Demand and Supply: Elasticities and Applications

Chapter 5

Price Elasticity of Demand

• The responsiveness of consumers to a change in the price of a good/service

• In other words: How much does changing the price of a good impact how much we demand of that good.

Price Elasticity of Demand

• Practice: Think about your spending habits. Come up with one good that you do not care what it costs when it comes to buying it…you will buy the same amount no matter what happens. Come up with one good that you would definitely buy more of it was cheaper and less of if it was more expensive.

Price Elasticity of Demand

• So how do we figure out exactly what the elasticity of demand is?

• A lovely formula!

• Ed = % change in Qd of X

% change in P of X

Price Elasticity of Demand

• Here’s another way of looking at it!

• Ed = (Q2 – Q1)/Q1

(P2 – P1)/P1

We always use absolute value when calculating elasticity!

Midpoint Formula

• Ed = (Q2 – Q1)/[(Q1 + Q2)/2]

(P2 – P1)/[(P1 + P2)/2]

• This is the formula you should actually use to calculate the elasticity of demand

• (why do they give you the other one too?....I don’t know!)

Let’s PracticePrice Per Cup of Coffee

Quantity Demanded

$10 0

$9 20

$8 40

$7 60

$6 80

$5 100

$4 120

$3 140

$2 160

$1 180

Free! 200

• Calculate the price elasticity of demand when price changes from $1 to $2

Let’s PracticePrice Per Cup of Coffee

Quantity Demanded

$10 0

$9 20

$8 40

$7 60

$6 80

$5 100

$4 120

$3 140

$2 160

$1 180

Free! 200

• Calculate the price elasticity of demand when price changes from $1 to $2

• Midpoint Formula = (Q2-Q1)/[(Q1+Q2)/2]

(P2-P1)/[(P1+P2)/2]

Let’s PracticePrice Per Cup of Coffee

Quantity Demanded

$10 0

$9 20

$8 40

$7 60

$6 80

$5 100

$4 120

$3 140

$2 160

$1 180

Free! 200

• Calculate the price elasticity of demand when price changes from $1 to $2

• Midpoint Formula = (160-180)/[160+180)/2]

($2.00-$1.00)/[($2.00+$1.00)/2]

Let’s PracticePrice Per Cup of Coffee

Quantity Demanded

$10 0

$9 20

$8 40

$7 60

$6 80

$5 100

$4 120

$3 140

$2 160

$1 180

Free! 200

• Calculate the price elasticity of demand when price changes from $1 to $2

• Midpoint Formula = -20/170

$1.00/$1.50

Let’s PracticePrice Per Cup of Coffee

Quantity Demanded

$10 0

$9 20

$8 40

$7 60

$6 80

$5 100

$4 120

$3 140

$2 160

$1 180

Free! 200

• Calculate the price elasticity of demand when price changes from $1 to $2

• Midpoint Formula = -.118

• .667

Let’s PracticePrice Per Cup of Coffee

Quantity Demanded

$10 0

$9 20

$8 40

$7 60

$6 80

$5 100

$4 120

$3 140

$2 160

$1 180

Free! 200

• Calculate the price elasticity of demand when price changes from $1 to $2

• Midpoint Formula = -0.18

• Use absolute value and change to percent = 0.18

Let’s PracticePrice Per Cup of Coffee

Quantity Demanded

$10 0

$9 20

$8 40

$7 60

$6 80

$5 100

$4 120

$3 140

$2 160

$1 180

Free! 200

• Calculate the price elasticity of demand when price changes from $1 to $2

• Use absolute value and change to percent = 0.18

• So what is our demand?! Inelastic? Elastic? Unit Elastic?

Elastic Demand

• %change in Qd > %change in P• Elasticity Ratio > 1

Inelastic Demand

• %change in Qd < %change in P• Elasticity Ratio < 1

Unitary Elasticity

• %change in Qd = %change in P• Elasticity Ratio = 1

Let’s PracticePrice Per Cup of Coffee

Quantity Demanded

$10 0

$9 20

$8 40

$7 60

$6 80

$5 100

$4 120

$3 140

$2 160

$1 180

Free! 200

• Calculate the price elasticity of demand when price changes from $1 to $2

• Use absolute value and change to percent = 0.18

• So what is our demand?! Inelastic? Elastic? Unit Elastic?

Let’s PracticePrice Per Cup of Coffee

Quantity Demanded

$10 0

$9 20

$8 40

$7 60

$6 80

$5 100

$4 120

$3 140

$2 160

$1 180

Free! 200

• Calculate the price elasticity of demand when price changes from $1 to $2

• Use absolute value and change to percent = 0.18

• Inelastic at this price point!

