Elasticity ECONOMICS. TM 5-2 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Define and calculate the price elasticity of demand Use

ElasticityElasticity

ECONOMICS

TM 5-2Copyright © 1998 Addison Wesley Longman, Inc.

Learning Objectives

• Define and calculate the price elasticity of demand

• Use a total revenue test and an expenditure test to estimate the price elasticity of demand

• Explain the factors that influence the price elasticity of demand


Learning Objectives (cont.)

• Define and calculate the cross elasticity of demand

• Define and calculate the income elasticity of demand

• Define and calculate the elasticity of supply


Learning Objectives





The Price Elasticity of Demand

You know that when supply increases, the equilibrium price falls and the equilibrium quantity increases.

But does the price fall by a large amount and the quantity increase by a little?

Or does the price barely fall and the quantity increase by a large amount?



The price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buyers’ plans remain the same.


S1

How a Change in Supply Changes Price and Quantity

Quantity (pizza per hour)

Pri

ce (

dolla

rs p

er p

izza

)

10.00

20.00

30.00

40.00

Da

0 255 10 15 2013

5.00

S0

An increasein supplybrings ...

… and a smallincrease in quantity...

Large price change and small quantity change

… a largefall in price...


S1

How a Change in Supply Changes Price and Quantity


Pri

ce (d

olla

rs p

er p

izza

)

10.00

20.00

30.00

40.00

Db

0 255 10 15 2017

15.00

S0

Small price change and large quantity change

An increasein supplybrings ...

… a smallfall in price...

… and a largeincrease in quantity...



Percent change in quantity demanded

Calculating Elasticity

Price elasticity of demand =Percent change in price

Express the changes in price and quantity demanded as percentages of the average price and the average quantity.



Calculating Elasticity (cont.)

The original price is $20.50 and the new price is $19.50,so the average price is $20.

The $1.00 price decrease is 5 percent of the average price.

∆P/Pavg = ($1/$20) x 100 = 5%




The original quantity demanded is 9 pizzas and the newquantity demanded is 11 pizzas.

The 2 pizza increase in the quantity demanded is 20 percentof the average quantity.

∆Q/Qavg = (2/10) x 100 = 20%




Price elasticity of demandP

Q

%

%

=20%

5%= 4


Calculating the Elasticity of Demand

9 10 11

19.50

20.50

D

Newpoint

Pavg = $20

= $1P

= 2Q


Pri

ce (

dolla

rs p

er p

izza

)

20.00

Elasticity = 4

Qavg = 10

Originalpoint



Average Price and Quantity

We use the average price and average quantity to avoid having two values for the elasticity of demand at a single point on the demand curve, depending whether the price falls or rises.



Percentages and Proportions

Elasticity is the ratio of the percentage change in the quantity demanded to the percentage change in the price.

Equivalently, the proportionate change in the quantity demanded divided by the proportionate change in price.



A Units-Free Measure

Elasticity is a units-free measure because the percentage change in each variable is independent of the units in which the variable is measured.

And the ratio of the two percentages is a number without units.



Minus Sign and Elasticity

The price elasticity of demand is a negative number.

But, it is the magnitude, or absolute value, of the price elasticity of demand that tells us how elastic demand is.

We use the magnitude and ignore the minus sign.



Inelastic and Elastic Demand

Perfectly inelastic demand Implies that quantity demanded remains constant when price changes occur.

Price elasticity of demand = 0



Inelastic and Elastic Demand (cont.)

Unit elastic demand Implies that the percentage change in quantity demanded equals the percentage change in price.

Price elasticity of demand = 1




Perfectly elastic demand

Implies that if price changes by any percentage, quantity demanded will fall to 0.

Price elasticity of demand =




Inelastic demand Implies the percentage change in quantity demanded is less than the percentage change in price.

Price elasticity of demand > 0 and < 1.




Elastic demand Implies the percentage change in quantity demanded is greater than the percentage change in price.

Price elasticity of demand > 1.



6

12

Pri

ce

Quantity

D1

Elasticity = 0

Perfectly inelastic demand

0



6

12

Pri

ce

Quantity

D2

1 2 3

Elasticity = 1

Unit elastic demand

0



6

12

Pri

ce

Quantity

D3

Elasticity =

Perfectly elastic demand

0



Elasticity Along a Straight-Line Demand Curve

Along a straight-line demand curve, the elasticity varies.

