Elasticity of Supply
Price elasticity of supply
Estimated price elasticities of supply
Vegetable
Percentage Change in
Quantity Supplied
Es 
Percentage Change in Price
Lima beans
Cabbage
Carrots
Cucumbers
Onions
Green peas
Green peppers
Tomatoes
Cauliflower
Celery
Spinach
Price elasticity
short run
long run
0.10
0.36
0.14
0.29
0.34
0.31
0.07
0.16
0.14
0.14
0.20
1.70
1.20
1.00
2.20
1.00
4.40
0.26
0.90
1.10
0.95
4.70
Further Examples of Elasticity
• Inelastic demand and addictive drugs:
– Supply side prevention
– Demand side prevention
• Luxury Taxes
– Who pays a tax? But with elasticity we find
out…
– Who really pays the tax? (tax incidence or
burden).
Government and Markets
• Price Controls
– Price Ceilings (e.g. rent control)
– Price Floors (e.g. water)
• Taxes
– Who appears to pay the tax?
• Buyers “pay” tax
• Sellers “pay” tax
– Who really pays the tax? Tax incidence and burden
Elasticity and Tax Incidence
• Intuitive approach:
– If the buyers can respond relatively more to
price changes more than suppliers, suppliers
pay more of the tax.
– If the suppliers can respond relatively more
than the buyers, then the buyers pay more of
the tax.
Application: Who pays the
luxury tax?
• Elasticity of demand is quite high for luxury
goods:
– Many subsitutes
– Not a necessity