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1.0 Elasticity of Demand and Supply

1.0 Elasticity of Demand and Supply. Real World Examples SOFTWARE UPGRADES Illustrates price elasticity of demand and its determinants CIGARETTE TAXATION Illustrates price inelastic demand and relation to revenue. SESSION 3: CHAPTER 5 . Image Source WSJ.

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1.0 Elasticity of Demand and Supply

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  1. 1.0 Elasticity of Demand and Supply • Real World Examples • SOFTWARE UPGRADES • Illustrates price elasticity of demand and its determinants • CIGARETTE TAXATION • Illustrates price inelastic demand and relation to revenue SESSION 3: CHAPTER 5 Image Source WSJ Tips for Navigation in the Video Lecture: The table of contents in the left frame : has links to each slide. The slide with the LECTURE OUTLINE lists the main topic s. These topics begin with a whole number (e.g. “2.0” ). The bottom frame : has options to print each slide and to display closed captioning of the audio. The image of the house appears on every slide in the upper left and operates as a hyper link to the slide “LECTURE OUTLINE” Chart Source WSJ © Prof. Harmon

  2. 1.1 Software Upgrades Elastic Demand Inelastic Demand Adapted from : Software Customers Force Change WSJ 1/2/2004 Software Customers Reactions to Fees for upgrades and maintenance Since software doesn't wear out,software companies provide upgrades free, generating additional revenue by selling users on new add-ons or increasing maintenance fees. These fees have crept up to as much as 22% or even 25% of the original license fee, from about 15% a few years ago. Some software companies now get the majority of their profits from such recurring revenue, with original license fees serving as an introductory loss leader. Some customers are happy to upgrade. The recent versions of most business applications, for example, allow better Web access to company data than previously possible For some customers the pain of an upgrade is outweighed by the value of the innovation. Many companies say the a business case for the hassles of installing a new version or adding on the latest bells and whistles..

  3. 1.2a One Public Policy Issue Is… • If cigarette smoking continues at current rates… Chart Source WSJ

  4. 1.2b Cigarette Taxes Raise Revenue: Low Demand Elasticity • A price rise of 10 percent on a pack of cigarettes would be expected to reduce demand for cigarettes in the short term: • by about 4 percent in high-income countries • by about 8 percent in low- and middle-income countries, where lower incomes tend to make people more responsive to price changes. • In both cases sales revenue increases because the percent increase in price is larger than the percent decline in quantity. (Remember revenue = price x quantity.) • Long-run price responsiveness is estimated to be twice as high. • Source: http://www.imf.org/external/pubs/ft/fandd/1999/12/jha.htm Chart Source WSJ

  5. 1.3 LECTURE OUTLINE • 1. First Slide • 2.0 Price Elasticity of Demand • 3.0 Supply Elasticity • 4.1 Income Elasticity • 5.1 Cross Price Elasticity • Substitutes, Complements • 6.0 Econ LabEnd

  6. 2.0 Price Elasticity of Demand • 2.1 Price Elasticity Formula • 2.2 Numerical Example • 2.3 Three points about elasticity of demand • 2.4 Categories of Elasticity • 2.5 Demand Elasticity and Total Revenue • 2.6 Constant Elasticity Cases • 2.7 Determinants of Elasticity

  7. 2.1a Price Elasticity • Thus far we have talked about the impact of changes in prices, incomes, and costs, on demand and supply in rather general terms • In fact, in the real world of policy implementation, more precision is used • The Law of demand says that a higher price will reduce quantity demanded, BUT BY HOW MUCH that is, will the number sold decline by only a little or by a lot?

  8. 2.1.b Formula for Price Elasticity of Demand • Price elasticity of demand measures in a standardized way how responsive consumers are to price change elasticity is another word for responsiveness • In simplest terms, the price elasticity of demand measures the percent change in quantity demanded divided by the percent change in price

  9. 2.1.c Price Elasticity of Demand Formula: In Words • To illustrate this process, let us write out the algebraic formula and do an example calculation.

