Elasticities Of Chapter Demand. And Supply Demand 5

CHAPTER CHECKLISTElasticities ofDemandand SupplyChapter51. Define, explain the factors that influence,and calculate the price elasticity ofdemand.2. Define, explain the factors that influence,and calculate the price elasticity of supply.3. Define and explain the factors thatinfluence the cross elasticity of demandand the income elasticity of demand.Copyright 2002 Addison WesleyLECTURE TOPICS The Price Elasticity of Demand The Price Elasticity of Supply Cross Elasticity and Income Elasticity5.1 THE PRICE ELASTICITY OF DEMANDPrice elasticity of demandA measure of the extent to which the quantitydemanded of a good changes when the price of thegood changes.To determine the price elasticity of demand, wecompare the percentage change in the quantitydemanded with the percentage change in price.1

5.1 THE PRICE ELASTICITY OF DEMAND Percentage Change in Price5.1 THE PRICE ELASTICITY OF DEMANDSuppose Starbucks cuts the price of a latte from 5 to 3 a cup. What is the percentage change in price?Suppose Starbucks raises the price of a latte from 3to 5 a cup. What is the percentage change in price?New price – Initial pricex 100Percent change in price New price – Initial priceInitial Pricex 100Percent change in price Initial Price 3 – 5 5 – 3Percent change in price x 100 – 40 percentPercent change in price x 100 66.67 percent 5 35.1 THE PRICE ELASTICITY OF DEMANDThe same price change, 2, over the same interval, 3to 5, is a different percentage change depending onwhether the price rises or falls.We need a measure of percentage change that doesnot depend on the direction of the price change.We use the average of the initial price and the newprice to measure the percentage change.5.1 THE PRICE ELASTICITY OF DEMANDThe Midpoint MethodTo calculate the percentage change in the price dividethe change in the price by the average price and thenmultiply by 100.The average price is at the midpoint between theinitial price and the new price, hence the namemidpoint method.New price – Initial pricePercent change in price x 100(New Price Initial Price) 22

5.1 THE PRICE ELASTICITY OF DEMAND Percentage Change in Quantity Demanded 3 – 5Percent change in price 5.1 THE PRICE ELASTICITY OF DEMANDx 100 50 percent( 5 3) 2The percentage change in price calculated by the midpointmethod is the same for a price rise and a price fall.If Starbucks raises the price of a latte, the quantity oflatte demanded decreases.Percent changein quantity Percent changein quantity 5.1 THE PRICE ELASTICITY OF DEMANDMinus SignWhen the price rises, the quantity demanded decreasesalong the demand curve. Price and quantity always changein opposite directions.So to compare the percentage change in the price and thepercentage change in the quantity demanded, we ignorethe minus sign and use the absolute values.New quantity – Initial quantity(New quantity Initial quantity) 2x 1005 – 15(5 15) 2x 100 – 100 Percent5.1 THE PRICE ELASTICITY OF DEMAND Elastic and Inelastic DemandElastic demandDemand is elastic if the percentage change in thequantity demanded exceeds the percentage change inprice.Unit elastic demandIf the percentage change in the quantity demandedequals the percentage change in price.3

5.1 THE PRICE ELASTICITY OF DEMANDInelastic demandIf the percentage change in the quantity demanded isless than the percentage change in price.Perfectly elastic demandWhen the quantity demanded changes by a very largepercentage in response to an almost zero percentagechange in price.Perfectly inelastic demandWhen the quantity demanded remains constant as theprice changes.5.1 THE PRICE ELASTICITY OF DEMANDFigure 5.1(b) shows anelastic demand.1. When the price of aSony Playstation risesby 10%,2. The quantity demandeddecreases by 20%.3. Demand for SonyPlaystations is elastic.5.1 THE PRICE ELASTICITY OF DEMANDFigure 5.1(a) shows aperfectly elastic demand. e price changes.10

