Economics: Elasticity-The Effect of Price on Demand and Supply

Price Elasticity of Supply - Simple Method

% change in Qs -------------------- % change in Pr

Example - Roses

- Pr = $40/dozen - Qs = 6 (million dozens) - Pr = $60 - Qs = 15 (million dozens)

Substitutions

-Can consumers substitute a cheaper good easily? -If yes, demand is elastic. -If no, demand is inelastic. Ex: -soap: if price increases, will you change brands? -rent: if rent increases, will you move? Ex: -the day price rises: demand is inelastic. -months later: demand becomes more elastic as drivers carpool or buy smaller cars. Ex: -what happens to qd of margarine, when price of butter rises? -margarine and butter are substitutes. pr butter = $1 bar, qd m = 3 bars per mo. pr butter = $2 bar, qd m = 5 bars per mo.

Why Economists Use Elasticity

-Elasticity is a unit-free measure. -Elasticities allow economists to quantify the differences among markets without standardizing units of measurement. -By comparing markets using elasticities, it does not matter how the price or the quantity in the markets are measured. -Understanding market responsiveness to price changes in important in economic analysis.

Income Elasticity of Demand - Example: Jewelry

-Impact of income changes on demand. -Size of shift in the demand curve when income changes. -Income increases 10%. -Qd jewelry increases 35%.

Cross Elasticity of Demand

-Impact of price change of substitutes or complements. -Size of shift in demand curve when price of a related good changes. Ex: -what happens to peanut butter sales when price of jelly rises? -pb & jelly are complements pr jelly = $3, qd pb = 2 jars per mo. pr jelly = $4, qd pb = 1 jar per mo.

Factors Influencing Demand

-Low Price Goods - changes in price will not result in a change in consumption. -Income Levels - the higher one's income level, the less sensitive one is to price. -Substitute Goods - if there are close substitutes for a product (Coke vs. Pepsi) a change in price will affect demand. -Basic Goods - items or services essential to an individual's well-being or a firm's activity, e.g. bread and phones -Linked Goods - items used in conjunction, e.g. cars and gas. -Time to Adjust - short term vs. long term.

What is Elasticity?

-Market response to changes in price -Price drives consumer demand and producer supply -The demand relationship between price and quantity is inverse, i.e. quantity moves in the opposite direction of price -For supply the relationship is direct, i.e. quantity moves in the same direction as price.

Example

-Oceanfront Property: can't make more and inelastic supply -Salt: almost an infinite amount and elastic supply

Demand Defined

-The desire to pay for a good or service and the ability to pay for that good or service. -Demand is not desire alone. We have many market desires, but if we can't pay for them firms will not categorize them as demand.

What makes demand elastic or inelastic?

Is it a luxury or necessity? -If luxury, demand is elastic. -If necessity, demand is inelastic. Ex: Mocha latte at Starbucks is a luxury; an appendectomy is not.

Elasticity Calculated

Pct. Chg. Price = (5 - 3)/3 or [66.6%] Pct. Chg. Quant. Demanded = (10 - 15)/15 or [-33.3%] Elasticity = Pct. Chg. Quant. Demanded / Pct. Chg. Price or -33.3% / 66.6% = [.5] Therefore the relationship is inelastic.

Price Elasticity of Demand

Price Elasticity of Demand Example ●Mocha Latte at Starbucks ●Price rises from $3 to $5 per cup ●Qd falls from 15 to 10 cups per hour

What makes supply or elastic or inelastic ?

Production possibilities Is the item easily produced? NO then supply is inelastic YES then supply is elastic

Rose Supply Elasticity

Q - (15 - 6)/6 = 150% P - (60 - 40)/40 = 50% Elasticity - (150 / 50) = 3

Production Complexity

Time frame - ●Short time horizon, supply is inelastic Example: ●Commercial Aircraft: takes time to build and supplies is inelastic.

Basic Idea

When price increases, quantity demanded decreases, quantity supplied increases. When price decreases, quantity demanded increases, quantity supplied decreases.

Price Elasticity of Supply

●Elasticity equals 1 - Unit Elastic ●Elasticity greater than 1 - Elastic ●Elasticity less than 1 - Inelastic ●Elasticity equals 0 - Perfectly Inelastic

Example: Cup of Latte

●Initial Pr = $3, Qd = 15. TR = $3 x 15 = $45 ●New Pr = $5, Qd = 5 TR = $5 x 5 = $25 ●Demand for latte is elastic TR falls as Pr rises

Summary

●Law of demand & supply -direction of change in qd or qs when p changes ●Price elasticity -how large are these qd or qs changes? ●Cross/income elasticity -size of shift in demand curve

Production Complexity - 2

●Less complexity means that production schedules are more elastic ●Example - Notebook computers

Computing Elasticity = Q/P

●Measuring the percentage change in quantity caused by percentage change in price. ●If the price rises by 1%, quantity demanded might fall by 5% or the quantity supplied might increase by 5%. ●The price elasticity of demand is [5] in this example. ●Elasticity values always are stated as absolute values.

General Formula for Price Elasticity - Simple Method

●P = Current price of a good ●Q = Quantity demanded at that price ●DP = Change in the current price ●DQ = Change in quantity demanded Elasticity = pct change in quantity/pct change in price

Starbucks Not Immune

●Price Rise at Starbucks Cuts Visits and Shares ●Starbucks, the world's largest chain of coffee shops, lowered its profit and sales forecasts yesterday after reporting its first decline in customer visits. The shares fell more than 7 percent in after-hours trading. The forecast revisions suggested that Starbucks was losing customers to McDonald's and Dunkin' Donuts, where a cup of coffee may cost $1 less. Bloomberg News - (Nov. 15, 2007)

Supply

●Supply consists of the goods and/or services firms are willing to offer consumers at various price levels. ●Firms will supply more goods and/or services as the price they receive increases. ●Lower prices will result in reduced goods and/or services.

Effect on Total Revenue

●Total Revenue (TR) = Pr x Q -If demand is elastic, TR falls as price rises. -If demand is inelastic, TR rises as price falls.

Price Elasticities

●Unit elastic: price elasticity is 1 ●Inelastic: price elasticity is less than 1 ●Elastic: price elasticity is greater than 1 ●Perfectly Inelastic: price elasticity equals 0 ●= 1 Unit Elastic (% chg. in price equals % chg. in quantity) ●> 1 Elastic (% chg. in quantity is greater than a % chg. in price) ●< 1 Inelastic (% chg. in quantity is less than a % chg. in price) ●= 0 Perfectly inelastic (quantity is not affected by a change in price)

Shelf-Life

Can you store it easily/cheaply? -If yes, then elastic -If no, then inelastic ●Bananas vs. Soup ●Short shelf life - supply inelastic ●Long shelf life - supply elastic