# Lesson-9. Elasticity of Supply and Demand

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1 Lesson-9 Elasticity of Supply and Demand Price Elasticity Businesses know that they face demand curves, but rarely do they know what these curves look like. Yet sometimes a business needs to have a good idea of what part of a demand curve looks like if it is to make good decisions. If Rick's Pizza raises its prices by 10 percent, what will happen to its revenue? The answer depends on how consumers will respond. Will they cut back purchases a little or a lot? This question of how responsive consumers are to price changes involves the economic concept of elasticity. Elasticity is a Measure of Responsiveness Two words are important here. The word "measure" means that elasticity results are reported as numbers or elasticity coefficients. The word "responsiveness" means that there is a stimulus reaction involved. Some change or stimulus causes people to react by changing their behavior, and elasticity measures the extent to which people react. The most common elasticity measurement is that of price elasticity of demand. It measures how much consumers respond in their buying decisions to a change in price. The basic formula used to determine price elasticity is as follows: e = (percentage change in quantity) / (percentage change in price) Elasticity is the percentage change in quantity divided by the percentage change in price. If price increases by 10% and consumers respond by decreasing purchases by 20%, the equation computes the elasticity coefficient as -2. The result is negative because an increase in price (a positive number) leads to a decrease in purchases (a negative

2 number). Because the law of demand says it will always be negative, many economists ignore the negative sign, as we will in the following section. An elasticity coefficient of 2 shows that consumers respond a great deal to a change in price. If, on the other hand, a 10% change in price causes only a 5% change in sales, the elasticity coefficient will be only 1/2. Economists would say in this case that demand is inelastic. Demand is inelastic whenever the elasticity coefficient is less than one. When it is greater than one, economists say that demand is elastic. Products that have few good substitutes generally have a lower elasticity of demand than products with many substitutes. As a result, more broadly defined products have a lower elasticity than narrowly defined products. The price elasticity of demand for meat will be lower than the price elasticity of pork. Similarly, the price elasticity for soft drinks will be less elastic than the price elasticity for colas, which, in turn, will be less elastic than the price elasticity for Pepsi. Time plays an important role in determining both consumer and producer responsiveness for many items. The longer people have to make adjustments, the more adjustments they will make. When the price of gasoline rose rapidly in the late 1970s as a result of the OPEC cartel, the only adjustment consumers could initially make was to drive less. With time, they could also move closer to work or find jobs closer to home, and switch to more fuel-efficient cars. The concept of elasticity can help explain some situations that at first glance may seem puzzling. If all American farmers have excellent harvests, they may have a very poor year financially. They may be better off if they all have mediocre harvests. If a bus company decides it needs more revenue and tries to get it by raising fares, its revenues may decrease rather than increase.

3 Figure A In the case of the farmers, the key to their problem is that the demand curve for their products is quite inelastic. This means that if the harvest is unusually good, a large drop in price is necessary to encourage consumers to use the additional grain. If the elasticity coefficient is.5, for example, and the harvest is 10% larger than the previous year, then a 20% drop in prices will occur (assuming that the many things which we keep constant in drawing the demand curve have remained constant). Because this price reduction more than offsets the effect of the larger harvest, the average farmer's income drops. Figure B

4 For the bus company, the key is that demand is elastic. For example, suppose that the elasticity is 1.5. Then, if price is raised by 10%, quantity (ridership) must drop by 15%. But the drop in ridership more than offsets the increase in price, and so, revenue will drop. Just as we can measure how responsive buyers are to a change in price, we can measure how responsive sellers are. This measurement, the price elasticity of supply, has the same formula as price elasticity of demand. Only the quantity in the formula will refer to the quantity that sellers will sell. As with demand elasticity, supply elasticity depends on the amount of time available for adjustment. In the very short run, there may be no adjustments that sellers can make, which would mean a perfectly vertical supply curve. For example, if on December 1 the price of apples doubles, there will be minimal effect on the number of apples available to the consumer. Producers cannot make adjustments until a new growing season begins. In the short run, producers can use their facilities more or less intensively. In the apple example, sellers can vary the amounts of pesticides and the amount of labor they use to pick the apples. Finally, in the long run, not only can producers change their facilities, but they can also leave the industry or new producers may enter it. In apple example, new orchards can be planted or old ones destroyed. Types of Price Elasticity of Demand Different commodities respond differently to changes in their price. A price change has relatively much less impact on quantity demanded of a necessity than it has on the quantity demanded of a luxury. In fact, it is the nature of a commodity which is responsible for differing elasticities of demand in case of different commodities. Conceptually, price elasticities of demand is generally classified into the following categories: 1. Perfectly Elastic Demand (e = 0)-- Where no reduction in price is needed to cause an increase in quantity demanded. [Fig. C (a)] 2. Absolutely Inelastic Demand (e = 0)-- Where a change in price, however large, causes no change in quantity demanded. [Fig. C (b)] 3. Unit Elasticity of Demand (e = 1)-- Where a given proportionate change in price causes an equally proportionate change in quantity demanded (in this case, the demand curve takes the form of a rectangular hyperbola). [Fig. C (c)] 4. Relatively Elastic Demand (e > 1)-- Where a change in price causes a more than proportionate change in quantity demanded. [Fig. C (d)]