Your turn!Price Per Cup of Coffee

Quantity Demanded

$10 0

$9 20

$8 40

$7 60

$6 80

$5 100

$4 120

$3 140

$2 160

$1 180

Free! 200

• Calculate the price elasticity of demand when price changes from $5 to $6

Your turn!Price Per Cup of Coffee

Quantity Demanded

$10 0

$9 20

$8 40

$7 60

$6 80

$5 100

$4 120

$3 140

$2 160

$1 180

Free! 200

• Calculate the price elasticity of demand when price changes from $5 to $6

• (80-100)/[(100+80)/2] ($6-$5)/[$5+$6)/2]• (-20/90)/($1/$5.50)• -.222/.182 = -1.22• Absolute value = 1.22• Elastic Demand!

PracticePrice Per Cup of Coffee

Quantity Demanded

$10 0

$9 20

$8 40

$7 60

$6 80

$5 100

$4 120

$3 140

$2 160

$1 180

Free! 200

• If the price changes from $3 per cup to $4 per cup, is demand elastic, inelastic or unit elastic?

PracticePrice Per Cup of Coffee

Quantity Demanded

$10 0

$9 20

$8 40

$7 60

$6 80

$5 100

$4 120

$3 140

$2 160

$1 180

Free! 200

• If the price changes from $3 per cup to $4 per cup, is demand elastic, inelastic or unit elastic?

• Inelastic!

Why Use Percentages?

1.Using absolute changes would be affected by the units used

Example: If $ units used: • $3$2 causes 60100 Qd change– Seems very responsive

If cents used:• 300200 causes 60100 Qd change– Does not seem as responsive

Why Use Percentages?

2. Easier to compare different products

• $ changes depend on the original cost of the good/service

• $1 increase in a good/service which costs $1 has a different impact than a $1 increase in a good/service which costs $20,000

Why Use Percentages?

In other words….

- Adding $1 to the price of a pack of starbursts is going to have a different impact that adding $1 to the price of a new car!

Elasticity Varies with Price Range

• Demand is more elastic in the upper left region of the demand curve than in the lower right region

Elasticity Varies with Price Range

• In upper left: –%change in quantity is large

because original quantity is small–%change in price is small because

the original price is large

Elasticity Varies with Price Range

• In lower right: –%change in quantity is small because

original quantity is large –%change in price is large because the

original price is small

Perfectly Inelastic Demand

• %change in price does not change the quantity demanded

• Demand Curve is Parallel to the Y Axis

Q

P D

15

100

700

Perfectly Elastic Demand

• %change increase in price causes quantity demanded to fall to zero

• %change decrease in price causes quantity demanded to increase to infinity

• Demand Curve is Parallel to the X Axis

P

Q

D16

10 20

Midpoint Formula

• If original formula used, two different answersP1=5; P2=4; Q1=4; Q2=5• Ed = (Q2 – Q1)/Q1

(P2 – P1)/P1

= (5-4)/4 (4-5)/5= (1/4)/1/5= 5/4=1.25

Midpoint Formula

• If original formula used, two different answersP1=4; P2=5; Q1=5; Q2=4

• Ed = (Q2 – Q1)/Q1

(P2 – P1)/P1

= (4-5)/5 (5-4)/4= (1/5)/(1/4)=.8

Determinants of Supply

Explain how each of these impacts supply:•Technology•Subsidies/Taxes•Costs/Resource Prices •Other good prices•Number of Sellers •Expectations/Fears

Slope Does NOT Measure Elasticity

• Slope is calculated from absolute changes in price and quantity, not percentage changes

Total Revenue Test

• TR = PQ

• Total revenue = Price X Quantity

Total Revenue Test

• Elastic Demand

– P increase leads to decrease in TR

– P decrease leads to increase in TR

– Firms tend to have sales on elastic goods

Total Revenue Test

• Inelastic Demand:

– P increase leads to increase in TR

– P decrease leads to decrease in TR

– Government taxes inelastic goods e.g., (sin taxes)

Total Revenue Test

• Unitary Demand:– P increasesNo change in TR

– P decreasesNo change in TR

Determinants of Price Elasticity of Demand

1. Substitutability

• The larger the number of substitutes, the greater the elasticity of demand

• There are how many different pizza places out there?

Vs.• There are how many utility companies out there?

1. Substitutability

• Individual products versus industry: Tide, All, Cheer versus laundry detergent

• Our demand for the industry might be inelastic (we need clean clothes!)

But• Our demand for a specific brand might be

elastic (I don’t care what makes them clean…just do it)

2. Proportion of Income

• Step One: Look at your income

• Step Two: Look at the price of the good/service

• Step Three: What portion of your income does it take to buy the good/service?

2. Proportion of Income

If it takes a large portion of your income to buy the good/service – greater the elasticity.

If it take a small portion of your income to buy the good/service – usually more inelastic.

– Low-priced items are usually more inelastic than high-priced items: salt versus cars

3. Luxuries versus Necessities

• Necessities = inelastic

• Luxuries = elastic

3. Luxuries versus Necessities

• Necessities = inelastic– Life saving heart surgery (probably doesn’t matter

if the price increases…I’m gonna go ahead and have that)

• Luxuries = elastic– Starbursts (while desirable…not worth it if the

price goes up!)

