All about demand, supply and elasticities of demand and supply
When a cold wave
hits Nagpur, the price of orange juice rises in supermarkets throughout the
country. When the weather turns warm in New Delhi every summer, the price of
hotel rooms in the area goes down. When a war breaks out in the Middle East,
the price of gasoline in the United States rises, and the price of a used Car
falls. What do these events have in common? They all show the workings of
supply and demand.
Supply and demand
are the two words that economists use most often—and for good reason. Supply
and demand are the forces that make market economies work. They determine the
quantity of each good produced and the price at which it is sold. If you want
to know how any event or policy will affect the economy, you must think first
about how it will affect supply and demand.
This chapter
introduces the theory of supply and demand. It considers how buyers and sellers
behave and how they interact with one another. It shows how supply and demand
determine prices in a market economy and how prices, in turn, allocate the
economy’s scarce resources.
MARKETS AND
COMPETITION
COMPETITIVE MARKETS
Markets take many forms. Sometimes markets are highly organized,
such as the markets for many agricultural commodities. In these markets, buyers
and sellers meet at a specific time and place, where an auctioneer helps set
prices and arrange sales.
More often, markets are less organized. For example, consider the
market for ice cream in a particular town. Buyers of ice cream do not meet
together at any one time. The sellers of ice cream are in different locations
and offer somewhat different products. There is no auctioneer calling out the
price of ice cream. Each seller posts a price for an ice-cream cone, and each
buyer decides how much ice cream to buy at each store.
Even though it is not organized, the group of ice-cream buyers and
ice-cream sellers forms a market. Each buyer knows that there are several
sellers from which to choose, and each seller is aware that his product is
similar to that offered by other sellers. The price of ice cream and the
quantity of ice cream sold are not determined by any single buyer or seller.
Rather, price and quantity are determined by all buyers and sellers as they
interact in the marketplace.
The market for ice cream, like most markets in the economy, is
highly competitive. A competitive market is a market in which there are
many buyers and many sellers so that each has a negligible impact on the market
price. Each seller of ice cream has limited control over the price because
other sellers are offering similar products. A seller has little reason to
charge less than the going price, and if he or she charges more, buyers will
make their purchases elsewhere. Similarly, no single buyer of ice cream can
influence the price of ice cream because each buyer purchases only a small
amount.
In this chapter we examine how buyers and sellers interact in
competitive markets. We see how the forces of supply and demand determine both
the quantity of the good sold and its price.
COMPETITION: PERFECT AND OTHERWISE
We assume in this chapter that markets are perfectly
competitive. Perfectly competitive markets are defined by two primary
characteristics: (1) the goods being offered for sale are all the same, and (2)
the buyers and sellers are so numerous that no single buyer or seller can
influence the market price. Because buyers and sellers in perfectly competitive
markets must accept the price the market determines, they are said to be price
takers.
There are some markets in which the assumption of perfect
competition applies perfectly. In the wheat market, for example, there are
thousands of farmers who sell wheat and millions of consumers who use wheat and
wheat products. Because no single buyer or seller can influence the price of
wheat, each takes the price as given.
Not all goods and services, however, are sold in perfectly
competitive markets.
Some markets have only one seller, and this seller sets the price.
Such a seller is called a monopoly. Your local cable television company,
for instance, may be a monopoly.
Residents of your town probably have only one cable company from
which to buy this service.
Some markets fall between the extremes of perfect competition and
monopoly. One such market, called an oligopoly, has a few sellers that
do not always compete aggressively. Airline routes are an example. If a route
between two cities is serviced by only two or three carriers, the carriers may
avoid rigorous competition to keep prices high. Another type of market is monopolistically
competitive; it contains many sellers, each offering a slightly different
product. Because the products are not exactly the same, each seller has some
ability to set the price for its own product. An example is the software
industry. Many word processing programs compete with one another for users, but
every program is different from every other and has its own price.
Despite the diversity of market types we find in the world, we
begin by studying perfect competition. Perfectly competitive markets are the
easiest to analyze. Moreover, because some degree of competition is present in
most markets, many of the lessons that we learn by studying supply and demand
under perfect competition apply in more complicated markets as well.
QUICK QUIZ: What is a market? _ What does it mean for
a market to be competitive?
DEMAND
We begin our study of markets by examining the behavior of buyers.
Here we consider what determines the quantity demanded of any good,
which is the amount of the good that buyers are willing and able to purchase.
To focus our thinking, let’s keep in mind a particular good—ice cream.
WHAT DETERMINES THE QUANTITY AN INDIVIDUAL DEMANDS?
Consider your own demand for ice cream. How do you decide how much
ice cream to buy each month, and what factors affect your decision? Here are
some of the answers you might give.
quantity demanded the amount of a good that buyers are
willing and able to purchase
Price If the price of ice cream rose to $20 per scoop, you would buy
less ice cream. You might buy frozen yogurt instead. If the price of ice cream
fell to $0.20 per scoop, you would buy more. Because the quantity demanded
falls as the price rises and rises as the price falls, we say that the quantity
demanded is negatively related to the price. This relationship between
price and quantity demanded is true for most goods in the economy and, in fact,
is so pervasive that economists call it the law of demand: Other things
equal, when the price of a good rises, the quantity demanded of the good falls.
Income What would happen to your demand for ice cream if you lost your
job one summer? Most likely, it would fall. A lower income means that you have
less to spend in total, so you would have to spend less on some—and probably
most— goods. If the demand for a good falls when income falls, the good is
called a normal good.
Not all goods are normal goods. If the demand for a good rises
when income falls, the good is called an inferior good. An example of an
inferior good might be bus rides. As your income falls, you are less likely to
buy a car or take a cab, and more likely to ride the bus.
Prices of Related Goods Suppose that the price of
frozen yogurt falls. The law of demand says that you will buy more frozen
yogurt. At the same time, you will probably buy less ice cream. Because ice
cream and frozen yogurt are both cold, sweet, creamy desserts, they satisfy
similar desires. When a fall in the price of one good reduces the demand for
another good, the two goods are called substitutes. Substitutes are
often pairs of goods that are used in place of each other, such as hot dogs and
hamburgers, sweaters and sweatshirts, and movie tickets and video rentals.
