CHAPTER 20

ELASTICITY of DEMAND &

SUPPLYBy: Amanda Reina

&

Sandra Avila

Three types of Elasticity Price Elasticity Cross Elasticity Income Elasticity

Price Elasticity Response of consumers and producers to

price change Price Elasticity of Demand Price Elasticity of Supply

Price Elasticity of Demand (Formulas)

Ed=

% change in quantity demanded

of product X

____________________________

% change in price of product X

Price Elasticity of Demand (Formulas)

Ed=

[change in quantity demanded of X /

original quantity demanded of X]

__________________________________

[change in price of X / original price of X]

Price Elasticity of DemandElimination of Minus Sign

Price and Quantity demanded are inversely related because of the down-sloping of the demand curve. Coefficient (first number) of demand Ed will

ALWAYS be negative (-). Take the absolute value. P

0 Q

Down-Sloping

D1

Price Elasticity of DemandExample

Ed= % change in quantity demanded of product X __________________________ % change in price of product

P↓ Qd ↑

This means that the numerator in the

formula will be positive and the denominator negative.

Price Elasticity of Demand Interpretations of Ed

Elastic Demand: Ed > 1 Inelastic Demand: Ed < 1 Unit Elasticity: Ed = 1 Perfectly Inelastic: Ed = 0

Consumers have NO response to price change (Vertical Line)

Perfectly Elastic: Ed =∞ A slight price fall causes consumers to increase their

purchases from 0 to all they can get (Horizontal Line)

Ed= % change in quantity demanded of product X __________________________ % change in price of product

Mid-Point Formula

Ed = [Change in quantity /(sum of quantities/2)]

[Change in price /(sum of prices/2)]

Graphical Analysis Demand is :

Elastic with high prices (lower quantity) Inelastic with low prices (higher quantity)

Total Revenue Test

TR = P X QP= PriceQ= Quantity

Total Revenue Test Elastic

↓P = TR↑

Inelastic ↓P = TR ↓

Example

5

4

4 5 Quantity Demanded

Price ($)

Unit Elastic

Ed = 1

Elastic

Ed > 1

Inelastic

Ed < 1

Determinants of Price Elasticity of Demand Substitutability:

Higher # of Substitute goods = greater Ed

Proportion of Income: Higher price of good relative to consumer’s income =

greater Ed

Luxuries v. Necessities: The more the good is luxury = the greater Ed is

Time: Longer time period = greater Ed

Price Elasticity of Supply Response of consumers and producers to

price change

Es = % change in quantity supplied

of product X

____________________________

% change in price of product X

Degree of Price Elasticity of Supply

How quickly and easily producers can shift resources b/w alternative uses “The longer the time, the greater the resource

“shiftability.”

Impact of time on Elasticity of Supply

Immediate market period Period that occurs immediately after a change in

market price, where it is too soon for producers to respond with a change in quantity supplied

Perfectly inelastic supply

0D1

D2

Sm

P0

Pm

Q

P

Qo

Impact of time on Elasticity of Supply Short run

Period too short to change plant capacity but long enough to use a fixed plant more or less intensively

P

Q 0D1

D2

Ss

P0

Ps

Qo Qs

**Supply more elastic than market period

Impact of time on Elasticity of Supply

Long run Period long enough for all desired adjustments to

be made

P

Q

SL

D2

D1

P0

Pl

Qo Ql

**Supply is even more elastic

Cross Elasticity of Demand Measures how sensitive consumer

purchases of product X are to a change in the price of product Y. Related products Change in income

Cross Elasticity of DemandFormula

Exy =

% change in quantity demanded

of product X

__________________________

% change in price of product Y

Cross Elasticity of Demand Substitute goods have a positive Exy

Sales of X is related to price changes of Y Beef and Chicken

Complementary goods have a negative Exy

Increase in price X = Decrease demand in Y Milk and Chocolate powder

Independent goods have zero Exy

X and Y are unrelated Candy and Books

Income Elasticity of Demand Measurement of the consumers’ response

to a change in their incomes by buying more/less goods

Ei = % change in quantity demanded

% change in income

Income Elasticity of Demand Positive Ei = Normal/ Superior Goods

Qd & I move in the same direction

Negative Ei = Inferior Goods Qd & I move in opposite direction