5.2 THE PRICE ELASTICITY OF SUPPLY5.2 THE PRICE ELASTICITY OF SUPPLYFigure 5.5(a) shows perfectlyelastic supply.Figure 5.5 (b) shows anelastic supply.1. A small rise in the the price,1. A 10% rise in the priceof a book,2. Decreases the quantitysupplied by a very largeamount,2. Increases the quantitysupplied by 20%.3. Supply is perfectly elastic.5.2 THE PRICE ELASTICITY OF SUPPLY3. The supply of books iselastic.5.2 THE PRICE ELASTICITY OF SUPPLYFigure 5.5(c) shows a unitelastic supply.Figure 5.5(d) shows aninelastic supply.1. A 10 % rise in the priceof fish,1. A 20% rise in the priceof a hotel room,2. Increases the quantitysupplied of fish by 10%.2. Increases the quantitysupplied of hotel rooms by10%.3. The supply of fish is unitelastic.3. The supply of hotelrooms is inelastic.11

5.2 THE PRICE ELASTICITY OF SUPPLYFigure 5.5(e) shows aperfectly inelastic supply.1. A small rise in the price ofa beachfront lot,2. Increases the quantitysupplied by 0%.3. The supply of beachfrontlots is perfectly inelastic.5.2 THE PRICE ELASTICITY OF SUPPLYTime Elapsed Since Price ChangeAs time passes after a price change, producers find iteasier to change their production plans, so supplybecomes more elastic.Storage PossibilitiesThe supply of a storable good is highly elastic.The cost of storage is the main influence on theelasticity of supply of a storable good.5.2 THE PRICE ELASTICITY OF SUPPLY Influences on the Price Elasticity of SupplyThe two main influences are: Production possibilities Storage possibilitiesProduction PossibilitiesGoods that can be produced at a constant (or verygently rising) opportunity cost have an elastic supply.Goods that can be produced in only a fixed quantityhave a perfectly inelastic supply.5.2 THE PRICE ELASTICITY OF SUPPLY Computing the Price Elasticity of SupplyPrice elasticityof supplyPercentage change in quantity supplied Percentage change in quantity price If the price elasticity of supply is greater than 1,supply is elastic. If the price elasticity of supply equals 1, supply isunit elastic. If the price elasticity of supply is less than 1, supplyis inelastic.12

5.2 THE PRICE ELASTICITY OF SUPPLY Cross Elasticity of DemandFigure 5.6 showshow to calculatethe price elasticityof supply.Cross elasticity of demandA measure of the extent to which the demand for a goodchanges when the price of a substitute or complementchanges, other things remaining the sameBy using the formula,the price elasticity ofsupply equals 120%divided by 66.67%.Crosselasticity ofdemandThe price elasticityof supply is 1.8.5.3 CROSS ELASTICITY AND INCOME ELASTICITYSuppose that when the price of a burger falls by 10percent, the quantity of pizza demanded decreases by 5percent.Crosselasticity ofdemand5.3 CROSS ELASTICITY AND INCOME ELASTICITY – 5 percent– 10 percent 0.5 Percentage change in quantitydemanded of a goodPercentage change in the price ofone of its substitutes orcomplements5.3 CROSS ELASTICITY AND INCOME ELASTICITYThe cross elasticity of demand for a substitute is positive. A fall in the price of a substitute brings a decrease inthe quantity demanded of the good. The quantity demanded of a good and the price of itssubstitute change in the same direction.13

5.3 CROSS ELASTICITY AND INCOME ELASTICITYThe cross elasticity of demand for a complement isnegative. A fall in the price of a complement brings an increase inthe quantity demanded of the good. The quantity demanded of a good and the price of oneof its complements change in opposite directions.5.3 CROSS ELASTICITY AND INCOME ELASTICITYFigure 5.7 showscross elasticity ofdemand.Pizzas and burgers aresubstitutes. Crosselasticity is positive.Pizzas and soda arecomplements. Crosselasticity is negative.5.3 CROSS ELASTICITY AND INCOME ELASTICITY Income Elasticity of Demand5.3 CROSS ELASTICITY AND INCOME ELASTICITYFigure 5.8 shows the ranges of income elasticity of demand.Income elasticity of demandA measure of the extent to which the demand for agood changes when income changes, other thingsremaining the sameIncomeelasticity ofdemand Percentage change in quantity demandedPercentage change in income14

ChapterThe End5Copyright 2002 Addison Wesley15

5.1 THE PRICE ELASTICITY OF DEMAND Applications of Price Elasticity of Demand Farm Prices and Total Revenue Price elasticity of demand for agricultural products is 0.4. So a 1 percent decrease in the quantity harvested will lead to a 2.5 percent rise in the price. Demand is inelastic and farmers’ total revenue will increase.