  10. 2.1.d Price Elasticity of Demand Formula: Algebraic Expression • Generalize the price elasticity formula • If the price drops from p to p’, other things constant, the quantity demanded increases from q to q’ • The change in price can be represented as Δp and the change in quantity as Δq

  11. 2.2 Demand Curve for Cigarettes For the price elasticity to be a useful measure, we should come up with the same result between points a and b as we get between b and a. To do this we must take the average of the initial price and the new price and use that as the base in computing the percent change in price. a $1.10 b 0.90  in our example the base used for price is the average of $1.10 and $0.90 = $1.00  the change in price is -$0.20 divided by $1.00  -20% Price per taco D The same process should be used for changes in quantity demanded  the average quantity demanded is 100,000 and the change in quantity demanded is 10,000  10% change Thousands per day 0 95 105 Price elasticity between point “a” and “b” is: = 10% / - 20% = - 0.5

  12. 2.3 .1 Three Points about Price Elasticity of Demand: Point #1 • Because the average quantity and average price are used as a base for computing percent change, the same elasticity results whether going from the higher price to the lower price or the other way around

  13. 2.3.2 Point #2 • Elasticity expresses a relationship between two amounts • The percent change in quantity demanded • The percent change in price • Because the law of demand states that price and quantity demanded are inversely related, the change in price and the change in quantity demanded have opposite signs  the price elasticity of demand has a negative sign

  14. 2.3.3 Point #3 • Since constantly referring to elasticity as a negative number gets cumbersome, we will discuss the price elasticity of demand as an absolute value  positive number • For example, absolute value of the elasticity for cigarettes computed earlier will be referred to as 0.5 rather than –0.5

  15. 2.4.1 Three Categories of Elasticity • The price elasticity of demand can be divided into three general categories depending on how responsive quantity demanded is to a change in price • If the percent change in quantity demanded is smaller than the percent change in price, the resulting price elasticity has an absolute value between 0 and 1.0  demand is inelastic  quantity demanded is relatively unresponsive to a change in price • If the percent change in quantity demanded just equals the percent change in price  a price elasticity with an absolute value of 1.0  unit-elastic demand

  16. 2.4.2Numerical Ranges of the Categories • If the percent change in quantity demanded exceeds the percent change in price, the resulting price elasticity has an absolute value exceeding 1.0  demand is said to be elastic  quantity is responsive to changes in price • Summary • Elastic  absolute value greater than 1.0  responsive • Unit elastic  absolute value equal to 1.0 • Inelastic  absolute value between 0 and 1.0  unresponsive

  17. 2.5.1 Elasticity and Total Revenue • Knowledge of price elasticity is especially valuable because it indicates the effect of a price change on total revenue • Total revenue (TR) is the price (p) multiplied by the quantity demanded (q) at that price  TR = p x q • What happens to total revenue when price decreases?

  18. 2.5.2 Elasticity and Total Revenue • A lower price means producers get less for each unit sold which tends to decrease total revenue • However, a lower price increases quantity demanded which tends to increase total revenue • Thus, the overall impact of a lower price on total revenue depends on the net result of these opposite effects

  19. 2.5.3Elasticity and Total Revenue • Specifically • When demand is elastic, the percent increase in quantity demanded exceeds the percent decrease in price  total revenue increases • When demand is unit elastic, the two are equal  total revenue remains unchanged • When demand is inelastic, the percent increase in quantity demanded is more than offset by the percent decrease in price  total revenue decreases • The next slide presents these relationships in a diagram

  20. (a) Demand and Price Elasticity e u n e v e r l a t o T Panel (a) shows the linear demand curve and panel (b) shows the total revenue generated by each price-quantity combination along the demand curve. 2.5.4 Diagram: Demand, Price Elasticity and Total Revenue $100 90 Elastic ED > 1 80 70 Slope = rise/run Unit elastic ED = 1 60 50 Price per unit 40 Inelastic ED < 1 30 Since the demand curve is linear, its slope is constant  a given decrease in price always causes the same unit increase in quantity demanded. 20 10 D 0 100 200 500 800 900 1,000 Quality per period (b) Total Revenue TR = p x q $25,000 The price elasticity of demand is greater on the higher-price end of the demand curve than on the lower-price end. Total revenue (Hint: the same price change at a high price level translates into a smaller denominator Quantity per period 500 1,000 0

