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Study Session 4 - Reading 13 Elasticity

Saturday, August 23, 2008


12:45 PM
• Elasticity is a units free measure of the degree to which the quantity supplied or
demanded of a product responds to changes in any one of the variables while
everything else remains constant
• 3 demand elasticity measures reflect the factors that affect the quantity
demanded( Item Price, Price of Related items and incomes)
o Price Elasticity
• Price is the most important variable that affects the demand quantity
• A measure of sensitivity along the demand curve
Price elasticity of demand = % change in quantity demanded / %
change in price
Where: Percentage change = Change in value/average value =
Ending – Beginning /Avg Value

When E > 1 -> Demand is elastic - Price changes cause opposite


movements in Revenue
When E < 1 -> Demand is inelastic - Price changes cause direct movements
in Revenue
When E= 1 -> Demand is Unit Elastic - No Change at all

o A perfectly elastic demand curve is a horizontal line


o A perfectly inelastic demand curve is a vertical line
o Unit Elastic demand curves is downward sloping
o Downward sloping straight lines are elastic when prices are high and
inelastic when prices are low
o 3 primary factors that influence price elasticity
• Substitutes - demand is more elastic for products that have many
close substitutes. Luxuries are more elastic than necessities
• Proportion of Income Spent - more elasticity exists when a larger
proportion of income is spent on a product
• Time elapsed since price change

o Cross elasticity - measures how a products demand responds to changes


in another product's price
• Similar formula to price elasticity but value can be + or - and the price
change is from the 2nd product
• When + - the two items are substitutes. If value is high they are very
close substitutes and not very close when value is low
• When - the two items are complements

o Income Elasticity - Measures the sensitivity of an item's demand to


changes in income levels
• Same as other formulas but change in income is in denominator now.
• Like cross elasticity can be + or -
Income Product Type Elasticity Type
Elasticity
+ and > 1 Normal Elastic
+ and < 1 Normal Inelastic
Negative Inferior

• Supply Elasticity - measures the sensitivity of the quantity supplied to its


change in price