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# Chapter 20 elasticity of demand and supply

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### Chapter 20 elasticity of demand and supply

1. 1. ELASTICITY OF DEMAND AND SUPPLY CHAPTER 20
2. 2. Price Elasticity of Demand Activity• Do you ever wonder if a change in price affects some goods more than others?• Compare the piece of elastic with the piece of yarn; which is more “responsive” to a change in the force affecting it? Why?• Now imagine that the force is a change in price, try to decide which of the products on the next slide are more responsive to this change in price.11/5/2012 2
3. 3. Price Elasticity of Demand Activity1. Newspapers2. Beer3. Gasoline4. Shoes5. Restaurant meals6. Bread7. Filet mignon8. Cars9. Salt11/5/2012 3
4. 4. Price Elasticity of Demand Activity• This responsiveness of the quantity demanded to a change in price is called the price elasticity of demand.• What are some characteristics of the good that determine how elastic demand for it is when a change in price occurs?• Share your thoughts with your group, and then we’ll discuss this in class.11/5/2012 4
5. 5. INTRODUCTIONA. Elasticity of demand measures how much the quantity demanded changes with a given change in price of the item, change in consumer’s income, or change in price of a related product.B. Price elasticity is a concept that also relates to supply. 5
6. 6. PRICE ELASTICITY OF DEMANDA. The law of demand tell us that consumers will respond to a price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more.B. The degree of responsiveness or sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand. 6
7. 7. PRICE ELASTICITY OF DEMAND1. If consumers are relatively responsive to price changes, demand is said to be elastic.2. If consumers are relatively unresponsive to price changes, demand is said to be inelastic.3. Note that with both elastic and inelastic demand, consumers behave according to the law of demand; that is, they are responsive to price changes. The terms elastic or inelastic describe the degree of responsiveness. 7
8. 8. PRICE ELASTICITY FORMULA• 8
9. 9. PRICE ELASTICITY FORMULA1. Using the two price-quantitycombinations of a demand schedule,calculate the percent change in quantityby dividing the absolute change inquantity by one of the two originalquantities. Then calculate the percentagechange in price by dividing the absolutechange in price by one of the two originalprices. 9
10. 10. PRICE ELASTICITY FORMULA2. If we calculate the elasticityusing the other original quantity andprice, the resulting elasticity wouldbe different. To eliminate thisproblem, economists use the mid-point formula, which uses the averageof the quantities and the prices asdenominators. 10
11. 11. PRICE ELASTICITY FORMULA3. Remember: what is beingcompared are the percentagechanges not the absolute changes.That is because the absolute changesdepend on the choice of units (achange in price of a \$10,000 car by\$1 is very different from a change inprice of \$10 shirt by \$1. 11
12. 12. PRICE ELASTICITY FORMULAPercentages also make it possible tocompare elasticities of demand fordifferent products. 12
13. 13. PRICE ELASTICITY FORMULA4. Because of the inverse relationshipbetween price and quantity demanded, theactual elasticity of demand will be anegative number. However, we will ignorethe minus sign and use the absolute valueof both percentage changes. 13
14. 14. PRICE ELASTICITY FORMULA5. The Coefficient of Elasticity:• If the coefficient of elasticity of demand is a number greater than one (Ed›1), we say demand is elastic.• In other words, the quantity demanded is “relative responsive” when Ed is greater than 1, and “relatively unresponsive” when Ed is les than 1.• A special case is if the coefficient equals one, it is called unit elasticity. 14
15. 15. PRICE ELASTICITY FORMULANOTE: Inelastic demand does not meanthat consumers are completelyunresponsive. This extreme situation iscalled perfectly inelastic demand, andwould be very rare. In this case, thedemand curve would be vertical, as thequantity demanded would not change at allat any price. 15
16. 16. PRICE ELASTICITY FORMULALikewise, an elastic demand does not meanthat consumers are completely responsiveto a price change. This extreme situation,in which a small reduction in price wouldcause buyers to increase their purchasesto all that is possible to obtain, isperfectly elastic, and the demand curvewould be horizontal. 16
17. 17. PRICE ELASTICITY FORMULA• 17
18. 18. LET’S PRACTICE! PROBLEM # 1Get your calculator out!On page 359, look at table 20.1. In yournotebook, compute the elasticity betweeneach two prices, using the midpointformula. Did you get the same numbersfrom the table? Awesome! You’re readyto move on to the next problem… 18
19. 19. PROBLEM # 22. Complete the following table: PRICE QUANTITY ELASTICITY CHARACTER DEMANDED COEFFICIENT OF DEMAND \$1.00 300 - - .90 400 .80 500 .70 600 .60 700 .50 800 .40 900 19
20. 20. PROBLEM # 3a) Graph the demand schedule shown below.b) Determine the Ed between the prices.c) Where is elastic demand found?d) Where is the demand schedule inelastic? PRICE QUANTITY DEMANDED \$5 1 4 2 3 3 2 4 1 5 20
21. 21. PROBLEM # 3e) What can you conclude about the relationship between the slope of the demand curve and its elasticity? How are they different?f) Explain in a nontechnical way why demand is elastic in the northwest segment and inelastic in the southeast segment. 21
22. 22. GRAPHICAL ANALYSISA. Elasticity varies over a range ofprices:1. Demand is more elastic in the upperleft portion of the curve because whenthe initial price is high and initial quantityis low, a unit change in price is a lowpercentage while the unit change inquantity is a high percentage change. Thepercent change in quantity exceeds thepercent change in price, making demandelastic. 22
