Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. A Lecture Presentation in PowerPoint...

Copyright © 2007, Nelson, a division of Thomson Canada Ltd..

A Lecture Presentation in PowerPoint

to accompany

Exploring Economicsby Robert L. Sextonand Peter Fortura


Chapter 5Elasticities


5.1 Price Elasticity of Demand

The law of demand establishes that quantity demanded changes inversely with changes in price, ceteris paribus.

But how much does quantity demanded change? This is very important to understand for many economic issues.



The price elasticity of demand measures how responsive quantity demanded is to a price change.

The price elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in price.


Price Elasticity of Demand

When economists say the price elasticity of demand is high, it means the quantity demanded changes by a relatively larger amount than the price change.

When the price elasticity of demand is low, it means that the quantity demanded changes by a relatively smaller amount than the price change.




Following the law of demand, there is an inverse relationship between price and quantity demanded.

For this reason, price elasticity of demand is, in theory, always negative.

In practice, however, this quantity is always expressed in absolute value terms, as a positive number, for simplicity.



If a change in price leads to a larger percentage change in the quantity demanded; demand is said to be elastic.

If a change in price leads to a smaller percentage change in the quantity demanded; demand is said to be inelastic.



A demand curve or a portion of a demand curve can be elastic, unit elastic, or inelastic.

A segment of a demand curve is elastic (Ed > 1) if the percentage change in quantity demanded is greater than the percentage change in price.

A perfectly elastic demand curve is horizontal. The elasticity of demand in this case is infinity because the quantity demanded is infinitely responsive to even a very small percentage change in price.



A segment of a demand curve is inelastic (Ed < 1) if the percentage change in quantity demanded is less than the percentage change in price.

A perfectly inelastic demand curve is vertical—the quantity demanded is the same regardless of price.



Exhibit 3: Inelastic DemandP

rice

Quantity

D

0

ED= =.20.10

=2%QD

%P

Q1

P1

P0

Q0

20%QD

Pri

ce

Quantity

0 Q1

P1

QD

P10%P P0

Q0

D

a. Inelastic Demand (ED < 1)

b. Perfectly Inelastic Demand (ED = 0)


A segment of a demand curve is unit elastic (Ed = 1) if the percentage change in quantity demanded equals the percentage change in the price.



DP0

Q0

Exhibit 4: Unit Elastic DemandP

rice

Quantity

0

%QD

%PED = =

.10

.10= 110%P

10%QD

Q1

P1


When the demand curve is relatively steep, ceteris paribus, its price elasticity of demand is relatively low (more inelastic).

When the demand curve is relatively flat, ceteris paribus, its price elasticity of demand is relatively high (more elastic).



The price elasticity of demand depends on the availability of close substitutes, the proportion of income spent on the good, and the amount of time people have to adapt to a price change.



Goods with close substitutes tend to have more elastic demands.

Goods without close substitutes tend to have less elastic demand.

Example: the elasticity of demand for a Ford, Toyota, or a Honda is more elastic than the demand for a car because there are more and better substitutes for a certain type of car than for a car itself.



The fewer the number of close substitutes, the less elastic the demand curve.

Examples: insulin for diabetics, heroin for an addict, and emergency medical care have few, if any, close substitutes.

The smaller the proportion of income spent on a good, the lower its elasticity of demand.



The more time that people have to adapt to a new price change, the greater the elasticity of demand.

The more time that passes, the more time consumers have to find or develop suitable substitutes and to plan and implement changes in their patterns of consumption. Hence, the short-run demand curve is generally less elastic than the long-run demand curve.



Exhibit 5: Short-Run and Long-Run Demand Curves

Pri

ce DLR

DSR

Quantity

0Q1

P1

P0

Q0Q2


5.2 Total Revenue and Price Elasticity of Demand

When demand is relatively price elastic (Ed > 1), total revenues will rise as the price declines.

This occurs because the percentage increase in the quantity demanded is greater than the percentage reduction in price.


