Chapter 5 Elasticity A. Price Elasticity of Demand 1. Elasticity the measure of responsiveness of one variable relative to another.

. We can do this for any variable, not just economic. 2. Price Elasticity of Demand Measures the percentage change in Qd relative to a change in percentage change in P. -It helps to give us a better idea of ho price changes affect Qd . -!ote" for our % formula we will use the midpoint method.
ED=%Q/%P= [(Q2-Q !/Qa"e#/[(P2-P !/Pa"e#

!ote" e ta#e absolute ith this measure e could use a negative sign just as easily. $ince demand follo s la of demand % as P & Qd ' ( that is hy e get a )-* sign. $o e get P and Q moving in opposite directions. 3. Elasticity Measures: a. Inelastic hen the responsiveness of Qd is less than the change in price. +his is defined to be values of ED , -, hich can be ritten as"
ED . %Q/%P , - %Q $ %P

!ote" / perfectly inelastic curve is vertical. 0ne can see that as P changes there are no change in Q. Graph 1: Perfectly Inelastic
P PP2

Q-

. Elastic - hen the responsiveness of Qd is greater than the change in price. +his is defined to be values of ED 1 -, hich can be ritten as"

ED . %Q/%P , - %Q % %P

!ote" / perfectly elastic curve is hori4ontal. 0ne can see that as P changes the result is a complete drop in demand to 5. If price ere raised to P2 then demand could be 5. Graph 2: Perfectly 6lastic
P P2 P-

Q c. unit!elastic hen the responsiveness of Qd is directly e7ual to the change in price. +his is defined to be values of ED . -, hich can be ritten as"
ED . %Q/%P . - %Q = %P

". Elasticity of Demand and #trai$ht!%ine Demand Cur&es a. +he elasticity of demand changes as e move along a demand curve. It is not constant. /s e move up the demand curve e get elastic measures and do n the demand curve inelastic measures. +his comes from the fact that at higher points P is greater )so the denominator is larger reducing the 6d measure* and at lo er prices e get the e8act opposite case. It is very important to note that elasticity is not slope. b. 9raph :" P 6lastic

Inelastic

Q 'ntuition: +his ma#es sense because at higher prices one ould thin# that people ould respond to price changes more than if they ere considering hether to purchase a good at lo er prices.

5. Determinants of Elasticity for Good a. /vailability of $ubstitutes ho many other goods can be used in place of the good. +he increased prevalence of substitutes means that the relative elasticity measure should go up. +his does not mean that the good is elastic, merely that the elasticity measure it greater than for goods ith less subs. !ote" )-* 9oods that are necessities are generally more inelastic. )2* 9oods here the time hori4on is e8tended to find subs. also increase the elasticity measure. b. Importance;< of =uyers =udget +he greater the percentage in budget the greater the elasticity measure as ell. If it costs more you ill consider more goods to use in place of it due to ho e8pensive it is to you personally. c. +ime /s mentioned before, the more time one has the greater elasticity measure due to the increased ability to find another good to use in its place. d. >o one defines the mar#et the more narro ly defined the more inelastic the measure, the greater the mar#et the increased availability of substitutes. e. ?u8ury vs. !ecessity since a necessity generally has fe substitutes it is generally less responsive. / lu8ury generally has more substitutes, so e ould e8pect that if a good or service is a lu8ury it ould have a greater elasticity measure. (. Elasticity and )otal *e&enue @ecall that +otal @evenue )+@* total amount of dollars received for the purchase of a 9;$. )a* Mathematically" +@ . PAQ If e manipulate the above formula ith the natural log and ta#e derivatives e can note that" )b* <B+@ . <BQ C <BP )for this formula use midpoint* We can then use this formula to find out if the price change for an inelastic good or elastic good is a good idea or not. Inelastic: @ecall that ED . %Q/%P , - %Q $ %P for an inelastic good. $o if e have a price increase e have" BP . )C* BQ . )-*

