Download Elasticity

CH5 :Elasticity
Asst. Prof. Dr. Serdar AYAN
The Concept of Elasticity

Elasticity is a measure of the responsiveness of
people to changes in economic variables.
How large is the response of producers and consumers to
changes in price? Before business firms and the
government decide to change prices and taxes, they
must anticipate the magnitude of response by those
affected.
Elasticity
elasticity A general concept used to quantify the
response in one variable when another variable
changes.
elasticity of A with respect to B 
%A
%B
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Price Elasticity of Demand
Slope and Elasticity
price elasticity of demand The ratio of the
percentage of change in quantity demanded to the
percentage of change in price; measures the
responsiveness of quantity demanded to changes
in price.
price elasticity of demand 
% change in quantity demanded
% change in price
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Price Elasticity of Demand
Types of Elasticity
TABLE 5.1 Hypothetical Demand Elasticities for Four Products
% Change In
Price
(% P)
% Change
In Quantity
Demanded
(% QD)
Insulin
+10%
0%
.0
Perfectly inelastic
Basic telephone service
+10%
-1%
-.1
Inelastic
Beef
+10%
-10%
-1.0
Unitarily elastic
Bananas
+10%
-30%
-3.0
Elastic
Product
Elasticity
(% QD ÷ %P)
perfectly inelastic demand Demand in which
quantity demanded does not respond at all to a
change in price.
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Price Elasticity of Demand
Types of Elasticity
inelastic demand
Demand that responds
somewhat, but not a great deal, to changes in
price. Inelastic demand always has a numerical
value between zero and -1.
A warning: You must be very careful about
signs. Because it is generally understood
that demand elasticities are negative
(demand curves have a negative slope), they
are often reported and discussed without the
negative sign.
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Price Elasticity of Demand
Types of Elasticity
unitary elasticity A demand relationship in which the
percentage change in quantity of a product demanded is
the same as the percentage change in price in absolute
value (a demand elasticity of -1).
elastic demand A demand relationship in which the
percentage change in quantity demanded is larger than
the percentage change in price in absolute value (a
demand elasticity with an absolute value greater than
1).
perfectly elastic demand Demand in which quantity
drops to zero at the slightest increase in price.
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Price Elasticity of Demand
Types of Elasticity
 FIGURE 5.2 Perfectly Inelastic and Perfectly Elastic Demand Curves
Figure 5.2(a) shows a perfectly inelastic demand curve for insulin. Price elasticity of demand
is zero. Quantity demanded is fixed; it does not change at all when price changes.
Figure 5.2(b) shows a perfectly elastic demand curve facing a wheat farmer. A tiny price
increase drives the quantity demanded to zero. In essence, perfectly elastic demand implies
that individual producers can sell all they want at the going market price but cannot charge a
higher price.
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Price Elasticity of Demand
Types of Elasticity
A good way to remember the difference
between the two “perfect” elasticities is:
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Interpreting the Value of Elasticity
Elasticity
Demand
Elasticity
Magnitudes
of Change
Response to
Price
Changes
Ed > 1
Elastic
%QD > %P
Responsive
Ed < 1
Inelastic
Value of
Unitary
elastic
The main determinant
of demand elasticity is
the availability of
substitutes for the
good in question.
Ed = 1
%QD < %P Unresponsive
%QD = %P
Type of
Elasticity
Proportional
Substitutes
Available
Elastic
Many
Inelastic
Few
Interpreting the Value of Elasticity

The price elasticity for
water (0.20) suggests
that a 10% increase in
the price of water would
decrease the quantity
demanded by only 2%.

The elasticity for specific
brands of coffee (5.6)
suggests that a 10%
increase in the price of a
specific
brand would
decrease
its
quantity
demanded by 56%.
Estimated price elasticities of
demand for selected products
Product
Price elasticity
of demand
Salt
0.1
Water
0.2
Coffee
0.3
Cigarettes
0.3
Shoes and footwear
0.7
Housing
1.0
Automobiles
1.2
Foreign travel
1.8
Restaurant meals
2.3
Air travel
2.4
Motion pictures
3.7
Specific brands of coffee
5.6
Computing the Price Elasticity of Demand
Percentage change in quantity demanded
Price elasticity of demand =
Percentage change in price
Example: If the price of an ice cream cone increases
from 2.00TL to 2.20TL and the amount you buy
falls from 10 to 8 cones, then your elasticity of
demand would be calculated as:
(10  8)
 100
20%
10

2
(2.20  2.00)
 100 10%
2.00
Computing Price Elasticity of Demand
percentage change in quantity demanded
Ed 
percentage change in price
85  100 15
% Q 

