Demand and Supply: Elasticities and Applications

1. Demand and Supply: Elasticities and Applications Chapter 5

2. 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.

3. 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.

4. 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

5. 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!

6. 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!)

7. Let’s Practice • Calculate the price elasticity of demand when price changes from $1 to $2

8. Let’s Practice • 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]

9. Let’s Practice • 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]

10. Let’s Practice • Calculate the price elasticity of demand when price changes from $1 to $2 • Midpoint Formula = -20/170 $1.00/$1.50

11. Let’s Practice • Calculate the price elasticity of demand when price changes from $1 to $2 • Midpoint Formula = -.118 • .667

12. Let’s Practice • 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

13. Let’s Practice • 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?

14. Elastic Demand • %change in Qd > %change in P • Elasticity Ratio > 1

15. Inelastic Demand • %change in Qd < %change in P • Elasticity Ratio < 1

16. Unitary Elasticity • %change in Qd = %change in P • Elasticity Ratio = 1

17. Let’s Practice • 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?

18. Let’s Practice • 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!

19. Your turn! • Calculate the price elasticity of demand when price changes from $5 to $6

20. Your turn! • 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!

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

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

23. Why Use Percentages? 1.Using absolute changes would be affected by the units used Example: If $ units used: • $3$2 causes 60100 Qd change • Seems very responsive If cents used: • 300200 causes 60100 Qd change • Does not seem as responsive

24. Why Use Percentages? • 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

25. 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!

26. Elasticity Varies with Price Range • Demand is more elastic in the upper left region of the demand curve than in the lower right region

27. 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

28. 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

30. D P 700 100 Q 15 Perfectly Inelastic Demand • %change in price does not change the quantity demanded • Demand Curve is Parallel to the Y Axis

31. P D 16 Q 10 20 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

32. Midpoint Formula • If original formula used, two different answers P1=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

33. Midpoint Formula • If original formula used, two different answers P1=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

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

35. Slope Does NOT Measure Elasticity • Slope is calculated from absolute changes in price and quantity, not percentage changes

36. Total Revenue Test • TR = PQ • Total revenue = Price X Quantity

37. 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

38. 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)

39. Total Revenue Test • Unitary Demand: • P increasesNo change in TR • P decreasesNo change in TR

40. Determinants of Price Elasticity of Demand

41. 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?

42. 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)

43. 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?

44. 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

45. 3. Luxuries versus Necessities • Necessities = inelastic • Luxuries = elastic

46. 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!)

47. 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.

48. Price Elasticity of Supply • The responsiveness of producers to price changes • Es = %change in quantity supplied of X %change in price of X • Es >1elastic • Es < 1inelastic • Es = 1unitary • You can still use the midpoint method to calculate this!

49. 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.

50. 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