Download Elasticity

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 (PD = 0)
D
P2
b
P1
a
O
Q1
Q
www.lrjj.cn
P
Perfectly elastic demand (PD = )
a
b
D
P1
O
Q1
Q2
Q
www.lrjj.cn
P
Unit elastic demand (PD = 1)
Expenditure stays the
same as price changes
20
a
b
8
D
O
40
100
Q
www.lrjj.cn
Price Elasticity of Supply
(PS)
• 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