Documents
Resources
Learning Center
Upload
Plans & pricing Sign in
Sign Out

Elasticity of Demand and Supply - PowerPoint

VIEWS: 882 PAGES: 35

									Elasticity of Demand and Supply

What is Elasticity?
• If my firm wants to raise revenue, should we decrease or increase the price? • The answer relies on elasticity • “Elasticity” is similar to “responsiveness” • Price Elasticity of Demand – a measure of how responsive quantity demanded is to a price change • Price Elasticity of Supply – a measure of how responsive quantity supplied is to a price change

Price Elasticity of Demand
Mathematically…
Priceelasticityof demand  Percentagechangein quantitydemanded Percentagechangein price q ' q ( q ' q ) / 2 p ' p ( p ' p ) / 2

Priceelasticityof demand 



Example
• What is the price elasticity of demand for CDs? • At a price of $14 per CD, there are 10,000 CDs sold • When the price is decreased to $12 per CD, 11,000 CDs are sold

$14 $12

(11  10) (12  14)  (11  10) / 2 (14  12) / 2 E D  (0.095 )  (0.154 )  0.616 ED 

D

10 11
Thousands of CDs

Keep this in mind…
• Because price and quantity are inversely related, the price elasticity of demand will be negative • This is because a price decrease will cause an increase in quantity demanded (and vice versa) • Most of the time, then, I will refer to the absolute value of the elasticity • The magnitude is most important

Categories of Price Elasticity of Demand
1. Inelastic Demand – a change in price has very little effect on the quantity demanded (-1 < ED < 0)
• These goods are often necessities

2. Elastic Demand – a change in the price has a relatively large effect on the quantity demanded (ED < -1)
• These are often more “unnecessary”

3. Unit-Elastic Demand – the percentage change in quantity demanded equals the percentage change in price (ED = -1)

Unit-Elastic

Elastic

Inelastic

Elasticity of Demand

-1

0

Elasticity…
1. Varies along the demand curve for the same product
• You respond differently if the price changes from 1 cent to 2 cents, than you do if the price changes from $5 to $10 (both are 100% increases) Regardless of where we are on the demand curve, you might expect the demand for milk to be less elastic than the demand for BMWs

2. Varies across products
•

P

More Inelastic

More Elastic

Demand Curve

Q

Elasticity and Total Revenue
• Total Revenue – the amount of money a firm collects through sales • TR = Price * Quantity • How is Total Revenue related to Elasticity? • Recall that a lower price leads to an increase in quantity demanded… • Whether Total Revenue increases or decreases change (due to a price decrease) will depend on whether the percentage increase in the quantity demanded is less than or greater than the price decrease

P

Elastic

Unit Elastic
Inelastic

Q TR

Q

What Does this Graph Show?
• Should you increase or decrease price to increase Total Revenue??? • In the elastic portion of the demand curve, the % change in quantity demanded is greater than the % change in price, so you should decrease price in order to increase total revenue • In the inelastic portion of the demand curve, the % change in quantity demanded is less than the % change in price, so you should increase price in order to increase total revenue • Total revenue is maximized at the unit elastic point

Constant-Elasticity Demand Curves
•
•

1.

2.

For a downward sloping linear demand curve, the price elasticity changes as you move along the demand curve Some demand curves have an elasticity that does NOT vary along the demand curve Perfectly Elastic Demand Curve – an increase in price reduces the quantity demanded to zero (horizontal demand curve) Perfectly Inelastic Demand Curve – price changes have no effect on the quantity demanded (vertical demand curve)

P

P

D

D

Q

Q

Perfectly Elastic Demand

Perfectly Inelastic Demand

Determinants of the Price Elasticity of Demand
• Availability of Substitutes – the more substitutes are available for a good, the more elastic the demand (if the price increases, you might be likely to switch to another good) • Proportion of a Consumer’s Budget Spent on the Good – the larger the percentage of a consumer’s budget, the greater the price sensitivity (ex. comparison shopping for cars) • Time – the longer you have to make your choice, the more elastic your demand will be (ex. what if your refrigerator breaks down?)

Price Elasticity of Supply
Mathematically…
Priceelasticityof supply Percentagechangein quantitysupplied Percentagechangein price q ' q ( q ' q ) / 2 p ' p ( p ' p ) / 2

Priceelasticityof supply



Categories of Price Elasticity of Supply
1. Inelastic Supply – a change in price has very little effect on the quantity supplied (0 < ES < 1) 2. Elastic Supply – a change in the price has a relatively large effect on the quantity supplied (ES > 1) 3. Unit-Elastic Supply – the percentage change in quantity supplied equals the percentage change in price (ES = 1)

Unit-Elastic

Inelastic

Elastic

0

1

Elasticity of Supply

Elasticity of Supply Also Varies…
• Just as the elasticity of demand varied both along the demand curve and across products, so does the elasticity of supply

P

More Inelastic

Supply Curve

More Elastic

Q

Constant-Elasticity Supply Curves
•
•

1.

2.