At high prices and small quantities, the elasticity is large and at low prices and large quantities, the elasticity is small.


Elasticity Along a Straight-Line Demand Curve

0 10 20 25 30 40 50

12.50

5.00

10.00

15.00

20.00

25.00


Pri

ce (

dolla

rs p

er p

izza

)

Elasticity = 1/4

Elastic

Inelastic

Elasticity = 1

Elasticity = 4


Learning Objectives





Total Revenue and Elasticity

When a price changes, the change in producers’ total revenue depends on the elasticity of demand.



Elastic demand: a 1 percent price cut increases the quantity sold by more than 1 percent and total revenue increases.

Unit elastic demand: a 1 percent price cut increases the quantity sold by 1 percent and so total revenue does not change.

Inelastic demand: a 1 percent price cut increases the quantity sold by less than 1 percent and total revenue decreases.



Total Revenue Test

Price elasticity of demand can be

estimated by observing the change in

total revenue that results from a price

change (ceteris paribus).



Total Revenue Test

If a price cut increases total revenue, demand is elastic.

If a price cut decreases total revenue, demand is inelastic.

If a price cut leaves total revenue unchanged, demand is unit elastic.


Elasticity and Total Revenue


350.00 25 50

12.50

5.00

10.00

20.00

25.00

0 25 50

150.00

200.00

250.00

312.50

Tot

al R

even

ue (

bill

ions

of

doll

ars)

Maximum total revenue

When demandis inelastic, price cut decreasestotal revenue

Unitelastic

Elasticdemand


Pric

e (d

olla

rs p

er p

izza

)

15.00

Inelastic demand

300.00

100.00

50.00

0

When demandis elastic, price cut increasestotal revenue



Your Expenditure and Your Elasticity

If your demand is elastic, a 1 percent price cut increases the quantity you buy by more than 1 percent and your expenditure on the item increases.



Your Expenditure and Your Elasticity (cont.)

If your demand is unit elastic, a 1 percent price cut increases your quantity bought by 1 percent and so your expenditure on the item does not change.



Your Expenditure and your Elasticity (cont.)

If your demand is inelastic, a 1 percent price cut increases your quantity bought by less than 1 percent and so your expenditure on the item decreases.


Some Real-World Price Elasticities of Demand

Good or Service ElasticityElastic Demand

Metals 1.52Electrical engineering products 1.30Mechanical engineering products 1.30Furniture 1.26Motor vehicles 1.14Instrument engineering products 1.10Professional services 1.09Transportation services 1.03

Inelastic DemandGas, electricity, and water 0.92Oil 0.91Chemicals 0.89Beverages (all types) 0.78Clothing 0.64Tobacco 0.61Banking and insurance services 0.56Housing services 0.55Agricultural and fish products 0.42Books, magazines, and newspapers 0.34Food 0.12


Learning Objectives





Factors That Influence Elasticity the Elasticity of Demand

Closeness of Substitutes.

The closer the substitutes, the more elastic the demand.

• necessities

• luxuries


Factors That Influence Elasticity the Elasticity of Demand

Proportion of Income Spent on the GoodThe greater the proportion of income spent on food, the more elastic the demand.

Time Elapsed Since Price Change

The longer the time, the more elastic the demand.

• Short-run demand

• Long-run demand


Price Elasticities in 20 Countries


Learning Objectives





More Elasticities of Demand

Cross elasticity of demand

Measures the responsiveness of the demand for a good to a change in the price of a substitute or complement good.

Cross elasticity of demand =

Percentage changein quantity demanded

Percentage change in price of a substitute or complement


Cross Elasticity of DemandP

rice

of

pizz

as

Quantity of pizzas

Price of soda, a complement, falls. Negativecross elasticity.

D2

Price of a burger, a substitute, falls.Positive cross elasticity. D0

D1

0


Learning Objectives





Income Elasticity of Demand

Income elasticity

Measures the responsiveness of the demand to a change in income.

