CHAPTER

Elasticity of Demand and Supply

price elasticities of demand and supply, income and cross

elasticities of demand, and using elasticity to forecast the impact of

taxes on prices

Copyright © 2010 Pearson Education, Inc. All rights reserved. 1

% change in quantity demanded % change in price

Q2/QP2/P

= = P2QQ2P

Price

Quantity demanded

P2

Q2

0

Calculating Price Elasticity of DemandPrice elasticity

of demand=

2Copyright © 2010 Pearson Education, Inc. All rights reserved.

3

Elasticity and Slope

Both slope and elasticity are measures of responsiveness. Slope is expressed in units such as $ per bushel. Elasticity is a pure number.

Elasticity is related to slope in the following way: Elasticity = (P/Q)(1/slope).

Because the demand curve’s slope is negative, price elasticity of demand is a negative number.

4

= =

Price

Quantity demanded

P2

Q2

0

Although slope is constant along a linear demand curve, price elasticity of demand varies from zeroto minus infinity along the curve.

Elasticity = –infinity

Elasticity = zero

Q2/QP2/P

P2QQ2P

5

Some Examples

1. Suppose a 20% increase in the price of gasoline causes a 10% decline in the quantity demanded.

The price elasticity of demand is:

–10%/20% = –0.5.

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Some Examples

2. Suppose the price elasticity of demand for men’s suits is –3. How much of a price cut will result in a 30% increase in quantity demanded?

The answer is –10%, because:

30%/10% = –3.

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A Real World Example

In 1991, Apple computer lowered the prices of its Macintosh machines by an average of 50%.

The resulting increase in quantity demanded amounted to 85%.

The price elasticity of demand for Macs at that time was, therefore, 85%/-50% = –1.7.

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Categorizing Elasticity of Demand

Demand is inelastic if the value of price elasticity of demand (ignoring the sign) is between zero and 1.

Demand is unit elastic if the value of price elasticity of demand (ignoring the sign) is 1.

Demand is elastic if the value of price elasticity of demand (ignoring the sign) exceeds 1.

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A Perfectly Inelastic Demand

DemandPrice

Quantity demanded

10

A Perfectly Elastic Demand

Demand

Quantity demanded

Price

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Total RevenueTotal revenue =

Total expenditure.TR = PQ. Total revenue

taken in by sellers can be represented by the area whose height is market price and whose length is quantity sold.

Price

Quantity

Supply

Demand

P

Q

12

What happens to total revenue when market price goes up?

The increase in price contributes to higher total revenue.

However, when the price goes up, quantity demanded falls. A decrease in quantity sold will contribute to decreased revenue. Quantity

Supply

Price

Demand

P’

P

QQ’

New supply

P Q

TR?

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Price Elasticity of Demand and Total Revenue If you know the price elasticity of demand of

a product, you can forecast the effects of price changes on total revenue.

If demand is elastic, the percentage change in quantity demanded will exceed the percentage change in price that caused it (ignoring direction of change).

If demand is elastic, the positive effect of a price increase on revenue will be offset by the negative effect of the fall in quantity demanded. Total revenue will, therefore, fall.

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Price Elasticity of Demand and Total Revenue If demand is inelastic, a price increase will

cause total revenue to rise. If demand is unit elastic, any change in price

will have no effect on total revenue. To test your understanding of the relationship

between changes in price, elasticity, and total revenue, work out the effects of a price decrease on revenue in cases of elastic, inelastic, and unit elastic demand.

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The equation of this demand curve is PQ = k.

Question: What is the price elasticity of demand at any point on this demand curve?

Answer: Price elasticity is always –1 because, no matter what happens to price, quantity adjusts to make total expenditure (or revenue) constant.

P

Q

Demand

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Box 1. Price Elasticity of Demand as a Gauge of Demand Responsiveness

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Box 6. Price Elasticity of Demand and Total Revenue or Expenditure

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Price Elasticity of Supply

Measures the sensitivity of changes in quantity supplied to changes in price of a good or service.

Price elasticity of supply is a positive number that can range from zero to infinity

Price elasticityof supply

% change in quantity supplied % change in price

=

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Examples

A 10-percent increase in the price of steel causes a 15-percent increase in the quantity supplied.

The price elasticity of supply for steel is 15%/10% = 1.5.

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Examples

Suppose the price elasticity of supply of bread is 2.

A 10-percent decline in the price of bread will, therefore, result in a 20-percent reduction in quantity supplied, because

–20%/ –10% = 2.

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Perfectly Inelastic Supply

Price

Quantity supplied

Supply

22

Price

Quantity supplied

Supply

Perfectly Elastic Supply

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Using Elasticity to Analyze the Effect of Taxes on Prices

Taxes can affect incentives to buy and sell goods and services.

An excise tax is a tax on the production or sale of a particular product, such as gasoline.

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Effect of a 10-Cent-per-Gallon Gasoline Tax

Price(dollars per gallon)

Gasoline (millions of gallons per month)

Demand

Initial supply

1.00

1.00

25

Price(dollars per gallon)

Gasoline (millions of gallons per month)

Demand

Initial supply

Supply after tax

1.04

1.10

1.00

0.94

1.00.95.75

Effect of a 10-Cent-per-Gallon Gasoline Tax

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Price(dollars per gallon)

Gasoline (millions of gallons per month)

Demand

Initial supply

Supply after tax

1.04

1.10

1.00

0.94

1.00.95.75

Tax paid by buyersTax paid by sellers Total tax collected

is $95,000 per month.

Effect of a 10-Cent-per-Gallon Gasoline Tax

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Conclusions

A tax on the sale of an item is unlikely to raise its equilibrium price by the full amount of the tax per unit.

The tax is likely to increase the price paid by buyers and to decrease the net price received by sellers.

In effect, the tax revenues paid are collected from both buyers and sellers of the product.

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Cases in which an Excise Tax is Fully Shifted Forward to Buyers

Case 1: Demand for the product is perfectly inelastic.

This case is extremely unlikely.

P

Q

Demand

Initialsupply

Supplyaftertax

1.00

1.10

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Case 2: Supply of the product is perfectly elastic.

This is a likely case, over long periods, if sellers must receive at least $1 net per gallon to cover costs. If price doesn’t rise to $1.10, some firms will go out of business.

P

Q

Demand

Supply after tax

Initial supply1.001.10

Q1Q2

Cases in which an Excise Tax is Fully Shifted Forward to Buyers

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Box 7. Price Elasticity of Supply as a Gauge of Supply Responsiveness