Download ECS 1501 Study Unit 6 Summary Document Composer: Christiaan

ECS 1501 Study Unit 6 Summary
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Christiaan Gouws
Economics for South African Student (Fifth Edition)
6
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18 Oct '15
6.1 Introduction
Elasticility is a measure of responsiveness of one variable to changes in another variable.
Demand and supply curves are used in economics to
 explain economic phenomenon
 predict what will happen in an economic variable changes
 analyse the effetc of policy decisions
Direction and magnitude of change in supply and demand curves are of interest.
We need to measure how responsive the quantity demanded and quinstity supplied are to price
changes.
We want to know by how much the quintity demanded and the quantity supplied will change in
response to change in price. In technical terms we say that information is required about the price
elasticity of demand and supply.
6.2 A general definition of elasticity
Elasticity is a measure of responsiveness or sensitivity.
When 2 variables are related, one often wants to know how sensitve or responsive the dependant
variable is to changes in the independant variable. The measure of such responsiveness or
sensitivity is called elasticity.
Formal definition: percentage change in the dependant variable (one that is affected) if the
relevant independant variable (the one that causes change) changes by 1
percent.
Elasticity =
percentage change in dependant variable
--------------------------------------------------------percentage change in independant variable
There are 4 types of elasticity
 the price elasticity of demand
 the income elasticity of demand
 the cross elasticity of demand
 the price elasticity of supply
6.3 The price elasticity of demand
Market demand curve:
Qd = f(Px) ceteris paribus
Quantity demanded is dependable variable.
Price elasticity of demand is the percentage change in the quantity demanded if the price of the
product changes by one per cent, cp.
We measure the percentage change in quantity demanded that results from a percentage change
in price, in other words, how sensitive the quantity demanded is to a change in price.
Price elasticity of demand tells businesses that if they decrease or increase the price of their
products, by how much will the quantity demanded increase or decrease?
ep = price elasticity of demand
Say ep = 2. This means that 1% change in price of product = 2% change in quantity demanded.
The sensitivity of the quantity demanded to a change in price will depend on the slope of the
demand curve.
F 6-1 (a)
rightward shift of supply curve will lead to a decrease in price from P1 to P2, and and increase in
quantity demanded from Q1 to Q2.
F 6-1 (b)
edmand curve is steeper than in F6-1 (a).
change in quanitity is smaller and the change in price larger.
Important aspects and implications of price elasticity of demand
 Elasticity is calculated by using percentage changes, which are relative changes, not
absolute changes. Prices are expressed in monatary units. Quantities are expressed in
physical units. Using percentages makes the units in which prices and quantities are
measured not affect the result.



Price elasticity of demand is a ratio of percentage change in quantity demanded to the
percentage change in price. Ratio is called elasticity coefficient, which is a number.
Elasticity coefficients enable us to compare how consumers react to changes in prices for
different goods and services.
Measured price elasticity of demand has a negative sign. Change in price and change in
quantity demanded move in opposite directions. We only concentrate on absolute value of
price elasticity of demand.
Calculating price elasticity of demand
Quantity demanded
Change in quantity demanded
Price
Change in price
point elasticity formula
 equation (6-2)
slope of liniar demand curve
inverse of slope of liniar demand curve
Q
ΔQ
P
ΔP
ΔP/ΔQ
ΔQ/ΔP
constant
straight line
ratio between price and quantity
P/Q
at a point on the demand curve
varies
price elasticity of demand will be different at each point on the demand curve
point elasticity
 elasticity coefficient calculated at a point on the demand curve
 used if price change is relatively small (6-2)
arc elasticity formula
 used for larger fluctuations in price
 use average of 2 quantities and average of 2 prices
ignore negative sign, take absolute difference
Price elasticity of demand and total revenue
Price elasticity of demand
 used to determine how much total expenditure by consumers on a product changes when
the price of the product changes
 used to determine how much total revenue of firms producing that product changes when
the price of the product changes
Total Revenue, Total expenditure by consumers
Price of a good or service
Quintity sold
TR
P
Q
TR = P x Q
There is an inverse relationship between quintity demanded (Q) and price of a product (P).
Change in P leads to change in Q in opposite direction.
The effect of the ΔP on TR will depend on relative sizes of price change in quantity demanded.
 if ΔP leads to proportionally greater ΔQ (price elasticity demand > 1), TR will change in the
opposite direction of the price change
 if ΔP leads to equi-proportional change in quantity demanded (price elasticity = 1), TR will
remain the same
 if ΔP leads to proportionally smaller ΔQ (price elasticity demand < 1), TR will change in the
same direction of the price change
T6-1 and F6-2(b) illustrates 3 important results:
 as long as price elasticity of demand > 1, TR increases as quantity sold increases
 TR reaches a maximum when the price elasticity of demand is equal to 1
 when price elasticity of demand is less that 1, TR falls as the quantity sold Q increases
Different catagories of price elasticity of demand
1. Perfectly inelastic demand (ep = 0)
2. Inelastic demand (ep between 0 and 1)
3. Unitarily elastic demand or unitary elasticity of demand (ep = 1)
4. Elastic demand (ep lies bewteen 1 and ∞)
5. Perfectly elastic demand (ep = ∞)
Perfectly inelastic demand
 producers can raise their revenue by
raising the price of the product
Inelastic demand
 quantity demanded changes in
response to change in price
 %ΔQ < %ΔP
 0 < elasticity coefficient < 1
 elasticity coefficient varies from point
to point along DD
 steep curve (not accurate)
 if price of product increases, TR will
increase
Unitarily elastic demand
 %ΔQ = %ΔP
 elasticity coefficient = 1
 producers cannot raise TR by
decreasing or increasing the price of
their product
 TR from sales are maximized
Elastic demand
 %ΔQ > %ΔP
 elasticity coefficient > 1
 elasticity coefficient varies along the
curve
 producers can increase TR by lowering the price of their product
 increase in TR should not be confused with increase in Total Profit (TP)
 if producers raise prices, reslulting decrease in quantity demanded will be proportianally
greater than the increase in price, so TR will fall
Perfectly elastic demand
 elaticity coefficient = ∞
 consumers are willing to purchase any quantity at a certain price
 if price is raises only fractionally, quintity demanded falls to 0
Determinants of the price elasticity of demand
We have to assume ceteris paribus.
Differenct consumers or groups of consumers respond differenctly to price changes (poor vs rich).
Substotution possibilities
Availible substitutes are most imprtant determinant of consumer's reaction to price changes.
The larger the no of substitutes and closer the substitutes are, the greater the price elasticity of
demand.
Examples of elastic demand
 beef and mutton
 butter and margerine
 taxi services (bus, train)
 hamburgers and hot dogs
 apples and pears
Examples of inelastic demand
 salt