For an upward sloping linear supply curve, the price elasticity changes as you move along the supply curve Some supply curves have an elasticity that does NOT vary along the supply curve Perfectly Elastic Supply Curve – at the right price, any amount of the product will be supplied (horizontal supply curve) Perfectly Inelastic Supply Curve – price changes have no effect on the quantity supplied, which is likely a fixed amount (vertical supply curve)

P

P

S

S

Q

Q

Perfectly Elastic Supply Perfectly Inelastic Supply

Determinants of the Price Elasticity of Supply
Both depend on how easy it is to alter output when price changes • Cost of Supplying Additional Output – if it is costly to increase output, then a price increase won’t cause the firm to expand output significantly (therefore, supply is inelastic) • Time – how long does the firm have to make the output change? The longer the time, the more elastic the supply

Other Elasticity Measures
• Income Elasticity of Demand – a measure of the responsiveness of demand to changes in income
• Cross-Price Elasticity of Demand- a measure of how responsive one good’s quantity demanded is to a change in the price of another good (i.e. how do brand X’s sales respond to changes in the price of brand Y)

Income Elasticity of Demand
• Normal Good – a good with an income elasticity greater than zero
– Why is the elasticity greater than zero? Because the demand curve shifts out with income increases – Most goods are normal goods

• Inferior Good – a good with an income elasticity less than zero
– Why is the Income Elasticity of Demand negative? Because the demand curve shifts in with income increases

Cross-Price Elasticity of Demand
• Substitutes – if an increase in the price of one good leads to an increase in the demand for another good, they are substitutes
– The Cross-Price Elasticity is POSITIVE – Example: Coke and Pepsi have a positive cross-price elasticity

• Complements – if an increase in the price of one good leads to a decrease in the demand for another good, they are complements
– The Cross-Price Elasticity is NEGATIVE – Example: Peanut butter and jelly or hot dogs and buns

Elasticity Examples
• To help us think about elasticity concepts, we are going to look at four different industries/products:
– Cars, soft drinks, cereal, and beer – Your book has a ton of other examples

• When you look at the elasticities, try to explain the differences among brands and products
– Substitutability, proportion of income spent on the item, and time to make your decision

Elasticity of Automobiles
• Price elasticity of demand:
– BMW 735i = -9.376 – Honda Accord = -51.637 – Ford Escort = -106.497

• Cross-price elasticity of demand:
– BMW 735i & Lexus LS400 = 0.336 – BMW 735i & Honda Accord = 0.203 – BMW 735i & Ford Escort = 0.009

• Which cars are close substitutes? What role does income play? Which consumers are most price sensitive?

Elasticity of Breakfast Cereal
• Price elasticity of demand:
– Kellogg’s Corn Flakes = -3.379 – Lucky Charms = -2.536 – Rice Krispies = -2.340

• Cross-price elasticity of demand:
– – – – Corn Flakes & Wheaties = 0.242 Corn Flakes & Lucky Charms = 0.019 Corn Flakes & Cinnamon Toast Crunch = 0.026 Lucky Charms & Cin. Toast Crunch = 0.102

Elasticity of Soft Drinks
• Price elasticity of demand:
– Coke (2-liter bottle) = -3.89 – 7-Up (2-liter bottle) = -4.25 – Mountain Dew (2-liter bottle) = -3.75

• Cross-price elasticity of demand:
– Coke & Pepsi = 0.63 – Coke & Mountain Dew = 0.12 – Coke & Diet Coke = 0.81

Elasticity of Beer
• Price elasticity of demand:
– Miller Lite = -2.10 – Budweiser = -3.80 – Heineken = -0.42

• Cross-price elasticity of demand:
– Miller Lite & Bud Light = 1.26 – Miller Lite & Heineken = 0.12 – MGD & Bud = 1.68

Questions to think about?
• Why is the price elasticity of the Ford Escort lower than the BMW? • Why is the price elasticity of cereal less than the price elasticity of cars? • Why is the cross-price elasticity greater for Corn Flakes & Wheaties than it was for Corn Flakes & Lucky Charms? • Are Miller Lite and Bud Light closer substitutes than Miller Lite and Heineken?

Selected Income Elasticities of Demand
Product Income Elasticity Product Income Elasticity

Private education Automobiles Wine Owner-occupied housing Furniture Dental service Restaurant meals Shoes Chicken Spirits (“hard” liquor) Clothing

2.46 2.45 2.45 1.49 1.48 1.42 1.40 1.10 1.06 1.02 0.92

Physicians’ services Coca-Cola Beef Food Coffee Cigarettes Gasoline and oil Rental housing Beer Pork Flour

0.75 0.68 0.62 0.51 0.51 0.50 0.48 0.43 0.27 0.18 –0.36

In-Class Problem to Solve
• Last year, Homer had an income of $40,000 from his job at the Springfield Nuclear Power Plant. At that level of income, Homer consumed 15 units of Good X. This year, Homer received a $15,000 raise. After his raise, he consumed 18 units of Good X.
Using the above information, please calculate Homer’s income elasticity of demand. b. Is Good X a normal or inferior good? c. If Homer’s boss gave him an additional 10% raise, what would happen to Homer’s consumption of Good X? a.

Solutions
qnew  qold I new  I old EI   qnew  qold  / 2 I new  I old  / 2 18  15 55,000  40,000   18  15 / 2 (55,000  40,000) / 2 3 15,000    0.1875  0.3158 16.5 47,500  0.59

•

Normal good => EI > 0
% change in consumptio n EI  % change in income ?  0.59   ?  5.9 10


								
To top