+his is by la of demand. We can note that the change in P is greater so hen e plug this into our previous e7uation e get" <B+@ . <BQ C <BP . )-* C )C* . overall )C* since e have %Q $ %P . $ince the percent change in +@ is positive a price increase for an inelastic good is a good idea. !ote" +he opposite case is also true i.e. P ' for an inelastic good results in less +@ and is therefore a bad idea. Elastic: @ecall that ED . %Q/%P 1 - %Q % %P for an elastic good. $o if e also have a price increase as before e have" BP . )C* BQ . )-* +his is by la of demand. We can note that the change in P is greater so hen e plug this into our previous e7uation e get" <B+@ . <BQ C <BP . )-* C )C* . overall )-* since e have %Q % %P . $ince the percent change in +@ is negative a price increase for an inelastic good is a bad idea. !ote" +he opposite case is also true i.e. P ' for an elastic good results in more +@ and is therefore a good idea. /lso, for a unit elastic good e get <BQ . <BP , so there is no change in +@. $o, changing price results in no change in +@. +. Price Elasticity of #upply 1. Price Elasticity of #upply Measures the percentage change in Qs relative to a change in percentage change in P. -It helps to give us a better idea of ho price changes affect Qs .
E&= %Qs/%P = [(Q2-Q !/Qa"e#/[(P2-P !/Pa"e #

!ote" )a* e donDt need to ta#e absolute ith this measure this is due to the la of supply giving us both positive measures. +o #no that e are using supply rather than demand you must loo# at hat info is given. $ince supply follo s la of supply % as P & Qs & ( that is hy e get a )C* sign. $o e get P and Q moving in the same directions. )b* e can use the same ideas as before ith elasticity of demand ith the terms inelastic, elastic, and unit elastic here.

2. 'nfluences on Price Elasticity of #upply a. Production Possibility , if the 9;$ has a very fle8ible or constant 0F, so these are more elastic. If 9;$ has a very fi8ed rate of production, then e ould e8pect them to be more inelastic. 68amples" paper and printing presses for te8tboo#s and maga4ines have multiple uses and are therefore elastic. b. +ime 6lapse $ince Price Fhange - as the time increases e find that once again that the elasticity measure increases because it allo s suppliers more time to find alternate methods of production. c. $torage Possibility if the good can be stored it increases the elasticity measure. +his ma#es intuitive sense because if the price s ings to the disadvantage of the supplier, if they have storage options they ould store it and supply the good at a more favorable price. !ote that the cost of storage is a large determining factor ith this variable. C. -ther Elasticity Measures @ecall" that elasticity in general measures responsiveness of one variable to changes in another. We donDt simply need to loo# at P and Q. Gust as e tal#ed about other variables affecting demand of a good, e can also loo# at ho altering these variables affect Qd. !ote" $ince e are dealing no ith other variables besides price e are loo#ing at ho the demand curve shifts. When e get a shift in demand e are actually noting that 3 & Qd & at every price level or the opposite case. 1. 'ncome Elasticity of Demand: Measures the percentage change in Qd caused by a -< change in income. a. mathematically: 6I . <BQ;<BI. %)Q2-Q-*;Qave(;%)I2-I-*;Iave( b. normal vs. inferior good normal good hen 6I 1 5. +his value is obtained from the fact that Income & 3emand & %or Qd & at every price (. Inferior good hen 6I , 5. +his value is obtained from the fact that Income & 3emand ' %or Qd ' at every price (.

