Chapter 6
DESCRIBING SUPPLY
AND DEMAND:
ELASTICITIES
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-2
Today’s lecture will:
• Use the terms price elasticity of supply
and price elasticity of demand to
describe the responsiveness of
quantities to changes in price.
• Calculate elasticity graphically and
numerically.
• Distinguish five elasticity terms that are
used to differentiate varying degrees of
responsiveness.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-3
Today’s lecture will:
• Explain the importance of substitution in
•
•
•
determining elasticity of supply and demand.
Relate price elasticity of demand to total
revenue.
State how other elasticity concepts are useful
in describing the effect of shift factors of
demand.
Explain how the concept of elasticity makes
supply and demand more useful.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-4
Price Elasticity
Price elasticity of demand (ED)
Percentage change in quantity demanded
ED 
Percentage change in price
Price elasticity of supply (ES)
Percentage change in quantity supplied
ES 
Percentage change in price
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-5
Calculating Elasticity of Demand
Q 2  Q1
%Q 21 (Q1  Q 2 )
E

P2  P1
%P
1
2 (P1  P2 )
Demand
$26
B
24
22
midpoint
20
A
18
Elasticity between A and B:
10  14
4
1
(14  10) 12  .33
ED  2


 1.27
26  20
6
.26
1
23
2 ( 26  20)
16
14
0
C
10
12
14
Quantity of software (in thousands)
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-6
Calculating Elasticity of Supply
$6.00
5.50
5.00
B
4.50
A
4.00
C
Q 2  Q1
%Q 21 (Q1  Q 2 )
E

P2  P1
%P
1
2 (P1  P2 )
Elasticity between A and B:
3.50
3.00
0
476 485
485  476
9
1
.0187
2 ( 485  476)
ES 
 480.5 
 .18
5  4.50
.50
.105
1
4.75
2 (5  4.50)
Quantity of workers
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-7
Calculating Elasticity at a Point
$10
9
8
7
6
5
4
3
2
1
To calculate elasticity at a point determine
a range around that point and calculate
the arc elasticity.
C
Eat A
A
B
20 24 28
Quantity
McGraw-Hill/Irwin
28  20
8
1
.33
2 (28  20)
24