If the price rises and the quantity demanded falls, then total revenue falls.

This occurs because the percentage decrease in the quantity demanded is greater than the percentage increase in price.



Exhibit 1: Elastic Demand and Total Revenue

Pri

ce

cb

a

DELASTIC

Quantity

020 40 60 80 100

A$10

B$5


When demand is relatively price inelastic (Ed < 1), total revenues will fall as the price declines.

Total revenues fall because the percentage increase in the quantity demanded is less than the percentage reduction in price.



If the price rises and the quantity demanded falls, then total revenue rises.

Total revenue rises because the percentage decrease in the quantity demanded is less than the percentage increase in price.



Exhibit 2: Inelastic Demand and Total Revenue

Pri

ce

b c

a

DINELASTIC

Quantity

010 20 30 40

$10A

$5B


Total Revenue an Inelastic Demand

If the demand for food is inelastic(which is generally the case) a good harvest could result in a reduction in total revenue for farmer’s and a bad harvest could result in an increase in total revenue for farmer’s—see the next two exhibits.


Exhibit 3: Total Revenue and Inelastic Demand:A Reduction in Supply

Pri

ce

bD

a(gain)

c(loss)

S0

Q0

Quantity

0Q1

S1

P0

P1


Pri

ce o

f W

hea

t

bD

a(loss)

c(gain)

Quantity of Wheat

0

S0

Q0 Q1

S1

P1

P0

Exhibit 3: Total Revenue and Inelastic Demand: An Increase in Supply


A straight-line demand curve (having a constant slope) will change price elasticity continuously as you move up or down it.

When the price falls on the upper half of the demand curve, there is a negative relationship between price and total revenue.

Demand is relatively price elastic.



When the price falls on the lower half of the demand curve, there is a positive relationship between price and total revenue.

Demand is relatively price inelastic.



Exhibit 4: Price Elasticity Along a Linear Demand Curve

Pri

ce

cb

a

Quantity

0

ED > 1 = Elastic

D

Pri

ce

fe

d

Quantity

0

ED < 1 = InelasticD

MidpointED = 1

P0

Q0

P1

Q1

P2

Q2

P3

Q3

a. Elastic Range

MidpointED = 1

b. Inelastic Range


5.3 Price Elasticity of Supply

According to the law of supply, there is a positive relationship between price and quantity supplied, ceteris paribus.

But by how much does quantity supplied change as price changes?

The price elasticity of supply measures how responsive the quantity sellers are willing to sell is to changes in the price.



In other words, price elasticity of supply measures the relative change in the quantity supplied that results from a change in price.

The price elasticity of supply (Es) is defined as the percentage change in the quantity supplied divided by the percentage change in price.




Goods with a supply elasticity that is greater than 1 (Es > 1 ) are relatively elastic in supply.

With that, a 1 percent change in price will result in a greater than 1 percent change in quantity supplied.

The extreme case is perfectly elastic supply, where Es = infinity.



Goods with a supply elasticity that is less than 1 (Es < 1) are relatively inelastic in supply.

This means that a 1 percent change in the price of these goods will induce a proportionately smaller change in the quantity supplied.

The extreme case is perfectly inelastic supply, where Es = 0.



Exhibit 1: The Price Elasticity of Supply

Pri

ce

Quantity

0

= = 4%QS

%PES =

.20

.05

S

20%QS

5%PP0

Q0

P1

Q1

a. Elastic Supply (ES > 1)


Pri

ce

Quantity

0

= = .25.05.20ES =

%QS

%P

S


P1

Q1

P0

Q0

20%P

5%QS

b. Inelastic Supply (ES < 1)



Pri

ce

Quantity

0 Q0 = Q1

S

P0

P1

20%P

c. Perfectly Inelastic Supply ES = 0)



Pri

ce

Quantity

0

P0

Q0

P1 SP

d. Perfectly Elastic supply (ES = )


Time is usually critical in supply elasticities because it is more costly for producers to bring forth and release resources in shorter periods of time.

