Download Our Friend Elasticity

Our Friend
Elasticity
Or, how I learned to love
percentages
Measuring Responsiveness or
Sensitivity
• Slope
– Unit dependent
• Currency
• Quantities
– No Starting Point
• Percentages
– Unit free
– Relational
Computing Elasticity
• Price elasticity of demand = %change in
quantity demanded/% change in price
• Income elasticity of demand = %change
in demand/% change in income
• Cross-price elasticity of demand =
%change in demand/% change in the
price of a related good
An Intuitive Approach to
Elasticity
• Since price elasticity is always zero (law of
demand) we ignore the negative sign and
take the absolute value of price elasticity.
• Ep > 1 Responsive or elastic
– %ΔQd > %ΔP a small %ΔP creates a large %ΔQd
• Ep < 1 Not responsive or inelastic
– %ΔQd < %ΔP a large %ΔP creates a small %ΔQd
• Ep = 1 unit elastic
– %ΔQd = %ΔP a given %ΔP creates an equal
%ΔQd
So????
Price and Total Revenue
TR= P X Q
• Ep > 1 Responsive or elastic
– %ΔQd > %ΔP if P goes down (up) total revenue
goes up (down)
• Ep < 1 Not responsive or inelastic
– %ΔQd < %ΔP if P goes down (up) total revenue
goes down (up)
• Ep = 1 unit elastic
– %ΔQd = %ΔP if P goes down (up) total revenue
stays the same
Determinants of Price
Elasticity
•
•
•
•
•
Availability of close substitutes
Necessity versus luxury
Definition of the market
Time horizon
Percentage of consumer budget
Price Elasticity – Using
Numbers
Ep = %ΔQd/ %ΔP
= (Q2- Q1)/[(Q2+ Q1)/2]
(P2- P1)/[(P2+ P1)/2]
Calculating Price Elasticitymputing the
Price Elasticity of Demand
(100 - 50)
ED 
Price
$5
4
0
Demand
50
(4.00 - 5.00)
(100  50)/2
(4.00  5.00)/2
67 percent

 -3
- 22 percent
100 Quantity
Demand is price elastic
Linear Demand Curve:Elasticity
Elasticity of Other Demand Curves
• Perfectly Elastic
• Perfectly Inelastic
• Unit Elastic
Elasticity of Supply
• Price elasticity of supply = %change in
quantity supplied/% change in price
Es
= %ΔQs/ %ΔP
= (Q2- Q1)/[(Q2+ Q1)/2]
(P2- P1)/[(P2+ P1)/2]
• Perfectly elastic and inelastic supply and unit
elastic (crossing the P or Q axis)
• Supply curves where elasticity varies
• Determinants of elasticity of supply
– Ability to increase or decrease production
(e.g Ellensburg agates, farm crops,
automobiles)
– Time period
Applications of Elasticity
• Farmers : fallacy of composition and
good crop/bad revenue years
• The economics of addictive drugs
• Pricing decisions and your future
business
Government and Markets
• Price Controls
– Price Ceilings (e.g. rent control)
– Price Floors (e.g. water)
• Taxes
– Who appears to pay the tax?
• Buyers “pay” tax
• Sellers “pay” tax
– Who really pays the tax? Tax incidence and
burden
• Case study – The payroll tax: Federal
Insurance Contribution Act (FICA) for
Social Security and Medicare
Elasticity and Tax Incidence
• Intuitive approach:
– If the buyers can respond relatively more to
price changes more than suppliers,
suppliers pay more of the tax.
– If the suppliers can respond relatively more
than the buyers, then the buyers pay more
of the tax.
• Extreme examples:
– Perfectly elastic demand
– Perfectly elastic supply
– Perfectly inelastic demand
– Perfectly inelastic supply
• Less extreme examples (e.g. the luxury
tax)