Now suppose that the price of hot fudge falls. According to the
law of demand, you will buy more hot fudge. Yet, in this case, you will buy more
ice cream as well, because ice cream and hot fudge are often used together.
When a fall in the price of one good raises the demand for another good, the
two goods are called complements. Complements are often pairs of goods
that are used together, such as gasoline and automobiles, computers and
software, and skis and ski lift tickets.
Tastes The most obvious determinant of your demand is your tastes. If you
like ice cream, you buy more of it. Economists normally do not try to explain
people’s tastes because tastes are based on historical and psychological forces
that are beyond the realm of economics. Economists do, however, examine what
happens when tastes change.
Expectations Your expectations about the future may
affect your demand for a good or service today. For example, if you expect to
earn a higher income next month, you may be more willing to spend some of your
current savings buying ice cream. As another example, if you expect the price
of ice cream to fall tomorrow, you may be less willing to buy an ice-cream cone
at today’s price.
law of demand the claim that, other things equal, the
quantity demanded of a good falls when the price of the good rises
normal good a good for which, other things equal, an
increase in income leads to an increase in demand
inferior good a good for which, other things equal, an
increase in income leads to a decrease in demand
substitutes two goods for which an increase in the
price of one leads to an increase in the demand for the other
complements two goods for which an increase in the
price of one leads to a decrease in the demand for the other
THE DEMAND SCHEDULE AND THE DEMAND CURVE
We have seen that many variables determine the quantity of ice
cream a person demands. Imagine for the moment that we hold all these variables
constant except one—the price. Let’s consider how the price affects the
quantity of ice cream demanded.
Table 4-1 shows how many ice-cream cones Catherine buys each month
at different prices of ice cream. If ice cream is free, Catherine eats 12
cones. At $0.50 per cone, Catherine buys 10 cones. As the price rises further,
she buys fewer and fewer cones. When the price reaches $3.00, Catherine doesn’t
buy any ice cream at all.
Table 4-1 is a demand schedule, a table that shows the
relationship between the price of a good and the quantity demanded. (Economists
use the term schedule because the table, with its parallel columns of
numbers, resembles a train schedule.)
Figure 4-1 graphs the numbers in Table 4-1. By convention, the
price of ice cream is on the vertical axis, and the quantity of ice cream
demanded is on the horizontal axis. The downward-sloping line relating price
and quantity demanded is called the demand curve.
CETERIS PARIBUS
Whenever you see a demand curve, remember that it is drawn holding
many things constant. Catherine’s demand curve in Figure 4-1 shows what happens
to the quantity of ice cream Catherine demands when only the price of ice cream
varies. The curve is drawn assuming that Catherine’s income, tastes,
expectations, and the prices of related products are not changing.
Economists use the term ceteris paribus to signify
that all the relevant variables, except those being studied at that moment, are
held constant. The Latin phrase literally means “other things being equal.” The
demand curve slopes downward because, ceteris paribus, lower prices mean
a greater quantity demanded.
Although the term ceteris paribus refers to a hypothetical
situation in which some variables are assumed to be constant, in the real world
many things change at the same time. For this reason, when we use the tools of
supply and demand to analyze events or policies, it is important to keep in
mind what is being held constant and what is not.
PRICE
OF ICE-CREAM CONE QUANTITY OF CONES DEMANDED
$0.00
12
0.50
10
1.00
8
1.50
6
2.00
4
2.50
2
3.00
0
Table 4-1
Table 4.1 CATHERINE’S DEMAND SCHEDULE. The demand schedule shows
the quantity demanded at each price
MARKET DEMAND VERSUS INDIVIDUAL DEMAND
So far we have talked about an individual’s demand for a product.
To analyze how markets work, we need to determine the market demand, which
is the sum of all the individual demands for a particular good or service.
Table 4-2 (p. 00) shows the demand schedules for ice cream of two
individuals— Catherine and Nicholas. At any price, Catherine’s demand schedule
tells us how much ice cream she buys, and Nicholas’s demand schedule tells us
how much ice cream he buys. The market demand is the sum of the two individual
demands.
Because market demand is derived from individual demands, it
depends on all those factors that determine the demand of individual buyers.
Thus, market demand depends on buyers’ incomes, tastes, expectations, and the
prices of related goods. It also depends on the number of buyers. (If more
consumers were to join Catherine and Nicholas, the quantity demanded in the
market would be higher at every price.) The demand schedules in Table 4-2 show
what happens to quantity demanded as the price varies while all the other
variables that determine quantity demanded are held constant.
Figure 4-2 shows the demand curves that correspond to these demand
schedules. Notice that we sum the individual demand curves horizontally to
obtain the market demand curve. That is, to find the total quantity demanded at
any price, we add the individual quantities found on the horizontal axis of the
individual demand curves. Because we are interested in analyzing how markets
work, we will work most often with the market demand curve. The market demand
curve shows how the total quantity demanded of a good varies as the price of
the good varies.
Figure 4.2 MARKET
DEMAND AS THE SUM OF INDIVIDUAL DEMANDS. The market demand curve is found by
adding horizontally the individual demand curves. At a price of $2, Catherine
demands 4 ice-cream cones, and Nicholas demands 3 ice-cream cones. The quantity
demanded in the market at this price is 7 cones.
Table
4.2 INDIVIDUAL AND MARKET DEMAND SCHEDULES. The quantity demanded in a market
is the sum of the quantities demanded by all the buyers.
SHIFTS IN THE DEMAND CURVE
Suppose that the American Medical Association suddenly announces a
new discovery: People who regularly eat ice cream live longer, healthier lives.
How does this announcement affect the market for ice cream? The discovery
changes people’s tastes and raises the demand for ice cream. At any given price,
buyers now want to purchase a larger quantity of ice cream, and the demand
curve for ice cream shifts to the right.
Whenever any determinant of demand changes, other than the good’s
price, the demand curve shifts. As Figure 4-3 shows, any change that increases
the quantity demanded at every price shifts the demand curve to the right.
Similarly, any change that reduces the quantity demanded at every price shifts
the demand curve to the left.
Figure
4.3 SHIFTS IN THE DEMAND CURVE. Any change that raises the quantity that buyers
wish to purchase at a given price shifts the demand curve to the right. Any
change that lowers the quantity that buyers wish to purchase at a given price
shifts the demand curve to the left.
