Introduction. Learning Objectives. Chapter 20. Demand and Supply Elasticity

Transcription

1 Chapter 20 Demand and Supply Elasticity Introduction Between 1981 and 1992, it appeared that one battle in the nationwide war against illicit drugs was being won. Marijuana use among both teens and adults was declining steadily. The between the mid-1990s and the mid-2000s, the number of U.S. residents using marijuana increased by an estimated 45%. Why the dramatic increase? Part of the answer to this question depends on how responsive quantities demanded are to decreases in the market prices of these illicit drugs 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 20-3

2 Learning Objectives (cont'd) 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 Classify supply elasticities and explain how the length of time for adjustment affects the price elasticity of supply 20-4 Chapter Outline Price Elasticity Price Elasticity Ranges Elasticity and Total Revenues Determinants of the Price Elasticity of Demand Cross Price Elasticity of Demand Income Elasticity of Demand Price Elasticity of Supply 20-5 Did You Know That... Estimates indicate that every 10% decline in earnings reduces the amount of health insurance coverage purchased by uninsured people by 1.5%. In addition, every 10% increase in the price of health insurance generates an estimated 3.5% reduction in health insurance coverage by individuals without employer-provided health coverage. Together, these facts help to explain why estimates of the number of U.S. residents without health coverage remains as high as 40 million. 20-6

3 Price Elasticity Price Elasticity of Demand (E p ) The responsiveness of quantity demanded of a commodity to changes in its price Defined as the percentage change in quantity demanded divided by the percentage change in price 20-7 Price Elasticity (cont'd) Price Elasticity of Demand (E p ) E p = Percentage change in quantity demanded Percentage change in price 20-8 Price Elasticity (cont'd) Example Price of oil increases 10% Quantity demanded decreases 1% E p = 1% +10% =

4 Price Elasticity (cont'd) Question How would you interpret an elasticity of 0.1? Answer A 10% increase in the price of oil will lead to a 1% decrease in quantity demanded Price Elasticity (cont'd) 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. By convention, the minus sign is ignored Price Elasticity (cont d) Calculating Elasticity Elasticity formula: E p = Change in Q Sum of quantities/2 or Change in P Sum of quantities/2 in Q E p = (Q 1 + Q 2 )/2 in P (P 1 + P 2 )/

5 Example: The Price Elasticity of Demand for Oranges Between 2006 and 2007, the price of oranges increased from $1.56 per pound to $1.91 per pound. As a consequence, the total quantity of oranges consumed in the United States declined from 16.4 billion pounds to 13.8 billion pounds. What is the price elasticity of demand? Example: The Price Elasticity of Demand for Oranges (cont'd) Use the elasticity formula: $ $1.56 ( )/2 ($1.91+$1.56)/2 = 2.6 billion $ billion/2 $3.47/2 = 0.85 The price elasticity of 0.85 means that a 1% increase in price generated a 0.85% decrease in the quantity of oranges demanded Price Elasticity Ranges Elastic Demand Percentage change in quantity demanded is larger than the percentage change in price Total expenditures and price are inversely related in the elastic region of the demand curve E p >

6 Price Elasticity Ranges (cont'd) Unit Elasticity of Demand Percentage change in quantity demanded is equal to the percentage change in price Total expenditures are invariant to price changes in the unit-elastic region of the demand curve E p = Price Elasticity Ranges (cont'd) Inelastic Demand Percentage change in quantity demanded is smaller than the percentage change in price Total expenditures and price are directly related in the inelastic region of the demand curve E p < Price Elasticity Ranges (cont'd) Elastic demand % change in Q > % change in P; E p > 1 Unit-elastic % change in Q = % change in P; E p = 1 Inelastic demand % change in Q < % change in P; E p <

7 Price Elasticity Ranges (cont'd) 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. A demand that exhibits zero responsiveness to price changes Figure 20-1 Extreme Price Elasticities, Panel (a) Price Elasticity Ranges (cont'd) 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

8 Figure 20-1 Extreme Price Elasticities, Panel (b) Policy Example: Who Pays Higher Beer Taxes? State governments impose beer taxes, which are assessed as an amount per unit sold. These taxes are paid by sellers of beer from the revenues they earn from their total sales. To receive the same price per quantity the seller would need a price higher by the tax amount Figure 20-2 Price Elasticity and a Tax on Beer, Panels (a) and (b) 20-24

9 Figure 20-2 Price Elasticity and a Tax on Beer, Panel (c) Elasticity and Total Revenues When demand is elastic, a negative relationship exists between changes in price and changes in total revenues. When demand is unit-elastic, changes in price do not change total revenues. When demand is inelastic, a positive relationship exists between changes in price and total revenues Figure 20-3 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service, Panel (a) 20-27

10 Figure 20-3 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service, Panel (b) Figure 20-3 The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service, Panel (c) Elasticity and Total Revenues (cont'd) Elasticity-revenue relationship Total revenues are the product of price times units sold. The law of demand states along a given curve, price is inverse to quantity

