Chapter 18 The Elasticities of Demand and Supply 18-1 Copyright 2002 by The McGraw-Hill Companies,...
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Transcript of Chapter 18 The Elasticities of Demand and Supply 18-1 Copyright 2002 by The McGraw-Hill Companies,...
Chapter 18
The Elasticities of Demand and Supply
18-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
• The elasticity of demand
• The determinants of elasticity
• Elasticity and total revenue
• The elasticity of supply
• Tax incidence
18-2Copyright 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 Demand• The elasticity of demand for a good or service
measures the change in quantity demanded in response to a change in price– In other words, elasticity measures the sensitivity
(measured in percentage change) of quantity demanded because of a change (percentage) in price
– When 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 response
• Elasticity answers the “how much” question
18-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Measuring Elasticity
Calculate the coefficient of price elasticity (Ep)
Ep =Percentage change in quantity demanded
Percentage change in price
Ep =Q2 - Q1 P2 + P1
XQ2 + Q1 P2 - P1
P1 is the initial price; P2 is the new price
Q1 is the initial quantity sold; Q2 is the new quantity sold
18-5Copyright 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 + P1
Q2 + Q1 P2 - P1 X
Ep =140 -100 8 + 10140 + 100 8 - 10
X
Ep = 24040
X18-2 = - 1.4999994
Ep = 1.5
So the negative sign is ignoredNote: the answer is always negative
18-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Price is raised from $40 to $41, and quantity sold declines from 15 to 12
Ep = Q2 - Q1 P2 + P1
Q2 + Q1 P2 - P1 X
Ep =15 - 12 41 + 4012 + 15 41 - 40
X
Ep = 27-3
X811 = -8.9999991
Ep = 9.0
So the negative sign is ignoredNote: the answer is always negative
18-7Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Meaning of Elasticity• Elasticity is many things
– First, elasticity is a number• An Ep greater than 1 is elastic• This means that demand is relatively sensitive to price
changes• The larger the number, the greater will be the sensitivity to
price changes
– This number represents the percent change in quantity demanded resulting from each 1% change in a goods price
• An Ep of 10 means that for every 1% change in price there will be a 10% change in QD
18-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Meaning of Elasticity
• An Ep less than 1 is inelastic• This means that demand is relatively less
sensitive to price changes
• The smaller the number, the greater the insensitivity to price changes
• An Ep of .1 means that for every 1% change in price there will be a .1% change in quantity demanded
18-9Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Meaning of Elasticity
– An Ep that is exactly 1 is unit elastic• This means that demand is neither elastic nor
inelastic
• An Ep of 1 means that for every 1% change in price there will be a 1% change in QD
18-10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Perfectly Elastic Demand Curve
Quantity
D
14
8
6
4
2
10 15 20 25 305
12
10
The elasticity of a perfectly elastic demand curve is infinity
18-11Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Perfectly Inelastic Demand Curve
Quantity
D
30
25
20
15
10
5
5 10 15 20 25
The elasticity of a perfectly inelastic demand curve is 0
18-12Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Relativity Elasticity of Demand Curves
Quantity
D1
D2
18-13Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Straight Line Demand Curve
Quantity
D
11
10
9
8
7
6
5
4
3
2
1
00 1 2 3 4 5 6 7 8 9 10 11
18-14Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Elasticity of Straight Line Demand Curve
Quantity
D
11
10
9
8
7
6
5
4
3
2
1
0
Very elastic
e = 6.33
Slightly elastic
Unit elastic
Slightly inelastic
Veryinelastic
e = .29
e = 1.0
0 1 2 3 4 5 6 7 8 9 10 11
Relatively Inelastic Demand Curve
18-15Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Quantity
D
Relatively Elastic Demand Curve
18-16Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Quantity in pounds
D
5
4
3
2
1
1 2 3 4 5 6 7 8 9 10 11 12
Determinants of the Degree of Elasticity of Demand
• The availability of substitutes is the most important influence on the elasticity of demand
• The question of necessity versus luxury• The product’s cost relative to the buyer’s
income• The passage of time• The number of uses
18-17Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Advertising
• Purpose– To make the demand for a product greater– To make the demand for a product more
inelastic
D D
18-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Elasticity and Total Revenue
18-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Prices were raised from $10 to $12 and quantity demanded fell from 20 to 12
Elastic Demand and Total Revenue
Solution: P1 = 10; P2 = 12; Q1 = 20; Q2 = 12
12-20 12+10 8 2212+20 12-10 32 2
. .= = .25 X 11 = 2.75
Price QD TR
$10 20 $200
12 12 144
Calculate Ep
When demand is elastic, a price increase will lead to a fall in total revenue!
