Elasticity Final 2

7/30/2019 Elasticity Final 2

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Elasticity and Its

Applications


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Elasticity . . .

allows us to analyze supply and demand

with greater precision.

is a measure of how much buyers and sellers

respond to changes in market conditions


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THE ELASTICITY OF DEMAND

Price elasticity of demandis a measure of how

much the quantity demanded of a good

responds to a change in the price of that good.

Price elasticity of demand is the percentage

change in quantity demanded given a percent

change in the price.


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The Price Elasticity of Demand and ItsDeterminants

Availability of Close Substitutes

Necessities versus Luxuries

Definition of the Market

Time Horizon


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The Price Elasticity of Demand and ItsDeterminants

Demand tends to be more elastic :

the larger the number of close substitutes.

if the good is a luxury.

the more narrowly defined the market.

the longer the time period.


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Computing the Price Elasticity of Demand

The price elasticity of demand is computed asthe percentage change in the quantity demanded

divided by the percentage change in price.

Price elasticity of demand =Percentage change in quantity demanded

Percentage change in price


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Example: If the price of an ice cream cone

increases from $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:


Price elasticity of demand =Percentage change in quantity demanded


( )

( . . )

.

10 810

100

2 20 2 00

2 00100

20%

10%2


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The Midpoint Method: A Better Way toCalculate Percentage Changes andElasticities

The midpoint formula is preferable whencalculating the price elasticity of demand

because it gives the same answer regardless of

the direction of the change.

Price elasticity of demand =( ) / [( ) / ]

( ) / [( ) / ]

Q Q Q Q

P P P P

2 1 2 1

2 1 2 1

2

2


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The Midpoint Method: A Better Way toCalculate Percentage Changes andElasticities

Example: If the price of an ice cream coneincreases from $2.00 to $2.20 and the amount

you buy falls from 10 to 8 cones, then your

elasticity of demand, using the midpointformula, would be calculated as:

( )

( ) /( . . )

( . . ) /

..

10 8

10 8 22 20 2 00

2 00 2 20 2

22%9 5%

2 32


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Geometric (Point) method

Geometric (Point) method measures elasticityof demand at any given point on the curve

t

M

K

T


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Elasticity= Lower segment/ Upper segment

At point K, e= KT/Kt

e=1

At point M, e=MT/Mt

e>1

At point L, e=LT/Lte


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Arc Method

E= proportionate change in quantity

---------------------------------------

proportionate change in price


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The Variety of Demand Curves

Inelastic Demand

Quantity demanded does not respond strongly to

price changes.

Price elasticity of demand is less than one.

Elastic Demand

Quantity demanded responds strongly to changes in

price. Price elasticity of demand is greater than one.


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Demand is priceinelastic

$54

Demand

Quantity1000 50

-3percent22-

percent67

5.00)/2(4.005.00)-(4.00

50)/2(10050)-(100

ED

Price


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Perfectly Inelastic

Quantity demanded does not respond to price

changes.

Perfectly Elastic Quantity demanded changes infinitely with any

change in price.

Unit Elastic Quantity demanded changes by the same percentage

as the price.


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Because the price elasticity of demandmeasures how much quantity demanded

responds to the price, it is closely related to the

slope of the demand curve.


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Figure 1 The Price Elasticity of Demand

Copyright2003 Southwestern/Thomson Learning

(a) Perfectly Inelastic Demand: Elasticity Equals 0

$54

Quantity

Demand

1000

1. Anincreasein price . . .

2. . . . leaves the quantity demanded unchanged.

Price


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(b) Inelastic Demand: Elasticity Is Less Than 1

Quantity0

$5

90

Demand1. A 22%increasein price . . .

Price

2. . . . leads to an 11% decrease in quantity demanded.

4

100


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2. . . . leads to a 22% decrease in quantity demanded.

(c) Unit Elastic Demand: Elasticity Equals 1

Quantity

4

1000

Price

$5

80

1. A 22%increasein price . . .

Demand


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(d) Elastic Demand: Elasticity Is Greater Than 1

Demand

Quantity

4

1000

Price

$5

50


2. . . . leads to a 67% decrease in quantity demanded.


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(e) Perfectly Elastic Demand: Elasticity Equals Infinity

Quantity0

Price

$4 Demand

2. At exactly $4,consumers willbuy any quantity.

1. At any priceabove $4, quantitydemanded is zero.

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


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Total Revenue and the Price Elasticity ofDemand

Total revenue is the amount paid by buyers andreceived by sellers of a good.

Computed as the price of the good times the

quantity sold.

TR = P x Q


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Figure 2 Total Revenue


Demand

Quantity

Q

P

0

Price

P Q = $400

(revenue)

$4

100


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Elasticity and Total Revenue along a LinearDemand Curve

With an inelastic demand curve, an increase inprice leads to a decrease in quantity that is

proportionately smaller. Thus, total revenue

increases.

Figure 3 How Total Revenue Changes When Price


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Figure 3 How Total Revenue Changes When PriceChanges: Inelastic Demand


Demand

Quantity0

Price

Revenue = $100

Quantity0

Price

Revenue = $240

Demand$1

100

$3

80

An Increase in price from $1to $3

leads to an Increase in

total revenue from $100 to$240


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Elasticity and Total Revenue along a LinearDemand Curve

With an elastic demand curve, an increase inthe price leads to a decrease in quantity

demanded that is proportionately larger. Thus,

total revenue decreases.

Figure 4 How Total Revenue Changes When Price


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Figure 4 How Total Revenue Changes When PriceChanges: Elastic Demand


Demand

Quantity0

Price

Revenue = $200

$4

50

Demand

Quantity0

Price

Revenue = $100

$5

20

An Increase in price from $4to $5

leads to an decrease in

total revenue from $200 to$100


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Elasticity of a Linear Demand Curve


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Income Elasticity of Demand

Income elasticity of demandmeasures howmuch the quantity demanded of a good

responds to a change in consumers income.

