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CONTEXT and PURPOSE
Supply and demand analysis show how market equilibrium price and
quantity are determined. It also predicts the direction of change
when one of the variables changes. The concept of elasticity more
precisely reports the magnitudes of these changes. The elasticity
measures are a way to quantify the direction and size of changing
equilibrium price and quantity.
LEARNING OBJECTIVES
From this chapter, students should:
- know the meaning of elasticity of demand;
- learn the determinants of demand elasticity;
- know the meaning of elasticity of supply;
- learn the determinants of supply elasticity; and
- be able to apply the elasticity concept to different
situations.
LECTURE NOTES and TEACHING TIPS
1. Elasticity of Demand
The law of demand tells us that people will want to buy fewer
units of a good when its price goes up. However, as stated, the
law of demand does NOT tell us whether people want to buy a lot
less or just a little less of the good. In order to get a precise
measure of consumers' reactions to price changes, we use the concept
of price elasticity of demand.
As a starting point, consider two "extreme" possibilities.
The first case we can think of as an exception to the law of demand.
Assume that regardless of price, people will always want to buy
the same quantity of a good, say, 1000 units. Mathematically we
can see that for a given change in price the quantity demanded
will always be 1000. For any change in price, the percentage change
in quantity demanded will always be zero. In this case we say
demand is perfectly inelastic, and the demand curve would
be vertical (see Figure 5-1). At the other extreme is a demand
curve in which consumer response is "infinite." In this
case a very small change in price will result in a very large
change in quantity demanded and demand would be perfectly elastic.
Such a demand schedule would be horizontal (see Figure 5-1).
If consumers are highly sensitive or responsive to price changes
- that is, if they purchase a lot more of the good if its price
decreases or purchase a lot less of the good if its price increases
- then we say that demand is elastic. On the other hand,
if consumers are relatively unresponsive to price changes - that
is, if they purchase only a little more or a little less as a
result of a price decrease or increase - then we say that demand
is inelastic. (See Figure 5-2)
2. Determinants of Price Elasticity of Demand
Demand tends to be more elastic:
- 1. if the good is a luxury;
- 2. the longer the time period;
- 3. the greater the number of close substitutes; and
- 4. the more narrowly defined the market.
Demand tends to more inelastic:
- 1. if the good is a necessity;
- 2. the shorter the adjustment time;
- 3. if there are few good substitutes; and
- 4. the more broadly defined the market.
To show clearly the differences between relatively elastic
and inelastic demand schedules and the determinants of price elasticity
of demand consider using a graph such as Figure 5-2.
FIGURE 5-2
3. Computing the Elasticity Coefficient
In words, price elasticity of demand tells us numerically
how responsive buyers are to price changes. It does so by reporting
the ratio of the percentage change in quantity demanded to
the percentage change in the price of the good. That is:
% change in QD (quantity demanded)
EDD =
% change in P (price)
where ED is the price elasticity of demand coefficient
(number).
The percentage change in quantity demanded is the absolute change
in quantity divided by the beginning value of the two quantities.
The percentage change in price is calculated similarly - the change
in price divided by the beginning price. Once we know these percentage
changes, we divide the percentage change in quantity demanded
by the percentage change in price. The result is a number or coefficient
between zero and infinity.
To be compatible with the text, be sure to use the mid-point
method of calculating percentage changes. Also make it clear to
the students it is not enough to judge elasticity by looking only
at the slope of a demand schedule. Elasticity depends upon relative
percentage changes in the variables.
As can be seen from the formula, if consumer response is great,
the percentage change in quantity demanded (the numerator) will
be large relative to the percentage change in price (the denominator).
Whenever the demand elasticity coefficient is greater than
one, we say that demand is elastic. And the larger
the number, the more elastic (responsive) is demand. On the other
hand, if the coefficient is less than one, we say that
demand is inelastic. In this case, the smaller the number,
the more inelastic (unresponsive) is demand.
4. Sellers' Revenue (Consumer Expenditures) and the Price Elasticity
of Demand
Knowing demand elasticities for a good can help students make
some useful predictions about reactions to market changes. Ask
them toconsider the following. If a firm raises its price, it
may or may not increase its revenues from the sale of the good.
Why? The change in total consumer expenditures on a good is the
product of price times quantity. A price increase, by itself,
will tend to cause spending on the good to increase. However,
at the same time, consumers will buy (suppliers will sell) fewer
units of the good, which tends to cause spending (revenue) to
decrease.
If we know the elasticity of demand, it is easy to predict which
way revenue (spending) will change when price changes. The relationship
is as follows:
- if demand is elastic (ED >1), a price increase
will cause total spending (revenue) to decline, while a price
decrease will cause total spending (revenue) to go up.
- if demand is inelastic (ED <1), a price increase
will cause total spending (revenue) to increase, while a price
decrease will cause total spending (revenue) to decrease.