  21. (a) Demand and Price Elasticity e u n e v e r l a t o T 2.5.5 Diagram: Demand, Price Elasticity and Total Revenue $100 Consider a movement from point a to point b on the demand curve. 90 12% a 80 b 70 60 The 100-unit increase in quantity demanded is a percent change of 100/150 = 67% 50 c Price per unit 40 30 20 d 67% 10 e D while the $10 drop in price is a percent change of 10/85 = 12%  the price elasticity of demand here is 5.6 = (67%/12%) 0 100 200 500 800 900 1,000 67% Quality per period 12% (b) Total Revenue TR = p x q $25,000 Between points d and e on the lower end, the 100-unit quantity increase is a percent change of 100/850 = 12% and the $10 price decrease is a percent decline of 10/15 = 67%  a price elasticity of 0.2 = (12%/67%) Total revenue Quantity per period 500 1,000 0

  22. (a) Demand and Price Elasticity e u n e v e r l a t o T Demand becomes less elastic as we move down the curve. Halfway down, the elasticity equals 1.0. Since we have a linear demand curve, the slope is constant but the elasticity varies  slope is not the same thing as elasticity. 2.5.6 Summary: Demand, Price Elasticity and Total Revenue $100 90 Elastic ED > 1 a 80 b 70 Unit elastic ED = 1 60 50 c Price per unit 40 Inelastic ED < 1 30 20 Where demand is elastic, a decrease in price will increase total revenue because the gain in revenue from selling more units exceeds the loss in revenue from selling at the lower price. d 10 e D 0 100 200 500 800 900 1,000 Quality per period (b) Total Revenue TR = p x q Unit elastic ED = 1 $25,000 Where demand is inelastic, a price decrease reduces total revenue because the gain in revenue from selling more units is less than the loss in revenue at the lower price. Total revenue Elastic ED > 1 Inelastic ED < 1 When Elasticity is unitary Total Revenue is at its peak 500 1,000 0 Quantity per period

  23. 2.5.7 Example of Pricing & Inelastic Demand • When Elmo Live arrives in stores on Tuesday, it will cost $60 -- about a third more than last year's model, and above the $50 tag that once was the high-water mark for most toys. Elmo Live hits stores as economic uncertainty is gripping consumers and prompting retailers such as Wal-Mart Stores Inc. and KB Toys Inc. to pitch low-cost toys to lure customers. Source: Mattel Gambles on Pricey Elmo for Holidays (WSK 10/9/08) To be increasing prices, sellers of Elmo must be of the view that demand is inelastic and hence the price increases will increase revenue

  24. 2.6 Constant Elasticity Demand Curves (a) Perfectly elastic (b) Perfectly inelastic (c) Unit elastic D' t t t i i i n n n u E = 1 u u ¥ D r r r E = e e e D p p p D p E = 0 e e e D a $10 c c c i i i r r r P P P b 6 D" 0 Q 0 60 100 0 Quantity Quantity Quantity per period per period per period Demand curve in (b) is vertical, quantity demanded does not vary when the price changes  no matter how high the price, consumers will purchase the same quantity  perfectly inelastic demand curve. Demand curve in (a) indicates consumers will demand all that is offered at the given price, p. If the price rises above p, quantity demanded drops to zero  perfectly elastic demand curve. (c) shows a unit-elastic demand curve where any percent change in price results in an identical offsetting percent change in quantity demanded.

  25. 2.7 Determinants • Time to turn to the issue of why price elasticities of demand vary for different goods • Three basic determinants • Availability of substitutes • Proportion of the consumer’s budget spent on the good • A matter of time

  26. 2.7.1 Availability of Substitutes • The greater the availability of substitutes for a good and the closer the substitutes, the greater the good’s price elasticity of demand • The number and similarity of substitutes depend on how we define the good  the more broadly we define a good, the fewer the substitutes and the less elastic the demand

  27. 2.7.2 Proportion of Consumer’s Budget • Because spending on some goods represents a large share of the consumer’s budget, a change in the price of such a good has a substantial impact on the amount consumers are able to purchase • Generally, the more important the item is as a share of the consumer’s budget, other things constant, the greater will be the income effect of a change in price  the more price elastic will be the demand for the item