Hence, supply tends to be more elastic in the long run than the short run.



Exhibit 2: Short-run and Long-run Supply Curves

Pri

ce

Quantity

0

SSR

SLR

P0

Q0

P1

QSR QLR


The relative elasticity of supply and demand determines the distribution of the tax burden for a good.

If demand has a lower elasticity than supply in the relevant tax region, the largest portion of the tax is paid by the consumer.

5.3 Price Elasticity of Supply and Demand


However, if demand is relatively more elastic than supply in the relevant tax region, the largest portion of the tax is paid by the producer.

In general, the tax burden falls on the side of the market that is less elastic, which has nothing to do with who actually pays the tax at the time of the purchase.

5.3 Price Elasticity of Supply and Demand


Tax Paid by Consumer

Tax Paid by Producer

Exhibit 3: Elasticity and the Burden of TaxationP

rice

Quantity

0

S

S + $.50 tax

D

QAT

$1.40

.90

QBT

1.00 $.50

a. Demand Is Relatively Less Elastic than Supply


Tax Paid by Consumer

Tax Paid by Producer

Exhibit 3: Elasticity and the Burden of TaxationP

rice

Quantity

0

D

SS + $.50 tax

$.50

QBT

1.00

.60

QAT

$1.10

b. Demand Is Relatively More Elastic than Supply


Drugs Across the Border


Drugs Across the Border


5.4 Consumer behaviour

In economics we assume that each individual seeks to maximize his or her own well-being or satisfaction.

Economists developed the concept of utility to allow them to study the relative levels of satisfaction that consumers get from the consumption of goods and services.


5.4 Consumer behaviour

Marginal utility is the additional satisfaction generated by the last unit of a good that is consumed.

Total utility increases with additional consumption.

The incremental satisfaction–the marginal utility–that results from the consumption of additional units tends to decline as consumption increases.


40

30

20

10

1 2 3 40T

ota

l Uti

lity

Quantity of Pizza Slices(per hour)

20

15

10

5

1 2 3 40

Mar

gin

al U

tilit

y(p

er p

izza

slic

e)

Quantity of Pizza Slices(per hour)

Exhibit 1: Total and Marginal Utility

Marginal utility Total

utility


5.4 Consumer and Producer Surplus

What a consumer actually pays for a good is usually less than what she is willing to pay.

The monetary difference between what the consumer is willing and able to pay and the price the consumer actually pays is called consumer surplus.


If the consumer is a buyer of several units of a good, the earlier units will have greater marginal value and therefore create more consumer surplus because marginal willingness to pay falls as greater quantities are consumed in any period.



Exhibit 1: Consumer Surplus for Iced Tea

Pri

ce o

f Ic

ed T

ea (

per

gla

ss)

Quantity of Iced Tea (by glass)0

$3

$1

Consumer surplus =$3 + $1 = $4

DICED TEA

$1Market price

$3

1

$4

2

$2

3

$ .50



Consumer surplus is shown graphically as the area under the demand curve (willingness to pay for the units consumed) and above the market price (what must be paid for those units).


Exhibit 2: Consumer Surplus


Exhibit 3: The Impact of an Increase in Supply on Consumer Surplus


Producer surplus is the difference between what a producer is paid for a good and the seller's cost for producing each unit of the good.

Because some units can be produced at a cost that is lower than the market price, the seller receives a surplus, or net benefit, from producing those units.



Producer surplus for a particular unit is the difference between the market price and the seller's cost of producing that unit.

Total producer surplus is shown graphically as the area under the market price (what was paid for those units) and above the supply curve (the total cost, or sum of marginal costs, of producing those units).



Exhibit 4: Producer Surplus


A higher market price due to an increase in demand will increase total producer surplus.

Part of the added surplus is due to a higher price for the quantity already being produced.

Part is due to the expansion of output made profitable by the higher price.



