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# Agri 2312 chapter 5 supplement

## by Rita Conley, Instructor at University of Arkansas at Pine Bluff on Oct 17, 2011

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Elasticity of Demand

Elasticity of Demand

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## Agri 2312 chapter 5 supplementPresentation Transcript

• chapter nine: The Concept of Elasticity part two: microeconomics
• Consumers will accept an increase in the price of a given product without too much reaction.
• But an increase in the price of another good will be met with stubborn resistance and a refusal to purchase.
• A strong price increase for some commodities will induce large numbers of producers to increase production.
• And further interest of others in becoming producers.
• Still other products will absorb a price increase with little reaction on the part of producers.
• A third situation is that an increase in consumer income will be associated with a reduction in the use of one commodity, an increase in the use of another, and no change in the use of a third.
• A measure of the sensitivity of consumers and producers to changes in prices and incomes is known as elasticity .
• It deals with the sensitivity of the quantity demanded, or quantity supplied to changes in some other factor.
• Through the use of elasticity estimates, managers can anticipate the probable magnitude of market impact of various sorts of changes.
• While the number of elasticities is almost limitless, four fundamental elasticity concepts—demand, supply, cross-price, and income—can be used to characterize any given market.
• ELASTICITY OF DEMAND
• We define elasticity of demand as responsiveness of the quantity demanded to a change in the price.
• Degree of responsiveness is measured by an elasticity coefficient — frequently called elasticities.
• ELASTICITY OF DEMAND
• We define the elasticity coefficient to be:
If the rate of change of the quantity demanded is greater than the rate of change in price, we say the demand relationship is elastic . If the rate of change of quantity is less than the rate of change of price, the relationship is said to be inelastic . If demand for a good is elastic, then we know that consumers are very responsive to price changes.
• ELASTICITY OF DEMAND
• The concept of elasticity, and elasticity coefficients has a lot to do with rates of change.
• As you move along a demand curve, both price & quantity are changing simultaneously.
• We measure the elasticity of demand coefficient by dividing rate of change in the quantity demanded by rate of change in price for a small segment, or arc, along a given demand curve.
• ELASTICITY OF DEMAND Algebraically, the relationship may be expressed as: The mathematical symbol Δ (delta) means “change in.” This algebraic formulation is shown geometrically at left.
• ELASTICITY OF DEMAND The calculation of the elasticity of demand with respect to price for a move from point A to point B:
• ELASTICITY OF DEMAND Elasticity of demand coefficient for a move from point B to point A.
• ELASTICITY OF DEMAND We can modify our basic elasticity formula to eliminate the discrepancy arising from selecting either of the two endpoints of the arc as the initial situation.
• ELASTICITY OF DEMAND The calculation for our example.
• ELASTICITY OF DEMAND If the value of the demand elasticity coefficient is between zero and -1 then demand is inelastic . If the value of the coefficient is less than -1, or absolute value is greater than 1), demand is elastic . If the elasticity coefficient should be exactly equal to -1 elasticity is said to be unitary .
• ELASTICITY OF DEMAND
• Demand curves often exhibit all three ranges of elasticity in a single curve.
• Always true when a demand curve is a straight line.
Straight line demand curves are elastic with respect to price at relatively high prices, and inelastic at relatively low prices.
• ELASTICITY OF DEMAND
• Both elastic & inelastic ranges can occur in a single demand curve.
• As consumers pass from the elastic to the inelastic range, they must pass through a point (or range) of unitary elasticity.
For a straight line demand curve, as shown, this always occurs at the midpoint on the quantity axis, between the origin & where the demand curve hits the horizontal axis.
• ELASTICITY OF DEMAND - Some Special Cases
• Two extreme cases of elasticity of demand:
• Cases in which the elasticity coefficient is equal to zero (or perfectly inelastic ) at all points on the function.
• ELASTICITY OF DEMAND - Some Special Cases The same quantity will be demanded no matter what the price happens to be. The demand function is perfectly vertical. Largely theoretical, but the demand for an item that normally represents a small part of the total budget and is an absolute necessity — such as table salt, or insulin — will approach this situation.
