Roger LeRoy Miller Economics Today Twelfth Edition Chapter 20 Demand and Supply Elasticity Introduction Cigarette consumption is relatively unresponsive to price changes, so higher cigarette taxes do not reduce smoking significantly. How would cigarette smoking be affected if taxes on beer were increased? Copyright 2004 Pearson Addison Wesley. All rights reserved. Slide 20-2 Learning Objectives Learning Objectives Express and calculate price elasticity of demand Understand the relationship between the price elasticity of demand and total revenues Discuss the factors that determine the price elasticity of demand Describe the cross price elasticity of demand and how it may be used to indicate whether two goods are substitutes or complements Explain the income elasticity of demand Slide 20-3 Slide 20-4 1
Learning Objectives Chapter Outline Classify supply elasticities and explain how the length of time for adjustment affects the price elasticity of supply Price Elasticity Price Elasticity Ranges Elasticity and Total Revenues Determinants of the Price Elasticity of Demand Slide 20-5 Slide 20-6 Chapter Outline Did You Know That... Cross Price Elasticity of Demand Income Elasticity of Demand Elasticity of Supply Lower beer prices are associated with an increase in the number of violent incidents on campus? Slide 20-7 Slide 20-8 2
Price Elasticity Price Elasticity Price Elasticity of Demand (E p ) The responsiveness of quantity demanded of a commodity to changes in its price Price Elasticity of Demand (E p ) percentage change in quantity demanded E p = percentage change in price E p = % Q d % P Slide 20-9 Slide 20-10 Price Elasticity Price Elasticity Example Price of oil increases 10 percent Quantity demanded decreases 1 percent E p = -1% +10% = -.1 Question How would you interpret an elasticity of -0.1? Answer A one percent increase in the price of oil will lead to a one percent decrease in quantity demanded Slide 20-11 Slide 20-12 3
Price Elasticity Relative quantities only Elasticity is measuring the change in quantity relative to the change in price Always negative An increase in price decreases the quantity demanded, ceteris paribus Policy Example: Making the Price of a High Higher Youthful cocaine abusers are three times as sensitive to price changes compared to adults. Legal crackdowns on cocaine dealers to decrease supply and raise prices may be an appropriate strategy in the war on drugs. Slide 20-13 Slide 20-14 Calculating Elasticity Price Elasticity Calculating elasticity change in Q d % change in Q d = original Q d The basics of measuring percentage changes If price increases from $1 to $2, then the percent change in price is: % change in price = change in price original price % P = 1 1 = 100% Slide 20-15 Slide 20-16 4
Price Elasticity Price Elasticity The basics of measuring percentage changes If price falls from $2 to $1, then the percent change in price is: The basics of measuring percentage changes The percentage is influenced by the base of the original value. % P = 1 2 = 50% Slide 20-17 Slide 20-18 Calculating Elasticity Calculating Elasticity Adjusting for the percent change bias change in Q change in P E p = sum of quantities/2 sum of quantities/2 change in Q change in P or E p = (Q 1 + Q 2 )/2 (P 1 + P 2 )/2 Example If the price increases from 1 to 2: 1 % P = =.67 3/2 or E p = Q Avg. Q P Avg. P Slide 20-19 Slide 20-20 5
Calculating Elasticity Example If the price decreases from 2 to 1: 1 % P = =.67 3/2 International Example: Price Elasticity of Demand for World s Fair Tickets Price of admission to World s Fair in Hannover, Germany was lowered from $12 to $5. Daily attendance rose from 60,000 to 100,000. Slide 20-21 Slide 20-22 International Example: Price Elasticity of Demand for World s Fair Tickets International Example: Price Elasticity of Demand for World s Fair Tickets Q P E p = (Q 1 + Q 2 )/2 (P 1 + P 2 )/2 100,000-60,000 (100,000 + 60,000)/2 E p = 12-5 (12 + 5)/2 E p = 40,000 80,000 Interpretation 7.0 8.5 =.61 A 1 percent decrease in price would increase quantity demanded by.61 percent. Slide 20-23 Slide 20-24 6
Price Elasticity Ranges Price Elasticity Ranges Elastic Demand Percentage change in quantity demanded is larger than the percentage change in price E p > 1 Unit Elasticity of Demand Percentage change in quantity demanded is equal to the percentage change in price E p = 1 Slide 20-25 Slide 20-26 Price Elasticity Ranges Price Elasticity Ranges Inelastic Demand Percentage change in quantity demanded is smaller than the percentage change in price E p < 1 Elastic demand % Q > % P; E p > 1 Unit elastic % Q = % P; E p = 1 Inelastic demand % Q < % P; E p < 1 Slide 20-27 Slide 20-28 7