It is computed as the percentage change in thequantity demanded divided by the percentage

change in income.


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Computing Income Elasticity

Income elasticity of demand =

Percentage changein quantity demanded

Percentage changein income


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Income Elasticity

Types of Goods Normal Goods

Inferior Goods

Higher income raises the quantity demanded fornormal goods but lowers the quantity demanded

for inferior goods.


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Income Elasticity

Goods consumers regard as necessities tend tobe income inelastic

Examples include food, fuel, clothing, utilities, and

medical services. Goods consumers regard as luxuries tend to be

income elastic.

Examples include sports cars, furs, and expensivefoods.


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Mathematically.q / q

Y / Y

Ey =

Quantity demanded @initial Income

Change in quantitydemanded after change in

Income (q1q2)

Original IncomeChange in Income

(Y1Y2)

Incomein

ChangePercentage

DemandedQuantityinChangePercentage

=(Ey)DemandofElasticityIncome


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Demand0

Income

e

Ed > 1

d Ed = 1

C

Ed < 1b

Ed = 0

a

Ed < 0


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Demand

0

Income

e

Ed > 1

d Ed = 1

C

Ed < 1b

Ed = 0

a

Ed < 0

Inferior Goods

(Jowar, Bajra)

Neutral Goods

(Salt,

Matchbox,)

Necessary

Food grains

Normal Goods

(Fruits &

Vegitables)

Luxury

Goods (Cars,

Microwave


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CROSS ELASATICITY OFDEMAND

Cross elasticity of demand is defined as the ratio of the

% of change in demand for one good to the % change

in the price of other goods.

YcommodityofPrice

in theChange%

XcommodityforDemand

inChange%

=YandXofDemandofElasticityCross

If CED is + ve then goods are Substitutes ( Px : Dy)


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TYPES

Positive Cross elasticity - As the price of Bincreases quantity demanded of A increases

(substitutes)

Zero Cross elasticity - Quantity demanded ofA remains unaltered due to change price of B

(unrelated goods)

Negative Cross elasticityQuantity demandedof A increases as price of B decreases

( complementary goods)


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THE ELASTICITY OF SUPPLY

Price elasticity of supply is a measure of howmuch the quantity supplied of a good responds

to a change in the price of that good.

Price elasticity of supply is the percentagechange in quantity supplied resulting from a

percent change in price.

Fig re 6 The Price Elasticit of S ppl


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Figure 6 The Price Elasticity of Supply


(a) Perfectly Inelastic Supply: Elasticity Equals 0

$5

4

Supply

Quantity1000

1. Anincreasein price . . .

2. . . . leaves the quantity supplied unchanged.

Price



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(b) Inelastic Supply: Elasticity Is Less Than 1

110

$5

100

4

Quantity0


Price

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

Supply



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(c) Unit Elastic Supply: Elasticity Equals 1

125

$5

100

4

Quantity0

Price



Supply



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(d) Elastic Supply: Elasticity Is Greater Than 1

Quantity0

Price



4

100

$5

200

Supply



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(e) Perfectly Elastic Supply: Elasticity Equals Infinity

Quantity0

Price

$4 Supply

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

2. At exactly $4,producers willsupply any quantity.

1. At any priceabove $4, quantitysupplied is infinite.


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Determinants of Elasticity of Supply

Ability of sellers to change the amount of thegood 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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Computing the Price Elasticity of Supply

The price elasticity of supply is computed asthe percentage change in the quantity supplied


Price elasticity of supply =

Percentage changein quantity supplied



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APPLICATION of ELASTICITY

Can good news for farming be bad news forfarmers?

What happens to wheat farmers and the market

for wheat when university agronomists discovera new wheat hybrid that is more productive

than existing varieties?

THE APPLICATION OF SUPPLY


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THE APPLICATION OF SUPPLY,DEMAND, AND ELASTICITY

Examine whether the supply or demand curveshifts.

Determine the direction of the shift of the

curve. Use the supply-and-demand diagram to see how

the market equilibrium changes.

Figure 8 An Increase in Supply in the Market for Wheat


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Figure 8 An Increase in Supply in the Market for Wheat


Quantity of

Wheat

0

Price of

Wheat

3. . . . and a proportionately smaller

increase in quantity sold. As a result,

revenue falls from $300 to $220.

Demand

S1S2

2. . . . leads

to a large fall

in price . . .

1. When demand is inelastic,an increase in supply . . .

2

110

$3

100


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Compute the Price Elasticity of Supply

ED

100 110100 110 2

300 2 00300 2 00 2

0095

0 40 24

( ) /

. .( . . ) /

.

..

Supply is inelastic


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Summary

Price elasticity of demand measures how muchthe quantity demanded responds to changes in

the price.

Price elasticity of demand is calculated as thepercentage change in quantity demanded


If a demand curve is elastic, total revenue fallswhen the price rises.

If it is inelastic, total revenue rises as the price

rises.


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Summary

The income elasticity of demand measures howmuch the quantity demanded responds to

changes in consumers income.

The cross-price elasticity of demand measureshow much the quantity demanded of one good

responds to the price of another good.

The price elasticity of supply measures howmuch the quantity supplied responds to changes

in the price. .


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Summary

In most markets, supply is more elastic in thelong run than in the short run.

The price elasticity of supply is calculated as

the percentage change in quantity supplieddivided by the percentage change in price.

The tools of supply and demand can be applied

in many different types of markets.

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Elasticity Final 2