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Elasticity and its Application www.lrjj.cn Definition of Elasticity • Elasticity measures the responsiveness of one variable to changes in another variable • How much does Y (dependent variable) change if X changes by 1% (independent variable) www.lrjj.cn Examples • • • • Price elasticity of demand Income elasticity of demand Cross price elasticity of demand Price elasticity of supply www.lrjj.cn Price Elasticity of Demand (PeD) • Responsiveness of quantity demanded to a change in price • The percentage change in quantity demanded, resulting from a 1% change in price PeD = %QD / %P www.lrjj.cn Market supply and demand S2 S1 Price b P2 c P3 a The effect on price of a shift in supply depends on the responsiveness of demand to a change in price. D' P1 D O Q3 Q2 Q1 Quantity www.lrjj.cn Determinants of PeD • • • • Availability of close substitutes Necessities versus luxuries Definition of the market Time horizon www.lrjj.cn Measuring elasticity using the arc method 10 m 8 n 6 P (£) 4 Demand 2 0 0 10 20 30 Q (000s) 40 50 www.lrjj.cn Measuring elasticity using the arc method 10 Ped = m Q mid Q P mid P 8 P = –2 7 n 6 P (£) Q = 10 Mid P 4 Demand 2 0 0 10 15 Mid Q 20 30 Q (000s) 40 50 www.lrjj.cn Measuring elasticity using the arc method 10 Ped = m 8 = P = –2 7 mid Q 10 15 P mid P -2 7 n 6 P (£) Q Q = 10 Mid P 4 Demand 2 0 0 10 15 Mid Q 20 30 Q (000s) 40 50 www.lrjj.cn Measuring elasticity using the arc method 10 Ped = m 8 = P = –2 7 n 6 P (£) = Q mid Q P mid P 10 15 - 2.33 -2 7 Q = 10 Mid P 4 Demand 2 0 0 10 15 Mid Q 20 30 Q (000s) 40 50 www.lrjj.cn PeD & Consumer Expenditure • Total Consumer Expenditure / Firm’s total revenue TE (TR) = P x Q • Applications to pricing decisions www.lrjj.cn Elastic Demand • Elasticity greater than 1 (PeD > 1) • Effect of price change – P rises: TE falls – P falls: TE rises www.lrjj.cn Elastic demand between two points Expenditure falls as price rises Expenditure rises as price falls P(£) 5 b a 4 0 D 10 20 Q (millions of units per period of time) www.lrjj.cn Inelastic Demand • Elasticity less than 1 (PeD < 1) • Effects of a price change – P rises: TE rises – P falls: TE falls www.lrjj.cn Inelastic demand between two points Expenditure rises as price rises 8 c Expenditure falls as price falls P(£) a 4 D 0 15 20 Q (millions of units per period of time) www.lrjj.cn Special cases • PeD = 0 (Perfectly Inelastic Demand) • PeD = (Perfectly Elastic Demand) • PeD = 1 (Unit Elastic Demand) www.lrjj.cn P Perfectly inelastic demand (PD = 0) D P2 b P1 a O Q1 Q www.lrjj.cn P Perfectly elastic demand (PD = ) a b D P1 O Q1 Q2 Q www.lrjj.cn P Unit elastic demand (PD = 1) Expenditure stays the same as price changes 20 a b 8 D O 40 100 Q www.lrjj.cn Price Elasticity of Supply (PS) • Responsiveness of quantity supplied to a change in price • The percentage change in quantity supplied, resulting from a 1% change in price PeS = %QS / %P www.lrjj.cn Price elasticity of supply P S1 P0 O Q0 Q www.lrjj.cn Price elasticity of supply P S1 S2 P1 P0 O Q0 Q1 Q2 Q www.lrjj.cn Income elasticity of demand (YeD) • Responsiveness of demand to a change in consumer incomes • The percentage change in quantity demanded, resulting from a 1% change in consumers income YeD = %QD / %Y www.lrjj.cn Income elasticity of demand (YeD) • Normal goods: – Positive income elasticity – If the income increases (decreases) the quantity demanded increases (decreases) – Example: Clothing, wine • Inferior goods: – Negative income elasticity – If the income increases (decreases) the quantity demanded decreases (increases) – Example: public transport www.lrjj.cn Cross-Price Elasticity of Demand (CeDab) • The responsiveness of demand for one good to a change in the price of another. • The percentage change in quantity demanded of one good, resulting from a 1% change in price of another good. CeDab = %QDa / %Pb www.lrjj.cn Cross-Price Elasticity of Demand (CeDab) • Substitutes: – Positive cross-price elasticity – If the price of good B increases the demand for good A increases – Example: hamburgers & burritos • Complements: – Negative income elasticity – If the price of good B increases the demand for good A decreases – Example: crude oil & cars www.lrjj.cn Why are elasticity useful? • Managers – Price elasticity of demand: Pricing strategy – Cross-price elasticity of demand: Defining the company’s market – Income elasticity: Forecast long-term demand • Government policy – Price elasticity of demand: Decision on Tax rate – Cross-price elasticity of demand: Competitive forces in a market www.lrjj.cn