  28. 2.7.3a A Matter of Time • The process of finding substitutes takes time • Thus, the longer the adjustment period, the greater the consumers’ ability to substitute away from relatively higher-priced products toward lower-priced substitutes  the more responsive the change in quantity demanded is to a given change in price • The next slide demonstrates this

  29. 2.7.3b Demand Becomes More Elastic over Time Initial price = $1.00 Dw = the demand curve one week after the price change Dm = one month after Dy, = one year after. Suppose the price now increases to $1.25. The more time for consumers to respond to price increase, the greater will become the reduction in quantity demanded. $1.25 1.00 Dy Price per unit Dw shows that one week after the price increase, the quantity demanded has not changed much – in this case from 100 to 95 per day. However, after one month, the curve Dm showsquantity demanded has declined to 75, and Dw showsafter one year to 50 per day. Dm Dw 0 Quantity per period 50 75 95 100 Note that among these demand curves and over the range starting from the point where the demand curves intersect, the flatter the demand curve, the more price elastic the demand.

  30. 2.8.1 Elasticity Estimates • When estimating price elasticity, economists often distinguish between a period during which consumers have little time to adjust – the short run – and a period during which consumers can more fully adjust to a price change – the long run. • Exhibit 6 provides some short-run and long-run price elasticity estimates for selected products

  31. 2.8.2 Selected Price Elasticities of Demand Product Short Run Long Run Cigarettes (among adults) — 0.4 Electricity (residential) 0.1 1.9 Air travel 0.1 2.4 Medical care and hospitalization 0.3 0.9 Gasoline 0.4 1.5 Milk 0.4 — Fish (cod) 0.5 — Wine 0.7 1.2 Movies 0.9 3.7 Natural gas (residential) 1.4 2.1 Automobiles 1.9 2.2 Chevrolets — 4.0

  32. 3.0 Price Elasticity of Supply 3.1 Definition 3.2 Graph 3.3 Categories 3.4 Polar Cases 3.5 Determinants

  33. 3.1 Price Elasticity of Supply • The price elasticity of supply equals the percent change in quantity supplied divided by the percent change in price • Since the higher price usually results in an increased quantity supplied, the percent change in price and the percent change in quantity supplied move in the same direction  the price elasticity of supply is usually a positive number • Exhibit 7 depicts a typical upward-sloping supply curve

  34. 3.2 Price Elasticity of Supply S If the price increases from p to p', the quantity supplied increases from q to q' p' p The price elasticity of Es, is Price per unit Where  q is the change in quantity supplied and  p is the change in price. q q' Quantity per period 0

  35. 3.3 Categories of Supply Elasticity • The terminology for supply elasticity is the same as for demand elasticity • If supply elasticity is less than 1.0, supply is inelastic • If it equals 1.0, supply is unit elastic • If it exceeds 1.0, supply is elastic • Exhibit 8 illustrates some special cases of supply elasticity to consider

  36. 3.4 Constant-Elasticity Supply Curves (a) Perfectly elastic (b) Perfectly inelastic (c) Unit elastic S' t t t i i i S" n n n u u u ¥ E = 1 r r r S E = e e e S p p $10 p S p E = 0 e e S e c c c i i i r r r P P P 5 Quantity per period Quantity per period Quantity per period 0 0 0 10 20 Q At one extreme is the horizontal supply curve. Here producers will supply none of the good at a price below p, but will supply any amount at a price of p, as in (a). The most unresponsive relationship is where there is no change in the quantity supplied regardless of the price, as shown in (b) where the supply curve is perfectly vertical. Any supply curve that is a straight line from the origin such as shown in (c) is a unit-elastic supply curve.

