Chapter 18. The Elasticities of Demand and Supply

Chapter 18The Elasticities of Demand and Supply 18-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter ObjectivesThe elasticity of demandThe determinants of elasticityElasticity and total revenueThe elasticity of supplyTax incidence18-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.18-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Elasticity of DemandThe elasticity of demand for a good or service measures the change in quantity demanded in response to a change in priceIn other words, elasticity measures the sensitivity (measured in percentage change) of quantity demanded because of a change (percentage) in priceWhen price goes up, we know that quantity demanded declines.But we don’t know by how much?Elasticity provides us a way of measuring this responseElasticity answers the “how much” question18-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Measuring ElasticityCalculate the coefficient of price elasticity (Ep)Ep =Percentage change in quantity demandedPercentage change in priceEp =Q2 - Q1 P2 + P1XQ2 + Q1 P2 - P1 P1 is the initial price; P2 is the new priceQ1 is the initial quantity sold; Q2 is the new quantity sold18-5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.A firm has been selling 100 chairs a week. It runs a sale, charging $8 instead of the usual $10. Sales go up to 140 chairs.Ep = Q2 - Q1 P2 + P1Q2 + Q1 P2 - P1 XEp =140 -1008 + 10140 + 1008 - 10XEp =24040X18-2=- 1.4999994Ep = 1.5So the negative sign is ignoredNote: the answer is always negative18-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Price is raised from $40 to $41, and quantity sold declines from 15 to 12Ep = Q2 - Q1 P2 + P1Q2 + Q1 P2 - P1 XEp =15 - 1241 + 4012 + 1541 - 40XEp =27-3X811=-8.9999991Ep = 9.0So the negative sign is ignoredNote: the answer is always negative18-7Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Meaning of ElasticityElasticity is many thingsFirst, elasticity is a numberAn Ep greater than 1 is elasticThis means that demand is relatively sensitive to price changesThe larger the number, the greater will be the sensitivity to price changesThis number represents the percent change in quantity demanded resulting from each 1% change in a goods priceAn Ep of 10 means that for every 1% change in price there will be a 10% change in QD18-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Meaning of ElasticityAn Ep less than 1 is inelasticThis means that demand is relatively less sensitive to price changesThe smaller the number, the greater the insensitivity to price changesAn Ep of .1 means that for every 1% change in price there will be a .1% change in quantity demanded18-9Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Meaning of ElasticityAn Ep that is exactly 1 is unit elasticThis means that demand is neither elastic nor inelasticAn Ep of 1 means that for every 1% change in price there will be a 1% change in QD18-10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Perfectly Elastic Demand CurveThe elasticity of a perfectly elastic demand curve is infinity18-11Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Perfectly Inelastic Demand CurveThe elasticity of a perfectly inelastic demand curve is 018-12Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Relativity Elasticity of Demand Curves18-13Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Straight Line Demand Curve18-14Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Elasticity of Straight Line Demand CurveRelatively Inelastic Demand Curve18-15Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Relatively Elastic Demand Curve18-16Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Determinants of the Degree of Elasticity of Demand The availability of substitutes is the most important influence on the elasticity of demandThe question of necessity versus luxuryThe product’s cost relative to the buyer’s incomeThe passage of timeThe number of uses18-17Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.AdvertisingPurposeTo make the demand for a product greaterTo make the demand for a product more inelasticDD18-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Elasticity and Total Revenue18-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Prices were raised from $10 to $12 and quantity demanded fell from 20 to 12Elastic Demand and Total RevenueSolution: P1 = 10; P2 = 12; Q1 = 20; Q2 = 1212-20 12+10 8 2212+20 12-10 32 2..==.25 X 11 = 2.75Price QD TR$10 20 $200 12 12 144Calculate EpWhen demand is elastic, a price increase will lead to a fall in total revenue!Elasticity and Total Revenue18-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Prices were raised from $10 to $12 and quantity demanded fell from 20 to 12Elastic Demand and Total RevenueSolution: P1 = 10; P2 = 12; Q1 = 20; Q2 = 1212-20 12+10 8 2212+20 12-10 32 2..