Price Elasticity Ranges Extreme Price Elasticities Extreme elasticities Perfectly Inelastic Demand A demand curve that is a vertical line It has only one quantity demanded for each price No matter what the price, quantity demanded does not change Price 0 Slide 20-29 Quantity Demanded per Year (millions of units) Slide 20-30 Extreme Price Elasticities Extreme Price Elasticities D D P 1 Price Perfect inelasticity, or zero elasticity Price P 0 Perfect inelasticity, or zero elasticity 0 8 0 8 Quantity Demanded per Year Quantity Demanded per Year Figure 20-1, Panel (a) (millions of units) Slide 20-31 (millions of units) Slide 20-32 8
Price Elasticity Ranges Extreme Price Elasticities Extreme elasticities Perfectly Elastic Demand A demand curve that is a horizontal line It has only one price for every quantity The slightest increase in price leads to zero quantity demanded Price (cents) 0 Slide 20-33 Quantity Demanded per Year (millions of units) Slide 20-34 Extreme Price Elasticities Extreme Price Elasticities P 1 never touches the demand curve P 1 Price (cents) 30 D Perfect elasticity, or infinite elasticity Price (cents) 30 D Perfect elasticity, or infinite elasticity 0 0 Quantity Demanded per Year Quantity Demanded per Year Figure 20-1, Panel (b) (millions of units) Slide 20-35 (millions of units) Slide 20-36 9
Policy Example: Who Pays Gasoline Taxes? Price Elasticity: A Gasoline Tax State and federal governments impose gasoline taxes that are assessed as a flat amount per gallon Who pays the tax depends on price elasticity of demand Slide 20-37 Figure 20.2, Panels (a) and (b) Slide 20-38 Policy Example: Who Pays GasolineTaxes? The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service Figure 20.2, Panel (c) Slide 20-39 Figure 20.3, Panel (a) Slide 20-40 10
The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service 1.10 1.00.90 1.10 1.00.90 Elastic (E p > 1) Unit-Elastic (E p = 1) Inelastic (E p < 1) Price per Minute ($).80.70.60.50.40.30 Price per Minute ($).80.70.60.50.40.30 Demand, or average revenue curve.20.20.10.10 D 0 10 20 30 40 50 60 70 80 90 100 110 Quantity per period (billions of minutes) Slide 20-41 0 Figure 20-3, Panel (b) 10 20 30 40 50 60 70 80 90 100 110 Quantity per period (billions of minutes) Slide 20-42 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service 3.0 3.0 Elastic Total Revenue ($ billions) 2.5 2.0 1.5 1.0 Total Revenue ($ billions) 2.5 2.0 1.5 1.0 D Unit-Elastic Inelastic Total revenue curve 0.5 0.5 0 10 20 30 40 50 60 70 80 90 100 110 Quantity per period (billions of minutes) Slide 20-43 0 10 20 30 40 50 60 70 80 90 100 110 Figure 20-3, Panel (c) Quantity per period (billions of minutes) Slide 20-44 11
Elasticity and Total Revenues Elasticity and Total Revenues Elastic Demand A negative relationship exists between small changes in price and changes in total revenue Unit-Elastic Demand Changes in price do not change total revenue Slide 20-45 Slide 20-46 Elasticity and Total Revenues Relationship Between Price Elasticity of Demand and Total Revenues Inelastic Demand A positive relationship exists between changes in price and total revenues Price Elasticity of Demand Effect of Price Change on Total Revenues (TR) Price Price Decrease Increase Inelastic (E p < 1) TR TR Unit-elastic (E p = 1) No change in TR No change in TR Elastic (E p > 1) TR TR Slide 20-47 Slide 20-48 12
Example: Boosting Revenues with Markdown Optimizer ShopKo uses a software package that estimates the optimal markdown for items already in stores Optimally-timed markdowns have resulted in improved revenues on those items Determinants of Price Elasticity of Demand Existence of substitutes The closer the substitutes and the more substitutes there are, the more elastic is demand. Share of the budget The greater the share of the consumer s total budget spent on a good, the greater is the price elasticity. Slide 20-49 Slide 20-50 Determinants of Price Elasticity of Demand Determinants of Price Elasticity of Demand The length of time allowed for adjustment The longer any price change persists, the greater is the price elasticity of demand. Price elasticity is greater in the long-run than in the short-run. How to define the short run and the long run The short run is a time period too short for consumers to fully adjust to a price change. The long run is a time period long enough for consumers to fully adjust to a change in price other things constant. Slide 20-51 Slide 20-52 13
