Elasticities of Demand and Supply

CHAPTER 7

Elasticities of Demand and Supply

-Describing the responsive of the quantity demanded of a good or service to a small change in the price.

e.g. 10% Price cut on McDonald’s hamburger

the amount of money spent on McDonald’s hamburgers is likely to be greater after the 10% price cut.

Formula for measuring the P-elasticity of Demand

% Qd

Ed = ------

Ed - Elasticity of Demand

Qd – Change in quantity demanded

P - Change in Price

Example 1:

What is elasticity of the Demand if a business firm increases the price of one of its products by 10% and finds that the quantity sold drops by 20%?

Ed = % Qd / %P

% Qd = 20%

%P = 10 %

Ed = 20 % / 10 % = 2  answer

Example 2:

If the elasticity of demand for a firm’s product is 1.6, what will happen if the price is reduced by 10%?

% Qd

Ed = ------therefore %Qd = Ed x %P

% Qd = ??

%P = 10 %

Ed = 1.6 x 10 = 16%

Answer: The quantity sold will increase by 16%

Example 3:

If the elasticity of demand for a firm's product is 1.2, what reduction in price will be necessary to increase the quantity sold by 20%?

1.2= 20% / %P

%P = 20% / 1.2 = 16.7 %

Answer: The price is reduced by 16.7%.

Example 4:

If the elasticity of the Demand is 0.5, what will happen if the price is increased by 10%?

Ed = % Qd / %P

% Qd = ??? = n

%P = 10 %

Ed = 0.5

0.5 = n / 10 %

n = 0.5 x 10% = 5%

% Qd = 5% decreases

Another formula

Qd / Avg Qd

Price elasticity of demand = P / Avg P

Relationship between Price-Elasticity of Demand and Total Revenue

Total Revenue = Price per Quantity x number of Quantity sold

TR = P x Q

Types of Price-Elasticity

3 main types

i)Elastic

ii)Inelastic

iii)Unitary elasticity

Elastic Demand

a)Ed > 1

b)If a reduction in the price of a good caused a larger corresponding increase in the quantity demanded.

P  more proportionate Qd.

c)Demand curve is flatter.

d)P  Change in TR

Price Elastic Demand

5 D

100200

Quantity

Perfectly Elastic Demand Curve

P D

Demand curve is horizontally straight

The price elasticity = Ed = infinity ()

Inelastic Demand

a)Ed < 1

b)The price increase of a good met by less than corresponding increase in quantity demanded.

P  less proportionate Qd.

c)Demand Curve is very Steep

d)P  Change in TR

Price Inelastic Demand

5 D

200

Quantity

Perfectly Inelastic

-Straight vertical line

-Ed = 0

Unitary Elasticity Demand (Unit-Elastic Demand)

-Ed = 1

-The price increase of a good met by corresponding increase in quantity Supplied.

-P  TR unchanged

-Curve is not steep or flatter

Price Unit-Elastic Demand

5 D

200 250

Quantity

Example

A business is selling 10,000 units of each of two products, A and B, at a price of $5.00 each, for total revenue for each product of $50,000. Manager B believes the firm would be better off by raising the price of each of the two products to $6.00.

In fact, the elasticity of demand for each product is different:

For A, it is 2.0

For B, it is 0.5

What would happen to the total revenue from each product, if Manager B has his way?

1)First find % change in price and quantity demanded

2)Then find the TR for each products

% Change in Price = [ (Higher Price / Smaller Price x 100% ] – 100%

Higher Price = $6

Smaller Price = $5

% Change in Price = [6 / 5 x 100%] – 100%

= 20%  increased

% Change in Quantity demanded???

% Qd

Ed = ------therefore %Qd = Ed x %P

Product A

Ed = 2 and %P

%Qd = Ed x %P

= 2 x 20%

= 40%  decreased

Sold 10,000 x (100% - 40%) = 6000 units

TR = P x Q

= $6 X 6000

= $ 36,000  decreased

P  Change in TR  Elastic Demand

Product B

Ed = 0.5 and %P

%Qd = Ed x %P

= 0.5 x 20%

= 10 %  decreased

Sold 10,000 x (100% - 10%) = 9000 units

TR = P x Q

= $6 x 9000

= $ 54,000  increased

P  Change in TR  Inelastic Demand

Some other factors should we take into account in determining whether the firm will be better or worse off. It depends on basis of its price elasticity.

Factors that Affects Price Elasticity of Demand

4 factors

i)Portion of consumer Income

-If the price of a product is a hefty portion of consumer incomes, consumer will be more responsive to price changes.

-E.g. whether or not to buy a stereo; a price change can determine whether they make the purchase.

-(Price is cut in half  Qd. Higher percentage, but sugar to buy pays little attention to price.

ii)Access to Substitute

-If there are many close substitutes for a product, consumers will be more responsive to changes in the product’s price, because they have more options and can easily change their buying patterns.

-E.g. Particular brand of athletic shoes has more elastic demand than the athletic shoes in general.

iii)Necessities Versus Luxuries

-Bread and milk  basic needs rather than wants. Consumers tend to buy similar amounts of necessities regardless of their price.

-Necessities  inelastic demand.

-Luxuries, tourist travel, expensive sports cars can live easily without it  elastic demand

iv)Time

-Demand tends to become elastic over time.

-In short run  consumers do not generally respond greatly to price. E.g. immediately after a price increase, eaters of nachos will not modify their buying habits. Over time, however, consumers change their habits and needs.

Supply elasticity

Measures the responsiveness of producers (and the quantity they supply) to changes in the products’ own price.

Formulas

Qs / Avg Qs

Price elasticity of Supply = P / Avg P

% Qs

Es = ------

3 types of Elasticity

Elastic supply
Inelastic supply
Unitary Elasticity

Price S

Q 100 300 Q Q Q

Elastic Supply

Increase in the price of a good or service leads to a larger percentage change in quantity supplied.

- in other words, the quantity that producers are willing to offer for a sale is very responsive to price change.

Es > 1
Higher the Es, the greater the elasticity is.

Perfectly Elastic supply

Producers are willing to supply as much of the good as is required at the existing price.
Horizontal Supply curve
Es = infinity (very large)

Inelastic Supply

% Change in price results in a smaller % change in quantity supplied.

-in other words, the quantity that producers are willing to offer for a sale is less responsive to price change.

Es <1

Smaller Es, the more Inelasticity is.

Perfectly Inelastic supply

-Producers will supply no more of a good or service whatever is market price.

-Represented by vertical line. S

-Es = 0 P

Unitary Elasticity

-% Change in price of a good or service is result in an equal % change in the quantity supplied.

-Es = 1

Factors that affect Supply Elasticity

-Passage of time

-Price elasticity of supply differs in each period of time.

-The short run and the long run

Short Run – the period during which the quantity of at least one of the resources used by business in an industry cannot be varied

Long Run – The quantities of all resources used in an industry can be varied. Business may enter or leave the industry.