Exhibit 5: The Impact of an Increase in Demand on Producer Surplus


With the tools of consumer and producer surplus, we can better analyze the total gains from exchange.

The demand curve represents a collection of maximum prices that consumers are willing and able to pay for additional quantities of a good or service.



The supply curve represents a collection of minimum prices that suppliers require to be willing to supply additional quantities of that good or service.

At the market equilibrium, consumers receive consumer surplus and producers receive producer surplus.

Both benefit from trading every unit up to the market equilibrium output.



Buyers purchase each good, except for the very last unit, for less than the maximum amount that they would have been willing to pay.

Sellers receive more than the minimum amount they would have been willing to accept to supply the good.



Once the equilibrium output is reached at the equilibrium price, all of the mutually beneficial trade opportunities between the suppliers and the demanders will have taken place.

The sum of consumer and producer surplus is maximized.



The total welfare gain to the economy from trade in a good is the sum of the consumer and producer surplus created.

Consumers benefit from additional amounts of consumer surplus and producers benefit from additional amounts of producer surplus.



Improvements in welfare come from additions to both consumer and producer surplus.

In competitive markets, where there are large numbers of buyers and sellers at the market equilibrium price and quantity, the net gains to society are as large as possible.



CSCS

CS

PS

PSPS

Exhibit 6: Consumer and Producer Surplus

D

SP

rice

Quantity

1 2 3 4

5

4

3

$8

7

6

2

1

0


5.6 The Welfare Effects of Taxes and Price Controls

We can use consumer and producer surplus to measure the welfare effects of various government programs, such as taxes and price controls.


Exhibit 1: The Supply and Demand of a TaxP

rice

Quantity

Tax Revenue

T Q1

PS

Supply

Demand

Q0

Tax

Q1

PB


Welfare Effects of a Tax


That is, the more elastic the curves are, the greater the change in output and the larger the deadweight loss.



Exhibit 3: Elasticity and Deadweight Loss

Pri

ce

Quantity

0

$.50 Tax

D

S

Q1 Q0

Deadweight lossis relatively

small.



Pri

ce

Quantity

0

$.50 TaxD

S

Q0Q1

Deadweight loss is relatively small.



Pri

ce

D

Quantity

0

$.50 Tax

Deadweight lossrelatively large.

S

Q1 Q0


Elasticity differences can help us understand tax policy.

Those goods that are heavily taxed often have a relatively inelastic demand curve in the short run.

This means that the burden falls mainly on the buyer.

It also means that the deadweight loss to society is smaller than if the demand curve was more elastic.



We can see the welfare effects of a price ceiling by observing the change in consumer and producer surplus from the implementation of the price ceiling.

Consumers can now buy at a lower price, but cannot buy as much as before (since suppliers will not supply as much).



Producers lose producer surplus from the lower imposed ceiling price.

The net loss is the resulting deadweight loss triangle, just as with a tax.



We can also use consumer and producer surplus to see the welfare effects of a price floor, where the government buys up the surplus.

Consumers lose consumer surplus due to the higher price floor, and must also pay taxes to pay for the buying and storing of the unsold (to consumers) output.



Producers gain producer surplus from the higher prices and greater output (since the government buys up what is not sold on the market).

On net, there is a deadweight loss from the price floor, illustrated in Exhibit 6.



Exhibit 5: Agricultural Price Supports

Pri

ce o

f C

hee

seS

Price Floor

0

$4

P

Quantity of Cheese

D

Surplus thegovernmentmust absorb

QSQD

DA

CB

$3

Q


Exhibit 6: Welfare Effects of a Price Floor When Government Buys the Surplus


Deficiency Payment Program

If govt. sets target price at P1, producers will supply QS and sell all they can at the market price PM.

PS increases by area bcd and CS increases by area higf; the cost to govt. bcdehigf is greater than the sum of CS and PS and the deadweight loss is area e.

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Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. A Lecture Presentation in PowerPoint...

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