Short-Run and Long-Run Price Elasticity of Demand Short-Run and Long-Run Price Elasticity of Demand Price per Unit P 1 P e E D 2 In the short run, quantity demanded falls slightly. However, with more time for adjustment the demand curve becomes more elastic and quantity demanded falls by a greater amount. Price per Unit P 1 P e E D 2 D 3 In the short run, quantity demanded falls slightly. However, with more time for adjustment the demand curve becomes more elastic and quantity demanded falls by a greater amount. D 1 D 1 Q 2 Q 1 Q e Quantity Demanded per Period Slide 20-53 Figure 20-4 Q 3 Q 2 Q 1 Q e Quantity Demanded per Period Slide 20-54 Demand Elasticity for Selected Goods Cross Price Elasticity of Demand Estimated Elasticity Category Short Run Long Run Air travel (vacation) 1.1 2.7 Air travel (business). 4 1.2 Beef.6 Cheese.3 Electricity.1 1.7 Fresh tomatoes 4.6 Gasoline. 2.5 Hospital services.1.7 Intercity bus service.6 2.2 Physician services.1.6 Private education 1.1 1.9 Restaurant meals 2.3 Tires.9 1.2 Slide 20-55 Cross Price Elasticity of Demand (E xy ) The percentage change in the demand for one good (holding its price constant) divided by the percentage change in the price of a related good The responsiveness of change in demand of one good to the change in prices of related goods Slide 20-56 14
Cross Price Elasticity of Demand Formula for computing cross elasticity of demand E xy = % in demand for good X % in price of good Y Substitutes Cross Price Elasticity of Demand E xy would be positive An increase in the price of X would increase the quantity of Y demanded at each price. Complements E xy would be negative An increase in the price of X would decrease the quantity of Y demanded at each price. Slide 20-57 Slide 20-58 Income Elasticity of Demand Income Elasticity of Demand Income Elasticity of Demand (E i ) The percentage change in demand for any good, holding its price constant, divided by the percentage change in income The responsiveness of demand to changes in income, holding the good s relative price constant E i = percentage change in demand percentage change in income Slide 20-59 Slide 20-60 15
Income Elasticity of Demand Income elasticity of demand refers to a horizontal shift in the demand curve in response to changes in income Price elasticity of demand refers to a movement along the curve in response to price changes How Income Affects Quantity of DVDs Demanded Number of CDs Period Demanded per Month Income per Month 1 6 $4,000 2 8 6,000 Slide 20-61 Slide 20-62 How Income Affects Quantity of DVDs Demanded Income increases from $400 to $600 per month How Income Affects Quantity of DVDs Demanded Income decreases from $6000 to $4000 per month (8-6)/6 E i = = 1/3 (6000-4000)/4000 1/2 2 = =.667 3 (6-8)/8 E i = = -1/4 3 = =.75 (4000-6000)/6000-1/3 4 Slide 20-63 Slide 20-64 16
Income Elasticity of Demand Income Elasticity of Demand Eliminating the bias of the base Quantity Income E i = sum of quantities/2 sum of income/2 Demand and elasticities Accurate estimates of E p and E i can yield accurate forecasts of the demand for goods and services. Slide 20-65 Slide 20-66 Elasticity of Supply Elasticity of Supply Price Elasticity of Supply (E i ) The responsiveness of the quantity supplied of a commodity to a change in its price The percentage change in quantity supplied divided by the percentage change in price Formula for computing price elasticity of supply percentage change in quantity supplied E S = percentage change in price Slide 20-67 Slide 20-68 17
Elasticity of Supply Elasticity of Supply Classifying supply elasticities Perfectly Elastic Supply Quantity supplied falls to zero when there is any decrease in price. The supply curve is horizontal at a given price. Classifying supply elasticities Perfectly Inelastic Supply Quantity supplied is constant no matter what happens to price. The supply curve is vertical at a given price. Slide 20-69 Slide 20-70 The Extremes in Supply Curves The Extremes in Supply Curves S S Perfect inelasticity Perfect inelasticity Price per Unit Price per Unit P 1 S Perfect elasticity Q 1 Q 1 Quantity Supplied per Period Quantity Supplied per Period Figure 20-5 Slide 20-71 Figure 20-5 Slide 20-72 18
