Chapter 20

Chapter 20 – Elasticity of Demand and Supply

Law of demand – dictates that consumers will buy more or less of something if the price is lowered/increased.

The price Elasticity of demand is the measure of how responsive the quantity demanded is to a change in price

Price Elasticity Coefficient and Formula

                Ed = (percentage change in quantity demanded)/(percentage change in price)

Percentages – use them because they give you a better idea of relative prices

Elimination of minus sign – b/c elasticity of demand is always negative, most people don’t bother writing it in

Elastic Demand – Demand is elastic if a specific percentage change results in a larger change in quantity demanded

Inelastic demand – If a specific percentage change in price causes a smaller change in quantity demanded then demand is inelastic

Unit elasticity – if a percentage change in price causes the same percentage change in demand

Extreme Cases/Perfectly inelastic – in the case that a change in price causes NO CHANGE in demand, a good is known to be perfectly inelastic.  A good example is insulin or an addict for heroin.  This only really occurs for a supplier in an extremely competitive market when they lower prices a little

However there is a problem when deciding what price should be the reference point to calculate elasticity of demand. If you calculate a 5-4 dollar change then going one way it is a 20% decrease the other way is a 25% increase.  You calculate Elasticity from the midpoint of the two prices (4.5 dollars)

Ed = ( Change in quantities/(average quantities)) / (change in price/(average price))

Graphical Analysis – Elasticity varies for price ranges, typically more elastic for the higher price ranges than towards the lower price ranges.  This is because the original reference quantity is quite small in comparison to large values so a small change in price results in a larger percentage change.  The opposite is true for larger values

The flatness/steepness of the demand curve is not a good way to judge elasticity because it is based on absolute (instead of relative) changes in price/quantity.

Total Revenue test – TR is the total amount the seller receives from the sale of a product in a particular time period,  TR  = price * quantity

If demand is elastic then a decrease in price will increase total revenue and vice versa

If demand is inelastic – a price decrease will decrease total revenue and vice versa.  This is because lowering the price will have a relatively small effect on quantity.

Unit elasticity – An increase or decrease in price leaves total revenue the same

Price Elasticity and the Total-Revenue Curve

If total revenue moves in the opposite direction as price then demand is inelastic, if it doesn’t change then it is unit-elastic

Determinants of Price Elasticity of Demand

                Substitutability – if something else can be substituted then it is more elastic

Proportion of Income – the higher the price of the good relative to the consumers income, the more elastic

Luxeries versus necessities – The more its considered a luxury, the greater the elasticity because people can easier justify it not worth purchasing

Time – Product demand is more elastic the longer the time period under consideration, If something changes an established price, initially demand won’t be especially affected, later people will find a way to work around it

Applications of Price-elasticity of demand

Large Crop Yields – demand for farm products is highly inelastic so a good growing season actually decreases total revenue for the farms

Excise Taxes – The higher price resulting from imposing an excise tax can decrease the sales of an object – and thus the tax revenue.  Therefore, most excise taxes are on fairly inelastic goods – Liquor, gasoline, cigarettes etc

Price-elasticity of supply

Es = (Percentage change in quantity supplied)/(Percentage change in price)

Price elasticity of supply depends on the ease and speed at which producers can reallocate resources

Distinguish between short term and long term elasticity of supply

The market period – the period of time before the suppliers can react with a change in quantity supplied, for example one growing season

The short run – the amount of time too short to change production capacity but possible to change production efficiency

The long run – the time period necessary for an industry to make changes in quantity supplied

There is no total-revenue test for elasticity of supply.  Supply shows a direct relationship between price and quantity supplied, regardless of the elasticity, price and total revenue move together

Cross Elasticity and elasticity of income

                Cross Elasticity – measures how responsive one product’s demand is to the demand of another

Ec = (Percentage change in quantity of Product X)/(Percentage change in quantity demanded of product Y)

Substitute Goods – If the Cross Elasticity is positive then they are substitute goods.  When Cross elasticity is negative, they are Independent goods.

In the case that two substitute goods are in competition, the government will try to maintain this competition because otherwise, the price could be raised if they merged

Income elasticity of demand – the measure of how much consumers react to a change in their income by buying more or less of a good

Ei = (% change in quantity demanded)/(% change in income)

                Normal Goods – Usually Ei is positive for normal/superior goods

                Inferior Goods – A negative income-elasticity coefficient designates an inferior good