Download ELASTICITY

Chapter 4
Application on
Demand and
Supply
1
Elasticity
 Elasticity
is a general concept
that can be used to quantify the
response in one variable when
another variable changes.
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How to measure elasticity
% A
elasticity of A with respect to B 
% B
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Price Elasticity of Demand
 A popular
measure of elasticity is
price elasticity of demand
measures how responsive
consumers are to changes in the
price of a product.
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How to measure P.E.D
% change in quantity demanded
price elasticity of demand 
% change in price
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The absolute term
• The value of demand elasticity
is always negative, but it is
stated in absolute terms.
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Slope and Elasticity
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
The value of the slope of the demand
curve and the value of elasticity are not
the same.

Unlike the value of the slope, the value
of elasticity is a useful measure of
responsiveness.
Slope and Elasticity
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continue
 Changing
the units of measure
yields a very different value of the
slope, yet the behavior of buyers in
both diagrams is identical.
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Types of Elasticity
 Hypothetical
Demand
Elasticities for Four Products
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Hypothetical Demand Elasticities for Four Products
PRODUCT
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%
% CHANGE IN
CHANGE
QUANTITY
IN PRICE
DEMANDED (%QD)
(%P)
ELASTICITY
(%QD d %P)
Insulin
+10%
0%
0.0
Perfectly
inelastic
Basic telephone
service
+10%
-1%
-0.1
Inelastic
Beef
+10%
-10%
-1.0
Unitarily
elastic
Bananas
+10%
-30%
-3.0
Elastic
Perfectly Elastic and
Perfectly Inelastic Demand Curves
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Perfect elasticity
When demand does not respond at all
to a change in price, demand is
perfectly inelastic.
 Demand is perfectly elastic when
quantity demanded drops to zero at the
slightest increase in price.

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Calculating Elasticities
P2  P1
% change in price 
x 100%
P1
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% change in Quantity
Q2  Q1
% change in quantity demanded 
x 100%
Q1
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Calculating Elasticities
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Elasticity
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
Elasticity is a ratio of percentages.

Using the values on the graph to compute
elasticity, using percentage changes yields
the following result:
Price Elasticity
 100%
price elasticity of demand 
  3.0
 33.3%
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Calculating Elasticities
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The midpoint formula
 A more
accurate way of computing
elasticity than percentage changes
is the midpoint formula:
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The midpoint formula
Q2  Q1
x 100%
%  Qd
(Q1  Q2 ) / 2

P2  P1
% P
x 100%
( P1  P2 ) / 2
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The midpoint formula
10  5
x 100%
%  Qd (5  10) / 2


2 3
% P
x 100%
( 3  2) / 2
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5
x 100% 66.7%
7.5
=
  167
.
-1
-40.0%
x 100%
2.5
Interpret Elasticities
Here is how to interpret two different values of
elasticity:
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
When e = 0.2, a 10% increase in price leads
to a 2% decrease in quantity demanded.

When e = 2.0, a 10% increase in price leads
to a 20% decrease in quantity demanded.
Elasticity Changes along a
Straight-Line Demand Curve
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Elasticity along a Straight-Line
Price elasticity of demand decreases as
we move downward along a straight
line demand curve.
 Demand is elastic in the upper range
and inelastic in the lower range of the
line.

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Elasticity
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
Along the elastic range, elasticity values are
greater than one.

Along the inelastic range, elasticity values
are less than one.
Elasticity and Total Revenue
TR  P  Q
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Value
of Ed
Change in
quantity versus
change in price
Effect of an
increase in
price on total
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
Type of
demand
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Elasticity and Total Revenue
 When demand is inelastic, price and total
revenues are directly related. Price
increases generate higher revenues.
 When demand is elastic, price and total
revenues are indirectly related. Price
increases generate lower revenues.
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The Determinants of Demand Elasticity


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Availability of substitutes -- demand is more
elastic when there are more substitutes for
the product.
Time dimension -- demand becomes more
elastic over time.
continue

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Importance of the item in the budget -demand is more elastic when the item is a
more significant portion of the consumer’s
budget.
Home Exam

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Define economics and it main branches.
What is elasticity, and what is its application?
Give example to calculate price elasticity of demand
& explain its importance.
Explain the relation between elasticity & revenue?
How to use the relation in decision making? Give
numerical examples.
What are factors determines the elasticity?
Use Graphs and numerical examples as much as
you can in answers.
Other Important Elasticities
elasticity of demand –
measures the responsiveness of
demand to changes in income.
 Income
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The form
% change in quantity demanded
income elasticity of demand 
% change in income
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Other Important Elasticities

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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.
The form
% change in quantity of Y demanded
cross-price elasticity of demand 
% change in price of X
37
Other Important Elasticities
 Elasticity
of supply: A measure
of the response of quantity of a
good supplied to a change in price
of that good. Likely to be positive
in output markets.
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The form
% change in quantity supplied
elasticity of supply 
% change in price
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Other Important Elasticities
 Elasticity
of labor supply: A
measure of the response of labor
supplied to a change in the price of
labor.
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The form
% change in quantity of labor supplied
elasticity of labor supply 
% change in the wage rate
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The
Price System:
Rationing and Allocating
Resources
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The market system
 The
market system, performs two
important and closely related
functions:
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The first
1.
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Resource allocation: the market
system determines the allocation of
resources among produces and the
final mix of outputs.
The second
2. Price rationing: the
market system distributes
goods and services on the
basis of willingness and
ability to pay.
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Price Rationing
 A decrease
in supply creates a
shortage at the original price.
 The lower supply is rationed to
those who are willing and able to
pay the higher price.
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Price Rationing

There is some price that will clear any
market.
• The price of a rare painting will
eliminate excess demand until there is
only one bidder willing to buy the single
available painting.
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Constraints on the Market
 A price
ceiling is a maximum price
that sellers may charge for a good,
usually set by government.
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In 1974, the government set a price
ceiling to distribute the available supply
of gasoline.
 At an imposed price of 57 cents per
gallon, the result was excess demand.

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Prices and the Allocation of Resources
 Price
changes resulting from shifts
of demand cause profits to rise or
fall.
 Profits attract capital; losses lead
to disinvestment.
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

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Higher wages attract labor and encourage
workers to acquire skills.
At the core of the system, supply, demand,
and prices in input and output markets
determine the allocation of resources and the
ultimate combinations of things produced.
Price Floors
 A price
floor is a minimum price
below which exchange is not
permitted.
–
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The most common example of a
price floor is the minimum wage,
which is a floor set under the price of
labor.
 The
result of setting a price floor
will be excess supply, or higher
quantity supplied than quantity
demanded.
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Consumer Surplus
 Consumer
surplus is the
difference between the maximum
amount a person is willing to pay
for a good and its current market
price.
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Consumer Surplus
 Some
consumers are willing to pay
as much as $5 each for
hamburgers.
 Since the price is only $2.50, they
receive a consumer surplus of
$2.50.
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Consumer Surplus
 Others
are willing to pay something
less than $5.00 but more than
$2.50.
 Consumer surplus is the area
below the demand curve and
above the price level
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