c. ?u8ury or !ecessity We can use the fact that e #no that smaller measures of an elasticity mean less responsiveness to changes in the other variable to define economic lu8uries and necessities. 6conomic necessity hen - 16I 1 5. +his value is obtained from the fact that Income & e donDt have Qd changing a hole lot. +his implies that even though income might change you still purchase the same amount of the good, hich implies it is a necessity. 6conomic lu8ury hen 6I 1 -. +his value is obtained from the fact that Income & e have Qd changing a hole lot. +his implies that hen income does change there is a large responsiveness, so it must be some type of lu8ury. 2. Cross .Price/ Elasticity of Demand: measures ho changing the price of a related good affects the demand of the good in 7uestion. a. mathematically" 68y = %Q'/%P( = [(Q2-Q !/Qa"e#/[(P2-P !/Pa"e# b. $ubstitute or Fomplement @ecall the relationship e defined before for both subs and complements $ubstitute good hen Psub & 3 &. $o hen 68y 1 5 e define it to be a substitute good. Fomplement good - hen Pcomp & 3 '. $o hen 68y , 5 e define it to be a complement good. !ote" hen the values are much greater than 5 then they are considered strongly related. Ior values that are around 5 they are much more ea#ly related.
3. E0amples of Elasticity Measures: a. E0ample 1: Elasticity of Demand )i* $uppose e ere loo#ing at the demand for Mc3onaldDs >amburgers at a particular location. When they had a p.J5.KH they had a Qd.-555 hamburgers per day. +he o ner of the Mc3onaldDs decided to raise price to p.J-.55 and found that demand dropped to Qd.L55 per day. Falculate the elasticity of demand for hamburgers at this Mc3onaldDs. )ii*. Is the good elastic or inelasticM )iii*. Was the price change probably a good idea or notM 68plain in terms of total revenue. i -Recall the formula for elasticity: Elasticity of demand = %Q / %P= [(Q 2-Q ! / Qa"e# / [(P2-P ! / Pa"e# $%%lyin& the a'o"e formula to the data &i"en (e &et: [()**- ***!/)+*#/[( ,**-,-+!/,.-+#/,01.

ii - 2e o'tain an ans(er (ith an elasticity of 3 4 so 'y definition (e 5no( the &ood is inelastic, $n inelastic &ood im%lies that there is a &reater chan&e in P than there is in Q (i,e, the numerator chan&e is less than the denominator!, 6n this case a % chan&e in %rice results in a ,01.% chan&e in Q, iii - 7ince the %rice chan&es more than 8uantity4 9c:onald;s should not e<%ect the 8uantity demanded to dro% off that much, =ecause of this fact4 they should e<%ect to earn more money (ith the %rice chan&e e"en thou&h there (as some decrease in Qd, 2e can see this fact for sure '/c >,-+? ***=>-+* (hile > ,**?)**=>)**, 7o they should earn an e<tra > +* each day (ith the %rice increase, 2e can also o'tain the same information usin& the formula: %@R = %Q A %P, 6n this case (e &et %@R = -, *+ A ,2.+ = , ., 7o %@R B * or %ositi"e4 so it (as a &ood idea, . E0ample 2: Cross Price Elasticity and 'ncome Elasticity )i*. $uppose no that e ere loo#ing at ho t o fast-food locations affect one another. If e find that the change in price of taco bell tacos from J5.KH to J-.2H causes the Mc3onalds that is very near it to increase in >amburger sales for the ee# from -H,555 to -K,555. Falculate the cross-price elasticity of demand and e8plain hether it is a substitute or complement based on your calculation. )ii*. If you have an income increase of -H< and you purchase :< more filet mignonDs as a results, find the income elasticity of the filets. -. Is this a normal or inferior goodM 2. >o do you #no M :. Is this a lu8ury or necessityM i - Cross Price Elasticity of :emand = %Q< / %Py = [(Q 2-Q !/Qa"e#/[(P2-P !/Pa"e# $%%lyin& the a'o"e formula to the data &i"en (e &et: [( -***- +***!/ 1***#/[( ,2+-,-+!/ ,**# = ,2+ B * @his tells us that there is a %ositi"e chan&e in Q< as (e chan&e the %rice of y or as the %rice of taco 'ell &oes u% there is in increase in the 8uantity of 9c:onald;s ham'ur&ers %urchased, @his im%lies that the &ood are su'stitutes, $s (e &et an increase in the %rice of one (e &et an increase demand for the other, ii - Income 6lasticity of 3emand . <BQ ; <BI. :;-H= ,2B * @his tells us that there is a %ositi"e chan&e in Q as (e ha"e an increase in income, , 7o4 this is a normal &ood, 2, $s income &oes u% (e %urchase more of the &ood, E6B* 0, Decessity, 2e 5no( this 'ecause our "alue of B E6B*4 (hich im%lies that e"en (hen our income (ent u% (e (ere already %urchasin& it to 'e&in (ith, 7o our income &oin& u% has little affect on ho( (e %urchase the &ood and it must therefore 'e a necessity,