Download Elasticity

ECNE610
Managerial
Economics
Week 5
APRIL 2014
Chapter-4
1
Dr. Mazharul Islam
2
DEMAND
ELASTICITY
4
5
Dr. Mazharul Islam
3
Lesson Objectives
 define
and measure elasticity.
 apply
concepts of price elasticity,
cross-elasticity, and income elasticity.
 understand
determinants of elasticity.
 show
how elasticity affects business
revenue.
Dr. Mazharul Islam
4
Elasticity:
 In
economics, elasticity is the
measurement of how changing one
economic variable affects others.
Example: "If I lower the price of my
product, how much more will I sell?"
percent change in sell
Elasticity 
percent change in price
Dr. Mazharul Islam
5
Price elasticity of demand:
 The
responsiveness of the quantity demanded of a
good to a 1% change in its price when all other
influences on buying plans remain the same.
Qd  Qd
(Qd  Qd ) / 2
% Quantity
Ep 

P  P
% Price
( P  P) / 2
Here, P = initial price, Qd = initial quantity demanded,
P′ = new price, Q′d = new quantity demanded,  =
change
Dr. Mazharul Islam
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Point elasticity:
It measured elasticity
at a given point of a demand (or a supply)
curve. The point elasticity of a linear
demand function can be expressed as:
Q P1
p 

P Q1
Dr. Mazharul Islam
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Categories of elasticity
The price elasticity of demand can be divided into
three general categories depending on how
responsive quantity demanded is to a change in
price.
If the percent change in quantity demanded is
smaller than the percent change in price, the
resulting price elasticity has an absolute value
between 0 and 1.0  demand is inelastic. So we can
write: 0 < Ep < 1
Dr. Mazharul Islam
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Inelasticity Demand
$1.10
b
Price per taco
0.90
a
D
0 Thousands per day 95 105
Dr. Mazharul Islam
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Unit Elastic Demand
the percent change in quantity
demanded just equals the percent
change in price  a price elasticity
with an absolute value of 1.0  unitelastic demand.
Price per unit
If
E D=
$10
a
b
6
0
1
D"
60
100
Quantity
per period
Dr. Mazharul Islam
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Elastic Demand
If
the percent change in quantity
demanded exceeds the percent
change in price, the resulting price
elasticity has an absolute value
exceeding 1.0  demand is said to
be elastic.
Dr. Mazharul Islam
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Elastic Demand
$1.10
a
b
Price per taco
0.90
0
D
65
105
Thousands per day
Dr. Mazharul Islam
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Elasticity varies along a linear demand curve.
Dr. Mazharul Islam
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Perfectly Inelastic Demand
If
no change in quantity demanded
with the change in price  a price
elasticity with an absolute value of
0.0  perfectly inelastic demand.
Dr. Mazharul Islam
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Perfectly Elastic Demand
If
the percentage change in the
quantity demanded is infinitely large
when the price barely changes  a
price elasticity with an absolute
value of   perfectly elastic
demand.
Dr. Mazharul Islam
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Summary of the Categories of
elasticity of Demand
 Demand
is Elastic if : Ep > 1
 Demand is inelastic if : 0 < Ep < 1
 Demand is unit elastic if : Ep = 1
 Demand is perfect elastic: Ep = ∞
 Demand is perfect inelastic: Ep = 0
Dr. Mazharul Islam
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The Factors that Influence the
Elasticity of Demand
The availability and closeness of
substitutes goods.
The proportion of income spent
on the good.
The time elapsed since a price
change.
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The Factors that Influence the
Elasticity of Demand
The availability and closeness of
substitutes.
The greater and closer the substitutes for a
good or service, the more elastic is the
demand for the good or service. Because
consumers could choose its substitutes easily.
The
demand for a good is elastic if a substitute for
it is easy to find.
The demand for a good is inelastic if a substitute
for it is hard to find.
Dr. Mazharul Islam
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The Factors that Influence the
Elasticity of Demand
The proportion of income spent
on the good
The greater the proportion of income consumers
spend on a good, the larger is the elasticity of
demand for that good. Because a change in the
price of such a good has an affect consumers'
budget with a bigger magnitude. Consumers will
respond by cutting back more on these product
when price increases.
Dr. Mazharul Islam
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The Factors that Influence the
Elasticity of Demand
Time Elapsed Since Price
Change
The longer the time after the price change,
the more elastic will be the demand. It is
because consumers are given more time to
carry out their actions. The longer the
adjustment period, increase the consumers’
ability to substitute away from relatively
higher-priced products toward lower-priced
substitutes.
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Initial price = $1.00
Dw = the demand curve one week
after the price change
Dm = one month after
Dy, = one year after.
Suppose the price now
increases to $1.25. The
more time for consumers to
respond to price increase,
the greater the reduction in
quantity demanded.
$1.25
$1.00
Dw shows that one week after
the price increase, the quantity
demanded has not changed
much – in this case from 100
to 95. Conversely, after one
month, the quantity demanded
has declined to 75, and after
one year to 50 per day.
Dy
Dw
0
50
75 95 100
Dm
Quantity per
period
Note that among these demand curves, the
flatter the demand curve, the more price
elastic the demand.
Dr. Mazharul Islam
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Cross Elasticity of Demand
 Cross-elasticity
of
demand:
The
responsiveness of the demand for one
good to changes in the price of another
good is called the cross-price elasticity of
demand
In simplest term: the percentage change in
quantity consumed of one product as a
result of a 1 percent change in the price of
a related product
Ex 
% Q A
% PB
EX 
Q2 A  Q1 A
P2 B  P1B