5 5. Relatively Inelastic Demand (e < 1)-- Where a change in price causes a less than proportionate change in quantity demanded. [Fig. C (e)] Figure C Computing Price Elasticity Elasticity can be calculated in two different ways: 1. Point Elasticity 2. Arc Elasticity When we try to use the equation to calculate elasticity coefficients, we run into a problem. If we look at an increase in price from \$3.00 to \$4.00, we have an increase of

6 33%. However, if we have a price reduction from \$4.00 to \$3.00, we have a reduction of 25%. Thus, there are two ways of viewing what happens between \$3.00 and \$4.00. Suppose that when price of a product is \$3.00, people will buy 60, but when price is \$4.00, they will buy only 50. What is the elasticity over this segment of the demand curve, between prices \$3.00 and \$4.00? Should one start at the price of \$3.00 and compute a price rise of 33 1/3% and a quantity decline of 16 2/3%, or e = (16.67%) / (33.33%) =.5 Or, should one start at the \$4.00 price, and then compute a price decline of 25% and a quantity increase of 20%, or e = (20%) / (25%) =.8 The formula mentioned earlier does not tell us which way to proceed, and it matters. To get around the problem of deciding which starting point to use, economists compute elasticity based on the midpoint, or in the example above at a price of \$3.50. The formula that does this is as follows: e = (Change in quantity divided by average quantity) / (Change in price divided by average price) or e = [(Q1 - Q2) / ((Q1 + Q2)/2)] / [(P1 - P2) / ((P1 + P2)/2)] By putting the numbers from the previous example into this equation, we get: e = [(60-50) / ( )/2] / [(\$4 - \$3) / (\$4 + \$3)/2]

7 or e = (10/55) / (1.00/3.50) = (10/55) x (35/10) = 7/11 =.6363 This formula is the formula for arc elasticity, or the elasticity between two points on the demand curve. As the two points get closer to each other, arc elasticity approaches point elasticity, the measure of elasticity preferred by professional economists. With a bit of algebra, we can show that the equation for elasticity above can be rewritten as follows: e = [1/(Slope of Demand Curve)] x [(Average Price)/(Average Quantity)] Using this equation, consider what happens when the slope gets steeper, which means that the slope becomes a bigger number. Elasticity becomes smaller, which means that consumers are less responsive. As the demand curve approaches a vertical line, the slope approaches infinity and elasticity approaches zero. As the demand curve approaches a horizontal line, the slope approaches zero and elasticity approaches infinity. We can also see what happens when the slope is constant, which means that the demand curve is a straight line. As one moves along the line, elasticity changes because average price and average quantity change. At the top of the demand curve, price is high and quantity is low, so elasticity is high. At the bottom, price is low and quantity is high, so elasticity is low. Other Elasticities In addition to price elasticities of supply and demand, economists frequently refer to other elasticity measurements. Income elasticity of demand measures the responsiveness of people's purchases to changes in income. It is defined as

8 Income elasticity = (Percentage change in amount bought)/(percentage change in income) Income elasticity measures whether a good is a normal or an inferior one. A product is a normal good when its income elasticity is positive, meaning that higher income causes people to purchase more of the product. For an inferior good, income elasticity is negative because an increase in income causes people to buy less of the product. Cross-price elasticity, often simply called just cross-elasticity, measures whether goods are substitutes or complements. It looks at the response of people in buying one product when the price of another product changes. The formula for cross-price elasticity is Cross-price elasticity = (Percentage change in amount of A bought)/(percentage change in price of B) If goods are complements, cross-price elasticity will be negative. For example, if the price of gasoline rises, the sales of large cars will decline. The positive change in the denominator (bottom) is matched with a negative change in the numerator (top) of the equation. The result is, therefore, negative. If cross-price elasticity is positive, B is a substitute for A. For example, sales of Coke will fall if the price of Pepsi falls because some Coke drinkers will switch from Coke to Pepsi. Revenue and Demand The demand curve is a useful illustration. We have seen that the downward slope tells us there is an indirect relationship between price and quantity. One can also see the demand curve as separating a region in which sellers can operate from a region forbidden to them. But there is more, especially when one considers what an area on the graph represents. If people will buy 100 units of a product when its price is \$10.00, as the graph below (Figure D) illustrates, total revenue for sellers will be \$1000. The area of the rectangle formed under the demand curve is calculated by multiplying the height of the rectangle by its width. Because the height is price and the width is quantity, and since price

