8/14/2019 Bryan Becher

1/3

Bryan Becher 2/3/10 EC 111

Chapter 5: Elasticity of Demand and Supply

- In a market economy, prices tell producers and consumers about the relative scarcity ofproducts and resources- A firms success or failure often depends on how much it knows about the demand for itsproduct- The price elasticity of demand measures, in a standardized way, how responsive consumersare to a change in price

- Measures the percentage change in quantity demanded divided by the percentagechange in price- = Percentage change in quantity demanded / Percentage change in price

- Price elasticity formula Percentage change in quantity demanded divided by the percentagechange in price; the average quantity and the average price are used as bases for computingpercentage changes in quantity and in price

- ED = (q / ((q + q1) / 2)) / (p / ((p + p1) / 2))

- Elasticity expresses a relationship between two amounts: the percentage change in quantitydemanded and the percentage change in price

- In the elasticity formula, the numerator and the denominator have opposite signs, leaving theprice elasticity of demand with a negative sign- Inelastic demand A change in price has relatively little effect on quantity demanded; thepercentage change in quantity demanded is less than the percentage change in price; the resultingprice elasticity has an absolute value less than 1.0- Unit-elastic demand The percentage change in quantity demanded equals the percentagechange in price; the resulting price elasticity has an absolute value of 1.0- Elastic demand A change in price has a relatively large effect on quantity demanded; thepercentage change in quantity demanded exceeds the percentage change in price; the resultingprice elasticity has an absolute value exceeding 1.0- Knowledge of price elasticity of demand is especially valuable to producers

- Indicates the effect of a price change on total revenue- Total revenue (TR) Price multiplied by the quantity demanded at that price

- TR = p x q- If the positive effect of a greater quantity demanded more than offsets the negativeeffect of a lower price, then total revenue rises- If demand is elastic, the percentage increase in quantity demanded exceeds thepercentage decrease in price, so total revenue increases- If demand is unit elastic, the percentage increase in quantity demanded just equals thepercentage decrease in price, so total revenue remains unchanged- If demand is inelastic, the percentage increase in quantity demanded is more than offsetby the percentage decrease in price, so total revenue decrease

- Linear demand curve A straight-line demand curve; such a demand curve has a constant

slope but usually has a varying price elasticity- A given decrease in price always causes the same unit increase in quantity demanded

- If the demand curve is linear, consumers are more responsive to a given price change when theinitial price is high than when its low- Demand becomes less elastic as one moves down the curve- A point halfway down the linear demand curve divides a linear demand curve into an elasticupper half and an inelastic lower half

8/14/2019 Bryan Becher

2/3

Bryan Becher 2/3/10 EC 111

- A price decline increases total revenue if demand is elastic, has no effect on total revenue ifdemand is unit elastic, and decreases total revenue if demand is inelastic- The slope of a demand curve is not the same as the price elasticity of demand- Perfectly elastic demand curve A horizontal line reflecting a situation in which any priceincrease would reduce quantity demanded to zero; the elasticity has an absolute value of infinity- Perfectly inelastic demand curve A vertical line reflecting a situation in which any pricechange has no effect on the quantity demanded; the elasticity value is zero- Unit-elastic demand curve Everywhere along the demand curve, the percentage change inprice causes an equal but offsetting percentage change in quantity demanded, so total revenueremains the same; the elasticity has an absolute value of 1.0- Constant-elasticity demand curve The type of demand that exists when price elasticity isthe same everywhere along the curve; the elasticity value is unchanged- The greater the availability of substitutes and the more similar these substitutes are to the goodin question, the greater that goods price elasticity of demand- The more narrow the definition, the more substitutes, and, thus, the more elastic the demand- The more important the item is as a share of the consumers budget, other things constant thegreater is the income effect of a change in price, so the more price elastic is the demand for the

item- The longer the period of adjustment, the more responsive the change in quantity demanded is toa given change in price- When estimating price elasticity, economists often distinguish between a period during whichconsumers have little time to adjust, the short run, and a period during which consumers canmore fully adjust to a price change, the long run- The price elasticity of demand is greater in the long run because consumers have more time toadjust- Price elasticity of supply A measure of the responsiveness of quantity supplied to a pricechange; the percentage change in quantity supplied divided by the percentage change in price

- The percentage change in price and the percentage change in quantity supplied move inthe same direction, so the price elasticity of supply is usually a positive number

- ES = (q / ((q + q1) / 2)) / (p / ((p + p1) / 2))

- Inelastic supply A change in price has relatively little effect on quantity supplied; thepercentage change in quantity supplied is less than the percentage change in price; the priceelasticity of supply has a value less than 1.0- Unit-elastic supply The percentage change in quantity supplied equals the percentage changein price; the price elasticity of supply equals 1.0- Elastic supply A change in price has a relatively large effect on quantity supplied; thepercentage change in quantity supplied exceeds the percentage change in price; the priceelasticity of supply exceeds 1.0- Constant-elasticity supply curves Supply curves whose elasticity does not change along thecurves

- Perfectly elastic supply curve A horizontal line reflecting a situation in which any pricedecrease drops the quantity supplied to zero; the elasticity value is infinity- Perfectly inelastic supply curve A vertical line reflecting a situation in which a price changehas no effect on the quantity supplied; the elasticity value is zero- Unit-elastic supply curve A percentage change in price causes an identical percentagechange in quantity supplied; depicted by a supply curve that is a straight line from the origin; theelasticity value equals 1.0- The elasticity of supply indicates how responsive producers are to a change in price

8/14/2019 Bryan Becher

3/3

Bryan Becher 2/3/10 EC 111

- Their response depends on how easy it is to alter quantity supplied when the pricechanges

- Just as demand becomes more elastic over time as consumers adjust to price changes, supplyalso becomes more elastic over time as producers adjust to price changes

- The longer the adjustment period under consideration, the more able producers are toadapt to a price change

- The elasticity of supply is typically greater the longer the period of adjustment- The ability to increase quantity supplied in response to a higher price differs across industries- Income elasticity of demand The percentage change in demand divided by the percentagechange in consumer income; the value is positive for normal goods and negative for inferiorgoods- Normal goods with income elasticities less than 1 are called income inelastic- Necessities often have income elasticities greater than 1- Luxuries Have income inelasticities greater than 1- Because demand is price inelastic, total revenue falls when the price falls- Cross-price elasticity of demand The percentage change in demand of one good divided bythe percentage change in the price of another good; its negative for substitutes, positive for

complements, and zero for unrelated goods- The responsiveness of the demand for one good to change in the price of another good

- If an increase in the price of one good leads to an increase in the demand for another good, theircross-price elasticity is positive

- The two goods are substitutes- If an increase in the price of one good leads to a decrease in the demand for another, theircross-price elasticity is negative

- The goods are complements- Most pairs of goods selected at random are unrelated, so their cross-price elasticity is zero- Elasticity measures the willingness and ability of buyers and sellers to alter their behavior inresponse to changes in their economic circumstances

- Firms try to estimate the price elasticity of demand for their products- Governments also have an ongoing interest in various elasticities