Table
4.3 THE DETERMINANTS OF QUANTITY DEMANDED. This table lists the variables that
can influence the quantity demanded in a market. Notice the special role that
price plays: A change in the price represents a movement along the demand
curve, whereas a change in one of the other variables shifts the demand curve.
Table
4-3 lists the variables that determine the quantity demanded in a market and
how a change in the variable affects the demand curve. Notice that price plays
a special role in this table. Because price is on the vertical axis when we
graph a demand curve, a change in price does not shift the curve but represents
a movement along it. By contrast, when there is a change in income, the price
of related goods, tastes, expectations, or the number of buyers, the quantity
demanded at each price changes; this is represented by a shift in the demand
curve.
In
summary, the demand curve shows what happens to the quantity demanded of a
good when its price varies, holding constant all other determinants of quantity
demanded.
SUPPLY
We now turn to the other side of the market and examine the
behavior of sellers. The quantity supplied of any good or service is the
amount that sellers are willing and able to sell. Once again, to focus our
thinking, let’s consider the market for ice cream and look at the factors that
determine the quantity supplied.
WHAT DETERMINES THE QUANTITY AN INDIVIDUAL SUPPLIES?
Imagine that you are running Student Sweets, a company that
produces and sells ice cream. What determines the quantity of ice cream you are
willing to produce and offer for sale? Here are some possible answers.
Price The price of ice cream is one determinant of the quantity
supplied. When the price of ice cream is high, selling ice cream is profitable,
and so the quantity supplied is large. As a seller of ice cream, you work long
hours, buy many ice cream machines, and hire many workers. By contrast, when
the price of ice cream is low, your business is less profitable, and so you
will produce less ice cream. At an even lower price, you may choose to go out
of business altogether, and your quantity supplied falls to zero.
Because the quantity supplied rises as the price rises and falls
as the price falls, we say that the quantity supplied is positively related to
the price of the good. This relationship between price and quantity supplied is
called the law of supply: Other things equal, when the price of a good
rises, the quantity supplied of the good also rises.
Input Prices To produce its output of ice cream,
Student Sweets uses various inputs: cream, sugar, flavoring, ice-cream
machines, the buildings in which the ice cream is made, and the labor of
workers to mix the ingredients and operate the machines. When the price of one
or more of these inputs rises, producing ice cream is less profitable, and your
firm supplies less ice cream. If input prices rise substantially, you might
shut down your firm and supply no ice cream at all. Thus, the supply of a good
is negatively related to the price of the inputs used to make the good.
Technology The technology for turning the inputs into ice cream is yet
another determinant of supply. The invention of the mechanized ice-cream
machine, for example, reduced the amount of labor necessary to make ice cream.
By reducing firms’ costs, the advance in technology raised the supply of ice
cream.
Expectations The amount of ice cream you supply today
may depend on your expectations of the future. For example, if you expect the
price of ice cream to rise in the future, you will put some of your current
production into storage and supply less to the market today.
quantity supplied the amount of a good that
sellers are willing and able to sell
THE SUPPLY SCHEDULE AND THE SUPPLY CURVE
Consider how the quantity supplied varies with the price, holding
input prices, technology, and expectations constant. Table 4-4 shows the
quantity supplied by Ben, an ice-cream seller, at various prices of ice cream.
At a price below $1.00, Ben does not supply any ice cream at all. As the price
rises, he supplies a greater and greater quantity. This table is called the supply
schedule.
Figure 4-5 graphs the relationship between the quantity of ice
cream supplied and the price. The curve relating price and quantity supplied is
called the supply curve. The supply curve slopes upward because, ceteris
paribus, a higher price means a greater quantity supplied.
MARKET SUPPLY VERSUS INDIVIDUAL SUPPLY
Just as market demand is the sum of the demands of all buyers,
market supply is the sum of the supplies of all sellers. Table 4-5 shows the
supply schedules for two ice-cream producers—Ben and Jerry. At any price, Ben’s
supply schedule tells us the quantity of ice cream Ben supplies, and Jerry’s
supply schedule tells us the quantity of ice cream Jerry supplies. The market
supply is the sum of the two individual supplies.
Market supply depends on all those factors that influence the
supply of individual sellers, such as the prices of inputs used to produce the
good, the available technology, and expectations. In addition, the supply in a
market depends on the number of sellers. (If Ben or Jerry were to retire from
the ice-cream business, the supply in the market would fall.) The supply
schedules in Table 4-5 show what happens to quantity supplied as the price
varies while all the other variables that determine quantity supplied are held
constant.
Table 4.5 INDIVIDUAL
AND MARKET SUPPLY SCHEDULES. The quantity supplied in a market is the sum of
the quantities supplied by all the sellers.
BEN’S
SUPPLY CURVE. This supply curve, which graphs the supply schedule in Table 4-4,
shows how the quantity supplied of the good changes as its price varies.
Because a higher price increases the quantity supplied, the supply curve slopes
upward.
Figure
4-6 shows the supply curves that correspond to the supply schedules in Table
4-5. As with demand curves, we sum the individual supply curves horizontally
to obtain the market supply curve. That is, to find the total quantity
supplied at any price, we add the individual quantities found on the horizontal
axis of the individual supply curves. The market supply curve shows how the
total quantity supplied varies as the price of the good varies.
SHIFTS IN THE SUPPLY CURVE
Suppose that the price of sugar falls. How does this change affect
the supply of ice cream? Because sugar is an input into producing ice cream,
the fall in the price of sugar makes selling ice cream more profitable. This
raises the supply of ice cream: At any given price, sellers are now willing to
produce a larger quantity. Thus, the supply curve for ice cream shifts to the
right.
Whenever there is a change in any determinant of supply, other
than the good’s price, the supply curve shifts. As Figure 4-7 shows, any change
that raises quantity supplied at every price shifts the supply curve to the
right. Similarly, any change that reduces the quantity supplied at every price
shifts the supply curve to the left.
Table 4-6 lists the variables that determine the quantity supplied
in a market and how a change in the variable affects the supply curve. Once
again, price plays a special role in the table. Because price is on the
vertical axis when we graph a supply curve, a change in price does not shift
the curve but represents a movement along it. By contrast, when there is a
change in input prices, technology, expectations, or the number of sellers, the
quantity supplied at each price changes; this is represented by a shift in the
supply curve.
