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Chapter 21

Chapter 21. Demand and Supply Elasticity. The evidence shows that an increase in the price of physician’s services or prescription medications results in a relatively small decrease in the quantity of these goods demanded.

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Chapter 21

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  1. Chapter 21 Demand and Supply Elasticity

  2. The evidence shows that an increase in the price of physician’s services or prescription medications results in a relatively small decrease in the quantity of these goods demanded. In contrast, an increase in the price of psychiatric services causes a significant reduction in the quantity demanded. Why is there a difference in the price responsiveness of these goods? Introduction

  3. 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

  4. Learning Objectives • 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

  5. Learning Objectives • Classify supply elasticities and explain how the length of time for adjustment affects the price elasticity of supply

  6. Chapter Outline • Price Elasticity • Price Elasticity Ranges • Elasticity and Total Revenues • Determinants of the Price Elasticity of Demand

  7. Chapter Outline • Cross Price Elasticity of Demand • Income Elasticity of Demand • Elasticity of Supply

  8. Did You Know That... • Lower beer prices are associated with an increase in the number of violent incidents on campus? • A reduction in the price of a good can cause either an increase or a decrease in total sales revenue collected?

  9. Price Elasticity • Price Elasticity of Demand (Ep) • The responsiveness of quantity demanded of a commodity to changes in its price

  10. percentage change in quantity demanded Ep = percentage change in price Price Elasticity • Price Elasticity of Demand (Ep)

  11. -1% Ep = = -.1 +10% Price Elasticity • Example • Price of oil increases 10 percent • Quantity demanded decreases 1 percent

  12. Price Elasticity • Question • How would you interpret an elasticity of -0.1? • Answer • A ten percent increase in the price of oil will lead to a one percent decrease in quantity demanded

  13. Price Elasticity • 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

  14. change in Q change in P Ep= or sum of quantities/2 sum of quantities/2 change in Q change in P Ep= (Q1 + Q2)/2 (P1 + P2)/2 Calculating Elasticity • Elasticity formula:

  15. Example: The Price Elasticity of Demand for Beer • Lowenbrau, a beer imported from Germany, recently increased in price from $4.67 to $7.00 per six-pack. • In response, annual sales of six-packs fell from 25 million to 16.67 million. • What is the elasticity of demand?

  16. Example: The Price Elasticity of Demand for Beer • Use the elasticity formula: • 25-16.67 ÷ $7.00 – 4.67(25 + 16.67)/2 ($7.00 +$4.67)/2 • Solve the formula, and you will find that elasticity equals 1.

  17. Price Elasticity Ranges • Elastic Demand • Percentage change in quantity demanded is larger than the percentage change in price • Ep> 1

  18. Price Elasticity Ranges • Unit Elasticity of Demand • Percentage change in quantity demanded is equal to the percentage change in price • Ep= 1

  19. Price Elasticity Ranges • Inelastic Demand • Percentage change in quantity demanded is smaller than the percentage change in price • Ep< 1

  20. Price Elasticity Ranges • Elastic demand % change inQ > % change inP;Ep > 1 Unit elastic % change inQ = % change inP;Ep = 1 Inelastic demand % change inQ < % change inP;Ep < 1

  21. Price Elasticity Ranges • 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

  22. Extreme Price Elasticities D Perfect inelasticity, or zero elasticity Price 0 8 Quantity Demanded per Year(millions of units) Figure 21-1, Panel (a)

  23. P1 P0 Extreme Price Elasticities D Price Perfect inelasticity, or zero elasticity 0 8 Quantity Demanded per Year(millions of units) Figure 21-1, Panel (a)

  24. Price Elasticity Ranges • 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

  25. Extreme Price Elasticities 30 D Price (cents) Perfect elasticity, or infinite elasticity 0 Quantity Demanded per Year(millions of units) Figure 21-1, Panel (b)

  26. Policy Example:Who Pays Gasoline Taxes? • State and federal governments impose gasoline taxes that are assessed as a flat amount per gallon. • Who pays the tax depends on price elasticity of demand.