(Q1 A  Q2 A ) / 2 ( P1B  P2 B ) / 2
Dr. Mazharul Islam
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Cross Elasticity of Demand
Cross
elasticity of demand
Its numerical value can be positive, negative,
or zero depending on the nature of goods.
 If goods are substitutes, the cross elasticity of
demand is positive
 If goods are complements, the cross
elasticity of demand is negative
 If goods are unrelated, the cross elasticity of
demand is zero.
Dr. Mazharul Islam
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Income Elasticity of Demand
 Income
elasticity of demand
the
percentage
change
in
quantity
demanded caused by a 1 percent change in
income. In simplest terms the percent change
in the demand of one good divided by the
percent change in income.
Percentage change in quantity demanded
income elasticity of demand = ---------------------------------------------------Percentage change in income
EY
Q2  Q1
Y2  Y1
% Q
EY 


(Q1  Q2 ) / 2 (Y1  Y2 ) / 2
% Y
Dr. Mazharul Islam
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More Elasticities of Demand
 Income
elasticity of demand
 If
the income elasticity of demand is greater
than 1, demand is income elastic and the
good is a normal good (luxury/superior goods)
 If the income elasticity of demand is greater
than zero but less than 1, demand is income
inelastic and the good is a normal good
(necessity goods)
 If the income elasticity of demand is less than
zero (negative) the good is an inferior good.
Dr. Mazharul Islam
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Elasticity of Supply
 The
elasticity of supply measures the
responsiveness of the quantity supplied to a
change in the price of a good when all other
influences on selling plans remain the same. In
simplest term, The price elasticity of supply
equals the percent change in quantity
supplied divided by the percent change in
price.
Percentage change in quantity supplied
Elasticity of supply =----------------------------------------------------------Percentage change in price
ES 
%  Quantity Supplied
%  Price
Es 
Q2  Q1
P2  P1