In summary, the supply
curve shows what happens to the quantity supplied of a good when its price
varies, holding constant all other determinants of quantity supplied. When one
of these other determinants changes, the supply curve shifts.
ELASTICITY
AND ITS APPLICATION
Imagine
yourself as a Kansas wheat farmer. Because you earn all your income from
selling wheat, you devote much effort to making your land as productive as it
can be. You monitor weather and soil conditions, check your fields for pests
and disease, and study the latest advances in farm technology. You know that
the more wheat you grow, the more you will have to sell after the harvest, and
the higher will be your income and your standard of living.
One
day Kansas State University announces a major discovery. Researchers in its agronomy department have devised a new hybrid
of wheat that raises the amount farmers can produce from each acre of land by
20 percent. How should you react to this news? Should you use the new hybrid?
Does this discovery make you better off or worse off than you were before? In
this chapter we will see that these questions can have surprising answers. The
surprise will come from applying the most basic tools of economics—supply and
demand—to the market
for
wheat.
The
previous chapter introduced supply and demand. In any competitive market, such
as the market for wheat, the upward-sloping supply curve represents the
behavior of sellers, and the downward-sloping demand curve represents the behavior
of buyers. The price of the good adjusts to bring the quantity supplied and
quantity demanded of the good into balance. To apply this basic analysis to understand
the impact of the agronomists’ discovery, we must first develop one more tool:
the concept of elasticity. Elasticity, a measure of how much buyers and sellers
respond to changes in market conditions, allows us to analyze supply and demand
with greater precision.
THE
ELASTICITY OF DEMAND
When we discussed the determinants of demand , we noted that
buyers usually demand more of a good when its price is lower, when their
incomes are higher, when the prices of substitutes for the good are higher, or
when the prices of complements of the good are lower. Our discussion of demand
was qualitative, not quantitative. That is, we discussed the direction in which
the quantity demanded moves, but not the size of the change. To measure how
much demand responds to changes in its determinants, economists use the concept
of elasticity.
THE PRICE ELASTICITY OF DEMAND AND ITS DETERMINANTS
The law of demand states that a fall in the price of a good raises
the quantity demanded. The price elasticity of demand measures how much
the quantity demanded responds to a change in price. Demand for a good is said
to be elastic if the quantity demanded responds substantially to changes
in the price. Demand is said to be inelastic if the quantity demanded
responds only slightly to changes in the price.
What determines whether the demand for a good is elastic or
inelastic? Because the demand for any good depends on consumer preferences, the
price elasticity of demand depends on
the many economic, social, and psychological forces that shape individual
desires. Based on experience, however, we can state some general rules about
what determines the price elasticity of demand.
Necessities versus Luxuries Necessities tend to have
inelastic demands, whereas luxuries have elastic demands. When the price of a
visit to the doctor rises, people will not dramatically alter the number of
times they go to the doctor, although they might go somewhat less often. By
contrast, when the price of sailboats rises, the quantity of sailboats demanded
falls substantially. The reason is that most people view doctor visits as a
necessity and sailboats as a luxury. Of course, whether a good is a necessity
or a luxury depends not on the intrinsic
properties of the good but on the preferences of the buyer. For an
avid sailor with little
concern over his health, sailboats might be a necessity with inelastic demand
and doctor visits a luxury with elastic demand.
elasticity a measure of the responsiveness of quantity demanded or
quantity supplied to one of its determinants
price elasticity of demand a measure of how much
the quantity demanded of a good responds to a change in the price of that good,
computed as the percentage change in quantity demanded divided by the
percentage change in price
Availability of Close Substitutes Goods with close
substitutes tend to have more elastic demand because it is easier for consumers
to switch from that good to others. For example, butter and margarine are
easily substitutable. A small increase in the price of butter, assuming the
price of margarine is held fixed, causes the quantity of butter sold to fall by
a large amount. By contrast, because eggs are a food without a close
substitute, the demand for eggs is probably less elastic than the demand for
butter.
Definition of the Market The elasticity of demand in
any market depends on how we draw the boundaries of the market. Narrowly
defined markets tend to have more elastic demand than broadly defined markets,
because it is easier to find close substitutes for narrowly defined goods. For
example, food, a broad category, has a fairly inelastic demand because there
are no good substitutes for food. Ice cream, a more narrow category, has a more
elastic demand because it is easy to substitute other desserts for ice cream.
Vanilla ice cream, a very narrow category, has a very elastic demand because
other flavors of ice cream are almost perfect substitutes for vanilla.
Time Horizon Goods tend to have more elastic demand
over longer time horizons. When the price of gasoline rises, the quantity of
gasoline demanded falls only slightly in the first few months. Over time,
however, people buy more fuel efficient cars, switch to public transportation,
and move closer to where they work. Within several years, the quantity of
gasoline demanded falls substantially.
COMPUTING THE PRICE ELASTICITY OF DEMAND
Now that we have discussed the price elasticity of demand in
general terms, let’s be more precise about how it is measured. Economists
compute the price elasticity of demand as the percentage change in the quantity
demanded divided by the percentage change in the price. That is,
For example, suppose that a 10-percent increase in the price of an
ice-cream cone causes the amount of ice cream you buy to fall by 20 percent. We
calculate your elasticity of demand as
In this example, the elasticity is 2, reflecting that the change
in the quantity demanded is proportionately twice as large as the change in the
price.
Because the quantity demanded of a good is negatively related to
its price, the percentage change in quantity will always have the opposite sign
as the percentage
change in price. In this example, the percentage change in price is a positive
10 percent (reflecting an increase), and the percentage change in quantity
demanded is a negative 20 percent (reflecting a decrease). For
this reason, price elasticities of demand are sometimes reported as
negative numbers. In this book we follow the common practice of dropping the
minus sign and reporting all price elasticities as positive numbers.
(Mathematicians call this the absolute value.) With this convention, a
larger price elasticity implies a greater responsiveness of quantity demanded
to price.
