Lecture Demand and Supply Elasticity

Transcription

1 Lecture Demand and Supply Elasticity dr Magdalena Klimczuk-Kochańska Elasticity - definition Elasticity allows us to analyze supply and demand with greater precision. Elasticity is a measure of how much buyers and sellers respond to changes in market conditions. When we talk about elasticity, that responsiveness is always measured in percentage terms. 1

2 Elasticity - Example If price rises by 11% what happens to demand? We know demand will fall, but by more than 11% or by less than 11%? Elasticity measure the extent to which demand will change. Elasticity of Demand and Supply - Types Price elasticity of demand Cross elasticity of demand Income elasticity of demand Price elasticity of supply 2

3 Price Elasticity of Demand A measure of the responsiveness of quantity demanded to changes in price. Measured by dividing the percentage change in the quantity demanded of a good by the percentage change in its price. Economists compute price elasticity of demand using midpoints as the base values of changes in prices and quantities demanded. Computing the Price Elasticity of Demand The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. Because the demand curve is downward sloping and the supply curve is upward sloping the elasticity of demand is negative and the elasticity of supply is positive. Often these signs are implicit and ignored. Price elasticity of demand = Percentage change in quantity demanded Percentage change in price 3

4 Computing the Price Elasticity of Demand The formula used to calculate the coefficient of price elasticity of demand is: Elasticity = E DP %ΔQ %ΔP = Q2 Q1 Q2 Q1 / 2 P P P P / ΔQ Q ΔP P Elastic vice Inelastic The responsiveness of demand to changes in price Where % change in demand is greater than % change in price elastic Where % change in demand is less than % change in price - inelastic 4

5 Elastic and Inelastic Demand Elastic Demand (E d > 1): the numerator is greater than the denominator, the coefficient is greater than 1 and demand is elastic. Inelastic Demand (E d < 1): the numerator is smaller than the denominator, the coefficient is smaller than 1, and demand is inelastic. Perfectly Elastic and Perfectly Inelastic Demand Perfectly Elastic Demand (Ed = ): If the quantity demanded is extremely responsive to a change in price. Perfectly Inelastic Demand (Ed = 0): If quantity demanded is completely unresponsive to changes in price, demand is perfectly inelastic. A change in price causes no change in quantity demanded. 5

6 Unit Elastic Demand Unit Elastic Demand (E d = 1): If the numerator and denominator are the same, the coefficient is equal to one. The quantity demanded changes proportionally to a change in price. Elasticity Along a Demand Curve Price $ E d = Perfectly elastic E d > 1 Elastic E d = 1 Unit elastic E d < 1 Inelastic E d = Quantity Perfectly inelastic Elasticity is not the same as slope. Elasticity changes along straight line demand curves slope does not. Elasticity declines along demand curve as we move toward the quantity axis. The price elasticity of demand decreases as we move downward along a linear demand curve. Demand is elastic on the upper half of the demand curve and inelastic on the lower half. 6

7 Price Elasticity of Demand Along a Straight Line Demand Curve - Example The Price Demand Elasticity Price The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded. They all have differing levels of elasticity. Quantity Demanded 7

8 Price Elasticity of Demand Price Perfectly Inelastic Demand Curve - Example 600 Quantity Demanded The demand curve is vertical, the quantity demanded is totally unresponsive to the price. Changes in price have no effect on consumer demand. When demand is perfectly inelastic, the quantity demanded is the same at every price, so the price elasticity of demand is zero. Perfectly inelastic demand curve represents the demand for insulin by the diabetic. A certain quantity is necessary to satysfy the need regardless of the price. 8

9 Price 200 Perfectly Elastic Demand Curve - Example When demand is perfectly elastic, the quantity demanded is infinitely responsive to changes in price, so the price elasticity of demand is infinite. The demand curve is horizontal, any change in price can and will cause consumers to change their consumption. A perfectly elastic demand curve represents the demand for one farmer s wheat. Because there are many other suppliers, buyers purchase wheat from the least expensive source. If this farmer s wheat is priced over so slightly above others farmers wheat, buyers will switch to another source. Also because this farmer is just one small producer in a huge market, he can sell everything wants at the market price. Other example: Pink marker pens Determinants of Price Elasticity of Demand Number of Substitutes: The more substitutes for a good, the higher the price elasticity of demand; is the fewer substitutes for a good, the lower the price elasticity of demand. The more broadly defined the good, the fewer the substitutes; the more narrowly defined the good, the greater the substitutes. Necessities Versus Luxuries: The more a good is considered a luxury rather than a necessity, the higher the price elasticity of demand. 9

10 Determinants of Price Elasticity of Demand Percentage of One s Budget Spent on the Good: The greater the percentage of one s budget that goes to purchase a good, the higher the price elasticity of demand; the smaller the percentage of one s budget that goes to purchase a good, the lower the elasticity of demand. Time: The more time that passes, the higher the price elasticity of demand for the good; the less time that passes, the lower the price elasticity of demand for the good. The Elasticity of Demand in Short and Long Time 10