 .66
53
2
.5
1
4
2 (5  3)
40
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-8
Elasticities and Supply and
Demand Curves
Perfectly
inelastic
demand
curve
Perfectly
elastic
demand
curve
0
0
Quantity
McGraw-Hill/Irwin
Quantity
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-9
Elasticity Along a Demand Curve
Ed = ∞
$10
9
8
7
6
5
4
3
2
1
Price
Ed > 1
Elasticity declines along the
demand curve as we move
toward the quantity axis
0
McGraw-Hill/Irwin
Ed = 1
Ed < 1
Ed = 0
1
2
3
4
5
6
7
8
9 10 Quantity
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-10
Elasticity Along a Supply Curve
S0
Price
$10
9
8
7
6
5
4
3
2
1
S1
Es declines
Es = 
0
Es rises
Es = 0
1
2
3
4
5
6
7
If the supply
curve intersects
the vertical axis,
Es declines as
you go up the
supply curve.
If the supply
curve intersects
the quantity axis,
Es increases as
you go up the
supply curve.
Quantity
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-11
Elasticity Summary
• Perfectly elastic – quantity responds
•
•
•
•
enormously to price changes (E=∞)
Elastic – the %Δ Q > the %Δ P (E>1).
Unit elastic – the %Δ Q = the %Δ P
(E=1).
Inelastic – the %Δ Q < the %Δ P (E<1).
Perfectly inelastic – quantity does not
respond at all to a change in price
(E=0).
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-12
Substitution and Demand
• As a general rule, the more substitutes a good
•
•
•
•
has, the more elastic is its supply and demand.
The larger the time interval considered, the
more elastic is the demand curve.
The less a good is a necessity, the more elastic
is its demand curve.
Demand becomes more elastic as the definition
of the good becomes more specific.
Demand for goods that represent a large
portion of one’s budget are more elastic.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-13
Substitution and Supply
• The longer the time period considered,
the more elastic the supply.
• There are three time periods relevant to
supply:
 The instantaneous period – supply is fixed,
perfectly inelastic.
 The short run – some substitution is
possible, supply is somewhat elastic.
 The long run – significant substitution is
possible, supply is very elastic.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-14
Short-Run and Long-Run
Elasticities of Demand
Product
Movies/motion picture
Electicity (household)
Tobacco products
Foreign travel
Beer
Health services
Gasoline
University tuition
McGraw-Hill/Irwin
Price elasticity
Short Run Long Run
0.87
3.67
0.13
1.89
0.46
1.89
0.14
1.77
0.56
1.39
0.20
0.92
0.08
0.38
0.52
—
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-15
Elasticity, Total Revenue,
and Demand
• The elasticity of demand tells suppliers how
•
•
•
their total revenue (PxQ) will change if their
price changes.
If ED > 1, an increase in price decreases total
revenue.
If ED = 1, an increase in price leaves total
revenue unchanged.
If ED < 1, an increase in price increases total
revenue.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-16
Elasticity and Total Revenue
Unit Elastic Demand
E=1
TR constant
$10
Price
8
F
6
Gained revenue
C
E
4
A
2
0
McGraw-Hill/Irwin
1
2
TRE= $4x6=$24
TRF= $6x4=$24
Lost
revenue
B
3
4
5
6
7
8
9
Quantity
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-17
Elasticity and Total Revenue
Inelastic Demand
E<1
TR rises if price increases
$10
Price
8
TRG = $1 x 9 = $9
TRH = $2 x 8 = $16
6
Gained
revenue
4
Lost
revenue
H
2
G
C
A
0
McGraw-Hill/Irwin
1
2
B
3
4
5
6
7
8
9
Quantity
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-18
Elasticity and Total Revenue
$10
Price
8
6
Elastic Demand
E>1
K
J
C
A B
TRJ = $8 x 2 = $16
TRK = $9 x 1 = $9
Gained
revenue
4
Lost
revenue
2
0
TR falls if price increases.
1
McGraw-Hill/Irwin
2
3
4
5
6
7
8
9
Quantity
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-19
Elastic ED > 1
ED = 1
Inelastic ED < 1
0
0
McGraw-Hill/Irwin
Q0
Quantity
Total revenue
Total
Revenue
Along a
Demand
Curve
Q0
Quantity
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-20
Elasticity of Individual and
Market Demand
• Price discrimination occurs when a firm
•
•
separates the people with less elastic demand
from those with more elastic demand.
Firms that price discriminate charge more to
the individuals with inelastic demand and less
to individuals with elastic demand.
Examples of price discrimination:
 Airlines’ Saturday stay-over specials
 Sales of new cars
 Almost-continual sales
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-21
Income Elasticity of Demand
• Income elasticity of demand
measures the responsiveness of
demand to changes in income.
Eincome
McGraw-Hill/Irwin
Percentage change in demand

Percentage change in income
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-22
Income Elasticity of Demand
• Normal goods are those whose consumption
•
increases with an increase in income.
Normal goods can be luxuries or necessities:
 Luxuries are goods that have an income elasticity
greater than one.
 A necessity has an income elasticity less than 1.
• Inferior goods are those whose consumption
decreases when income increases.
 Inferior goods have income elasticities less than
zero.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-23
Calculating Income Elasticity
(26 - 20)
1
.26
2 ( 26  20)
Eincome 

 1.3
20
.20
P0
P0
Shift due to
20% rise in
D0 D1 income
20 26
McGraw-Hill/Irwin
Quantity
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-24
Income Elasticities
of Selected Goods
Product
Motion pictures
Foreign travel
Hard liquor
Jewelry and watches
Tobacco products
Furniture
Homegrown food
McGraw-Hill/Irwin
Income elasticity
Short Run Long Run
0.81
3.41
0.24
3.09
2.5
—
1.00
1.64
0.21
0.86
2.60
0.53
—
-0.61
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-25
Cross-Price Elasticity of
Demand
• Cross-price elasticity of demand measures
the responsiveness of demand to changes in
prices of other goods.
Percentage change in demand
Ecrossprice 
Percentage change in price
of a related good
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-26
Calculating Cross-Price Elasticity
D0
(104 - 108)
1
 .038
2 (108  104)
Ecross 