11 Elasticity and Total Revenues (cont'd) What happens to the product of price times quantity depends on which of the opposing forces exerts a greater force on total revenues. This is what price elasticity of demand is designed to measure: responsiveness of quantity demanded to a change in price Table 20-1 Relationship Between Price Elasticity of Demand and Total Revenues Determinants of the Price Elasticity of Demand The price elasticity of demand for a particular commodity at any price depends on these factors: 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

12 Determinants of the Price Elasticity of Demand (cont'd) The length of time allowed for adjustment The longer any price change persists, the greater is the elasticity of demand. Price elasticity is greater in the long run than in the short run Determinants of the Price Elasticity of Demand (cont'd) 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 Figure 20-4 Short-Run and Long- Run Price Elasticity of Demand With more time for adjustment the demand curve becomes more elastic and quantity demanded falls by a greater amount In the short run, quantity demanded falls slightly 20-36

13 Example: What Do Real-World Price Elasticities of Demand Look Like? Economists have found that estimated elasticities of demand are greater in the long run than in the short run. Remember that even though we are leaving off the negative sign, there is an inverse relationship between price and quantity demanded Table 20-2 Price Elasticities of Demand for Selected Goods Cross Price Elasticity of Demand 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 20-39

14 Cross Price Elasticity of Demand (cont'd) Formula for computing cross price elasticity of demand between good X and good Y E xy = % Change in demand for good X % Change in price of good Y Cross Price Elasticity of Demand (cont'd) Substitutes 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 Example: Sending Mail First Class or Second Class? The U.S. Postal Service has raised rates on first-class mail, which it aims to deliver more speedily than second-class mail, several times in the past few years. Each time it does so, it must take into account the cross-price elasticity of demand between first-class mail and second-class mail. The estimated cross-price elasticity of demand between firstclass mail and second-class mail is about 0.3. Thus, first-class mail and second-class mail are substitutes

15 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 Income Elasticity of Demand (cont'd) E i = Percentage change in demand Percentage change in income Table 20-3 How Income Affects Quantity of DVDs Demanded 20-45

16 Income Elasticity of Demand (cont'd) Calculating the income elasticity of demand E i = Change in quantity Change in income Average quantity Average income The income elasticity of demand can be either negative or positive. Remember that in calculating the income elasticity of demand, the price of the good is assumed to be constant Price Elasticity of Supply Price Elasticity of Supply (E s ) 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 Price Elasticity of Supply (cont'd) Formula for computing price elasticity of supply E S = Percentage change in quantity supplied Percentage change in price 20-48

17 Price Elasticity of Supply (cont'd) Classifying supply elasticities Perfectly Elastic Supply Quantity supplied falls to zero when there is the slightest decrease in price The supply curve is horizontal at a given price Price Elasticity of Supply (cont'd) 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 Figure 20-5 The Extremes in Supply Curves 20-51

18 Price Elasticity of Supply (cont'd) Price elasticity of supply and length of time for adjustment 1. The longer the time allowed for adjustment, the more resources can flow into (out of) an industry through expansion (contraction) of existing firms. 2. The longer the time allowed for adjustment, the entry (exit) of firms increases (decreases) production in an industry Figure 20-6 Short-Run and Long- Run Price Elasticity of Supply As time passes the supply curve rotates from S 1 to S 2 and quantity supplied rises to Q 1 As more time passes the supply curve rotates from S 2 to S 3 and quantity supplied rises from Q 1 to Q Issues and Applications: Price Elasticity of Demand and the Upswing in Marijuana Use In the early 1990s, studies of marijuana use indicated that the percentage of people buying marijuana declined by more than 50% between 1981 and Today, however, more than 40% of high school seniors are reporting marijuana purchases, and marijuana use among adults has jumped. What happened between the early 1990s and today? The answer comes in two parts, both of which have to do with a change in the price of marijuana

19 Issues and Applications: Price Elasticity of Demand and the Upswing in Marijuana Use (cont'd) Since 1992, the price of marijuana has fallen by more than 30%. At the same time, the potency of a typical ounce of marijuana has increased by more than 50%. Most estimates indicate the absolute price elasticity of demand for regular users of marijuana is about 2.8. Thus the demand for marijuana is elastic. Why do you think that economists interpret the high price elasticity of demand for marijuana by regular users to be consistent with the fact that 90% of users do not become habitual users of the drug? 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 (cont'd) 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

20 Summary Discussion of Learning Objectives (cont'd) 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 (cont'd) 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 a related good If cross elasticity is positive, the goods are substitutes. If cross elasticity is negative, the goods are complements Summary Discussion of Learning Objectives (cont'd) Income elasticity of demand Responsiveness of the demand for the good to a change in income Percentage change in the demand for a good divided by the percentage change in income

21 Summary Discussion of Learning Objectives (cont'd) 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