petrol
electricity
certain medicines
Degree of complementarity of the product
complementary goods
 goods that tend to be used jointly with other goods rather than on their own
with complementary goods price elasticity of demand tends to be low
Examples
 sugar, tea, coffee
 motorcar tyres, motorcars, petrol
 food, salt
 golf balls, golf clubs
In many cases it is the absence of good substitutes rather than the degree of complimentarity
which is reponsible for inelastic demand of highly complematary goods.
Type of want satisfied by the product
necessities
lower price elasticity of demand
luxury good and services
higher price elasticity of demand
Time period under considertaion
Demand tends to be more price elastic in long run than short run.
Price discrimination
 practice of charging different prices to different sets of customers according to differences
in price elasticity
Proportion of income spent on the product
The greater the proportion of income spent on a product, the greater the price elasticity will be.
The smaller the proportion of income spent on a product, the lower the price elasticity will be.
Other possible determinants of price elasticity of demand
Definition of the product
 broader definition of product, smaller measure price elasticity of demand will be
 broader definitions reduce the number of substitutes
 price elasticity demand for beef is greater than price elasticity of demand for meat
Advertising
 price elasticity of demand for a particular product will be greater than the price elasticity of
demand for the product (OMO washing powder and washing powder)
 producers spend large amount on advertising and other forms on non-price competition
trying to convince consumers that their pariticular products have no real substitutes
Durability
 the more durable a good, the more elastic the demand will be
 non-durable goods (household cleaning material) cannot be used more than once and
therefore have a more inelastic demand
Number of uses for the production
 the greater the number of uses for a product, the greater the price elasticity of demand will
be
 substitutes are availible for certain of the uses
Addiction
 products that are habit forming tend to have a low price elasticity of demand
 cunsumer who are totally addicted, demand may be perfectly price inelastic
Combined effect of determinants
Example, salt
 has no real substitues
 complement to many foodstuffs
 essential
 non-durable
 spending on salt comprises a small proportion of average consumer income
 price elasticity of demand of 0.1
substitutability of a product is a critical factor
Inelastic demand goods (ep < 1)
 salt, matches, toothpics, bread, milk, petrol, electricity, water, eggs, patatoes, meat,
postage stamps, medical care, legal services, motorcar tyres
Elastic demand (ep > 1)
 motor vehicles, mutton, furniture, entertainment, restaurant meals, overseas holidays,
butter, chicken, veal, apples, peaches
Applications
whenever demand and supply can be used to analyse a particular situation, price elasticity
becomes important
6.4 Other demand elasticities
Income elasticity of demand
Quantity demanded of a product depends on the income of consumers.
As consumer's incomes rise, quantity demanded increases, ct.
How much will quantity demanded change relative to change in income?
Income elasticity of demand (ey) measures responsiveness of quantity demanded relative to
change in income.
Defined as ratio between percentage change in quantity demanded (dependant variable) and
percentage change in consumer's income (independant variable)
positive income elasticity means that increase in income is accompanied by an increase in
quantity demanded. Decrease in income is accompanied by a decrease in quantity demanded.
 normal goods
 luxury good or essential goods
 luxury good
 income elasticity of demand is greater than 1
 essential good
 income elasticity of demand is less than 1
negative income elasticity means that in increase in income leads to a decrease in quantity of
product demanded. Decrease in income leads to increase in quantity of product demanded.
 inferior good
Cross elasticity of demand
Quantity demanded of a perticular good also depends on the prices of related goods.
Cross elasticity of demand measures the responsiveness of the quantity demanded of a particular
good to changes in a price of a related good. Defined as (ec) the ration between the percentage
change in quantity demanded of a product (the dependant variable) and the percentage change in
the price of the related product (independant variable).
When 2 goods are unrelated cross elasticity of demand will be 0
 ec = 0
substitutes
 cross elasticity of demand is positive
 when price of butter increases, more margarine will be demanded, ct, as cosumers switch
to relatively cheaper margarine
complements
 cross elasticity of demand is negative
 change in price of one product (motorcars) will lead to change in opposite direction in the
quantity demanded of the complementary product (motorcar tyres)