23. 23. GRAPHICAL ANALYSIS2. Demand is more inelastic in the lowerright portion of the curve because theinitial price is low and the initial quantityis high, a unit change in price is a highpercentage change while a unit change inquantity is a low percentage change. Thepercentage change in quantity is less thanthe percentage change in price, makingdemand inelastic. 23
24. 24. ELASTICITY AND SLOPEIt is impossible to judge the elasticity ofa single demand curve by its steepness orflatness, since demand elasticity canmeasure both elastic and inelastic atdifferent points on the same demandcurve. 24
25. 25. ELASTICITY AND SLOPEIt is impossible to judge the elasticity ofa single demand curve by its steepness orflatness, since demand elasticity canmeasure both elastic and inelastic atdifferent points on the same demandcurve. 25
26. 26. PART 2:TOTAL REVENUE AND ELASTICITY 26
27. 27. THE TOTAL-REVENUE TESTThe total-revenue test is the easiest wayto judge whether demand is inelastic orelastic. This test can be used in place ofthe elasticity formula, unless there is aneed to determine the elasticitycoefficient.1. Elastic demand and the total-revenue test:Demand is elastic if a decrease in price resultsin a rise in total revenue, or if an increase inprice results in a decline in total revenue (priceand revenue move in different directions-indirectly related). 27
28. 28. THE TOTAL-REVENUE TEST2. Inelastic demand and the total-revenue test: Demand is inelastic if a decrease in price results in a fall in total revenue, or if an increase in price results in a rise in total revenue (price and revenue move in the same direction-directly related).3. Unit elasticity and the total revenue test: Demand has unit elasticity if total revenue does not change when the price changes. 28
29. 29. THE TOTAL-REVENUE TEST4. See the graphical representation of therelationship between the relationship betweentotal revenue and price elasticity shown in thedata from the table on page 359 and the Figure20.2 on page 360.5. Table 20.2 on page 362 shows the summaryof the rules and concepts related to elasticityof demand. 29
30. 30. DETERMINANTS OF ELASTICITYThere are several determinants of theprice elasticity of demand.1. Substitutes for the product: Generally, the more substitutes for the products, the more elastic the demand.2. The proportion of price relative to income: Generally, the larger the expenditure is relative to one’s budget, the more elastic the demand, because buyers notice the change in price more.30
31. 31. DETERMINANTS OF ELASTICITY3. Whether the product is a necessity or a luxury: Generally, the less necessary the item, the more elastic the demand.4. The amount of time involved: Generally, the longer the time period involved, the more elastic the demand becomes. 31
32. 32. DETERMINANTS OF ELASTICITYSee the table 20.3 from page 363, whichpresents some real-world elasticities.Use the determinants and to see if theactual elasticities are equivalent to whatyou would predict, based on thecharacteristics of the good. Discuss yourthoughts with your neighbors. 32
33. 33. APPLICATIONS OF ELASTICITYThere are many practical applications ofelasticity:1. Inelastic demand for agricultural products help explain why bumper crops depress the prices and total revenues for farmers. 33
34. 34. APPLICATIONS OF ELASTICITY2. Government looks at elasticity of demand when levying excise taxes. Excise taxes on products with inelastic demand will raise the most revenue (in taxes) and have the least impact on quantity demanded for those products. 34
35. 35. APPLICATIONS OF ELASTICITY3. Demand for cocaine is highly inelastic and presents problems for law enforcement. Stricter enforcement reduces supply, raises prices and revenues for sellers, and provides more incentives for sellers to remain in business. Crime may also increase as buyers have to find more money to buy their drugs. 35
36. 36. APPLICATIONS OF ELASTICITYa. Opponents of legalization think that occasional users or “dabblers” have a more elastic demand and would increase their use at lower, legal prices.b. Removal of the legal prohibitions might make drug use more socially acceptable and shift demand to the right.4. The impact of minimum-wage laws will be less harmful to employment if the demand for minimum-wage workers is inelastic. 36
37. 37. PART 3:PRICE ELASTICITY OF SUPPLY 37
38. 38. PRICE ELASTICITY OF SUPPLY• 38
39. 39. PRICE ELASTICITY OF SUPPLYB. The time period involved is very important in price elasticity of supply because it will determine how much flexibility a product has to adjust his/her resources to a change in the price. The degree of flexibility, and therefore the time period, will be different in different industries. 39
40. 40. PRICE ELASTICITY OF SUPPLY1. The market period is so short that elasticity of supply is inelastic; it could be almost perfectly inelastic or vertical. In this situation, it is virtually impossible for producers to adjust their resources and change the quantity supplied (for example, think of adjustments on a farm once the crop has been planted). 40
41. 41. PRICE ELASTICITY OF SUPPLY2. The short-run supply elasticity is more elastic than the market period and will depend on the ability of producers to respond to price change. Industrial producers are able to make some output changes by having workers work overtime or by bringing on an extra shift. 41
42. 42. PRICE ELASTICITY OF SUPPLY3. The long-run supply elasticity is the most elastic, because more adjustments can be made over time and quantity can be changes more relative to a small change in price. The producer has time to build a new plant. 42
43. 43. CROSS ELASTICITY OF DEMAND• 43
44. 44. INCOME ELASTICITY OF DEMAND• 44