THE MIDPOINT METHOD: A BETTER WAY TO CALCULATE PERCENTAGE
CHANGES AND ELASTICITIES
If you try calculating the price elasticity of demand between two
points on a demand curve, you will quickly notice an annoying problem: The
elasticity from point A to point B seems different from the elasticity from
point B to point A. For example, consider these numbers:
Point A: Price _ $4 Quantity _ 120 Point B: Price _ $6 Quantity _ 80
Going from point A to point B, the price rises by 50 percent, and
the quantity falls by 33 percent, indicating that the price elasticity of
demand is 33/50, or 0.66. By contrast, going from point B to point A, the price
falls by 33 percent, and the quantity rises by 50 percent, indicating that the
price elasticity of demand is 50/33, or 1.5.
One way to avoid this problem is to use the midpoint method for
calculating elasticities. Rather than computing a percentage change using the
standard way (by dividing the change by the initial level), the midpoint method
computes a percentage change by dividing the change by the midpoint of the
initial and final levels. For instance, $5 is the midpoint of $4 and $6.
Therefore, according to the midpoint method, a change from $4 to $6 is
considered a 40 percent rise, because (6 _ 4)/5 _ 100 _ 40. Similarly, a change
from $6 to $4 is considered a 40 percent fall.
Because the midpoint method gives the same answer regardless of
the direction of change, it is often used when calculating the price elasticity
of demand between two points. In our example, the midpoint between point A and
point B is:
Midpoint: Price _ $5 Quantity _ 100
According to the midpoint method, when going from point A to point
B, the price rises by 40 percent, and the quantity falls by 40 percent.
Similarly, when going from point B to point A, the price falls by 40 percent,
and the quantity rises by 40 percent. In both directions, the price elasticity
of demand equals 1.
We can express the midpoint method with the following formula for
the price elasticity of demand between two points, denoted (Q1, P1)
and (Q2, P2):
Price elasticity of demand _ .
(Q2 _ Q1)/[(Q2 _ Q1)/2]
(P2 _ P1)/[(P2 _ P1)/2]
The numerator is the percentage change in quantity computed using
the midpoint method, and the denominator is the percentage change in price
computed using the midpoint method. If you ever need to calculate elasticities,
you should use this formula.
Throughout this book, however, we only rarely need to perform such
calculations. For our purposes, what elasticity represents—the responsiveness
of quantity demanded to price—is more important than how it is calculated.
THE VARIETY OF DEMAND CURVES
Economists classify demand curves according to their elasticity.
Demand is elastic when the elasticity is greater than 1, so that
quantity moves proportionately more than the price. Demand is inelastic when
the elasticity is less than 1, so that quantity moves proportionately less than
the price. If the elasticity is exactly 1, so that quantity moves the same
amount proportionately as price, demand is said to have unit elasticity.
Because the price elasticity of demand measures how much quantity
demanded responds to changes in the price, it is closely related to the slope
of the demand curve. The following rule of thumb is a useful guide: The flatter
is the demand curve that passes through a given point, the greater is the price
elasticity of demand. The steeper is the demand curve that passes through a
given point, the smaller is the price elasticity of demand.
Figure 5-1 shows five cases. In the extreme case of a zero
elasticity, demand is perfectly inelastic, and the demand curve is
vertical. In this case, regardless of the price, the quantity demanded stays
the same. As the elasticity rises, the demand curve gets flatter and flatter.
At the opposite extreme, demand is perfectly elastic. This occurs as the
price elasticity of demand approaches infinity and the demand curve becomes
horizontal, reflecting the fact that very small changes in the price lead to
huge changes in the quantity demanded.
Finally, if you have trouble keeping straight the terms elastic
and inelastic, here’s a memory trick for you: Inelastic
curves, such as in panel (a) of Figure 5-1, look like the letter I. Elastic
curves, as in panel (e), look like the letter E. This is not a deep
insight, but it might help on your next exam.
TOTAL REVENUE AND THE PRICE ELASTICITY OF DEMAND
When studying changes in supply or demand in a market, one
variable we often want to study is total revenue, the amount paid by
buyers and received by sellers of the good. In any market, total revenue is P
X Q, the price of the good times the quantity of the good sold. We
can show total revenue graphically, as in Figure 5-2. The height of the box
under the demand curve is P, and the width is Q. The area of this
box, PX Q, equals the total revenue in this market. In Figure
5-2, where PX$4 and Q X100, total revenue is $4 X 100, or $400.
How does total revenue change as one moves along the demand curve?
The answer depends on the price elasticity of demand. If demand is inelastic,
as in Figure 5-3,
then an increase in the price causes an increase in total revenue.
Here
an increase in price from $1 to $3 causes the quantity demanded to fall only
from 100 to 80, and so total revenue rises from $100 to $240. An increase in
price raises P X Q because the fall in Q is
proportionately smaller than the rise in P.
Although the examples in these two figures are extreme, they
illustrate a general rule:
_ When a demand curve is inelastic (a price elasticity less than 1),
a price increase raises total revenue, and a price decrease reduces total
revenue.
_ When a demand curve is elastic (a price elasticity greater than
1), a price increase reduces total revenue, and a price decrease raises total
revenue.
_ In the special case of unit elastic demand (a price elasticity
exactly equal To 1), a change in the price does not affect total revenue.
Figure
5-1THE PRICE ELASTICITY OF DEMAND. The price elasticity of demand determines
whether the demand curve is steep or flat. Note that all percentage changes are
calculated using the midpoint method.
Figure
5-2 TOTAL REVENUE. The total amount paid by buyers, and received as revenue by sellers,equals the
area of the box under the demand curve, P XQ. Here, at a price of
$4, the quantity demanded is 100, and total revenue is $400.
Figure
5-3 HOW TOTAL REVENUE CHANGES WHEN PRICE CHANGES: INELASTIC DEMAND. With an
inelastic demand curve, an increase in the price leads to a decrease in
quantity demanded that is proportionately smaller. Therefore, total revenue
(the product of price and quantity) increases. Here, an increase in the price
from $1 to $3 causes the quantity demanded to fall from 100 to 80, and total
revenue rises from $100 to $240.
Figure
5.4 HOW TOTAL REVENUE CHANGES WHEN PRICE CHANGES: ELASTIC DEMAND. With an
elastic demand curve, an increase in the price leads to a decrease in quantity
demanded that is proportionately larger. Therefore, total revenue (the product
of price and quantity) decreases. Here, an increase in the price from $4 to $5
causes the quantity demanded to fall from 50 to 20, so total revenue falls from
$200 to $100.