- if demand is unitary elastic (ED =1), a price change
will leave total spending (revenue) unchanged.
Knowing the demand and supply elasticities will allow us to predict
the relative magnitudes of price changes caused by a change in
market demand or supply. If demand is inelastic, a given change
in supply will cause market price to change a lot. If demand is
elastic, a given change in supply will cause market price to change
only a little.
5. Income Elasticity of Demand
Just as a change in price will cause consumers to purchase more
or less of a good, so too does a change in consumer income. How
responsive consumer purchases are to income changes is measured
by the income elasticity of demand coefficient. In words,
the income elasticity of demand is the percentage change in quantity
purchased divided by the percentage change in income. That is,
% change in Q (quantity purchased)
YDD =
% change in Y (income)
where YD is the income elasticity of demand
coefficient (number).
For most goods, changes in income and changes in quantities purchased
are directly (positively) related such that the coefficient has
a value greater than zero. We call these normal goods.
In other instances, for various reasons, people purchase less
of some goods as their incomes increase. These are called inferior
goods, and they have a negative coefficient. Possible
examples include bus travel, most store-brand or generic labels,
and retreaded tires.
6. Elasticity of supply
Supply elasticity is very similar to demand elasticity. In the
extreme cases of no supply response and an infinite response,
the schedules are vertical and horizontal, respectively. A vertical
supply curve is called perfectly inelastic and a horizontal
supply curve is called perfectly elastic. Since a perfectly
inelastic supply curve has no quantity response to a price change,
it has a coefficient of zero. A perfectly elastic supply curve
has an elasticity coefficient of infinity. The formula is similar
to demand elasticity, but becomes:
% change in QS (quantity supplied)
ES =
% change in P (price)
where ES is the price elasticity of supply coefficient
(number).
The "in between cases" of supply are also very similar
to price elasticity of demand. If quantity supplied is not
very responsive to a price change, the coefficient will have
a value between zero and one and is inelastic. If quantity
supplied is highly responsive to a price change, the coefficient
will have a value greater than one and is said to be elastic.
Of course, we use the same mathematical technique to calculate
percentage changes in quantity supplied and price.
In most markets the primary determinants of supply elasticity
are the time period under consideration and ability of resources
to move into and out of various applications. Over the long run,
supply tends to become more elastic as new firms can enter the
market. Possible examples include compact discs, VHS tapes,
computer RAM chips, and some professions like law and medicine.
7. Applications of Supply, Demand, and Elasticity
% change in Qd = 20% (400/2000)
% change in P = 40% ($1.60/$4.00)
ED = .5 (inelastic)
Total Revenue SA = $4.00 x 2000 = $8000
Total Revenue SB = $2.60 x 2400 = $5760
In the case of a technological improvement that causes an increase
in supply, if market demand is inelastic, the new equilibrium
will result in a larger quantity sold but a decrease in total
seller revenues. This is what has happened over the past two centuries
in the U.S. and has caused a decrease in farm employment.
In the short run, the demand for oil is inelastic such that a
relatively small decrease in supply (5 percent) will lead to a
large increase in price (100 percent). Over the long run, demand
becomes more elastic forcing market price back down.
An application on illicit drug enforcement policies illustrates
how a decrease in supply (successful interdiction) causes price
to increase to such a degree that total spending on legal drugs
will be greater than before. If drug users finance their habits
by stealing, such a price increase will cause an increase in other
illegal and presumably more dangerous criminal activity. On the
other hand, successful efforts to discourage drug use will cause
a decrease in market demand and thereby lower the street price
of drugs.
CHAPTER SUMMARY
- Price elasticity of demand measures how responsive
quantity demanded is to a price change. Demand tends to be more
elastic the longer the time period, the more narrowly defined
the market, the more substitutes are available, and when the goods
are not very vital.
- The numerical value of the demand elasticity coefficient
is calculated as the percentage change in quantity demanded divided
by the percentage change in price. Demand is inelastic
if the coefficient is less than one, elastic if greater
than one, and unitary elastic if equal to one.
- If demand is inelastic, sellers revenue (consumers
expenditures) increase as price rises. If demand is elastic,
revenue falls as prices increases.
- Income elasticity of demand is the percentage change
in quantity purchased divided by (caused by) a given change in
consumer income. For a normal good, the coefficient is
positive; for an inferior good, the coefficient is negative.
- Price elasticity of supply measures how responsive
quantity supplied is to a price change. Supply is more responsive
the longer the time period under consideration and the easier
it is for resources to flow into and out of various product markets.
- The numerical value of the supply elasticity coefficient
is calculated as the percentage change in quantity supplied divided
by the percentage change in price.
- Demand and supply analysis can be applied to various
markets. It is most applicable to markets in which there are notable
changes in supply and/or demand.
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