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Elasticity of Demand and Supply Joudrey Elasticity of Demand • The formula that measures the actual change in quantity demanded for a product whose price has changed is the price elasticity of demand. • Coefficient of demand elasticity = % change in quantity demanded • % change in price Example • Gas sells for $0.50/liter and quantity demanded is 10 million liters each month. Then gas went up to $0.54/liter and quantity demanded went down to 9.5 million liters. Is gas considered elastic or inelastic? • To Solve: • Step 1: calculate the % change in quantity demanded: • Difference in quantity 9.5-10 x 100% = 5.13% Average quantity (9.5+10)/2 • We dropped the negative becasue we are interested in the change not the direction Example Cont. • Step 2: find the % change in price • Difference in price 0.54-0.5 Average price (0.54+0.50)/2 x100 =7.69% Example Cont. • Step 3: plug in the answers you found in Step 1 and Step 2 into your formula: • Coefficient of demand elasticity = % change in quantity demanded • % change in price • Coefficient of demand elasticity = 5.13% = 0.667 • 7.69% Making Sense of your Answer • Any coefficient between 0 and 1 has an Inelastic Coefficient. This means that given a percentage change in price there will be a smaller percentage change in quantity demanded. • In our example a 7.69% change in price resulted in a 5.13% change in quantity demanded. • As prices change for inelastic items the quantity demanded does not change as much (ex. Think of essential items or items that are inexpensive like a pencil). Another Example • If price rose from $0.66/liter to $0.70/liter and demanded decreased from 8 million liters to 7.5 million liters determine the coefficient of demand elasticity to determine if this product has an inelastic or elastic coefficient. • Remember elastic coefficients are greater than 1 • Unitary coefficients are equal to 1 • Inelastic coefficients are less than 1 Answer • Step 1: % change in Q Demanded =7.5-8 = -0.5 x100 = 6.45% • (7.5+8)/2 7.75 • Step 2: % change in Price = 0.7 – 0.66 = 0.04x 100% =5.88% • (0.7+0.66)/2 0.68 • Step 3: Coefficient of Demand Elasticity = 6.45% = 1.10 • 5.88% • Since the coefficient of demand elasticity is greater than 1 this item has an elastic demand. 5.88% change in price results in a 6.45% change in quantity demanded. • An elastic coefficient (greater than one) means a percentage change in price causes a greater percentage change in quantity demanded. • Elastic items (ex. Luxury, expensive items, items with substitutes or alternatives) • Unitary coefficient – when it is equal to one. Meaning a percentage change in price results in an equal percentage change in quantity demanded. Coefficient Related to Revenue • The coefficient will also tell you if the revenue will increase, decrease or stay the same. • Inelastic coefficient (between 0 and 1) revenue will rise • Elastic coefficient (greater than 1) revenue will decrease • Unitary coefficient (exactly one) revenue will stay the same Proof • Inelastic: • 10 million liters x $0.50/liter = $5 million • 9.5 million liters x $0.54/liter = $5.13 million • Resulting in an increase in revenue • Elastic: • 8 million liters x $0.66/liter = $5.28 million • 7.5 million liters x $0.70/liter = $5.25 million • Resulting in an decrease in revenue Elasticity of Supply • The concept of elasticity applies to the demand side as well as the supply side. • Generally as prices rise sellers will want to supply more because this will increase their profits. • The concept of elasticity of supply measures how responsive the quantity supplied by a seller is to a rise of fall in price. This is determined by the formula: • Coefficient of supply elasticity = % change in quantity supplied • % change in price Example • The market price of steel increases from $120/tonne to $140/tonne. The steel manufacturing company increases production from 1 million tonnes per day to 1.2 million tonnes. • Step 1: calculate the percentage change in quantity supplied: • = difference in quantity supplied = 1.2-1 x100% = 18.18% • Average quantity (1.2+1)/2 Example Continued • Step 2: Calculate the % change in price: • Difference in price = 140-120 x 100% = 15.38% • Average price (140+120)/2 • Step 3: Plug the two answers you just found into your formula: • Coefficient of supply elasticity= % change in Q. Supplied=18.18%=1.18 • % change in price 15.38% • If coefficient is: less than one – inelastic • Greater than one – elastic • Equal to one - unitary Making Sense of the Answer • The steel manufacturer’s ability to increase production supplied is elastic within this price range. • This means that when price increases by a certain % (in our example 15.38%) then manufacturer is able to increase quantity supplied at an even greater rate (in our example 18.18%) In General • A seller with an elastic supply can take more of an advantage of price increases than a seller with an inelastic supply. This means when the price of what company A is selling goes up, if company A has an elastic supply they can make more items to sell at the higher price, increasing their revenue. Video • www.khanacademy.org/economics-financedomain/microeconomics/elasticity-tutorial/price-elasticitytutorial/v/price-elasticity-of-demand