Elasticity and Total Revenue
18-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Prices were raised from $10 to $12 and quantity demanded fell from 20 to 12
Elastic Demand and Total Revenue
Solution: P1 = 10; P2 = 12; Q1 = 20; Q2 = 12
12-20 12+10 8 2212+20 12-10 32 2
. .= = .25 X 11 = 2.75
Price QD TR
$10 20 $200
12 12 144
Calculate Ep
When demand is elastic, a price decrease will lead to a rise in total revenue!
Elasticity and Total Revenue
18-21Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Prices were raised from $2 to $3 and quantity demanded fell from 9 to 8
Inelastic Demand and Total Revenue
Solution: P1 = 2; P2 = 3; Q1 = 9; Q2 = 8
8-9 3+2 1 5 8+9 3 -2 17 12
. .= = .0588235 X 5 = 0.29
Price QD TR
$2 9 $18
$3 8 $24
Calculate Ep
When demand is inelastic, a price increase will lead to a rise in total revenue!
- --
Elasticity and Total Revenue
18-22Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Prices were raised from $2 to $3 and quantity demanded fell from 9 to 8
Inelastic Demand and Total Revenue
Solution: P 1= 2; P2 = 3; Q1 = 9; Q2 = 8
8-9 3+2 1 5 8+9 3 -2 17 12
. .= = .0588235 X 5 = 0.29
Price QD TR
$2 9 $18
$3 8 $24
Calculate Ep
When demand is inelastic, a price decrease will lead to a fall in total revenue!
Elasticity of Supply
• Elasticity of supply is the responsiveness of quantity to changes in price– Elasticity of supply parallels the elasticity of
demand
– Elasticity of supply measures the responsiveness of quantity supplied to changes in price
• An elasticity of 10 means a 1% change in price brings about a 10% change in quantity supplied
• An elasticity of 0.2 means a 10% change in price gives rise to just a .2% change in quantity supplied
18-23Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
18-24Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Quantity
S
Quantity
S
Perfectly Elastic Supply
Curve
Perfectly Inelastic Supply
Curve
18-25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Relative Elasticities of Supply
Quantity
S1
S2
Elasticity over Time
• Remember, 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 output
• Economists have identified three distinct time periods – The market period
– The short run
– The long run
18-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Market Period
• The market period is the time immediately after a change in market price during which the sellers can’t respond by changing the quantity supplied– During 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 Run
• In the short run a firm has an essentially fixed productive capacity– A firm has some ability to increase output
• A firm could go from two 8-hour shifts to three 8-hour shifts
• Store hours could probably be extended
• And so, an increase in demand will result in more output
18-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Long Run
• In the long run there is sufficient time for a firm to alter its productive capacity– The firm can leave the industry– New firms can enter the industry– When a rise in demand is considered to be long
lasting, some existing firms will add to their plant and equipment
– If demand falls, some or all firms will cut back on their plant and equipment, while others may leave the industry
18-29Copyright 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)
D
S1
S2
0 2 4 6 8 10 12
2
0
4
6
8
$10
Output
Price
A tax increase lowers the supply
How much is the tax??
(hint . . . measure it vertically)
Answer: $3
18-31Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Tax Incidence(tells us who really pays the tax)
D
S1
S2
0 2 4 6 8 10 12
2
0
4
6
8
$10
Output
Price
A tax increase lowers the supply
Who pays the tax?
S1/D P=$6; QD=6
S2/D P=$7; QD=4
The Customer pays an additional $1
The 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)
D
S1
S2
0 2 4 6 8 10 12
2
0
4
6
8
$10
Output
Price
Who pays the tax?
S1/D P=$6; QD=6
S2/D P=$9; QD= 6
The demand curve is perfectly inelastic
The buyer pays and additional $3
Seller absorbs ($0)
The burden falls entirely on the buyer
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Tax Incidence(tells us who really pays the tax)
S1
S2
0 2 4 6 8 10 12
2
0
4
6
8
$10
Output
Price
Who pays the tax?
S1/D P=$6; QD=6
S2/D P=$8.30 QD=2
The supply curve is more elastic than the demand curve
The buyer pays and additional $2.30
Seller absorbs $.70
D
The burden falls mainly on the buyer
18-33
Summary
• When the supply is perfectly inelastic, the seller bears the entire tax burden
• When supply is perfectly elastic, the buyer bears entire tax burden
• As the elasticity of demand rises, the tax burden is shifted from the buyer to the seller
• As the elasticity of supply rises, the tax burden is shifted from the seller to the buyer
18-34Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