  27. Policy Example: Who Pays Gasoline Taxes? Figure 21-2, Panels (a) and (b)

  28. Policy Example: Who Pays Gasoline Taxes? Figure 21-2, Panel (c)

  29. Elasticity and Total Revenues • When demand is elastic, a negative relationship exists between small changes in price and changes in total revenue. • When demand is unit-elastic, changes in price do not change total revenue. • When demand is inelastic, a positive relationship exists between changes in price and total revenues.

  30. Determinants of Price Elasticity of Demand • 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.

  31. Determinants of Price Elasticity of Demand • The length of time allowed for adjustment • The longer any price change persists, the greater is the price elasticity of demand. • Price elasticity is greater in the long-run than in the short-run.

  32. Determinants of Price Elasticity of Demand • 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.

  33. Short-Run and Long-RunPrice Elasticity of Demand In the short run, quantity demanded falls slightly. However, with more time for adjustment the demand curve becomes more elastic and quantity demanded falls by a greater amount. P1 E Pe Price per Unit D2 D1 Q2 Q1 Qe Quantity Demanded per Period Figure 21-4

  34. Short-Run and Long-RunPrice Elasticity of Demand In the short run, quantity demanded falls slightly. However, with more time for adjustment the demand curve becomes more elastic and quantity demanded falls by a greater amount. P1 E Pe Price per Unit D3 D2 D1 Q3 Q2 Q1 Qe Quantity Demanded per Period Figure 21-4

  35. Example: Real-WorldElasticities of Demand Table 21-2

  36. Cross PriceElasticity of Demand • Cross Price Elasticity of Demand (Exy) • 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 • The responsiveness of change in demand of one good to the change in prices of related goods

  37. % change in demand for good X Exy= %change in price of good Y Cross PriceElasticity of Demand • Formula for computing cross elasticity of demand

  38. Cross PriceElasticity of Demand • Substitutes • Exywould be positive • An increase in the price of X would increase the quantity of Y demanded at each price. • Complements • Exywould be negative • An increase in the price of X would decrease the quantity of Y demanded at each price.

  39. E-Commerce Example:Cross-Price Elasticity of Telescopes • Economic researchers have estimated the cross-price elasticity of demand for different types of telescopes. • The finding was that the cross-price elasticity of demand between 3.5-inch and 5-inch telescopes was 13.33. • In contrast, the cross-price elasticity of demand between 5-inch and 8-inch telescopes was close to zero.

  40. E-Commerce Example:Cross-Price Elasticity of Telescopes • The conclusion is that 3.5-inch telescopes and 5-inch telescopes are substitutes for one another. But consumer behavior shows that the 5-inch telescope is not a substitute for the 8-inch one.

  41. Income Elasticity of Demand • Income Elasticity of Demand (Ei) • 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

  42. percentage change in demand Ei= percentage change in income Income Elasticity of Demand

  43. Income Elasticity of Demand • Income elasticity of demand • refers to a horizontal shift in the demand curve in response to changes in income • Price elasticity of demand • refers to a movement along the curve in response to price changes

  44. Income Elasticity of Demand • Formula: • Change in Quantity ÷ Change in IncomeAverage 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.

  45. Elasticity of Supply • Price Elasticity of Supply (Ei) • 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

  46. percentage change in quantity supplied ES= percentage change in price Elasticity of Supply • Formula for computing price elasticity of supply

  47. Elasticity of Supply • Classifying supply elasticities • Perfectly Elastic Supply • Quantity supplied falls to zero when there is any decrease in price. • The supply curve is horizontal at a given price.

  48. Elasticity of Supply • 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.

  49. S’ Q1 The Extremes in Supply Curves Perfect inelasticity Price per Unit Quantity Supplied per Period Figure 21-5

  50. P1 S The Extremes in Supply Curves S’ Perfect inelasticity Price per Unit Perfect elasticity Q1 Quantity Supplied per Period Figure 21-5

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