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Chapter 20

Chapter 20. Elasticity Supply and Demand. Price changes- do you still purchase it? How do demand and supply change in response to changes in price and quantity? The response we provide relates to Elasticity. Elasticity of Demand and Elasticity of Supply. Bottom Line on Elasticity of Supply.

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Chapter 20

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  1. Chapter 20 Elasticity Supply and Demand

  2. Price changes- do you still purchase it? How do demand and supply change in response to changes in price and quantity?The response we provide relates to Elasticity Elasticity of Demand and Elasticity of Supply

  3. Bottom Line on Elasticity of Supply If producers are relatively responsive to price changes supply is elastic If producers are relatively insensitive to price changes supply is inelastic

  4. When a large percentage change in price brings about a small percentage change in quantity supplied = inelastic…. (examples: Rise in costs of computers… takes time to shift resources) Over Time… more plants built, more engineers trained, and more computers supplied

  5. Other examples for inelastic supply • Ranchers in Texas • Decriminalization of Marijuana • City Planers decide to build a golf course. • Others?

  6. Antiques…. Supply elastic or inelastic? Inelastic…. Only a few authentic pieces, reproductions would be elastic Gold………Supply elastic or inelastic Gold is perfectly inelastic…(supply fixed)…

  7. When a small percentage change in price brings about a large percentage change in quantity supplied = elastic Example: Cowboys beat Philadelphia Eagles for wildcard playoff… T-shirt producer can raise his price just a “tad” and sell a ton more shirts…

  8. Other examples of elastic supply • Open up a home bakery. • Establish a sign-painting business. • Importing jewelry to sell. • Others?

  9. MAIN DETERMINATION OF ELASTICY OF SUPPLY? • TIME Many times this only has to do with the producers ability to shift resources… If resources are not shiftable, then new mix of inputs has to be determined.

  10. Ability to Respond to Price varies Often the ability of an individual firm to respond to an increase in price is limited or constrained by its existing scale of operations, or capacity, or ability to obtain resources….. IN SHORT RUN Examples: IN LONG RUN… can adjust. The greater the amount of time producers have to adjust, the greater their output response.

  11. TIME AND ELASTICITY OF SUPPLY Ss Sm SL D2 D2 D2 D1 D1 D1 Note: perfectly inelastic. (price)(quantity) Inelastic (price) (quantity) Elastic (price) (quantity) See relationship between small percentage increase in P and Q that follows.

  12. Terms to remember • Market Period = period that occurs when the quantity output is fixed. Producer will not produce more until some is sold. No change in quantity supplied. • SR in Micro = period of time too short to change plant capacity, but long enough to use current capacity more or less intensively.

  13. Examples of adjusting to the market period. truck farmer (farmer’s market) *limited growing season *accepts price as it is brought to market *can’t hold back on what is sold because of spoilage. *has to take price even if cost of production not met.

  14. Perfectly elastic supply curve Relatively elastic supply curve Perfectly inelastic supply curve Relatively inelastic supply curve

  15. Supply tends to be inelastic in SR Example: After WWII… cars impossible to get at any price. Resources needed to be converted back from tanks, jeeps and plane production. Even if you had the $1,000 it took to buy a car… had to put name on year waiting list.

  16. Additional Trivia on WW IILester R. Brown, Mobilizing to Save Civilization . P.10 • From early February 1942 through the end of 1944, nearly three years, essentially no cars were produced in the United States. Car production was banned. • “In his State of the Union address on January 6, 1942, one month after the bombing of Pearl Harbor, President Franklin D. Roosevelt announced the country’s arms production goals. The United States, he said, was planning to produce 45,000 tanks, 60,000 planes, 20,000 anti-aircraft guns, and several thousand ships. He added, “Let no man say it cannot be done.”

  17. 1946 Billboard Ad by Ford

  18. Remember… If butcher lowers his price…. He’s thinking revenue Supplier is looking at revenue Revenue Test = P x Q = TR What is profit? TR-TC Question is: If I decrease the price of steak $1 what will happen to my revenue?

  19. Math for Measuring Price Elasticity Problem: Sirloin steak drops $4.00 to $3.00 Butcher sales increase from 500 lbs to 1,000 lbs • Formula: Pe = % Change in Q % Change in P Let's Work The Math!

  20. 500 lbs to 1000 lbs = 500 / 500 = 1 (Q change = 100%) $4.00 to $3.00 = 1/ 4 = .25 1 / .25 = 4 The steak at this price is very elastic. Anything over 1 is elastic. Anything .01 to .99 is inelastic

  21. Helpful Hints To find coefficient of price elasticity supply or demand simply: Find % change in quantity and % change in price, then divide Q/P Hint: former-current/former Price increase $1 to $2, quantity decrease 10 to 8 1/1 x 100 = 100% = P 2/10 x 100 = 20% = Q 20/100 = .2 = inelastic

  22. Another Helpful Hint! What is the first movement for variables? i.e.. When a producer wants to check if he can get more $$ for increasing or decreasing, what is the first thing he does? Price OR Price Then the quantity adjusts accordingly P = trigger Q = response

  23. Elasticity of Demand Logic Dictates that: Firms contemplating a price hike want to know how consumers will respond GM advertises 0% financing for 60 months… huge reductions on Suburban's, Tahoes,Trucks) What do they expect consumers to do? What do the dealers expect to receive?