9 multiplied by quantity is total revenue, the area is total revenue. The fact that area on supply and demand graphs measures total revenue (or total expenditure by buyers, which is the same thing from another viewpoint) is a key idea used repeatedly in microeconomics. Figure D From the demand curve, we can obtain total revenue. From total revenue, we can obtain another key concept-- marginal revenue. Marginal revenue is the additional revenue added by an additional unit of output. In terms of a formula, it is: Marginal revenue = (Change in total revenue) / (Change in sales) According to the graph, people will not buy more than 100 units at a price of \$ To sell more, price must drop. Suppose that to sell the 101st unit, the price must drop to \$9.95. What will the marginal revenue of the 101st unit be? Or, in other words, by how much will total revenue increase when the 101st unit is sold? There is a temptation to answer this question by quoting "\$9.95." A little arithmetic shows that this answer is incorrect. Total revenue when 100 units are sold is \$1000. When 101 units are sold, total revenue is (101) x (\$9.95) = \$ The marginal revenue of the 101st unit is only \$4.95.

10 To see why the marginal revenue is less than price, one must understand the importance of the downward sloping demand curve. To sell another unit, sellers must lower price on all units. They received an extra \$9.95 for the 101st unit, but they lost \$.05 on the 100 units that they were previously selling. So the net increase in revenue was the \$9.95 minus the \$5.00, or \$4.95. There is another way to see why marginal revenue will be less than price when a demand curve slopes downward. Price is average revenue. If the firm sells 100 units for \$10.00, the average revenue for each unit is \$ But as sellers sell more, the average revenue (or price) drops. This can only happen if the marginal revenue is below price, pulling the average down. The reasoning of why marginal revenue will be below average if average is dropping can perhaps be better seen in another example. Suppose that the average age of 20 people in a room is 25 years, and that another person enters the room. If the average age of the people rises as a result, the extra person must be older than 25. If the average age drops, the extra person must be younger than 25. If the added person is exactly 25, then the average age will not change. Whenever an average is rising, its marginal must be above the average, and whenever an average is falling, its marginal must be below the average. If one knows marginal revenue, one can tell what happens to total revenue if sales change. If selling another unit increases total revenue, the marginal revenue must be greater than zero. If marginal revenue is less than zero, then selling another unit takes away from total revenue. If marginal revenue is zero, than selling another does not change total revenue. This relationship exists because marginal revenue measures the slope of the total revenue curve.

11 Figure E The graph above in the Figure E illustrates the relationship between total revenue and marginal revenue. The total revenue curve will be zero when nothing is sold, and zero again when a great deal is sold at a zero price. Thus, it has the shape of an inverted U. The slope of any curve is defined as the rise over the run. The rise for the total revenue curve is the change in total revenue, and the run is the change in output. Therefore, Slope of Total Revenue Curve = (Change in total revenue) / (Change in amount sold) But this definition of slope is identical to the definition of marginal revenue which demonstrates that marginal revenue is the slope of the total revenue curve. From Elasticity to Marginal Revenue Marginal revenue is the extra revenue from adding another unit of output. If a firm finds that when it sells six units, its revenue is 24, and when it sells eight units, its revenue is 28, then its extra revenue for adding two more units is four. Its marginal revenue, or the extra revenue for adding one more unit of production, will be two.

12 Figure F The graph in the Figure F above illustrates an alternative way to compute this extra revenue. When the firm sells six units, it can charge a price of \$4, but when it sells eight units, it can charge only \$3.50. Thus, six units at \$4 each give a total revenue of \$24 and eight units at \$3.50 each gives a total revenue of \$28. When the firm sells the extra two units, it adds two units at \$3.50 each or \$7 in total to its revenue. However, it also loses something because it had to lower the price on the six units it was previously selling. The loss in these six units is \$.5 each, or \$3. The net change in revenue is \$7 less \$3, or \$4. To get marginal revenue, the change in total revenue (\$4) must be divided by the change in output (2), which in this example gives us \$2. We have shown that marginal revenue can be computed as follows: [(Change in Q) P + (Change in P) Q] / [Change in Q] This formula holds true approximately when changes are big, but becomes exact as the changes get smaller. Because the change in price will be negative, the second term in the numerator will be subtracted from the first.

13 When changes in price and quantity are very, very small, the formula for price elasticity can be written as follows: e = [(Change in Q)/Q] / [(Change in P)/P] Use the above two formulas to show that the following equation is true: Marginal Revenue = Price (1-1/ elasticity ) The formula says divide one by the absolute value of elasticity and subtract this number from one. Then, take this second number and multiply it by price. The result is marginal revenue. The last formula says that if demand is inelastic (less than one), trying to sell more will reduce total revenue. Whereas if demand is elastic (greater than one), trying to sell more will increase total revenue. This should make intuitive sense. If people are not sensitive to price, then one must reduce price a great deal to sell more, which means that total revenue declines.

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