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ELASTICITY
A concept used by economists
to measure the responsiveness
of people to changes in
economic variables.
ELASTICITY
If people are very responsive to
changes in economic variables, the
measure is said to be elastic or highly
elastic.
If people are not very responsive to
changes in economic variables, the
measure is said to be inelastic.
PRICE ELASTICITY OF DEMAND
• How much more of a product will a
consumer buy when the product
price decreases.
• How much less of a product will a
consumer buy when the product
price increases.
• What is the responsiveness of
consumers to changes in price.
PRICE ELASTICITY OF DEMAND
percentage change in quantity demanded
Ed= -------------------------------------------percentage change in price
• Percentage change in price equals the absolute
change in price divided by the initial price;
• Percentage change in quantity equals the
absolute change in quantity divided by the initial
quantity.
PRICE ELASTICITY OF DEMAND
• If the price of milk increases from
$2.00/quart to $2.20/quart, and
• the resulting quantity demanded changes
from 100 million gallons of milk to 85
gallons of milk,
• what is the elasticity of demand for milk ?
PRICE ELASTICITY OF DEMAND
% change Quantity
Ed = -------------------------------------% change Price
(New Quantity - Original Quantity) / (Original Quantity)
Ed = ---------------------------------------------------------------(New Price - Original Price) / (Original Price)
PRICE ELASTICITY OF DEMAND
PRICE
OF MILK
$$
Market Demand
Curve
$2.20
$2.00
85
•
100
Millions of Gallons of Milk per Year
(85 -100) / 100
-15 / 100
Ed = ------------------------------ = -----------------------------$2.20 -$2.00) / $2.00
$0.20 / $2.00
• Ed = 15% / 10% = 1.50
Demand is elastic.
PRICE ELASTICITY OF DEMAND
Midpoint (More Precise) Approach
% change Quantity
Ed = ----------------------------% change Price
(New Quantity - Original Quantity) / (Average Quantity)
Ed = --------------------------------------------------------------- (New Price - Original Price) / (Average Price)
PRICE ELASTICITY OF DEMAND
Midpoint (More Precise) Approach
PRICE
OF MILK
$$
Market Demand
Curve
$2.20
$2.00
85
•
100 Millions of Gallons of Milk per Year
[ (85 - 100) ÷ (85 +100) ] / 2
Ed = ------------------------------------[ ($2.20 - $2.00) ÷ ($2.20 + $2.00) ] / 2
•
-15 / 92.5
16.22%
Ed = ---------------------------- = -------------------------- = 1.70 Demand is elastic.
$0.20 / $2.
9.52%
THREE ELASTICITY GROUPS OF
CONSUMER DEMAND
GROUP
QUANTITY TO PRICE RELATIONSHIP VALUE
ELASTIC
Percentage change in quantity
>1
greater than percentage change in price.
INELASTIC Petrcentage change in quantity
less than percentage change in price.
<1
UNIT
ELASTIC
=1
Percentage change in quantity
equal to percentage change in price.
PRICE ELASTICITY AND
SUBSTITUTES
• NO GOOD SUBSTITUTES -Consumers are not very responsive to changes
in price;
Example:
insulin for diabetics;
Price elasticity of demand is inelastic.
• MANY SUBSTITUTES -Consumers will readily switch to alternative
product for small price changes;
Example:
cornflakes;
Price elasticity of demand is elastic.
Estimated Price Elasticities of Demand
for Selected Products
PRODUCT
salt
water
coffee
cigarettes
shoes and footware
housing
automobiles
foreign travel
restaurant meals
air travel
motion pictures
ELASTICITY
0.1
0.2
0.3
0.3
0.7
1.0
1.2
1.8
2.3
2.4
3.7
Other Determinants of Demand Elasticity
• TIME Greater time permits finding more substitutes;
consequently, elasticity of demand increases
with time: Greater time -- greater elasticity.
• PERCENTAGE OF BUDGET The smaller the price of a product with respect
to the size of the household budget, the more
inelastic will be the product demand.
• NECESSITIES VERSUS LUXURIES The greater the need for a product, the more
inelastic will be the product demand.