  24. Bottom Line for Elasticity of Demand The responsiveness or (sensitivity) of consumers to a price change is measured by a product’s price elasticity of demand Inelastic demand perfectly inelastic totally elastic

  25. Explanation of Perfectly Inelastic Demand Unit Elasticity (Percentage change in price and resulting change in quantity demanded are the same. Where a price change results in nochange in quantity demanded, it = “Perfectly Inelastic” or “Unit Elastic” Example: Insulin for Diabetes What else? (certain medicines.. BP… Heart problems… etc.) In these cases… price-elasticity coefficient is zero (because no response to change in price)

  26. What is elasticity of demand? Elasticity of demand measures the percentage change in Quantity demanded in response to a percentage change in price. Law of demand states that as P increases Q decreases. But how much decrease? Measure responsiveness of QD to change in P by calculating the coefficient of price elasticity of demand (Ep) Ep = Percentage change in QD Percentage Change in P You have already done this!!

  27. What does that mean? If elasticity is greater than 1, demand is elastic. Price change causes revenue to change in opposite direction Decrease in price will increase TR Inelastic demand is defined as an elasticity of less than 1 (anything from 0 to .99) Price changes causes TR to change in same direction. Decrease in price causes TR to fall Unit elastic is 1 No change Price elasticity is 0 because an increase in price will not decrease revenue…nor will it increase revenue… there is no change in revenue with unit elastic.

  28. Elastic Demand = A small percentage change in price brings about a large percentage change in QD Example: cars, steak, CDs, gold jewelry, movies, air travel Inelastic Demand = Large percentage change in price brings about a small percentage change in QD. Drugs, gasoline, cigarettes, personal items, deodorant, furniture, coffee

  29. All of the inelastic demand concepts depend on available substitutes • Price of steak goes too high… substitute chicken • Price of gasoline too high… no substitute Income Effect Income effect simply indicates that at a lower price one can afford more of the good without giving up alternative goods.

  30. Decline in the price of a product will increase purchasing power of one’s money income Higher price has opposite effect. Substitution Effect = one has the incentive to substitute the cheaper good for similar goods which are now relatively more expensive. Cheap products for dear products

  31. Determinants of Elasticity • Necessity vs Luxuries ….examples: critical medicines, addiction, gas to drive, new car, boat, diamond ring…. • Availability of Substitutes…Zirconia, salt substitute, powdered milk, tea vs coffee… • Proportion of Income…the higher the price of a good relative to a consumers’ income, the greater the price elasticity of demand. • Time….As a rule, product demand is more elastic the longer the time period under consideration.

  32. Generally, the larger the number of substitute goods that are available, the greater the price elasticity of demand.. (variety of beer options on the market) Elasticity of Demand depends on how narrowly the product is defined. (Coach Handbag)

  33. Normal or Superior Goods • Income goes up… we buy more expensive items…. (lobster/fish sticks) Inferior or Poor Man’s Goods • Income goes down… take the bus rather than fly…second-hand clothing stores… garage sales.

  34. How can we calculate coefficient of price elasticities?Let’s re-visit our last example Let’s say that price is increased from $1.00 to $2.00 for a candy bar….. The quantity demanded decreases from 10 to 8…. How will this producer know if the price increase brings in more $ relative to decrease in demand or otherwise????

  35. Percent change in P 1-2=1/1 x 100 = 100% change in P Percent change in Q 10-8 = 2/10 = 20% change in Q Response/trigger (Q/P) …..Hence: E = 20/100 =.2 (% change in Q / % change in P) Trigger was the price…. Response the quantity Price moves…(trigger)… quantity change (response) Because % change is less than 1, candy producer will increase revenue by increasing price. (candy went from $1 to $2)

  36. Meaning of Elasticity • Elasticity is > than 1 … means demand is elastic (If elasticity is greater than 1, percentage change in quantity must be greater than percentage change in price.) • Inelasticity is anything < than 1 • If elasticity is equal to 1 then it is unitary elastic

  37. Let’s try two more problems Key chains are reduced from $5 to $4 The number of key chains purchased increases from 80 to 82 Was this inelastic or elastic… Revenue went up or down? Bottled Water increased from $3.00 to $5.00 The number of bottles purchased decreased from 250 to 125. Elastic or inelastic? Key chain- .125 (inelastic) Bottled water .75 (inelastic) Inelastic –direct revenue relationshipelastic- indirect revenue relationship

  38. Advertising Purpose • To sway the consumer. (Bayer and St. Joseph’s aspirin for children) which is better? • Producers through advertising want to increase our demand curve and make it more inelastic!

  39. To be Discussed later Total Revenue and Marginal Revenue…. If your company sold 4 computers at $3,200 each how much total revenue? (PxQ = $12,800) Marginal Revenue = Increase in TR when output sold goes up by one unit.($12,800 +3,200=$16,000 The additional revenue derived from selling one more unit. (see above)

  40. Kiley Dog Horn- Total Utility

  41. THE END! Let me out!!! I'm not elastic!

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