(Q1  Q2 ) / 2
( P1  P2 ) / 2
Dr. Mazharul Islam
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Elasticity of Supply
Note that the categories of supply
elasticity same as demand elasticity.
If
supply elasticity is less than 1.0, supply is
inelastic
If it equals 1.0, supply is unit elastic
If it exceeds 1.0, supply is elastic
If it is infinity, supply is perfectly elastic
If it is zero, supply is perfectly inelastic.
Dr. Mazharul Islam
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The Factors that Influence the
Elasticity of Supply
The elasticity of supply depends on
Resource
availability and
substitution
possibilities.
Time frame for supply decision.
Number of Producers
Easy of storing stock
Improvement in Technology
Stock of finished goods
Increase
in cost of production as
compared to output.
Dr. Mazharul Islam
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The Factors that Influence the
Elasticity of Supply
Resource availability and substitution
possibilities
The
easier it is to substitute among the
resources used to produce a good or service,
the greater is its elasticity of supply.
Alternatively also true.
So the greater the availability of resources,
the supply of goods and services will be
elastic and the smaller the availability, the
supply will be inelastic.
Dr. Mazharul Islam
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Time frame for supply decision
Supply becomes more elastic over time
producers adjust to price changes
Sw
Sm
Sy
Price per unit
Sw is the supply curve when the
period of adjustment is a week. In
this situation, the higher price does
not elicit much of a response in
quantity supplied because firms
have little time to adjust  supply
curve is inelastic if the price
increases from $1.00 to $1.25
as
Sm is the supply curve when the
adjustment period is one month.
Here the firms have a greater
0
ability to vary output  supply is
100
140 200 Quantity per period
110
more elastic
Supply is even more elastic when the adjustment period is a year as
shown by Sy
Dr. Mazharul Islam
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The Factors that Influence the
Elasticity of Supply
 Number
of producers
More producers mean that the output can be
increased more easily. Thus supply is more
elastic.
 Easy
of storing stocks
If goods can be stocked with ease and have a
long shelf life, the supply will be elastic,
otherwise inelastic. For example perishable
goods such as fresh flowers, vegetables have
comparatively inelastic supply because it is
difficult to store them for longer periods.
Dr. Mazharul Islam
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The Factors that Influence the
Elasticity of Supply
 Improvement
in Technology
In industries where there is a rapid improvement
in technology, the price elasticity of supply of
such goods will be more elastic as compared
to industries where there is not much
improvement in technology.
 Stock
of finished goods
In
industries
where
there
are
high
inventories/stocks of finished goods, the
suppliers can easily supply more as the price
rises. Thus, the price elasticity of supply for
these goods will be elastic.
Dr. Mazharul Islam
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The Factors that Influence the
Elasticity of Supply
Increase
in cost of production as
compared to output
In cases where there is a significant
increase in cost of production when
output is increased, supply is inelastic. This
is because suppliers will have to do a
significant investment in order to increase
the output. It will take time and some
suppliers may be hesitant in doing so.
Dr. Mazharul Islam
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Elasticity and Total Revenue
Total
revenue (TR) is the total amount
of money that received by selling
goods or services. That means TR
equals the price of the good multiplied
by the quantity sold  TR = p x q
What happens to total revenue when
price changes?
Dr. Mazharul Islam
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Chapter Four
Elasticity and Total Revenue
 The
relationship between price and
revenue depends on elasticity
Why? By itself, a price fall will reduce
receipts … BUT because the demand
curve is downward sloping, the drop in
price will also increase quantity
demanded
 Q: which effect will be stronger?
Dr. Mazharul Islam
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Elasticity and Total Revenue
If demand is elastic:
A given percentage rise in price brings a larger
percentage decrease in the quantity
demanded. Total revenue decreases.
If demand is inelastic:
A given percentage rise in price brings a smaller
percentage decrease in the quantity
demanded. Total revenue increases.
If demand is unit elastic: No change in total
revenue
Dr. Mazharul Islam
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Elasticity and Total Revenue
Total revenue test:
 If price and total revenue change in
the opposite directions, demand is
elastic.
 If a price change leaves total revenue
unchanged, demand is unit elastic.
 If price and total revenue change in
the same direction, demand is
inelastic.
Dr. Mazharul Islam
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Price per unit
Consider a movement from
point a to point b on the
demand curve. At point a,
TR = 100*90 = 9000. At
point b, TR = 200*80 =
16000. So is the demand of
good is elastic then
decrease in price will led
higher TR.
(a) Demand and Price Elasticity
$100
90
80
70
60
50
40
30
20
10
a
b
c
d
e
0
500
800 900 1,000
Quality per period
(b) Total Revenue
TR = p x q
$25,000
Total revenue
Between points d and e on
the lower end, calculate TR
and check what happens.
100 200
D
Total
revenue
0
Quantity per period
500
Dr. Mazharul Islam
1,000
38
Chapter Four
Elasticity and Total Revenue
 Marginal
revenue: the change in total
revenue resulting from changing quantity
by one unit
Total Revenue
MR 
Quantity
Elasticity and Total Revenue
 marginal
revenue
curve is twice as steep
as the demand
curve
Chapter Four
39
Elasticity and Total Revenue
 at
the point where
marginal revenue
crosses the X-axis, the
demand curve is
unitary elastic and total
revenue reaches a
maximum
Chapter Four
40
41
Do you have any question?
Dr. Mazharul Islam