Elasticity. The Concept of Elasticity

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1 Elasticity 1 The Concept of Elasticity Elasticity is a measure of the responsiveness of one variable to another. The greater the elasticity, the greater the responsiveness. 2 1

2 Types of Elasticity Price elasticity Income elasticity Cross elasticity 3 Price Elasticity The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. ED = Percentage change in quantity demanded Percentage change in price 4 2

3 Sign of Price Elasticity According to the law of demand, whenever the price rises, the quantity demanded falls. Thus the price elasticity of demand is always negative. Because it is always negative, economists usually state the value without the sign. 5 What Information Price Elasticity Provides Price elasticity gives the exact quantity response to a change in price. 6 3

4 Classifying Demand and Supply as Elastic or Inelastic Demand is elastic if the percentage change in quantity is greater than the percentage change in price. E > 1 7 Classifying Demand and Supply as Elastic or Inelastic Demand is inelastic if the percentage change in quantity is less than the percentage change in price. E < 1 8 4

5 Elastic Demand Elastic Demand means that quantity changes by a greater percentage than the percentage change in price. 9 Inelastic Demand Inelastic Demand means that quantity doesn't change much with a change in price. 10 5

6 Elasticity is Independent of Units Percentages allow us to have a measure of responsiveness that is independent of units. This makes comparisons of responsiveness of different goods easier. 11 Calculating Elasticity To determine elasticity divide the percentage change in quantity by the percentage change in price. Q P Q P 12 6

7 Table: The Endpoint Problem values are in absolute form P1 P2 P Q1 Q2 Q Elasticity ??? % change in P 33% or 50% % change in Q 100% or 50% 13 The End-Point Problem the percentage change differs depending on whether you view the change as a rise or a decline in price. 14 7

8 The Solution to the End-Point Problem Economists use the average of the end points to calculate the percentage change. (Q2 -Q 1) ½ ( Q2 + Q1 Elasticity ) = (P2 - P1) ½ P1+ P2 ( ) 15 Graphs of Elasticities Taka B C (midpoint) A D Quantity 16 8

9 Graphs of Elasticities $ C B (midpoint) A Quantity of workers 17 Tk 26 Calculating Elasticity of Demand Between Two Points B midpoint Elasticity of demand between A and B: C A E D = Demand % Q E = % P ( ) = = = ( ) Quantity 18 9

10 Calculating Elasticity of Supply Between Two Points $ C B A Quantity of workers E Elasticity of supply % Q between A and B: E = % P ( ) = ( ) = S = 2 = 19.2 So far, the method we have used to calculate elasticity is commonly known as the ARC ELASTICITY there is another method called the POINT ELASTICITY. Estimation of Point Elasticity requires knowledge of calculus

11 Calculating Elasticity at a Point To calculate elasticity at a point, we use calculus. the formula for calculating point elasticity of demand is: dq dp P Q 21 Calculating Elasticity at a Point Suppose the demand function is: Q = 100 P 2 if we assume that P = 5 and Q = 75 then the point elasticity is: 2 P = 2 (5) = 75 =

12 Elasticity and the Demand curve When the curve is flat, we call the curves perfectly elastic. The quantity changes enormously in response to a proportional change in price (E = ). 23 Elasticity and the Demand curve When the curves are vertical, we call the curves perfectly inelastic. The quantity does not change at all in response to an enormous proportional change in price (E = 0)

13 Perfectly Inelastic Demand Curve Perfectly inelastic demand curve 0 Quantity 25 Perfectly Elastic Demand Curve Perfectly elastic demand curve 0 Quantity 26 13

14 Demand Curve Shapes and Elasticity Perfectly Elastic Demand Curve The demand curve is horizontal, any change in price can and will cause consumers to change their consumption. Perfectly Inelastic Demand Curve The demand curve is vertical, the quantity demanded is totally unresponsive to the price. Changes in price have no effect on consumer demand. In between the two extreme shapes of demand curves are the demand curves for most products. 27 Substitution and Elasticity As a general rule, the more substitutes a good has, the more elastic is its supply and demand. The less a good is a necessity, the more elastic its demand curve. Necessities tend to have fewer substitutes than do luxuries

15 Substitution and Demand Goods that cost very little relative to your total expenditures are not worth spending a lot of time figuring out if there is a good substitute. It is worth spending a lot of time looking for substitutes for goods that take a large portion of one s income. 29 Substitution and Demand The larger the time interval considered, or the longer the run, the more elastic is the good s demand curve. There are more substitutes in the long run than in the short run. The long run provides more options for change

16 Determinants of the Price Elasticity of Demand The degree to which the price elasticity of demand is inelastic or elastic depends on: How many substitutes there are How well a substitute can replace the good or service under consideration The importance of the product in the consumer s total budget The time period under consideration 31 Implication of Inelastic Demand Curve Price Producer decides to lower price to attract sales 10 5 % Price = -50% % Quantity Demanded = +20% Ped = -0.4 (Inelastic) Total Revenue would fall Not a good move! D 5 6 Quantity Demanded 32 16

17 Implication of Elastic Demand Curve Price 10 7 Producer decides to reduce price to increase sales % in Price = - 30% % in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises Good Move! D 5 Quantity Demanded So, the decision is... If demand is price elastic: Reducing price would increase TR (% Qd > % P) If demand is price inelastic: Reducing price would reduce TR (% Qd < % P) 34 17

18 Cross Elasticity The responsiveness of demand of one good to changes in the price of a related good either a substitute or a complement Xed = % Qd of good t % Price of good y 35 Implication of Cross Elasticity Goods which are complements: Cross Elasticity will have negative sign (inverse relationship between the two) Goods which are substitutes: Cross Elasticity will have a positive sign (positive relationship between the two) 36 18

19 Income Elasticity The degree of responsiveness of quantity demanded to the change in income. 37 what is the sign of income elasticity? 38 19