Econ 20A- Lecture 7: Elasticity and it’s Applications

Elasticity
 Intro
o Law of Demand
 Fall in the price of a good raises the quantity demanded while a rise in
the price reduces quantity demanded
o the direction of movement of demand in response to price changes
 demand increases, price increases and vice versa
o Qualitative discussion we did not measure the size of the change/movement.
o Concept of elasticity will measure the size of the change
 Why do we need to study elasticity?
 Companies want to know if they increase the price of something
what will happen to the demand (with specific values and
quantities)
 Definition of Elasticity:
o Elasticity is the measure of the change in quantity demanded or quantity
supplied to a change in one of its determinants
 Determinants: price, income, price of related goods
o Price Elasticity of Demand: How much the quantity demanded of a good X
responds to a change in the price of that good X.
o We can also measure income elasticity of demand and elasticity of demand
when the price of related goods change
 How much the demand of good X or Y changes when someone’s income
changes, or price to produce changes
 Price Elasticity of Demand
o measures how willing consumers are willing to buy less (or more) of good X
when price of good X increases (or decreases)
o two types of demand curves we can observe
  Elastic demand:
 When the quantity demanded changes substantially in response
to changes in the price
 If change in price is 20%, change in demand may be 20% or more
 Inelastic demand:
 When the quantity demanded changes only slightly in response to
changes in the price
 If price changes by 10% the change in quantity demanded may be
5%
 Factors influencing elasticity
o 1. Availability of close substitutes
 goods with close substitutes: goods with close substitutes have more
elastic demand
 butter and margarine
 ice cream and fro-yo
 potato chips and tortilla chips
 sometimes people prefer a certain product, so even when there is a price
change they may stay loyal to type/brand
o 2. Necessities vs Luxuries
 necessities have inelastic demand
 salt, rice, gas, water
 even if the price of salt goes up, we still need to use it to prepare
food.
 If you have a car, you need gas. When gas prices change, you still
have to buy gas to drive
 Luxuries have elastic demand
 TV, boats, apple watch
 If you are planning to buy a boat, you can choose to delay
purchase, or not purchase at all, if the price goes up.
  You do not need this item immediately
o 3. Definition of the market
 narrower definition of the market =
 demand for food is inelastic, but demand for milk is more elastic
than that for food. 2% milk has even more elastic demand
 as you get more specific in a category demand becomes more
inelastic
o food  dairy  milk  2% milk
o elastic demand  inelastic demand
o if the price of 2% goes up, you can just buy whole milk
o 4. Time Horizon
 demand is more elastic over longer time horizons
 short run vs long run demand
 if the price of gas goes up, demand for gas is inelastic in the first
few months. If years pass, gas consumption falls substantially.
 Short run people may not care as much
 Long run people may start buying electric cars or using public
transportation
 Clicker Question:
o Which of the following statements is correct?
 The demand for hamburgers is more elastic than the demand for Kobe
beef
 The demand for ice cream is more elastic than the demand for chocolate
ice cream
 The demand for Coca-Cola is more elastic than the demand for soda
 The demand for gasoline is more elastic in the short-run than in the long
term.

 Clicker Question:
 o Which of the following goods would have the least elastic demand?
 Milk
 2% milk
 chocolate milk
 because each example describes milk, the price elasticity will be the same
for each good.
Compute Price Elasticity of Demand
 Method 1: Percentage change in quantity demanded divided by percentage change in
price
o Example: 10% increase in the price of an ice-cream cone causes 20% decrease in
the demand for ice-cream cones
(Q2-Q1)/Q1
 Price elasticity of demand Ep=(𝑃2−𝑃1)/𝑃1= (-20%) / (10%) = 2

o Though there is a minus sign, we drop it (it is just using absolute value)
 Method 2: Midpoint method:
o Two points on a demand curve: (Q1,P1) and (Q2, P2)
o Price elasticity of demand:
𝑄2+𝑄1
(𝑄2−𝑄1)⁄[ ]
 = 2
𝑃2+𝑃1
(𝑃2−𝑃1)⁄[ ]
2

o example: P1= 12, P2=10, Q1 = 4 Q2=5

 Change in price=(P2-P1)= -2
 Change in quantity= (Q2-Q1)= 1
 Average price =(P2+P1)/2= 11
 Average quantity =(Q2+Q1)/2= 2.5
 Price elasticity of demand=
 .22/.18 = 1.22
o EXAMPLE: Suppose the price of a Snickers bar is reduced from $1.65 to $1.35,
and as a result the quantity demanded increases from 1,400 to 1,600. Using the
midpoint method, what is the price elasticity of demand for Snicker bars?
o Solution:
 o P1 = 1.65, P2=1.35
o Q1=1400 Q2=1600
 Change in price=(P2-P1)= .30 (use absolute value)
 Change in quantity= (Q2-Q1)= 200
 Average price =(P2+P1)/2= 1.5
 Average quantity =(Q2+Q1)/2= 1500
 Price elasticity of demand=
 (200/1500) / (-.3/1.5)
 (2/15) / (1/5) = 2/3
 Do you use Method 1 or Method 2?

o (taken
from lecture presentation)
 always use Method 2!
Types of Demand
 Elastic Demand
o Demand is elastic when quantity changes more than proportionately to change
in the price.
 If q decrease by 60% and p increase by 22% its elastic
o Price elasticity of demand (EP)
 Inelastic Demand
o Demand is inelastic when quantity changes less than proportionately to change
in the price.
o Price elasticity of demand (EP)
 Demand has unit elasticity
 o Demand has unit elasticity: Change in the quantity equal to change in the price.
 If Q increases by 22% and P increases by 22%
o Price elasticity of demand (EP)
 Perfectly Elastic Demand:
o Price elasticity of demand (Ep) = infinity
o Demand curve is horizontal
 Perfectly Inelastic Demand:
o Price elasticity of demand (Ep) = 0
o Demand curve is vertical
o Over time it can change, but in the short run perfect inelastic
 Elasticity and Slope of demand curve
o Change in price / change in quantity = slope
o Elasticity is the inverse
 Change in quantity / change in price
o Rule of thumb:
 The flatter the demand curve at a point, then high price elasticity
 The steeper the demand curve is at a point, then low price elasticity
 CLICKER Question
o A vertical supply curve has a price elasticity (Ep) of zero?
 True
 False