• ELASTICITY OF DEMAND - Some Special Cases
• Two extreme cases of elasticity of demand:
• Cases in which the elasticity coefficient is infinite (or perfectly elastic ) at all points of the function.
• ELASTICITY OF DEMAND - Some Special Cases The manager cannot affect price received, no matter how much is sold. The market will absorb any quantity offered at the prevailing price. This approximates the conditions under which most farmers sell their products, thus, perfectly elastic demand is an important concept in the area of agricultural microeconomics.
• Elasticity of Demand Related to Total Revenue
• Elasticity of demand for a good & total revenues of a firm producing it are very much interrelated.
• Movement along a demand curve, left to right, will result in an increase in quantity consumed.
• And a decrease in the price per unit.
• As total revenue of the firm is equal to price times quantity, total revenue depends on whether quantity increases at a faster rate than price decreases.
• The demand elasticity coefficient tells us what will happen to total revenue as price & quantity change together.
• Elasticity of Demand Related to Total Revenue Price reductions in the elastic range of the demand curve are associated with increases in the total revenue.
• Elasticity of Demand Related to Total Revenue Price reductions in the inelastic range are associated with reductions in total revenue.
• Elasticity of Demand Related to Total Revenue When elasticity is unitary, total revenue is at its maximum, as shown here, graphically. That portion of a straight line demand curve which lies to the left of the midpoint is elastic with respect to price. The portion to the right of the midpoint is inelastic. At the midpoint, demand is unitarily elastic.
• Factors Affecting Demand Elasticity
• What are the characteristics of goods that determine whether demand is elastic or inelastic?
• In general, price elasticity of demand for any product will be more elastic as the number of substitutes is greater.
• Demand elasticity is normally more elastic if expenditure on the product represents a large item in the consumer’s total budget.
• Demand is likely more elastic for luxuries as opposed to necessities, since consumers can do without luxuries.
• Factors Affecting Elasticity - Substitutes
• Demand for goods with lots of substitutes tends to be elastic.
• As the price of one good goes up, ceteris paribus , the consumer will easily shift to substitute goods.
• Consumption of the good with the price increase will fall substantially.
• Demand for goods with few close substitutes tends to be inelastic.
• A good for which there are no viable substitutes is insulin, and, as a result, the demand for insulin is very inelastic.
• A good way to remember what is elastic and inelastic— INsulin is INelastic.
• Factors Affecting Elasticity - Budget Importance
• Elasticity of demand for items very important in the family budget — like a car or house — tends to be very elastic, indicating consumers are very price sensitive.
• By comparison, demand for items that are a small part of the budget is frequently inelastic.
• Goods in the latter category are frequently called impulse items as we buy then on the basis of a sudden impulse rather than on the basis of price.
• These items — lip balm, comb, fingernail file, replacement screws for eyeglasses — are usually located on displays by the checkout counter.
• Factors Affecting Elasticity - Luxury vs. Necessity
• Elasticity of demand for luxury goods is very elastic while, that of necessities tends to be inelastic.
• The family shopping for a summer vacation seeks different transportation alternatives and hotel deals.
• They are price sensitive, which means demand is elastic.
• The insulin consumer, or homeowner needing a drain unplugged are quite price insensitive or inelastic in their demand.
• B oth need something, as opposed to wanting something .
• Factors Affecting Elasticity - Luxury vs. Necessity
• Numerous other factors affect demand elasticity:
• Consumers are creatures of habit, only altering their customary patterns of consumption in response to price changes, over a period of time.
• Demand tends to be more elastic as the length of the time period in question is extended.
• Durability of some products will affect the elasticity of demand for them —r epairing older durable goods can be a good substitute for buying a new model.
• Culture and tradition can affect demand elasticity.
• In late November, U.S. demand for turkey becomes highly inelastic due to the Thanksgiving tradition, while the other 51 weeks of the year, demand may be quite elastic as there are numerous substitutes.
• CROSS-PRICE ELASTICITY