Elasticity of Supply The Extremes in Supply Curves Price elasticity of supply and length of time for adjustment The longer the time allowed for adjustment, the more elastic is supply. Firms can find ways to increase (or decrease) output. Resources can flow into (or out of) an industry through expansion (or contraction) of existing firms. Price per Unit Slide 20-73 Quantity Supplied per Period Slide 20-74 The Extremes in Supply Curves Short-Run and Long-Run Price Elasticity of Supply S 1 S 1 In the short run, the supply curve, S 1, is vertical with price P e and quantity supplied of Q e. If price increases to P 1 quantity stays unchanged Price per Unit P e E Price per Unit P 1 P e E Q e Q e Quantity Supplied per Period Slide 20-75 Quantity Supplied per Period Slide 20-76 19
Short-Run and Long-Run Price Elasticity of Supply Short-Run and Long-Run Price Elasticity of Supply S 1 S 2 S 1 S 2 S 3 Price per Unit P 1 P e E As time passes the supply curve rotates from S 1 to S 2 and quantity supplied rises first to Q 1. Price per Unit P 1 P e E As time passes the supply curve rotates to S 2 then to S 3 and quantity supplied rises first to Q 1 and then to Q 2. Q e Q 1 Q e Q 1 Q 2 Quantity Supplied per Period Slide 20-77 Figure 20-6 Quantity Supplied per Period Slide 20-78 International Example: French Truffle Production Takes a Nosedive Issues and Applications: Taxation and Cigarette Smoking Chinese competition caused the price of French truffles to fall 30 percent in 1996. Accordingly French production decreased by 25%. Short-run E S =.83 Would higher taxes on beer discourage cigarette smoking? Because the demand for cigarettes is relatively price inelastic, higher cigarette taxes do not appear to discourage smoking Slide 20-79 Slide 20-80 20
Issues and Applications: Taxation and Cigarette Smoking Web Links If alcoholic beverages and cigarettes are complements, then taxes on alcohol could reduce the amount of smoking Estimates indicate that the cross-price elasticity of demand between beer and cigarettes is -.2 Therefore, a 10 percent increase in beer prices would reduce the number of cigarettes consumed by 2 percent. Slide 20-81 The following Web links appear in the margin of this chapter in the textbook: http://ingrimayne.saintjoe.edu/econ/ TheFirm/ProductionFunct.html http://ingrimayne.saintjoe.edu/econ/ elasticity/elastic1.html http://hadm.sph.sc.edu/courses/econ/ Elast/Elast.html Slide 20-82 Summary Discussion of Learning Objectives Expressing and calculating the price elasticity of demand Percentage change in quantity demanded divided by the percentage change in price Summary Discussion of Learning Objectives The relationship between the price elasticity of demand and total revenues When demand is elastic, price and total revenue are inversely related When demand is inelastic, price and total revenue are positively related When demand is unit elastic, total revenue does not change when price changes Slide 20-83 Slide 20-84 21
Summary Discussion of Learning Objectives Factors that determine price elasticity of demand Availability of substitutes Percentage of a person s budget spent on the good The length of time allowed for adjustment to a price change Summary Discussion of Learning Objectives The cross price elasticity of demand and using it to determine whether two goods are substitutes or complements Percentage change in the demand for one good divided by the percentage change in the price of another If cross elasticity is positive, the goods are substitutes If cross elasticity is negative, the goods are complements Slide 20-85 Slide 20-86 Summary Discussion of Learning Objectives Summary Discussion of Learning Objectives Income elasticity of demand Percentage change in the demand for a good divided by the percentage in income Slide 20-87 Classifying supply elasticities and how the length of time for adjustment affects price elasticity of supply Elastic supply: price elasticity of supply is greater than 1 Inelastic supply: price elasticity of supply is less than 1 Unit-elastic supply: price elasticity of supply is equal to 1 The longer the time period for adjustment, the more elastic is supply Slide 20-88 22
End of Chapter Chapter 20 Demand and Supply Elasticity Copyright 2004 Pearson Addison Wesley. All rights reserved. 23