  37. 3.5 Determinants • The elasticity of supply indicates how responsive producers are to a change in price • Their responsiveness depends on how easy it is to alter output when price changes • If the cost of supplying additional units rises sharply as output expands, then a higher price will elicit little increase in quantity supplied • When overtime and hiring additional workers MC can be steep • But if the marginal cost rises slowly as output expands, the lure of a higher price will prompt a large increase in output • Marginal cost of producing additional copies of software is essentially zero

  38. 3.5.1 Length of Time • Just as demand becomes more elastic over time as consumers adjust to price changes, supply also becomes more elastic over time as producers adjust to price changes • The longer the time period under consideration, the more able producers are to adjust to changes in relative prices • The next slide illustrates this

  39. S S w m S y Price per unit 0 100 140 200 Quantity per period 110 3.5.1a Supply Becomes More Elastic over Time Sw is the supply curve when the period of adjustment is a week. In this situation, the higher price does not elicit much of a response in quantity supplied because firms have little time to adjust  supply curve is inelastic if the price increases from $1.00 to $1.25 $1.25 1.00 Sm is the supply curve when the adjustment period is one month. Here the firms have a greater ability to vary output  supply is more elastic Supply is even more elastic when the adjustment period is a year as shown by Sy

  40. S S w m S y Price per unit 0 100 140 200 Quantity per period 110 Mall Glut to Clog Market for Years Scarce Shoppers, Lack of Tenants Cause: a decade of overbuildingFor retailers, the glut can have an upside: cheaper rents, shorter lease terms and fatter allowances from landlords for outfitting stores. This year, the rents in new lease signings are 10.4% lower on average than the asking price, down from the 9.3% discount of two years agoWSJ 9/10/08 3.5.1b Supply Becomes More Elastic over Time Images Source WSJ $1.25 1.00 D1 D2 In the short run the decline in Demand will lead to sharp falls in rent, but in the longer run the rent adjustment will not be as large.

  41. 4.0 Income Elasticity of Demand 4.1 Definition 4.2 Formula 4.3 Categories 4.4 Selected Cases 4.5 Agricultural Producers

  42. 4.1 Income Elasticity of Demand • The income elasticity of demand measures how responsive demand is to a change in income • Measures the percent change in demand divided by the percent change in income • Categories • Goods with income elasticities less than zero are called inferior goods demand declines when income increases

  43. 4.2 Income Elasticity of Demand Formula: Algebraic Expression • The income elasticity formula • If the income rises from I to I’, other things constant, the demand increases from q to q’ • The change in income can be represented as ΔI and the change in quantity as Δq

  44. 4.3 Categories • Normal goods have income elasticities greater than zero  demand increases when income increases • Normal goods with income elasticities greater than zero but less than 1 are called income inelastic goods demand increases but not as much as does income • Goods with income elasticity greater than 1 are called income elastic demand not only increases when income increases but increases by more than does income • The next slide presents some income elasticity estimates for various goods and services A “fine” cup of coffee

  45. 4.4 Selected Income Elasticities of Demand Income IncomeProduct Elasticity Product Elasticity Private education 2.46 Physicians’ services 0.75 Automobiles 2.45 Coca-Cola 0.68 Wine 2.45 Beef 0.62 Owner-occupied housing 1.49 Food 0.51 Furniture 1.48 Coffee 0.51 Dental service 1.42 Cigarettes 0.50 Restaurant meals 1.40 Gasoline and oil 0.48 Shoes 1.10 Rental housing 0.43 Chicken 1.06 Beer 0.27 Spirits (“hard” liquor) 1.02 Pork 0.18 Clothing 0.92 Flour –0.36

  46. 4.5a The Case of Agricultural Producers: The Demand for Grain

  47. 4.5b The swings in Supply Dominate Demand Shifts: Greatly Changing Farm Revenue Hence the case for stabilizing farmer’s incomes by price controls Return to Outline

  48. 5.0 Cross Price Elasticity 5.1 Definition 5.2 Formula 5.3 Substitutes and Complements 5.4 Diagram It

  49. 5.1 Cross-Price Elasticity of Demand • The responsiveness of the demand for one good to changes in the price of another good is called the cross-price elasticity of demand • Defined as the percent change in the demand of one good divided by the percent change in the price of another good • Its numerical value can be positive, negative, or zero depending on whether the goods are substitutes, complements, or unrelated, respectively

  50. 5.2 Cross Price Elasticity of Demand Formula: Algebraic Expression • The cross price elasticity formula • The price of X changes from Px to Px’, other things constant, the demand for good Y changes from Qy to Qy’. • The change in the price of X can be represented as ΔPx and the change in quantity of good Y as ΔQy

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