11 Total Revenue The importance of elasticity for firms relates to the effect of price changes on total revenue and thus on profits. Profits = Total revenue Total cost = TR - TC Total revenue = Price X Quantity TR = P x Q The total inflow of receipts from selling a given amount of output Each time the firm chooses a level of output, it also determines its total revenue. Because once we know the level of output, we also know the highest price the firm can charge Total revenue and price elasticity of demand are related. The relationship will tell you if demand is elastic or inelastic. Predicting Changes in Total Revenue Price Quantity of Tickets Sold Total Revenue 4, $400 4,40 80 $352 An increase in the ticket price brings good news and bad news: Good news you get more money for each ticket sold. Bad news you sell fewer tickets. 11

12 Total Revenue and Elastic Demand Relationship Price Price of TVs is $200 per unit and 400 units is sold. Total revenue when price $200 = 200 x 400 = $ $200 $ Quantity Total Revenue and Elastic Demand Relationship Price Now price of the TVs is $100 per unit and 1200 units are sold Total revenue when price $100 = 100 x 1200 = $ $200 $

13 Price Total Revenue and Elastic Demand Relationship Revenue increases by $ Price elasticity of demand % change in demand = 200% % change in price = 100% $200 $100 Loss Additional profit Ep = 200 = Example: restaurant meals, air travel, movies, specific brands of coffee Total Revenue and Inelastic Demand Relationship Price Total revenue when price 400 = 400 x 350 = Quantity Demanded 13

14 Total Revenue and Inelastic Demand Relationship Price 400 Total revenue when price 400 = 400 x 350 = Total revenue when price 200 = 200 x 400 = Quantity Demanded Total Revenue and Inelastic Demand Relationship Price Loss Additional profit Revenue decreases by $ Price elasticity of demand % change in demand = (50 / 350) x 100 = 14% % change in price = 100% Ep = 14 = 0, Example: eggs, coffee, cigarettes, shoes Quantity Demanded 14

15 Total Revenue and Unitary Elastic Relationship An increase or decrease in the price leaves total revenue unchanged. The loss in revenue from a lower price is exactly offset by the gain in revenue from accompanying increase in sales. For example: Price of movie tickets is $6 per ticket and 1,000 tickets are sold Price of movie tickets goes to $5 per ticket and 1,200 tickets are sold Total revenue = $6 X 1,000 = $6,000 Total revenue = $5 X 1,200 = $6,000 No change in total revenue Elasticities, Price Changes and Total Revenue As price increases and E DP < 1, then TR increases E DP = 1, then TR does not change (remains constant) E DP > 1, then TR decreases As price decreases, and E DP < 1, then TR decreases E DP = 1, then TR does not change (remains constant) E DP > 1, then TR increases 15

16 Marginal Revenue Marginal revenue (MR) Change in total revenue from producing one more unit of output MR = ΔTR / ΔQ = (TR2 TR1) / (Q2 Q1) Tells us how much revenue rises per unit increase in output 31 Elasticity and Marginal Revenue If MR<0, demand is inelastic and the fall of the price will decrease TR. If MR = 0, demand is unit elastic and the TR achieves its maximum. If MR > 0, demand is elastic and the fall of the price will increase TR. 16

17 Predicting Changes in Total Revenue Marginal Revenue Unit elastic demand Elastic demand Inelastic demand Demand is elastic along the upper half of a linear demand curve, so an increase in quantity increases total revenue. Demand is inelastic along the lower half of a linear demand curve, so a decrease in price decreases total revenue. Total revenue reaches its maximum at the midpoint of the demand curve, where demand is unitary elastic. P Unit-elastic demand TR MR D Q TR Elastic demand Inelastic demand Q 17

18 Cross Elasticity of Demand Measures the responsiveness in the quantity demanded of one good to changes in the price of another good. This concept is often used to determine whether two goods are substitutes or complements and the degree to which one good is a complement to or substitute for another. Cross Elasticity of Demand The percentage change in the quantity demanded of one good associated with a one-percent change in the price of another good. E DC Q Q x 2 P 2 1 P P / 2 y 2 x 2 y Q Q P x 1 y 1 x 1 y / 2 18

19 Cross Elasticity of Demand - Substitutes and Complements Depending on whether the cross-price elasticity of demand of given goods is less than or greater than zero, goods may be classified as substitutes or complements: If E CD < 0, goods are complements, If E CD > 0, goods are substitutes, If E CD = 0, goods are independent. Cross Elasticity of Demand - Example 19

20 Income Elasticity of Demand Measures the responsiveness of quantity demanded to changes in income. Income Elasticity of Demand The income elasticity of demand measures of the responsiveness of demand to changes in income, indicating how much more or less of a particular product is purchased as income changes. 20

21 Income Elasticity of Demand If E y >1, demand is considered to be income elastic. If E y <1, demand is considered to be income inelastic. If E y =1, demand is considered to be unit elastic. Income Elasticity of Demand - Example 21