Elasticity Along a Linear Demand Curve
PRICE
$$
Elasticity = 4 = (20% / 5%)
80
76
Elasticity = 1.0 = (8% / 8%)
Elasticity = 0.25 =
(5% / 20%)
50
46
20
16
10 12 25 27 40 42
QUANTITY CONSUMED PER DAY
Elasticity Along a Linear Demand Curve
PRICE
$$
Elasticity = 4 : ELASTIC
80
76
Elasticity = 1.0 : UNIT ELASTIC
Elasticity = 0.25 :
INELASTIC
50
46
20
16
10 12 25 27 40 42
QUANTITY CONSUMED PER DAY
Using Elasticity of Demand to Calculate
Change in Quantity Demanded
GIVEN:
• Elasticity of Demand;
• Percentage change in Price;
• Ed = % change Quantity ÷ % change Price;
Percentage change in quantity may be
calculated from the two known values:
• % change Quantity = Ed x % change Price
Using Elasticity of Demand to Predict
changes in Total Revenue
DEMAND
Elastic
Elastic
PRICE TOTAL REVENUE
Increase
Declines
Decrease
Increases
(A negative relationship exists between price and total
revenue for an elastic demand.)
Inelastic
Inelastic
Increase
Decrease
Increases
Declines
(A positive relationship exists between price and total
revenue for an inelastic demand.)
PRICE ELASTICITY OF SUPPLY
• How much more of a product will a
producer make when the product price
increases.
• How much less of a product will a
producer make when the product price
drops.
• What is the responsiveness of producers
to changes in price.
PRICE ELASTICITY OF SUPPLY
percentage change in quantity supplied
Ed= ---------------------------------------percentage change in price
• Percentage change in price equals the absolute
change in price divided by the initial price;
• Percentage change in quantity equals the
absolute change in quantity divided by the initial
quantity.
PRICE ELASTICITY OF SUPPLY
• If the price of milk increases from
$2.00/quart to $2.20/quart, and
• the resulting quantity supplied changes
from 100 million gallons of milk to 120
gallons of milk,
• what is the elasticity of supply for milk ?
Elasticity of Supply
% change Quantity
Es = ------------------------------% change Price ;
(New Quantity - Original Quantity) / (Average Quantity)
Es = --------------------------------------------
(New Price - Original Price) / (Average Price)
Elasticity of Supply
PRICE
OF
MILK
$$
Market Supply
Curve
$2.20
$2.00
100
120
Millions of Gallons of Milk per Year
(20 /110)
Es = ------------------------- = 20% /10% = 2.0
( $0.20 / $2.10)
Supply is elastic;
PRICE ELASTICITY OF SUPPLY
• Increases with time;
• Limitations of production facilities in the
short run prevent firms from responding
with as much output increase as price
increases;
• As firms can increase production facilities,
in the longer run, the larger will be the
increase in quantity supplied.
Predicting Price Changes Using
Elasticities
An increase in demand (i.e., rightward shift):
• results in shortage at original price
(demand exceeds supply);
• establishes market equilibrium at higher
price, and quantity between original
equilibrium quantity and quantity
consumers now willing to buy at original
price;
• encourages producers to supply more and
consumers to buy less.
shortage
PRICE
OF MILK
$$
Supply S1
$2.00
Demand D2
Demand D1
100
150
Millions of Gallons of Milk per Year
Predicting Price Changes Using
Elasticities
With an increase in demand, the resulting
equilibrium price increase will be:
• small if consumers and producers are very
responsive to price changes (elastic
demand and elastic supply) ;
• larger if either is not very responsive (i.e.,
inelastic);
original
equilibrium
PRICE
OF MILK
$$
new
equilibrium
Supply S1
$2.05
$2.00
Demand D2
Demand D1
100 130
Millions of Gallons of Milk per Year
Predicting Price Changes Using
Elasticities
With an increase in demand, the resulting
percentage change in price can be found
by:
• Percentage change in price =
Percentage change in demand
------------------------------------------(Es + Ed)
Predicting Price Changes Using
Elasticities
With an increase in supply, the resulting
percentage change in price can be found
by:
• Percentage change in price =
Percentage change in supply
------------------------------------------(Es + Ed)
Predicting Price Changes Using
Elasticities
An increase in supply (i.e., rightward shift):
• results in excess at original price (supply
exceeds demand);
• establishes market equilibrium at lower
price, and quantity between original
equilibrium quantity and quantity
producers now willing to supply at original
price;
• encourages producers to supply less and
consumers to buy more.
PRICE
OF MILK
$$
Supply S1
$2.00
Supply S2
Demand D1
100
Millions of Gallons of Milk per Year
Predicting Price Changes Using
Elasticities
With an increase in supply, the resulting
equilibrium price decrease will be:
• small if consumers and producers are
responsive to price changes (elastic
demand and elastic supply) ;
• larger if either is not very responsive (i.e.,
inelastic);
original
equilibrium
PRICE
OF MILK
$$
new
equilibrium
Supply S1
$2.00
$1.80
Supply S2
Demand D1
100 110
Millions of Gallons of Milk per Year