• The Cross-price elasticity coefficient measures adjustments consumers make in their consumption of one product in response to a change in the price of another.
• It measures the extent to which the demands for various commodities are related.
• CROSS-PRICE ELASTICITY Shown here is the relationship of quantities of sausage that consumers will consume and alternative prices for sausage, ceteris paribus. An important ceteris paribus condition for the sausage market is the price of bacon. The sausage demand curve shown in black is drawn for a bacon price of \$2.00/lb, and labeled B = 2.
• CROSS-PRICE ELASTICITY What would happen in the sausage market if the price of bacon rose to \$3.00/lb? Consumers would substitute sausage for bacon in their morning diet, consuming a larger quantity of sausage at every sausage price. This would result in a demand shift in the sausage market, caused by the price change in bacon. The new demand curve is shown in blue and is labeled B = 3
• CROSS-PRICE ELASTICITY For any given sausage price of sausage, such as P s , the sausage quantity demanded has increased from Q 2 to Q 3 . The amount of increased sausage consumptions associated with an increase in the price of bacon is measured with a cross-price elasticity coefficient.
• CROSS-PRICE ELASTICITY To examine consumption of beef as the price of pork is changed, divide the rate of change in the quantity of beef purchased by the rate of change in the price of pork: … which may be modified into an operational form, using midpoints:
• CROSS-PRICE ELASTICITY
• When two commodities are substitutes for each other, the algebraic sign of the cross-price elasticity coefficient will be positive.
• If the price of one increases, the quantity of the other commodity purchased will also increase.
• Commodities that are complementary to each other have negative cross-price elasticity coefficients.
• Dress shirts and neckties serve as an illustration.
• The cross-price elasticity between the price of one product and the consumption of another may be quite different when the direction is reversed.
• INCOME ELASTICITY
• An income elasticity coefficient shows the extent to which consumers alter their purchases of any good as a result of changes in income.
• With slight alterations, our basic elasticity formula can be used to define an income elasticity coefficient:
… modified into the standard midpoint formula:
• INCOME ELASTICITY
• Normally, we expect the algebraic sign of the income elasticity coefficient to be positive.
• As a consumer has more income, his consumption of the good in question will increase.
• Such goods are called normal goods .
• There are a limited number of goods—lard, for example—that exhibit negative income elasticities.
• As consumers’ incomes rise, they tend to reduce their consumption of these inferior goods .
• If they can afford to substitute vegetable shortening for hog lard, they will do so.
• INCOME ELASTICITY
• If the income elasticity of demand for a particular good is 0.0, demand for that good is not affected by changes in income.
• Normally the case for items such as salt and other condiments that are an insignificant part of the budget.
• If income elasticity of demand is greater than 1.0, an increasing proportion of consumer income is spent on the good, as income increases.
• Examples are protein sources among the poor in developing countries.
• Numerous studies have found the income elasticity of demand for milk among the poor to be well above 1.0.
• INCOME ELASTICITY
• Most goods have an income elasticity of less than 1.0, meaning that the proportion of income spent on the good falls as the consumer becomes richer.
• Most foods in developed countries fall into this category.
• ELASTICITY OF SUPPLY
• The idea of elasticity of supply is almost identical with the concept of elasticity of demand.
• The formula is identical, but where the algebraic sign of the elasticity of demand coefficient is normally negative, that of the elasticity of supply coefficient is generally positive.
• Since quantity supplied increases as price increases, the supply function slopes upward, to the right, with a positive slope.
• Hence the positive elasticity of supply coefficient with respect to price.
• PRICE DISCRIMINATION
• When a firm produces a product sold in two different markets, with different demand elasticities, the firm can probably increase revenues by engaging in price discrimination .
• Charging different prices in the two different markets.
• An example in the food industry is a vegetable packer that can sell vegetables in either the fresh market (inelastic demand) or the frozen market (elastic demand).
• Another example is a producer of tomato sauce sells it either as a branded product (inelastic demand) or as a generic (elastic demand).
• END