ELASTICITY AND TOTAL REVENUE ALONG A LINEAR DEMAND CURVE
Although some demand curves have an elasticity that is the same
along the entire curve, that is not always the case. An example of a demand
curve along which elasticity changes is a straight line, as shown in Figure
5-5. A linear demand curve has a constant slope. Recall that slope is defined
as “rise over run,” which here is the ratio of the change in price (“rise”) to
the change in quantity (“run”). This particular demand curve’s slope is
constant because each $1 increase in price causes the same 2-unit decrease in
the quantity demanded.
Even though the slope of a linear demand curve is constant, the
elasticity is not. The reason is that the slope is the ratio of changes in
the two variables, whereas the elasticity is the ratio of percentage changes
in the two variables. You can see this most easily by looking at Table 5-1.
This table shows the demand schedule for the linear demand curve in Figure 5-5
and calculates the price elasticity of demand using the midpoint method
discussed earlier. At points with low price and high quantity, the demand curve
is inelastic. At points with a high price and low quantity, the demand curve is
elastic.
Table 5-1 also presents total revenue at each point on the demand
curve. These numbers illustrate the relationship between total revenue and
elasticity. When the price is $1, for instance, demand is inelastic, and a
price increase to $2 raises total revenue. When the price is $5, demand is
elastic, and a price increase to $6 reduces total revenue. Between $3 and $4,
demand is exactly unit elastic, and total revenue is the same at these two
prices.
OTHER DEMAND ELASTICITIES
In addition to the price elasticity of demand, economists also use
other elasticities to describe the behavior of buyers in a market.
income elasticity of demand
a measure of how much the quantity demanded of a good responds to
a change in consumers’ income, computed as the percentage change in quantity
demanded divided by the percentage change in income
The Income Elasticity of Demand Economists use the income
elasticity of demand to measure how the quantity demanded changes as
consumer income changes. The income elasticity is the percentage change in
quantity demanded divided by the percentage change in income. That is,
As
we discussed in Chapter 4, most goods are normal goods: Higher income
raises quantity demanded. Because quantity demanded and income move in the same
direction, normal goods have positive income elasticities. A few goods, such as
bus rides, are inferior goods: Higher income
lowers the quantity demanded. Because quantity demanded and income move in
opposite directions, inferior goods have negative income elasticities.
Even among normal goods, income elasticities vary substantially in
size. Necessities, such as food and clothing, tend to have small income
elasticities because consumers, regardless of how low their incomes, choose to
buy some of these goods. Luxuries, such as caviar and furs, tend to have large
income elasticities because consumers feel that they can do without these goods
altogether if their income is too low.
The Cross-Price Elasticity of Demand Economists
use the crossprice elasticity of demand to measure how the quantity
demanded of one good changes as the price of another good changes. It is
calculated as the percentage
change in quantity demanded of good 1 divided by the percentage
change in the price of good 2. That is,
Whether
the cross-price elasticity is a positive or negative number depends on whether
the two goods are substitutes or complements. As we discussed in Chapter 4,
substitutes are goods that are typically used in place of one another, such as hamburgers
and hot dogs. An increase in hot dog prices induces people to grill hamburgers
instead. Because the price of hot dogs and the quantity of hamburgers demanded
move in the same direction, the cross-price elasticity is positive. Conversely,
complements are goods that are typically used together, such as computers and
software. In this case, the cross-price elasticity is negative, indicating that
an increase in the price of computers reduces the quantity of software
demanded.
THE ELASTICITY OF SUPPLY
When we discussed the determinants of supply in Chapter 4, we
noted that sellers of a good increase the quantity supplied when the price of
the good rises, when their input prices fall, or when their technology
improves. To turn from qualitative to quantitative statements about supply, we
once again use the concept of elasticity.
THE PRICE ELASTICITY OF SUPPLY AND ITS DETERMINANTS
The law of supply states that higher prices raise the quantity
supplied. The price elasticity of supply measures how much the quantity
supplied responds to changes in the price. Supply of a good is said to be elastic
if the quantity supplied respondssubstantially to changes in the price.
Supply is said to be inelastic if the quantity supplied responds only
slightly to changes in the price.
The price elasticity of supply depends on the flexibility of
sellers to change the amount of the good they produce. For example, beachfront
land has an inelastic supply because it is almost impossible to produce more of
it. By contrast, manufactured goods, such as books, cars, and televisions, have
elastic supplies because the firms that produce them can run their factories
longer in response to a higher price. In most markets, a key determinant of the
price elasticity of supply is the time period being considered. Supply is
usually more elastic in the long run than in the short run. Over short periods
of time, firms cannot easily change the size of their factories to make more or
less of a good. Thus, in the short run, the quantity supplied is not very
responsive to the price. By contrast, over longer periods, firms can build new
factories or close old ones. In addition, new firms can enter a market, and old
firms can shut down. Thus, in the long run, the quantity supplied can respond substantially
to the price.
COMPUTING THE PRICE ELASTICITY OF SUPPLY
Now that we have some idea about what the price elasticity of
supply is, let’s be more precise. Economists compute the price elasticity of
supply as the percentage change in the quantity supplied divided by the
percentage change in the price.
That is,
For
example, suppose that an increase in the price of milk from $2.85 to $3.15 a
gallon raises the amount that dairy farmers produce from 9,000 to 11,000
gallons per month. Using the midpoint method, we calculate the percentage
change in price as Percentage change in price =(3.15 -2.85)/3.00X 100 = 10
percent. Similarly, we calculate the percentage change in quantity supplied as
Percentage change in quantity supplied = (11,000 -9,000)/10,000X 100=
20 percent.
In this case, the price elasticity of supply is
Price elasticity of supply =20%/10%=2.0.
In this example, the elasticity of 2 reflects the fact that the
quantity supplied moves proportionately twice as much as the price.