 015
. or 15%
100
100
$2.20  $2.00 $0.20
% P 

 10%
$2.00
$2.00
%  Q 15%

 150
.
%  P 10%
Elasticity Along a Linear Demand Curve
Price elasticity of demand
decreases as we move
downward along a linear
demand curve

Demand is elastic on the
upper part of the demand
curve and inelastic on the
lower part.
Percentage
Percentage
Elasticity
decrease in price increase in quantity
Point r to point s
4/80 = 5%
2/10 = 20%
20%/5% = 4.0
Point t to point u
4/50 = 8%
2/25 = 8%
8%/8% = 1
2/40 = 5%
5%/20% = 0.25
Point v to point w 4/20 = 20%
Calculating Elasticities
Elasticity and Total Revenue
In any market, P x Q is total revenue (TR)
received by producers:
TR = P x Q
total revenue = price x quantity
When price (P) declines, quantity demanded
(QD) increases. The two factors, P and QD
move in opposite directions:
Effects of price changes
on quantity demanded:
P  QD 
and
P  QD 
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Calculating Elasticities
Elasticity and Total Revenue
Because total revenue is the product of P and Q,
whether TR rises or falls in response to a price
increase depends on which is bigger:
the
percentage increase in price or the percentage
decrease in quantity demanded.
Effects of price increase on
a product with inelastic demand:
 P x QD   TR 
If the percentage decline in quantity demanded
following a price increase is larger than the
percentage increase in price, total revenue will
fall. Effects of price increase on
a product with elastic demand:
 P x QD   TR 
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Predicting Changes in Total Revenue
Elasticity and Total Revenue
Type of
deman
d
Value of Ed
Effect of an
increase in
Change in quantity
price on total
versus change in price revenue
Effect of a
decrease in price
on total revenue
Elastic
Greater than
1.0
Larger percentage change
in quantity
Total revenue
decreases
Total revenue
increases
Inelastic
Less than 1.0
Smaller percentage
change in quantity
Total revenue
increases
Total revenue
decreases
Unitary
elastic
Equal to 1.0
Same percentage change
in quantity and price
Total revenue
does not change
Total revenue does
not change
Calculating Elasticities
Elasticity and Total Revenue
The opposite is true for a price cut. When
demand is elastic, a cut in price increases total
revenues:
effect of price cut on a product
with elastic demand:
 P x QD   TR 
When demand is inelastic, a cut in price reduces
total revenues:
effect of price cut on a product
with inelastic demand:
 P x QD   TR 
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The Determinants of Demand Elasticity
Availability of Substitutes
Perhaps the most obvious factor affecting demand
elasticity is the availability of substitutes.
The Importance of Being Unimportant
When an item represents a relatively small part of
our total budget, we tend to pay little attention to its
price.
The Time Dimension
The elasticity of demand in the short run may be very
different from the elasticity of demand in the long run.
In the longer run, demand is likely to become more
elastic, or responsive, simply because households
make adjustments over time and producers develop
substitute goods.
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Other Important Elasticities
Income Elasticity of Demand
income elasticity of demand A measure of
the responsiveness of demand to changes in
income.
income elasticity of demand 
% change in quantity demanded
% change in income
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Income Elasticity
percentage change in quantity demanded
Ei =
percentage change in income
Classification of Goods According to Income
Elasticity
Income
Elasticity
Type of Good
Responsiveness
E i> 0
Normal
Ei<0
Inferior
Income 
QD 
Income
Ei>1
Luxury
% QQDD> % I
Ei<1
Necessity
% QD < % I
Other Important Elasticities
Cross-Price Elasticity Of Demand
cross-price elasticity of demand A measure of
the response of the quantity of one good
demanded to a change in the price of another
good.
% change in quantity of Y demanded
cross - price elasticity of demand 
% change in price of X
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Cross Elasticity of Demand
E xy
percentage change in quantity of X demanded
=
percentage change in price of Y
Classification of Goods According to Cross
Elasticity
Cross Elasticity Type
of Good Responsiveness
Exy > 0
Substitutes
Py   Qx
Exy < 0
Complements
Py   Qx
Price Elasticity of Supply
Price elasticity of supply is a measure of the
responsiveness in quantity supplied to
changes in price.
percentage change in quantity supplied
Es 
percentage change in price
Computing Price Elasticity of Supply
percentage change in quantity supplied
Es 
percentage change in price
120  100
20
% Qs 

 20%
100
100
$2.20  $2.00 $0.20
% P 

 10%
$2.00
$2.00
%  Qs 20%
Es 

 2.0
%  P 10%
Supply Elasticity and Time
Supply becomes more
elastic over time.
The increase in quantity
supplied as a response
to an increase in price
is greater when supply
is more elastic.
Higher market prices give business firms an incentive to expand
production and output. As time goes by, the ability of firms to
expand productive capacity is greater, and supply becomes more
elastic.