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Dr. Hisham H. Abdelbaki ECON 140 Chapter FOUR Chapter 4 Elasticity Two general rules: 1- Definition Rule: 2- Formula Rule: Types of elasticity Demand Price elasticity supply Income elasticity Cross elasticity 1- Price elasticity of demand (PED) i) Definition Price elasticity Responsiveness of a change in Qd to a change in the price of a product. ii) Formula = percentage change in Qd / percentage change in price = = Example: Price Qd 2 10 6 5 Please find the PED between prices 2 & 6. 1 Dr. Hisham H. Abdelbaki iii) ECON 140 Chapter FOUR The sign The sign of elasticity demand formula is always negative ….. why? The answer is because the relationship between quantity demanded and the price is negative. iv) The absolute value According to the absolute value of the elasticity demand formula, there are five types as follows: 1- Elastic demand when the value is greater than unity (>1) It happens when change in price leads to bigger change in the Qd (change in Qd, in percentage, is bigger than change in price). For instance the price of a good increase by 10% leads to decrease in Qd by 15%. In this case the absolute value will be more than unity. 2- Inelastic demand when the value is smaller than unity (< 1) It happens when change in price leads to lower change in the Qd (change in Qd, in percentage, is less than change in price). For instance, the price of a good increase by 20% leads to decrease in Qd by 15%. In this case the absolute value will be less than unity. 3- Unitary demand when the value equals unity ( = 1) It happens when change in price leads to same change in the Qd (change in Qd, in percentage, equals change in price). For instance the price of a good increase by 15% leads to decrease in Qd by 15%. In this case the absolute value = 1. 4- Perfectly inelastic when the value equals zero ( = zero) It happens when change in price does not lead to any change in the Qd. In this case the absolute value = zero. 2 Dr. Hisham H. Abdelbaki ECON 140 Chapter FOUR 5- Perfectly elastic when the value equals (=) It happens when change in price leads to massive change in the Qd. In this case the absolute value will be very big (nearly = ) Elasticity along a straight line demand curve Price Quantity demanded 3 Dr. Hisham H. Abdelbaki ECON 140 Chapter FOUR The relationship between elasticity and revenues Studying elasticity of demand is useful for both government and producers because they can indicate whether or not it will be useful to increase the price of their product according to their knowing the relationship between the elasticity demand and the revenues from selling their product. This relation is shown in the following table: Type of elasticity The relationship between price and revenues Elastic Inverse (negative) Inelastic Positive Unitary No effect Price Quantity Total Revenue Quantity The factors effect on elasticity of demand The closer the substitute for a good more elastic The greater the proportion of income spent on a good more elastic The longer the time that has elapsed since a price change more elastic 4 Dr. Hisham H. Abdelbaki ECON 140 Chapter FOUR Note: Necessity goods have no close substitutes, whereas, luxury ones have many. 2- Income elasticity of demand (IED) i) Definition Responsiveness of a change in Qd to a change in the income of the consumer. ii) Formula = percentage change in Qd / percentage change in income. = = Example: Income Qd 200 10 600 15 Please find the IED between incomes 200 & 600. iii) The sign You can use the sign of the elasticity equation to indicate the type of the good. Negative sign refers to inverse relationship between the income and quantity demanded consequently the good is inferior whilst the positive sign means the relationship between the income and quantity demanded is positive consequently the good will be normal good. less than zero ( - ) inferior good greater than zero ( + ) Normal good 5 Dr. Hisham H. Abdelbaki ECON 140 3- Cross elasticity of demand (CED) i) Definition Chapter FOUR Responsiveness of a change in Qd to a change in the price of other product. ii) Formula = percentage change in Qd in one product / percentage change in the price of the other product. = = Example: Price of good X Qd for good Y 2 10 6 5 Please find the CED between prices 2 & 6. iii) The sign The sign can be used to know the relationship between the two goods where: i- if the sign is negative then the goods are complements. ii- If the sign is positive then the goods are substitutes. iii- If the sign is neither positive nor negative (zero) then the goods are independents. Negative ( - ) the two goods are complements Positive ( + ) the two goods are substitutes Zero the two goods are independents (unrelated) 6 Dr. Hisham H. Abdelbaki ECON 140 4- Price elasticity of supply (PES) i) Definition Chapter FOUR Responsiveness of a change in Qs to a change in the price of the product. ii) Formula = percentage change in Qs / percentage change in the price = = Example: Price Qs 3 10 9 25 Please find the PES between prices 2 & 6. iii) The sign always positive ….. why? iv) The absolute value According to the absolute value of the elasticity demand formula. There are five types as follows: 1- Elastic supply when the value is greater than unity (> 1) It happens when change in price leads to bigger change in the Qs (change in Qs, in percentage, is bigger than change in price). For instance the price of a good increase by 10% leads to increase in Qs by 15%. In this case the absolute value will be bigger than unity. 7 Dr. Hisham H. Abdelbaki ECON 140 Chapter FOUR 2- Inelastic supply when the value is smaller than unity (<1) It happens when change in price leads to lower change in the Qs (change in Qs, in percentage, is smaller than change in price). For instance, the price of a good increase by 20% leads to increase in Qs by 15%. In this case the absolute value will be less than unity. 3- Unitary supply when the value equals unity ( = 1) It happens when change in price leads to same change in the Qs (change in Qs, in percentage, equals change in price). For instance the price of a good increase by 15% leads to increase in Qs by 15%. In this case the absolute value = 1. 4- Perfectly inelastic when the value equals zero (=zero) It happens when change in price does not lead to any change in the Qs. In this case the absolute value = zero. 5- Perfectly elastic when the value equals (=) It happens when change in price leads to massive change in the Qs. In this case the absolute value will be very big (nearly = ) PES = PES = Zero The factors effect on price elasticity of supply 1- resources substitution possibilities 2- time frame for the supply decision 8 Dr. Hisham H. Abdelbaki ECON 140 Chapter FOUR General Exercises: Exercise 1: You are given the following table: Price of Quantity demanded Price of Quantity demanded good A for good A good B for good B Income Quantity supplied of good B 12 10 3 15 50 10 8 15 6 10 100 20 6 20 9 5 200 30 Req. 1- Calculate PED for good A if price changes from 8 to 6? What is the type of demand in this case? In this case, if price increases, total revenue will …….. (complete). 2- Indicate the type of good B. 3- Indicate the relationship between good A and good B. 4- Calculate PES for good B if price changes from 6 to 3? What is the type of supply in this case? Exercise 2: From the following quotations, what, if anything, can you conclude about elasticity of demand? A- “As the price of CD players fell, producers found their revenue dropping precipitously.” B- “While I like cola, it is not an essential good—if they raise the price only a Files a can, I'll drink water inst Best Wishes 9