Elasticity & Applications of Supply & Demand Analysis
UAPP693 Economics in the Public & Nonprofit Sectors Steven W. Peuquet, Ph.D.
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2 Equilibrium of Supply & Demand
3 Disequilibrium of Supply & Demand
4 Price Elasticity of Demand
Law of Demand: all things being equal, as the price of a good falls, quantity demanded rises.
A note about “effective demand”
The “price elasticity of demand” measures how much the quantity demanded responds to a change in price. For a particular good, it’s how sensitive consumers are to changes in price.
5 Price Elasticity of Demand
Demand for a good is “elastic” if the quantity demanded responds substantially to changes in price.
Goods with close substitutes tend to have more elastic demand because it’s easier for consumers to switch from that good to others. Butter and margarine are close substitutes Eggs do not have a close substitute Other examples?
6 Price Elasticity of Demand
The opposite of elastic demand is inelastic demand, where the quantity demanded does not respond very much to changes in price.
Goods that are necessities tend to have inelastic demand, but goods that are luxuries tend to have elastic demand. What are some examples of necessities and luxuries?
What consumers deem to be a luxury or a necessity is dependent on consumer preferences.
7 Price Elasticity of Demand
The way a market is defined will have an effect on the elasticity of demand.
Narrowly defined markets will tend to have more elastic demand than broadly defined markets because it’s easier to find close substitutes for narrowly defined goods. “food” vs. “ice cream” vs. “vanilla ice cream” “entertainment” vs. “video games” vs. “combat- oriented video games”
The time horizon also matters -- demand is usually more elastic over a long period than
over a short time period (e.g., gasoline). 8 Price Elasticity of Demand
% ∆ Q PED = % ∆ P
Where: PED = price elasticity of demand ∆ = symbol for “change in” Q = quantity demanded P = price 9 Price Elasticity of Demand
Example: a 5% increase in the price of whole milk in Delaware results in a 2% reduction in the quantity of milk demanded. What is PED of whole milk?
% ∆ Q -.02 PED = = = -.4 % ∆ P .05
Important note: PED will always produce a negative number because QD and P are inversely related. However, it is common for the negative sign to be dropped when reporting the value of PED.
10 Price Elasticity of Demand
When percentage change is calculated, you can get different results based on what base (denominator) you use. This problem is avoided by using the “mid-point method” for calculating PED. (See pages 91-92 in the Mankiw textbook.)
(Q2 – Q1) / [(Q2 + Q1) / 2] PED =
(P2 – P1) / [(P2 + P1) / 2]
11 Price Elasticity of Demand
PED = 0 = Perfectly inelastic demand
PED < 1 = inelastic demand
PED = 1 = unit elastic demand
PED > 1 = elastic demand
PED = ∞ = infinite elasticity
Economists classify demand curves based on their elasticity!
12 Inelastic Demand
13 Unit Elasticity of Demand
14 Elastic Demand
15 Price Elasticity of Demand
At different points alone a linear demand curve, the PED changes. While the slope of the linear demand curve is constant, its elasticity is not.
16 Price Elasticity of Demand
Total Revenue and PED
TR = P x Q
Where: TR = total revenue P = price Q = quantity
17 Price Elasticity of Demand
The impact of a price change on TR depends on PED
Case of inelastic demand
Case of elastic demand
18 Other Elasticities
Cross-Price Elasticity of Demand: How the quantity demanded of one good is affected by a change in price of another good
% ∆ Qx CPED =
% ∆ Py
Where:
CPED = cross-price elasticity of demand ∆ = symbol for “change in” Q = quantity demanded of good x or y
P = price 19 Other Elasticities
Income Elasticity of Demand: How changes in income affect quantity demanded
% ∆ Q IED = % ∆ I
Where:
IED = income elasticity of demand ∆ = symbol for “change in” Q = quantity demanded I = income 20 Price Elasticity of Supply
Law of Supply: all things being equal, as the price of a good rises, quantity supplied also rises.
The “price elasticity of supply” measures how much the quantity supplied responds to changes in price. For a particular good, it’s how sensitive suppliers are to changes in price.
21 Price Elasticity of Supply
The price elasticity of supply depends on the flexibility of sellers (producers) to change the amount of the good they produce.
The supply of a good or service is “elastic” if the quantity supplied responds substantially to changes in price.
The supply of a good or service is “inelastic” if the quantity supplied responds only slightly to changes in price.
22 Price Elasticity of Supply
% ∆ Q PES = % ∆ P
Where: PES = price elasticity of supply ∆ = symbol for “change in” Q = quantity demanded P = price 23 Price Elasticity of Supply
PES = 0 = Perfectly inelastic supply
PES < 1 = inelastic supply
PES = 1 = unit elastic supply
PES > 1 = elastic supply
PES = ∞ = infinite supply
Like Demand curves, economists classify supply curves based on their elasticity! 24 Inelastic Supply
25 Unit Elasticity of Supply
26 Elastic Supply
27 An Application of Supply & Demand Analysis
28 Example of Rent Control
29 That’s it for today.
Thanks !
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