==.25 X 11 = 2.75Price QD TR$10 20 $200 12 12 144Calculate EpWhen demand is elastic, a price decrease will lead to a rise in total revenue!Elasticity and Total Revenue18-21Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Prices were raised from $2 to $3 and quantity demanded fell from 9 to 8Inelastic Demand and Total RevenueSolution: P1 = 2; P2 = 3; Q1 = 9; Q2 = 8 8-9 3+2 1 5 8+9 3 -2 17 12..==.0588235 X 5 = 0.29Price QD TR$2 9 $18 $3 8 $24Calculate EpWhen demand is inelastic, a price increase will lead to a rise in total revenue!---Elasticity and Total Revenue18-22Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Prices were raised from $2 to $3 and quantity demanded fell from 9 to 8Inelastic Demand and Total RevenueSolution: P 1= 2; P2 = 3; Q1 = 9; Q2 = 8 8-9 3+2 1 5 8+9 3 -2 17 12..==.0588235 X 5 = 0.29Price QD TR$2 9 $18 $3 8 $24Calculate EpWhen demand is inelastic, a price decrease will lead to a fall in total revenue!Elasticity of SupplyElasticity of supply is the responsiveness of quantity to changes in priceElasticity of supply parallels the elasticity of demandElasticity of supply measures the responsiveness of quantity supplied to changes in priceAn elasticity of 10 means a 1% change in price brings about a 10% change in quantity suppliedAn elasticity of 0.2 means a 10% change in price gives rise to just a .2% change in quantity supplied18-23Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.18-24Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Perfectly Elastic Supply Curve Perfectly Inelastic Supply Curve18-25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Relative Elasticities of SupplyElasticity over TimeRemember, supply grows more elastic over time, especially when enough time has passed for new firms to enter the industry and for existing firms to increase their outputEconomists have identified three distinct time periods The market periodThe short runThe long run 18-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Market PeriodThe market period is the time immediately after a change in market price during which the sellers can’t respond by changing the quantity suppliedDuring this period the supply curve may be perfectly inelastic or with some positive slope because firms have limited ability to increase output 18-27Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Short RunIn the short run a firm has an essentially fixed productive capacityA firm has some ability to increase outputA firm could go from two 8-hour shifts to three 8-hour shiftsStore hours could probably be extendedAnd so, an increase in demand will result in more output 18-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Long RunIn the long run there is sufficient time for a firm to alter its productive capacityThe firm can leave the industryNew firms can enter the industryWhen a rise in demand is considered to be long lasting, some existing firms will add to their plant and equipmentIf demand falls, some or all firms will cut back on their plant and equipment, while others may leave the industry18-29Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.18-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Tax Incidence(tells us who really pays the tax)DS1S20 2 4 6 8 10 1220468$10OutputPriceA tax increase lowers the supply How much is the tax??(hint . . . measure it vertically)Answer: $318-31Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Tax Incidence(tells us who really pays the tax)DS1S20 2 4 6 8 10 1220468$10OutputPriceA tax increase lowers the supply Who pays the tax?S1/D P=$6; QD=6S2/D P=$7; QD=4The Customer pays an additional $1The Supplier absorbed the rest ($2)18-32Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Tax Incidence(tells us who really pays the tax)DS1S20 2 4 6 8 10 1220468$10OutputPriceWho pays the tax?S1/D P=$6; QD=6S2/D P=$9; QD= 6The demand curve is perfectly inelasticThe buyer pays and additional $3Seller absorbs ($0)The burden falls entirely on the buyerCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Tax Incidence(tells us who really pays the tax)S1S20 2 4 6 8 10 1220468$10OutputPriceWho pays the tax?S1/D P=$6; QD=6S2/D P=$8.30 QD=2The supply curve is more elastic than the demand curveThe buyer pays and additional $2.30Seller absorbs $.70DThe burden falls mainly on the buyer18-33SummaryWhen the supply is perfectly inelastic, the seller bears the entire tax burdenWhen supply is perfectly elastic, the buyer bears entire tax burdenAs the elasticity of demand rises, the tax burden is shifted from the buyer to the sellerAs the elasticity of supply rises, the tax burden is shifted from the seller to the buyer18-34Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.