Income elasticity of demand =

Percentage changein quantity demanded

Percentage change in income



Income elasticity can be:

1 ) Greater than 1 (normal good, income elastic)

2 ) Between zero and 1 (normal good, income inelastic)

3 ) Less than zero (inferior good)



Income Income Income

Qua

ntit

y de

man

ded

Qua

ntit

y de

man

ded

Income

Qua

ntit

y de

man

ded

m

Income inelastic

Income elastic

Positiveincome elasticity

Negativeincome elasticity

Elasticity greaterthan 1

Elasticity betweenzero and 1

Elasticity less than 1and becomes negative


Some Real-World IncomeElasticities of Demand

Elastic DemandAirline Travel 5.82Movies 3.41Foreign Travel 3.08Electricity 1.94Restaurant meals 1.61Local buses and trains 1.38Haircutting 1.36Cars 1.07

Inelastic DemandTobacco 0.86Alcoholic beverages 0.62Furniture 0.53Clothing 0.51Newspapers and magazines 0.38Telephone 0.32Food 0.14


Income Elasticities in 15 Countries


Learning Objectives





Elasticity of Supply

Elasticity of supply measures the responsiveness of quantity supplied to a change in price.

Elasticityof supply =

Percentage change in quantity supplied

Percentage change in price


How a Change in Demand Changes Price and Quantity


Pri

ce (

dolla

rs p

er p

izza

)

10.00

30.00

40.00

D0

0 255 10 15 2013

Sa

… a largeprice rise...

Large price change and small quantity change

20.00

D1

An increasein demandbrings ...

… and a smallquantity increase...


How a Change in Demand Changes Price and Quantity


Pri

ce (

dolla

rs p

er p

izza

)

10.00

30.00

40.00

D0

0 255 10 15 20

Sb

… a smallprice rise...

Small price change and large quantity change

20.00

D1

An increasein demandbrings ...

21.00

… and a largequantity increase...



Supply elasticity depends on:

• Resource substitution possibilities

• Time frame for the supply decision



Pri

ce

Quantity

S1

Elasticity of supply = 0

Perfectly inelastic supply

0



Pri

ce

Quantity

S1

Elasticity of supply = 1

Unit elastic supply

0



Pri

ce

Quantity

S3

Elasticity of supply =

Perfectly elastic supply

0



Resource Substitution Possibilities

The more unique the resource, the more inelastic the supply.• Van Gogh painting - Van Gogh

• Wheat/corn — farmland



Time Frame for Supply Decisions

• Momentary supply

• Long-run supply

• Short-run supply

The longer producers have to adjust to a price change, the more elastic is supply.


A Compact Glossary of ElasticitiesPRICE ELASTICITIES OF DEMAND

A relationship isdescribed as

When itsmagnitude is

Which means that

Perfectly elasticor infinitely elastic

Unit elastic

In elastic

Perfectly inelasticor completely inelastic

Infinity The smallest possible increase in price causes an infinitely large decrease in quantity demanded

Less than infinitybut greater than 1

Greater than zerobut less than 1

Elastic

1

Zero

The percent decrease in the quantity demandedexceeds the percent increase in price

The percent decrease in the quantity demandedequals the percent increase in price

The percentage decrease in the quantity demandedis less than the percent increase in price.

The quantity demanded is the same at all prices


A Compact Glossary of ElasticitiesCROSS ELASTICITIES OF DEMAND



Which means that

Perfect substitutes Infinity The smallest possible increase in price of one good causes an infinitely large in the demand of the other good.

Positive, lessthan infinity

Substitutes If the price of one good increases, the quantitydemanded of the other good also increases.

Independent Zero The demand for one good remains constant,regardless of the price of the other good.

Complements Less than zero The demand for one good decreases when the price of the other good increases.


A Compact Glossary of ElasticitiesINCOME ELASTICITIES OF DEMAND



Which means that

Income elastic(normal good)

Greater than 1 The percent increase in the quantity demandedis greater than the percentage increase in income.

Less than 1 butgreater than zero

Income inelastic(normal good)

The percent increase in the quantity demandedis less than the percentage increase in income.

Negative income elastic(inferior good)

Less than zero When income increases, quantity demanded decreases.


A Compact Glossary of ElasticitiesELASTICITIES OF SUPPLY



Which means that

Perfectly elastic Infinity The smallest possible increase in price causes aninfinitely large increase in the quantity supplied.

Less than infinitybut greater than 1

Elastic The percent increase in the quantity supplied exceeds the percentage increase in the price.

Inelastic Greater than zerobut less than 1

The percentage increase in the quantity supplied is less than the percentage increase in price.

Perfectly inelastic Zero The quantity supplied is the same at all prices.

Documents

Elasticity ECONOMICS. TM 5-2 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Define and calculate the price elasticity of demand Use