Economics For Managers GTU MBA Sem 1 Chapter 05

7/31/2019 Economics For Managers GTU MBA Sem 1 Chapter 05

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Elasticity and Its

Application

Chapter 5

Author:

Prof. Sharif S. Memon


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Elasticity . . .

is a measure of how much buyers and

sellers respond to changes in marketconditions

allows us to analyze supply and

demand with greater precision.


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Determinants of

Price Elasticity of Demand

Necessities versus Luxuries

Availability of Close Substitutes

Definition of the Market

Time Horizon


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Determinants of

Price Elasticity of DemandDemand tends to be more elastic :

if the good is a luxury.the longer the time period.

the larger the number of close

substitutes. the more narrowly defined the market.


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Computing the Price Elasticity

of DemandThe price elasticity of demand is computed

as the percentage change in the quantity

demanded divided by the percentagechange in price.

Price Elasticity of Demand =

Percentage Change

in Quantity DemandedPercentage Change

in Price

Price Elasticity of Demand =

Percentage Change


in Price


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of Demand

priceinchangePercentage

demandedquatityinchangePercentagedemandofelasticityPrice

Example: If the price of an ice cream cone increasesfrom $2.00 to $2.20 and the amount you buy falls from

10 to 8 cones then your elasticity of demand would be

calculated as:

2percent10

percent20

100

002

002202

10010

810

.

)..(

)(


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Computing the Price Elasticity of

Demand Using the Midpoint

Formula

The midpoint formula is preferable when

calculating the price elasticity of demandbecause it gives the same answer regardless

of the direction of the change.

)/2]P)/[(PP(P

)/2]Q)/[(QQ(Q=DemandofElasticityPrice

1212

1212


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of Demand

Example: If the price of an ice cream cone increasesfrom $2.00 to $2.20 and the amount you buy falls from

10 to 8 cones the your elasticity of demand, using the

midpoint formula, would be calculated as:

32.25.9

22

2/)20.200.2(

)00.220.2(

2/)810()810(

percent

percent

)/2]P)/[(PP(P

)/2]Q)/[(QQ(Q=DemandofElasticityPrice

1212

1212


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Ranges of Elasticity

Inelastic DemandQuantity demandeddoes not respondstrongly to

price changes.Price elasticity of demand is less than one.

Elastic Demand

Quantity demandedresponds strongly to changesin price.

Price elasticity of demand isgreater than one.


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of Demand

Demand is price elastic

$5

4 Demand

Quantity1000

Price

50

-3percent22-

percent67

5.00)/2(4.00

5.00)-(4.00

50)/2(10050)-(100

ED


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Perfectly InelasticQuantity demanded does not respond to price

changes.Perfectly ElasticQuantity demanded changes infinitely with any

change in price.

Unit ElasticQuantity demanded changes by the same

percentage as the price.


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A Variety of Demand Curves

Because the price elasticity

of demand measures howmuch quantity demanded

responds to the price, it is

closely related to the slope ofthe demand curve.


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Perfectly Inelastic Demand

- Elasticity equals 0

Quantity

Price

4

$5

Demand

1002. ...leaves the quantity demanded unchanged.

1. Anincreasein price...


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Inelastic Demand- Elasticity is less than 1

Quantity

Price

4

$51. A 22%increasein price...

Demand

100902. ...leads to a 11% decrease in quantity.


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Unit Elastic Demand

- Elasticity equals 1

Quantity

Price

4


Demand



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Elastic Demand- Elasticity is greater than 1

Quantity

Price

4


Demand



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Perfectly Elastic Demand

- Elasticity equals infinity

Quantity

Price

Demand$4

1. At any priceabove $4, quantity

demanded is zero.

2. At exactly $4,

consumers willbuy any quantity.

3. At a price below $4,quantity demanded is infinite.


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Elasticity and Total Revenue

Total revenueis the amount paid by

buyers and received by sellers of a good.

Computed as the price of the good timesthe quantity sold.

TR = P x Q


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$4

Demand

Quantity

P

0

Price

P xQ= $400

(total revenue)

100Q



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With an inelastic demand

curve, an increase in price

leads to a decrease in quantitythat is proportionately

smaller. Thus, total revenue

increases.


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Elasticity and Total Revenue:

Inelastic Demand

$3

Quantity0

Price

80

Revenue = $240

Demand$1 Demand

Quantity0

Revenue = $100

100

Price

An increase in price

from $1 to $3...

leads to an increase

in total revenue

from$100 to $240


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With an elastic demand curve,

an increase in the price leads to

a decrease in quantity demandedthat is proportionately larger.

Thus, total revenue decreases.


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Elasticity and Total Revenue:

Elastic Demand

Demand

Quantity0

Price

$4

50

Demand

Quantity0

Price

Revenue = $100

$5

20

Revenue = $200

An increase in price

from $4 to $5...

leads to a decrease

in total revenue

from$200 to $100


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Income Elasticity of Demand

Income elasticity of demand measures

how much the quantity demanded of a

good responds to a change in consumersincome.

It is computed as the percentage change

in the quantity demanded divided by thepercentage change in income.


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Computing Income Elasticity

Income Elasticity

of DemandPercentage Change


in Income=


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Income Elasticity

- Types of Goods -Normal Goods

Inferior Goods

Higher incomeraises the quantity

demanded fornormal goodsbut lowers

the quantity demanded forinferior

goods.


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Income Elasticity

- Types of Goods -Goods consumers regard as necessities

tend to beincome inelastic

Examples include food, fuel, clothing, utilities,and medical services.

Goods consumers regard as luxuries tend

to beincome elastic.Examples include sports cars and expensivefoods.


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Price Elasticity of Supply

Price elasticity of supply is the

percentage change in quantity supplied

resulting from a percent change in price.It is a measure of how much the quantity

supplied of a good responds to a change

in the price of that good.


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Perfectly Elastic

ES=

Relatively Elastic

ES> 1

Unit ElasticES= 1


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Relatively Inelastic

ES< 1

Perfectly Inelastic

ES= 0


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Perfectly Inelastic Supply- Elasticity equals 0

Quantity

Price

4

$5

Supply

1002. ...leaves the quantity supplied unchanged.

1. Anincreasein price...


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Inelastic Supply- Elasticity is less than 1

Quantity

Price

4


110100

Supply

2. ...leads to a 10% increase in quantity.


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Unit Elastic Supply- Elasticity equals 1

Quantity

Price

4


125100

Supply



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Elastic Supply- Elasticity is greater than 1

Quantity

Price

4


200100

Supply



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Perfectly Elastic Supply- Elasticity equals infinity

Quantity

Price

Supply$4

1. At any priceabove $4, quantity

supplied is infinite.

2. At exactly $4,

producers willsupply any quantity.

3. At a price below $4,quantity supplied is zero.


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Determinants of

Elasticity of SupplyAbility of sellers to change the amount of

the good they produce.

Beach-front land is inelastic.Books, cars, or manufactured goods are

elastic.

Time period.Supply is more elastic in the long run.


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of SupplyThe price elasticity of supply is

computed as the percentage change

in the quantity supplied divided bythe percentage change in price.

Elasticity of Supply =Percentage Change inQuantity Supplied

Percentage Changein Price

Elasticity of Supply =Percentage Change inQuantity Supplied

Percentage Changein Price

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Economics For Managers GTU MBA Sem 1 Chapter 05