Elasticity

Dr. Katherine Sauer Principles of Microeconomics

I. Evaluating Elasticity

A. Rules for Evaluating Price Elasticity of Demand When d > 1, we say demand is ELASTIC - large change in Qd in response to a price change When d=1, we say demand is UNIT ELASTIC - proportional change in Qd in response to a price change When d <1, we say demand is INELASTIC - small change in Qd in response to a price change

Extreme Cases: There are some goods that no matter what the price is, consumers demand the same quantity. perfectly inelastic demand d=0 There are some goods that when the price changes even a little, consumers completely change their buying behavior. perfectly elastic demand d=

Examples of estimated price elasticities:

B. Rules for Evaluating Price Elasticity of Supply When s > 1, we say supply is ELASTIC - large change in Qs in response to a price change When s=1, we say supply is UNIT ELASTIC - proportional change in Qs in response to a price change When s <1, we say supply is INELASTIC - small change in Qs in response to a price change

Extreme Cases: There are some goods that no matter what the price is, there is only a fixed quantity. perfectly inelastic supply d=0 There are some goods that when the price changes even a little, producers completely change the quantity. perfectly elastic supply d= Note: firms often have capacity constraints. That is, they may be elastic at low levels of production and then very inelastic at high levels of production.

Ex: Consider the milk industry. - in the short run a farmer has a certain size of dairy and number of cows - in the long run, the farmer could expand the herd and size of the dairy It is estimated that a 10% increase in the selling price of milk will result in a 1.2% increase in quantity supplied in the short run. 25% increase in quantity supplied in the long run. Short Run s=?
s= 1.2 % / 10% = 0.12 inelastic supply

Long Run s=?

s= 25 % / 10% = 2.5 elastic supply

C. Rules for Evaluating Income Elasticity I > 0 normal good

I

<0

inferior good

Necessities have small income elasticities. Luxuries have large income elasticities.

D. Rules for Evaluating Cross Price Elasticity 1,2 > 0 substitutes 1,2 < 0 complements 1,2 = 0 not related

Go back to the worksheet and evaluate each elasticity.

II. Elasticity Graphically

A. Demand Inelastic Demand

price price

Elastic Demand

P1 P2

P1 P2

D
Q1 Q2

quantity

Q1

quantity

Q2

small change in quantity

large change in quantity

Perfectly Inelastic Demand

price price

Perfectly Elastic Demand

D =0
P2 P1

P2 P1

= D

Q1

quantity

Q2

Q1

quantity

no change in quantity

total change in quantity

B. Supply Inelastic Supply

price

Elastic Supply
price

S
P2 P1 P2 P1

Q1 Q2

quantity

Q1

Q2

quantity

small change in quantity

large change in quantity

Perfectly Inelastic Supply

price price

Perfectly Elastic Supply

S =0
P2 P1

P2 P1

= S

Q1

quantity

Q2

Q1

quantity

no change in quantity

total change in quantity

C. Applications: Supply, Demand, and Elasticity

Example 1: The demand for basic food commodities (e.g. wheat, corn) tends to be fairly inelastic. The supply of such commodities is fairly inelastic as well.
price S

D
Q

quantity

Suppose a new hybrid of wheat is developed that is more productive than those used in the past. What happens? - supply increases, price falls, and quantity rises - because demand is inelastic, the change in quantity demanded is less than the change in price price S S2 Farmers receive a lower price, but only sell a little more. Revenue for farmers falls.

P P2

D
Q Q2

quantity

Example 2: The demand and supply of oil tend to both be fairly inelastic in the short run. They tend to both be more elastic in the long run. In the 1970s and 1980s, OPEC restricted the supply of oil in order to increase prices (and revenues). S2 S price Because demand for oil is inelastic, even though the P2 price increased, quantity P only fell a little. Revenues for OPEC increased. D
Q2 Q

quantity

Over the long run, consumers switched to more fuel efficient cars and carpooled. Non-OPEC oil producers respond to the higher price of oil and increase drilling. When OPEC decreases supply, the effect on quantity is much more dramatic. S2 price S
P2 P

When demand is elastic, revenues for OPEC decrease when supply is reduced.

Q2

quantity

Example 3: The war on drugs: reducing supply vs reducing demand The demand for illegal drugs tends to be somewhat inelastic relative to supply . When the government focuses on
price S2

S
P2 P1

decreasing the supply of drugs entering the nation: - supply falls - price rises - quantity demanded falls, but not much The higher price often leads to higher crime.

D
Q2 Q1

Also, higher revenues for drug suppliers.

quantity

When the government instead pursues better drug education, the demand for drugs falls. The price and quantity will fall.
price

Also, revenues for drug suppliers will fall.

S

P1 P2

D2
Q2 Q1

D quantity

III. Elasticity and a Firms Revenue

On a linear demand curve, the elasticity changes as you move down the curve. - the slope is constant - the elasticity changes

price

ELASTIC

UNIT ELASTIC

INELASTIC D
quantity

The Price Elasticity of Demand Affects a Firms Revenue Total Revenue (TR) = Price x Quantity Sold Recall that for consumers, quantity is inversely related to price. When a firm raises prices, the quantity sold falls. When a firm lowers prices, the quantity sold rises. - elasticity tells us how much quantity rises or falls

If demand is elastic ( d > 1), consumers are quite responsive to a price change: - an increase in price by 5% will reduce quantity by more than 5% - total revenue will fall when price is increased

If demand is inelastic ( d < 1), consumers are not very responsive to a price change: - an increase in price by 5% will reduce quantity by less than 5% - total revenue will rise when price is increased

If demand is unit elastic ( d = 1), consumers have a proportional response to a price change: - an increase in price by 5% will reduce quantity by exactly 5% - total revenue will be unchanged when price is increased

Information on price elasticity of demand is very useful for businesses.