Elasticity of Demand and Supply

CHAPTER OVERVIEW

This is the second chapter in Part Two, “Price, Quantity, and Efficiency.” Both the elasticity coefficient and the total revenue test for measuring price elasticity of demand are presented in the chapter. The text attempts to sharpen students’ ability to estimate price elasticity by discussing its major determinants. The chapter reviews a number of applications and presents empirical estimates for a variety of products. Income elasticities of demand, and price elasticity of supply are also addressed.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, students should be able to:

1. Define price elasticity of demand and compute the coefficient of elasticity given appropriate data on prices and quantities.

2. Explain the meaning of elastic, inelastic, and unitary price elasticity of demand.

3. Recognize graphs of perfectly elastic and perfectly inelastic demand.

4. Use the total-revenue test to determine whether elasticity of demand is elastic, inelastic, or unitary.

5. List four major determinants of price elasticity of demand.

6. Explain how a change in each of the determinants of price elasticity would affect the elasticity coefficient.

7. Define price elasticity of supply and explain how the producer’s ability to shift resources to alternative uses and time affect price elasticity of supply.

8. Define income elasticity and its relationship to normal and inferior goods.

9. Apply the various types of elasticity to contemporary issues such as taxation and drug policy.

10. Define and identify the terms and concepts listed at end of the chapter.

LECTURE NOTES

I.Introduction

A.Elasticity of demand measures how much the quantity demanded changes with a given change in price of the item, change in consumers’ income, or change in price of related product. B.Price elasticity is a concept that also relates to supply. C.The chapter explores both elasticity of supply and demand and applications of the concept. II.Price Elasticity of Demand

A.Law of demand tells us that consumers will respond to a price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more. B.The degree of responsiveness or sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand. 1.If consumers are relatively responsive to price changes, demand is said to be elastic. 2.If consumers are relatively unresponsive to price changes, demand is said to be inelastic. 3.Note that with both elastic and inelastic demand, consumers behave according to the law of demand; that is, they respond to price changes. The terms elastic or inelastic describe the degree of responsiveness. A precise definition of what we mean by “responsive” or “unresponsive” follows. C.Price elasticity formula:

Quantitative measure of elasticity, Ed = percentage change in quantity/ percentage change in price. 1.Using two price-quantity combinations of a demand schedule, calculate the percentage change in quantity by dividing the absolute change in quantity by one of the two original quantities. Then calculate the percentage change in price by dividing the absolute change in price by one of the two original prices. 2.Estimate the elasticity of this region of the demand schedule by comparing the percentage change in quantity and the percentage change in price. Do not use the ratio formula at this time. Emphasize that it is the two percentage changes that are being compared when determining elasticity. 3.Show that if the other original quantity and price were used as the denominator that the percentage changes would be different. Explain that a way to deal with this problem is to use the average of the two quantities and the average of the two prices....