THE VARIETY OF SUPPLY CURVES
Because the price elasticity of supply measures the responsiveness
of quantity supplied to the price, it is reflected in the appearance of the
supply curve. Figure 5-6 shows five cases. In the extreme case of a zero
elasticity, supply is perfectly inelastic, and the supply
curve is vertical. In this case, the quantity supplied is the same regardless of
the price. As the elasticity rises, the supply curve gets flatter, which shows
that the quantity supplied responds more to changes in the price. At the
opposite extreme, supply is perfectly elastic. This occurs as the price
elasticity of supply approaches infinity and the supply curve becomes
horizontal, meaning that very small changes in the price lead to very large
changes in the quantity supplied. In some markets, the elasticity of supply is
not constant but varies over the supply curve. Figure 5-7 shows a typical case
for an industry in which firms have factories with a limited capacity for
production. For low levels of quantity supplied, the elasticity of supply is
high, indicating that firms respond substantially to changes in the price. In
this region, firms have capacity for production that is not being used, such as
plants and equipment sitting idle for all or part of the day.
Small
increases in price make it profitable for firms to begin using this idle
capacity. As the quantity supplied rises, firms begin to reach capacity. Once
capacity is fully used, increasing production further requires the construction
of new plants.
To
induce firms to incur this extra expense, the price must rise substantially, so
supply becomes less elastic. Figure 5-7 presents a numerical example of this
phenomenon. When the price rises from $3 to $4 (a 29 percent increase,
according to the midpoint method), the quantity supplied rises from 100 to 200
(a 67 percent increase). Because quantity supplied moves proportionately more
than the price, the supply curve has elasticity greater than 1. By contrast,
when the price rises from $12 to $15 (a 22 percent increase), the quantity
supplied rises from 500 to 525 (a 5 percent increase). In this case, quantity
supplied moves proportionately less than the price, so the elasticity is less
than 1.
Figure
5-7
HOW
THE PRICE ELASTICITY OF SUPPLY CAN VARY. Because firms often have a maximum
capacity for production, the elasticity of supply may be very high at low
levels of quantity supplied and very low at high levels of quantity supplied.
Here, an increase in price from $3 to $4 increases the quantity supplied from
100 to 200. Because the increase in quantity supplied of 100 percent is larger
than the increase in price of 33 percent, the supply curve is elastic in this
range. By contrast, when the price rises from $12 to $15, the quantity supplied
rises only from 500 to 525. Because the increase in quantity supplied of 5
percent is smaller than the increase in price of 25 percent, the supply curve
is inelastic in this range.
THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITY
Can good news for farming be bad news for farmers? Why did the
Organization of Petroleum Exporting Countries (OPEC) fail to keep the price of
oil high? Does drug interdiction increase or decrease drug-related crime? At
first, these questions might seem to have little in common. Yet all three
questions are about markets, and all markets are subject to the forces of
supply and demand. Here we apply the versatile tools of supply, demand, and
elasticity to answer these seemingly complex questions.
CAN GOOD NEWS FOR FARMING BE BAD NEWS FOR FARMERS?
Let’s now return to the question posed at the beginning of this
chapter: What happens to wheat farmers and the market for wheat when university
agronomists discover a new wheat hybrid that is more productive than existing
varieties? Recall from Chapter 4 that we answer such questions in three steps.
First, we examine whether the supply curve or demand curve shifts. Second, we
consider which direction the curve shifts. Third, we use the supply-and-demand
diagram to see how the market equilibrium changes.
In this case, the discovery of the new hybrid affects the supply
curve. Because the hybrid increases the amount of wheat that can be produced on
each acre of land, farmers are now willing to supply more wheat at any given
price. In other words, the supply curve shifts to the right. The demand curve
remains the same because consumers’ desire to buy wheat products at any given
price is not affected by the introduction of a new hybrid. Figure 5-8 shows an
example of such a change. When the supply curve shifts from S1 to S2,
the quantity of wheat sold increases from 100 to 110, and the price of wheat
falls from $3 to $2.
But does this discovery make farmers better off? As a first cut to
answering this question, consider what happens to the total revenue received by
farmers. Farmers’ total revenue is P _ Q, the price of the wheat
times the quantity sold. The discovery affects farmers in two conflicting ways.
The hybrid allows farmers to produce more wheat (Q rises), but now each
bushel of wheat sells for less (P falls). Whether total revenue rises or
falls depends on the elasticity of demand. In practice, the demand for basic
foodstuffs such as wheat is usually inelastic, for these items are relatively
inexpensive and have few good substitutes. When the demand curve is inelastic,
as it is in Figure 5-8, a decrease in price causes total revenue to fall. You
can see this in the figure: The price of wheat falls substantially, whereas the
quantity of wheat sold rises only slightly. Total revenue falls from $300 to
$220. Thus, the discovery of the new hybrid lowers the total revenue that
farmers receive for the sale of their crops.
If farmers are made worse off by the discovery of this new hybrid,
why do they adopt it? The answer to this question goes to the heart of how competitive
markets work. Because each farmer is a small part of the market for wheat, he
or she takes the price of wheat as given. For any given price of wheat, it is better to use the
new hybrid in order to produce and sell more wheat. Yet when all farmers do
this, the supply of wheat rises, the price falls, and farmers are worse off.
Although
this example may at first seem only hypothetical, in fact it helps to explain a
major change in the U.S. economy over the past century. Two hundred years ago,
most Americans lived on farms. Knowledge about farm methods was sufficiently
primitive that most of us had to be farmers in order to produce enough food.
Yet, over time, advances in farm technology increased the amount of food that
each farmer could produce. This increase in food supply, together with
inelastic food demand, caused farm revenues to fall, which in turn encouraged
people to leave farming.
A
few numbers show the magnitude of this historic change. As recently as 1950,
there were 10 million people working on farms in the United States,
representing 17 percent of the labor force. In 1998, fewer than 3 million
people worked on farms, or 2 percent of the labor force. This change coincided
with tremendous advances in farm productivity: Despite the 70 percent drop in
the number of farmers, U.S. farms produced more than twice the output of crops
and livestock in 1998 as they did in 1950.
This
analysis of the market for farm products also helps to explain a seeming paradox
of public policy: Certain farm programs try to help farmers by inducing them
not to plant crops on all of their land. Why do these programs do this? Their purpose
is to reduce the supply of farm products and thereby raise prices. With
inelastic demand for their products, farmers as a group receive greater total
revenue if they supply a smaller crop to the market. No single farmer would
choose to leave his land fallow on his own because each takes the market price
as given. Bu if all farmers do so together, each of them can be better off.
