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ITME no 5 Topic 3. Elasticity of demand and supply (2) Lecture slides available from my website: http://www.staff.city.ac.uk/j.s.cubbin Today’s lecture: Elasticity along a linear demand curve The relationship between price, demand and total revenue Factors that influence price elasticity of demand Other demand elasticities: income, prices of complements and substitutes Price elasticity of supply. Reading: Sloman Section 2.4. 478185602 1 ITME no 5 The arithmetic versus absolute value of elasticity Since demand elasticity PεD is usually negative in arithmetic terms we sometimes refer to its absolute value, written as | PεD| i.e. if PεD = - 1.5, then |PεD|= +1.5 Suppose that, for oranges PεD ( )= - 1.5, While for bananas PεD( ) = - 2.5, We might say that demand for bananas is more elastic for oranges – no problem. If we are tempted to say the elasticity is greater for bananas it is because we are thinking in terms of |PεD| the absolute value. But using such a phrase is dangerous as it is potentially ambiguous. 478185602 2 ITME no 5 1. PεD along a linear demand schedule Another reason why PεD is a better measure of ‘responsiveness’ than the slope of a linear demand schedule… PεD changes along a linear demand curve Price |PεD|> 1 80 70 |PεD| = 1 60 50 |PεD| < 1 40 30 20 10 0 0 1000 2000 3000 4000 5000 6000 7000 8000 Quantity Question… As you reduce prices along a linear, downward-sloping demand curve, what happens to total revenue on each part of the demand curve (elastic and inelastic)? What do you notice about total revenue at the point where |PεD| =1?(Hint: check extremes first) 478185602 3 ITME no 5 2. Some unusual cases where PεD is constant along the demand schedule. a. Perfectly elastic i.e. PεD = ∞ 80 70 60 Price 50 40 30 20 10 0 1000 2000 3000 4000 5000 6000 7000 8000 Quantity b. Perfectly inelastic i.e. PεD = 0 80 70 60 Price 50 40 30 20 10 0 0 1000 2000 3000 4000 5000 6000 7000 8000 Quantity 478185602 4 ITME no 5 c. Unitary elasticity i.e. PεD = 1 90 80 70 Price 60 50 40 30 20 10 0 0 10 20 30 40 50 60 70 80 90 Quantity (00s) 3. What factors influence PεD? a. Closeness of substitutes b. Proportion of income spent on the good d. Time elapsed since the price change In which direction do you think these effects work? 478185602 5 ITME no 5 4. Other demand elasticities Cross-price elasticity of demand = % Δ Qdx % Δ PY Some key definitions: If cross-price elasticity is…. Then the goods are…. positive substitutes zero independent negative complements 478185602 6 ITME no 5 5. Income elasticity of demand IεD = % Δ Qd % Δ income If income elasticity is…. Then the good is …. greater than one a luxury positive, but less than one a necessity negative inferior Can you provide examples of goods and services you would hypothesise to be luxuries? Inferior goods? 478185602 7 ITME no 5 Test your understanding… The price of good X increases from £2 to £2.40 and as a result the number of good Y sold per month increases from 950 to 1050. Using the ‘mid point’ (arc) method, the cross price elasticity of demand is: (a) 1.818 and goods X and Y are complements (b) -1.818 and goods X and Y are substitutes (c) –0.1818 and goods X and Y are complements (d) –0.55 and goods X and Y are complements (e) 0.55 and goods X and Y are substitutes (For calculation, see Cross price elasticity example.xls) 478185602 8 ITME no 5 6. Price elasticity of supply …measures the responsiveness the supply of a good to a change in its price. PεS = % Δ Qs % Δ price What determines PεS? resource substitution possibilities the rate at which costs rise as output rises the time elapsed since the price change 478185602 9 ITME no 5 7. Elastic and inelastic supply PεS = _____________ PεS = _____________ PεS = _____________ PεS = _____________ PεS = _____________ 478185602 10