 .12
.33
 .33
D1
P0
P0
Shift due to 33% decrease
in price of pork
104
108
Quantity of Beef
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-27
Complements and Substitutes
• Substitutes are goods that can be used
in place of another.
 Substitutes have positive cross-price
elasticities.
• Complements are goods that are used in
conjunction with one another.
 Complements have negative cross-price
elasticities.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-28
Cross-Price Elasticities
Cross-Price
Elasticity
Commodities
Beef in response to price change in pork
Beef in response to price change in chicken
U.S. cars in response to price changes
in European and Asian automobiles
European automobiles in response to price
changes in U.S. and Asian automobiles
Beer in response to changes in wine
Hard liquor in response to price changes in
beer
McGraw-Hill/Irwin
0.11
0.02
0.28
0.61
0.23
- 0.11
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-29
Effects of Shifts in Supply
on Price and Quantity
D
Elastic Demand
S0
S1
Price
Price
Inelastic Demand
S0
S1
D
P0
P1
P0
P1
Quantity
McGraw-Hill/Irwin
Q0 Q1
Quantity
Q0 Q1
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-30
Elasticity and Shifting
Supply and Demand
The more elastic
the demand
(supply), the
greater the effect
of a supply
(demand) shift on
quantity, and the
smaller the effect
on price.
McGraw-Hill/Irwin
% S
% P 
ED  E S
% D
% P 
ED  E S
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-31
Elasticity and Shifting
Demand and Supply
Suppose that demand increases by 5%, the elasticity of demand is 0.8,
and the elasticity of supply is 2. Price will increase by
%D
5
5
%P 


 1.8%
ED  ES .8  2 2.8
Suppose that supply increases by 33%, the elasticity of demand and
supply are both 1. Price will fall by
%S
33
33
%P 


 16.5%
ED  ES 1  1 2
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-32
Summary
Elasticity is percentage change in quantity
divided by percentage change in some variable
that affects demand (supply). The most
common elasticity is price.
Percentage change in quantity demanded
ED 
Percentage change in price
Percentage change in quantity supplied
ES 
Percentage change in price
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-33
Summary
• Five elasticity terms are:





Elastic E>1
Inelastic E<1
Unit elastic E=1
Perfectly inelastic E=0
Perfectly elastic E=∞
• The more substitutes a good has, the greater its
•
elasticity.
The most important factor affecting the number
of substitutes in supply is time. The longer the
time interval, the more elastic is supply.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-34
Summary
• Factors affecting the number of
substitutes in demand are:




Time period
Degree to which the good is a luxury
Market definition
Importance of the good in one’s budget
• Demand becomes less elastic as we
move down along a demand curve.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-35
Summary
• When a supplier raises price:
 If demand is inelastic total revenue increases.
 If demand is elastic, total revenue decreases.
 If demand is unit elastic, total revenue remains
constant.
• Other important elasticities are:
 Income elasticity – the percentage change in
demand divided by the percentage change in
income
 Cross-price elasticity – the percentage change in
demand divided by the percentage change in the
price of a related good
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-36
Given the following demand and supply of pizza:
Price
per Pizza
Quantity
Supplied
Quantity
Demanded
$8
200
60
7
150
80
6
100
100
5
50
120
Review Question 6-1 Calculate the elasticity of supply of
pizza between $7 and $8.
200  150
50
1
.29
175
2 (200  150)
ES 


 2.2
87
1
.13
1
7.5
2 (8  7)
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
6-37
Given the following demand and supply of pizza:
Price
per Pizza
Quantity
Supplied
$8
7
6
5
200
150
100
50
Quantity
Demanded
60
80
100
120
Review Question 6-2 Calculate the elasticity of demand for
pizza between $6 and $7.
80  100
20
1
.22
90
2 (80  100)
ED 


 1.5
76
1
.15
1
6.5
2 (7  6)
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.