When analyzing the effects of farm technology or farm policy, it
is important to keep in mind that what is good for farmers is not necessarily
good for society as a whole. Improvement in farm technology can be bad for
farmers who become increasingly unnecessary, but it is surely good for
consumers who pay less for food.
Similarly, a policy aimed at reducing the supply of farm products
may raise the incomes of farmers, but it does so at the expense of consumers.
WHY DID OPEC FAIL TO KEEP THE PRICE OF OIL HIGH?
Many of the most disruptive events for the world’s economies over
the past several decades have originated in the world market for oil. In the
1970s members of the Organization of Petroleum Exporting Countries (OPEC)
decided to raise the world price of oil in order to increase their incomes.
These countries accomplished this goal by jointly reducing the amount of oil
they supplied. From 1973 to 1974, the price of oil (adjusted for overall
inflation) rose more than 50 percent. Then, a few years later, OPEC did the
same thing again. The price of oil rose 14 percent in 1979, followed by 34
percent in 1980, and another 34 percent in 1981. Yet OPEC found it difficult to
maintain a high price. From 1982 to 1985, the price of oil steadily declined at
about 10 percent per year. Dissatisfaction and disarray soon prevailed among
the OPEC countries. In 1986 cooperation among OPEC members completely broke
down, and the price of oil plunged 45 percent. In 1990 the price of oil
(adjusted for overall inflation) was back to where it began in 1970, and it has
stayed at that low level throughout most of the 1990s. This episode shows how
supply and demand can behave differently in the short run and in the long run.
In the short run, both the supply and demand for oil are relatively inelastic.
Supply is inelastic because the quantity of known oil reserves and the capacity
for oil extraction cannot be changed quickly. Demand is inelastic because
buying habits do not respond immediately to changes in price. Many drivers with
old gas-guzzling cars, for instance, will just pay the higher price. Thus, as
panel (a) of Figure 5-9 shows, the short-run supply and demand curves are
steep. When the supply of oil shifts from S1 to S2, the price
increase from P1 to P2 is large.
The
situation is very different in the long run. Over long periods of time,
producers of oil outside of OPEC respond to high prices by increasing oil
exploration and by building new extraction capacity. Consumers respond with
greater conservation, for instance by replacing old inefficient cars with newer
efficient ones. Thus, as panel (b) of Figure 5-9 shows, the long-run supply and
demand curves are more elastic. In the long run, the shift in the supply curve
from S1 to S2 causes a much smaller increase in the price.
This
analysis shows why OPEC succeeded in maintaining a high price of oil only in
the short run. When OPEC countries agreed to reduce their production of oil,
they shifted the supply curve to the left. Even though each OPEC member sold less
oil, the price rose by so much in the short run that OPEC incomes rose. By
contrast, in the long run when supply and demand are more elastic, the same
reduction in supply, measured by the horizontal shift in the supply curve,
caused a smaller increase in the price. Thus, OPEC’s coordinated reduction in
supply proved less profitable in the long run.
OPEC
still exists today. You will occasionally hear in the news about meetings of
officials from the OPEC countries. Cooperation among OPEC countries is less common now, however, in part because of the organization’s
past failure at maintaining a high price.
DOES DRUG INTERDICTION INCREASE OR DECREASE DRUG-RELATED CRIME?
A persistent problem facing our society is the use of illegal
drugs, such as heroin, cocaine, and crack. Drug use has several adverse
effects. One is that drug dependency can ruin the lives of drug users and their
families. Another is that drug addicts often turn to robbery and other violent
crimes to obtain the money needed to support their habit. To discourage the use
of illegal drugs, the U.S. government devotes billions of dollars each year to
reduce the flow of drugs into the country. Let’s use the tools of supply and
demand to examine this policy of drug interdiction.
Suppose the government increases the number of federal agents
devoted to the war on drugs. What happens in the market for illegal drugs? As
is usual, we answer this question in three steps. First, we consider whether
the supply curve or demand curve shifts. Second, we consider the direction of
the shift. Third, we see how the shift affects the equilibrium price and
quantity.
Although the purpose of drug interdiction is to reduce drug use,
its direct impact is on the sellers of drugs rather than the buyers. When the
government stops some drugs from entering the country and arrests more
smugglers, it raises the cost of selling drugs and, therefore, reduces the
quantity of drugs supplied at any given price. The demand for drugs—the amount
buyers want at any given price—is not changed. As panel (a) of Figure 5-10
shows, interdiction shifts the supply curve to the left from S1 to S2
and leaves the demand curve the same. The equilibrium price of drugs rises from
P1 to P2, and the equilibrium quantity falls from Q1 to Q2.
The fall in the equilibrium quantity shows that drug interdiction does reduce
drug use.
But what about the amount of drug-related crime? To answer this
question, consider the total amount that drug users pay for the drugs they buy.
Because few drug addicts are likely to break their destructive habits in
response to a higher price, it is likely that the demand for drugs is
inelastic, as it is drawn in the figure.
If demand is inelastic, then an increase in price raises total
revenue in the drug market. That is, because drug interdiction raises the price
of drugs proportionately more than it reduces drug use, it raises the total
amount of money that drug users pay for drugs. Addicts who already had to steal
to support their habits would have an even greater need for quick cash. Thus,
drug interdiction could increase drug-related crime.
Because of this adverse effect of drug interdiction, some analysts
argue for alternative approaches to the drug problem. Rather than trying to
reduce the supply of drugs, policymakers might try to reduce the demand by
pursuing a policy of drug education. Successful drug education has the effects
shown in panel (b) of Figure 5-10. The demand curve shifts to the left from D1
to D2. As a result, the equilibrium quantity falls from Q1 to Q2,
and the equilibrium price falls from P1 to P2. Total revenue,
which is price times quantity, also falls. Thus, in contrast to drug
interdiction, drug education can reduce both drug use and drug-related crime.
Advocates of drug interdiction might argue that the effects of this policy are
different in the long run than in the short run, because the elasticity of
demand may depend on the time horizon. The demand for drugs is probably
inelastic over short
periods of time because higher prices do not substantially affect drug use by
established addicts. But demand may be more elastic over longer periods of time
because higher prices would discourage experimentation with drugs among the
young and, over time, lead to fewer drug addicts. In this case, drug
interdiction would increase drug-related crime in the short run while
decreasing it in the long run.
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