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Price Elasticity of Demand and Supply

Tutor2u Economics March 2001

Price Elasticity of Demand and Supply

Definition of Price Elasticity


Price elasticity (Ped) measures responsiveness of demand to change in price of good itself Ped = % change in Qdx / % change in Px When price falls we expect to see an expansion of demand When price rises we expect to see a contraction of demand Therefore an inverse relationship between price and demand (negative value for Ped)

Price Elasticity of Demand and Supply

Price elasticity of demand

Ped =

% change in quantity demanded % change in price Ped > 1 elastic demand

Ped = 1

unit-elastic demand

Ped < 1

inelastic demand

Price Elasticity of Demand and Supply

Straight-line demand curve


Price ED > 1

ED = 1

Unit elastic

ED < 1

0 Quantity demanded

Price Elasticity of Demand and Supply

Extreme values for elasticity


Price D Price

Insulin

Perfectly inelastic demand ED = 0

Perfectly elastic demand ED = o o

Price Elasticity of Demand and Supply

Range and Meaning of Ped


Type Perfectly Inelastic Inelastic Unit Elasticity Elastic Perfectly Elastic Value of 0 <1 1 >1 Meaning No change in quantity when price changes Quantity changes by less than price Quantity & price change by same % Quantity changes by more than price Demand only exists at one price

Price Elasticity of Demand and Supply

Factors that determine Ped

The closer the substitutes for a good, the more elastic is demand

The more substitutes for a good, the more elastic is demand


The lower the cost of substitution the more elastic is demand The higher the proportion of income spent on a good, the more elastic is demand The greater the time elapsed since a price change, the more elastic is demand Necessities have an inelastic demand. Luxuries have more elastic demand. Habit forming goods tend to have an inelastic demand

Price Elasticity of Demand and Supply

Elastic or inelastic demand?


Gateway cuts the price of their desktop PCs by 10% A fall in the price of Euro-star tickets An increase in the price of the Financial Times A taxi home from a night-club on a Friday night A rise in average car insurance premiums

A two week foreign holiday for a student to Greece


Motorway petrol prices rise by 5% after the budget Vodafone cuts their mobile phone charges
Price Elasticity of Demand and Supply

Time Frame and Elasticity

Longer time frame => more elastic demand

Two World oil price shocks of the 1970s


Response to higher oil prices was modest in the immediate period after price increases, As time passed, people found ways to consume less petroleum and other oil products
better mileage from their cars higher spending on insulation in homes car pooling for commuters

Car manufacturers invested enormous sums in more fuel efficient vehicles


Price Elasticity of Demand and Supply

Using price elasticity of demand

How much tax revenue will higher sin taxes on cigarettes and alcohol provide? Why do airlines often give discounts for advance bookings? What happens to our demand for foreign holidays when the exchange rate appreciates? Why do hotels lower rates at weekends?

Will a business always pass on higher costs to consumers?


Will the introduction of road tolls cut road congestion?

Price Elasticity of Demand and Supply

Elasticity and total revenue


Price

8
6

0 B 30

What happens to total revenue as price falls?

40

D 30 E

0 Quantity demanded
Price Elasticity of Demand and Supply

0 5 10 15 20

Price Elasticity of Supply

Elasticity of supply - responsiveness of the quantity supplied of a good to a change in its price Elasticity of supply (Pes) is the
% change in quantity supplied divided by the % change in price Normally as price rises - so does supply

Price Elasticity of Demand and Supply

Price elasticity of supply

ES =

% change in quantity supplied % change in price

ES > 1 price-elastic supply


ES = 1 unit-elastic supply

ES < 1 price-inelastic supply

Price Elasticity of Demand and Supply

What Determines Supply Elasticity?


Factor substitution possibilities
Can labour/capital be switched easily When substitution is possible, supply is elastic

Spare production capacity available Stocks (inventories) available to meet changes in demand Time frame for the supply to the market
Momentary period (fixed supply) Short run (inelastic supply) Long run (elastic supply)

Price Elasticity of Demand and Supply

Applying concept of Pes

Seats in a football stadium


Short run capacity is fixed Long run expansion of stadium capacity

Supply of seat-belts when the government made them compulsory


Substitutability of factors of production?

An increase in demand for fresh salmon


Time lags in the production process

World supply of oil following a large rise in world demand


Amount of spare capacity of major oil producers Can stocks be put onto the market to meet the rise in demand?

Price Elasticity of Demand and Supply

Elasticity of Supply and Time Frame

Price

Momentary Supply Short Run Supply

Long Run Supply

Quantity supplied per time period

Price Elasticity of Demand and Supply

Short Run Elasticity of Supply


Short Run Supply

Price of kitchens

D2 D1 Quantity supplied per time period

Price Elasticity of Demand and Supply

Long-run elasticity of supply


Short Run Supply

Price of kitchens

Long Run Supply

D3
D2 D1

Quantity supplied per time period

Price Elasticity of Demand and Supply

Extreme values for Pes


ES = 0 Price Perfectly elastic

ES = 1

Unit elastic

ES = o o

Perfectly inelastic

Quantity supplied

Price Elasticity of Demand and Supply