22 Types of Goods Income elasticity of demand depends on kind of the good. There are: Normal good, Necessity good, Luxury good, Inferior good. Normal Good Normal goods are those goods which have a direct relationship with the consumer s income. The consumer s tends to demand more of the normal goods when they get an increase in their income and their demand decreases with a decrease in their income. Demand rises as income rises and vice versa. A positive sign (+) denotes a normal good. Normal goods have a positive income elasticity of demand. Normal goods have an income elasticity of demand of between 0 and

23 Normal Good All normal goods have negatively sloped demand curves and income elasticity of demand is greater than 0 (E DI > 0). A good may be classified as a necessity or a luxury, depending on whether its income elasticity of demand is less than or greater than one: E DI > 1 luxury goods E DI < 1 necessity goods Luxury Good Luxury goods are those goods the demand for which demand rises more than proportionate to a change in income. Luxuries have an income elasticity of demand > +1 Example: international air travel, private education, designer clothes, fine wines and spirits, high quality chocolates (e.g. Lindt) and luxury holidays overseas; audio visual equipment, 3G mobile phones and designer kitchens; sports and leisure facilities (including gym membership and sports clubs). 23

24 Necessity Good (Necessities) These are those goods which are not very expensive and are necessary for everyday life. Demand for such goods remains constant throughout. Example: fresh vegetables and fruit, instant coffee, shampoo, toothpaste, toilet paper, cigarettes, low-priced own label foods in supermarkets, council-owned properties. Inferior Good Inferior goods are those goods that have an inverse relationship with the consumer s income. The demand for inferior goods increases with the decrease in consumer s income and the demand decreases with the increase in consumer s income. Demand falls as income rises and vice versa. And that why we use a negative sign (-) denotes an inferior good. Inferior goods have a negative income elasticity of demand. 24

25 Inferior Goods Inferior goods have negative income elasticity of demand (E DI < 0) Example: canned meat, frozen fruits and vegetables, store brand items, basic food mass transport (bus and rail), beer and takeaway pizza. Income elasticity of demand is positive (E y > 0) for a normal good. The demand for an inferior good decreases as income increases. 25

26 Income Elasticity and Different Goods Good Income Elasticity Customer budget change Normal good Ei > 0 Increase / decrease Demand change Increase Luxury good Ei >1 Increase Increase more than 1% Necessity good 0<E i <1 Decrease Increase less than 1% Inferior good Ei <1 Decrease Decrease Income Elastic or Inelastic Demand Elastic goods are seen as LUXURIES Inelastic goods are seen as NORMAL or NECESSITIES 26

27 Example Ei = Good is an inferior good but inelastic a rise in income of 10% would lead to demand falling by 6%. Ei = Good is an inferior good and elastic a rise in incomes of 10% would lead to a fall in demand of 21%. Ei = Good is a normal good and elastic a rise in incomes of 10% would lead to demand rising by 16%. Ei = Good is a normal good but inelastic a rise in incomes of 10% would lead to demand rising by 4%. Price Elasticity of Supply Identical in concept to elasticity of demand. formula is the same, it is also related to the slope of the supply curve but is not simply the slope of the supply curve, terminology is the same. 27

28 Price Elasticity of Supply Measures the responsiveness of quantity supplied to changes in price. Defined as the percentage change in quantity supplied of a good divided by the percentage change in the price of the good. Supply can be classified as elastic, inelastic, unit elastic, perfectly elastic or perfectly inelastic. The Price Elasticity of Supply The price elasticity of supply measures the responsiveness of producers to changes in price. E SP Q P P / Q Q2 Q1 / 2 P P 28

29 Price Elasticity of Supply Economists distinguish the following three cases of the price elasticity of supply: E PS < 1, supply is said to be inelastic, E PS = 1, supply is said to be unit elastic, E PS > 1, supply is said to be elastic, in the case of vertical supply curve, supply is said to be perfectly inelastic, in the case of a horizontal supply curve, supply is said to be perfectly elastic. Price Elasticity of Supply 29

30 The Price Elasticity of Supply A 10% increase in the price of milk (from $2 to $2.20) increases the quantity supplied by 20% (from 100 million gallons to 120 million), so the price elasticity of supply is 2.0 = 20%/10%. Perfectly Inelastic Supply and Perfectly Elastic Supply When supply is perfectly inelastic, the quantity supplied is the same at every price, so the price elasticity of supply is zero. Example: water from a mineral spring. When supply is perfectly elastic, the quantity supplied is infinitely responsive to changes in price, so the price elasticity of supply is infinite. Example: sand used to make silicon used by computer chip makers. 30

31 Price Elasticity of Supply and Time The longer the period of adjustment to a change in price, the higher the price elasticity of supply. Additional production takes time. Reducing production takes time. Summary of the Four Elasticity Concepts 31

32 Importance of Elasticity Relationship between changes in price and total revenue. Importance in determining what goods to tax (tax revenue). Importance in analysing time lags in production. Influences the behavior of a firm. 32