4. Time

• Goods tend to have more elastic demand over longer time periods

Consider the market for gasoline:• When the price rises, the quantity of gasoline in

the first few months/years changes very little • Over longer periods of time quantity will

change as people switch to public transportation, buy fuel efficient cars or move closer to work.

Price Elasticity of Supply

• The responsiveness of producers to price changes• Es = %change in quantity supplied of X

%change in price of X• Es >1elastic• Es < 1inelastic• Es = 1unitary• You can still use the midpoint method to calculate

this!

Determinants of Price Elasticity of Supply

• How flexible are sellers when it comes to changing the amount of the good they produce?

For example:• Land in Manhattan for development – inelastic

supply because you can’t really create more of it• Soccer balls produced by a factory – elastic supply

because you could operate your factory for longer, hire more workers, etc. to produce more if you wanted.

Determinants of Price Elasticity of Supply

• Time Period

Long Time = All factors of production are adjustable = more elastic the supply

• Firms have a longer amount of time to shift resources to adjust to a price change

Short Run = plant capacity is fixed = more inelastic supply

• Harder to make changes in production quickly

Determinants of Price Elasticity of Supply

• There is no revenue test for Price Elasticity of Supply

Homework

Read “Why Did OPEC Fail to Keep the Price of Oil High?” in your book starting on page 105– Answer question 10 on page 110– Be prepared to share your answer tomorrow.

Group Work

• We are going to assemble into groups of four• Once you are in your group, the youngest two

people in the group are partners and the oldest two are partners

• Each pair will be given a topic to take notes on as you read about it in your book.

• Using these notes, the pair must devise a short lesson designed to share this information with the rest of the class

Group Work

• You may utilize technology, posters, the board or any other supplies you feel are necessary in order to teach your lesson.

• You must design a lesson plan that contains all the components listed on your half sheet.

• When you are finished, you will turn your lesson plan into Mrs. Krieger

• Young ones – your topic is Cross Elasticity of Demand • Oldies – your topics is Income Elasticity of Demand

Cross Elasticity of Demand

• Responsiveness of quantity demanded of good/service X when the price of good/service Y changes

• Exy = %change in quantity demanded of X %change in price of Y

If Cross Elasticity of Demand is:

1. PositiveX and Y are Substitutes2. NegativeX and Y are Complements3. (Near) ZeroX and Y are Independent (i.e.,

no relation to each other)

Income Elasticity of Demand

• Responsiveness of quantity demanded to a change in income

• Ei = %change in quantity demanded of X %change in income

• Ei > 0Normal Goods• Ei < 0Inferior Goods

Government Intervention

• Price Ceilings and Price Floors

• Basically the same thing as a surplus or shortage caused by the government!

Price Ceilings and Floors

• Everyone point to the ceiling now

• Now point to the floor

• Now forget everything you ever thought you knew about ceilings and floors

Price Ceiling

• A Price Ceiling is actually located BELOW equilibrium price

• It is a set price that suppliers may not charge more than – that’s why it’s called a ceiling

Price Ceiling

Examples of Price Ceilings

• Live Nation

• Ticketmaster

Price Floors

• A Price Floor is actually located ABOVE equilibrium price

• This is a set price that suppliers may not charge less than – that’s why it’s called a floor

Price Floors

Famous Price Floor = MILK

Attempts to Correct

• Ticket Scalpers– Sell tickets to those in need – but at a higher

price! Changing the quantity demanded

• Got Milk? Campaign– Increase demand for milk and bring equilibrium

price up to floor

Discussion Question

• How would elasticity impact the shortage/surplus caused by a ceiling/floor?

Homework

• Read pages 124 through 127 in your textbook talking about taxes.

• Create a graphic organizer (chart is probably the easiest way to go) including information on the three steps to analyzing taxes on buyers and sellers and the implications of these taxes.

Homework

• For example:Taxes on Buyers Taxes on Sellers

Step One

Step Two

Step Three

Implications

Taxes on Buyers

• Which curve would this impact? Demand or Supply?

• This is a tax on consumers. Which curve deals with consumers?

• The Demand Curve– This is the curve that is going to be shifting.

Taxes on Buyers

• Which curve would this impact? Demand or Supply?

• This is a tax on consumers. Which curve deals with consumers?

• The Demand Curve– This is the curve that is going to be shifting.

Taxes on Buyers

• Which way is our curve going to move?

• Does this added tax make the product more or less desirable?

• Less desirable – shifting to the left

• The amount of the shift is determined by looking at the amount of the tax.

Taxes on Buyers

• Now we examine what actually happened with the tax:– Compare the new equilibrium to the old

equilibrium– Money going to sellers goes down– Quantity will go down – The tax has reduced the size of the market!

Taxes on Buyers

• What does this mean? – Consumers pay higher prices due to the tax• Even though equilibrium price might be lower, there is

still a 50 cent tax on top!

– Sellers receive less for each product • Due to the decrease in equilibrium

Taxes on Buyers

• What does this mean? – Taxes make markets shrink • Quantity at equilibrium goes down

– Buyers and sellers both get hurt• Buyers pay more for the good• Sellers make less for the good