Download Intro to Elasticity

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Several components
Price Elasticity- the buying and selling
responses of consumers and producers to
price changes; that is, how MUCH change
occurs.
Cross Elasticity- the buying response of
consumers of one product when the price of
another product changes.
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Third: Income Elasticity- the buying response
of consumers when incomes change.
And we will look at markets in which
government set prices rule. Although we have
talked about this briefly, we will look a little
more closely.
Definition: 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 QD of a good
responds to a change in price of that good,
computed as the percentage change in
quantity demanded divided by the percentage
change in price.
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Since the law of demand states that a
decrease in the price of a good raises the
quantity demanded, we have a qualitative
tool. To have a quantitative tool elasticity is
invoked.
Price elasticity of demand measures how
much quantity demanded responds to a
change in price.
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Demand for a good is said to be elastic if the
quantity demanded responds substantially to
changes in price.
Demand is said to be inelastic if the quantity
demanded responds only slightly to changes
in price.
Elasticity is, then, a measure of how willing
consumers are to move away from a good as
its price rises. So elasticity reflects more than
just economic forces shaping tastes.
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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.
Examples: butter and margarine
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Necessities versus Luxuries: Necessities tend
to have inelastic demand curves, whereas
luxuries have elastic demand curves. We will
look at some examples. Also it is important
to remember that whether a good is a
necessity or luxury is buyer dependent.
Doctor visits and sailboats
Definition of the Market:
The elasticity of demand in any market
depends on how the boundaries of the
market are perceived. Narrowly defined
markets tend to have more elastic demand
than broadly defined markets. This is
because, generally, it is easier to find
substitutes for narrowly defined goods.
Food as a broad category, ice cream as a
narrow category.
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Time Horizon:
Goods tend to have more elastic demand over
longer time horizons. This is true in many cases,
but we will look at gasoline to examine this
determinant.
Gasoline tends to be relatively inelastic in the short
run. If the price of gasoline increases, short run
QD decreases relatively little. However, over time
consumers will move away from using gasoline,
so the QD will fall more quickly as time goes on
and Ceteris Paribus.
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Coefficient Ed defined as
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% change in QD of product
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% change in price of product
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or
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Ed=
 ∆ in QD of product
original QD of product
Divided by
∆ in Price of product
Original Price of product
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Because of the confusion that results from
positive and negative signs in the co-efficient
equations, economists tend to use absolute
value. So will we.
Using the Mid Point Formula: Because using
the coefficient formula will deliver results that
appear contradictory, the mid point formula
has been developed to smooth out possible
errata in calculation of elasticity.
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Ed=
Change in Q
divided by Change in Price
sum of quantities/2
sum of prices/2
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Perfectly Inelastic demand: elasticity =0
An increase in price leaves the qd unchanged
Inelastic demand: elasticity is less than 1
An increase in price lead to an decrease in qd
of less than an equal percentage but greater
than 0
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Unit Elastic Demand: an increase in price
leads to the exact same percentage decrease
in QD. In other words elastiticy = 1
Elastic Demand: Elasticity is greater than 1.
An increase in price leads to a decrease in QD
by greater than than 1x’s the percentage
increase in price.
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Perfectly elastic demand. Elasticity equal
infinity.
At any price above the horizontal demand
curve QD is zero. At any price on the
horizontal demand curve, consumers will buy
any quantity. At any price below the
horizontal demand curve, consumers QD is
infinite.
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One way to study elasticity is from the
perspective of revenue.
The variable, Total Revenue, which is the
amount paid by buyers and received by
sellers of the good. In any market total
revenue is P x Q (price of the good times
quantity of good sold.)
So, does total revenue change as movement
occurs along a demand curve?
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The answer is dependent on the elasticity of
demand
If demand is inelastic then an increase in P
causes an increase in total revenue. This is due to
the fact that by definition the percentage
increase in P is GREATER than the percentage
decrease in Q.
If demand is elastic, then an increase in P will
cause a decrease in total revenue. This is also
due to the fact that by definition, the percentage
increase in P is SMALLER than the percentage
decrease in Q.
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When demand is inelastic (price elasticity
coefficient less than 1) price and total
revenue move in the same direction
When demand is elastic ( price elasticity
coefficient is more than 1) price and total
revenue move in opposite directions.
If demand is unit elastic (price elasticity
coefficient is exactly equal to 1) total revenue
is constant when price changes.
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While the slope of a linear curve is constant,
the elasticity is not. Remember, the slope is
the ratio of changes in the two variables (p
and q) while elasticity is the ratio of
percentage changes in the two variables (p
and q).
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This measures how the quantity demanded of
one good changes as the price of another
good changes. It is calculated as the %
change in QD of good 1 divided by the %
change in the P of good 2. (Confused yet?)
Cross-price Elasticity of Demand=
%change in quantity demanded of good 1
% change in price of good 2
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IF cross elasticity of demand is positivemeaning that sales of good 1 move in the
direction of price of good 2, this indicates
good 1 and 2 are SUBSTITUTE goods. The
larger the cross-elasticity coefficient the
greater the substitutability of the two goods.
As you can see this gives us a much deeper
insight into the determination of demand
change.
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When cross-elasticity of demand is negative
(you will notice that we are NOT using
absolute value in cross elasticity) we know
that goods 1 and 2 are complementary. The
larger the negative coefficient, the more
complementary the two goods must be. This
is called, and I kid you not, the
complementarity of the two goods.
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Independent goods would be connoted by a
zero or near zero coefficient cross elasticity
of demand. These are goods where there is
no expectation that a change in price of one
would cause any change in Q of the other.
Cross elastiticy- substitutability is important
to business. How does the price change of
one brand affect another? Government may
also use this to assess mergers. If cross
elasticity is high, and substitutability is there,
mergers would be less likely.
Income Elasticity of Demand: measures how
the quantity demanded changes as consumer
income changes. (This is another determinant
of simple demand as I am sure you have
already gathered.) It is calculated as the %
change in QD divided by the % change in
income.
 Income elasticity of demand=
Percentage change in quantity demanded
Percentage change in income
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For most goods the income elasticity
coefficient Ei is positive, meaning more of
them are demanded as incomes rise. Such
goods are called normal or superior goods.
However, the value of Ei varies greatly among
normal goods. Farm products have fairly low
values and manufactured goods have
relatively high values.
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A negative income elasticity of demand
coefficient designates an inferior good.
Consumers decrease purchase of these goods
as incomes increase,
This income elasticity may help to explain the
growth and contraction of industries. Growth
will tend to go towards highly positive
coefficient goods and not towards low
coefficient goods.
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Elasticity in supply will examine the same
thing as in demand, that is, the quantitative
changes brought about in quantity supplied
by change in price.
Price elasticity of supply measures this
response. Supply of a good is said to be
elastic if the QS responds substantially to
changes in the P. Supply is said to be inelastic
if the QS responds only slightly to changes in
P.
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Price elasticity of supply depends on the
flexibility of sellers to change the amount of the
good they produce. Some goods are relatively
inelastic in supply, such as beachfront property.
By contrast, manufactured goods tend to have
elastic supplies because firms that produce them
can run plants longer in response to a higher
price.
In most markets a key determinant to price
elasticity of supply is the TIME PERIOD being
considered.
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In the long run supply is usually more elastic
than in the short run. Firms cannot easily
change the size of factories or make more or
less of a good in the short run. Thus in the
short run the quantity supplied is not very
responsive to price. In the long run firms can
make these changes and supply more, so the
quantity supplied can respond more
substantially to price change in the long run
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Pe of S= % ∆ in QS/ % ∆ in P
Milk P ↑ from $2.85 to $3.15 per gallon
Milk QS ↑ from 9,000 to 11,000 gallons
% ∆ in P (3.15-2.85)/3.00 (using midpoint
method) x100 = 10 %
% ∆ in QS= (11,000-9,000)/10,000
(midpoint method) x 100= 20%
Pe of S = 20%/10% =2 so QS moves 2 times
as quickly as P increases
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Perfectly Inelastic Supply: AN increase in price
leaves the quantity supplied unchanged.
There is a vertical supply curve
Inelastic supply: Elasticity coefficient is less
than 1. A % change in P leads to a smaller %
change in QS
Unit Elastic Supply: Elasticity equals exactly 1.
A certain % change in P leads to the same %
change in QS
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Elastic Supply: Elasticity is greater than 1. A %
increase in P leads to a % increase in QS
greater than that of change in price
Perfectly Elastic Supply: Elasticity equals
infinity. At any price above the supply curve,
QS is infinite. At exactly the price of the
horizontal supply curve, producers will supply
any quantity. At a price below the horizontal
supply curve, quantity supplied is zero.
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Elasticity of the supply curve may or may not be
constant depending on the market. For low levels
of QS elasticity is usually high or elastic because
firms have idle capacity and can respond quickly
with more production as a small increase in price
makes it profitable to do so. As QS rises, firms
reach capacity. Once capacity is fully engaged,
increasing production further requires significant
outlays to construct new plants. To induce this,
price must rise substantially for a reduced
increase in QS thus the supply curve becomes
more inelastic.