Elasticity

1. Price Elasticity

The degree of responsive of quantity demanded to the change in price.

Ep = percentage change in Q due to 1% change in P

Ep = 0 Perfectly inelastic

0<Ep<1 Inelastic

Ep = 1 Unitary elastic (elastic)

Ep>1 Elastic

Ep = infinity Perfectly elastic

Ep= (ΔQ/ΔP)(P/Q) (point elasticity)

P Q
P1 =10 Q1 =20
P2 =20 Q2 =10

Ep = (-10/10).(10/20) = -0.50 Ep absolute = 0.50 < 1 inelastic

If P rises by 1%, Q falls by 0.50% and vice versa, other things remaining the same.

If P changes by 1%, Q changes by 0.50% in the opposite direction, other things remaining the same.

P Q
P1 =20 Q1 =10
P2 =10 Q2 =20

Ep = (10/-10). (20/10) = - 2 Ep absolute = 2 > 1 elastic

If P changes by 1%, Q changes by 2% in the opposite direction, other things remaining the same.

Ep= (ΔQ/ΔP)(Average P/Average Q) (Arc elasticity)

= (10/-10) (15/15) = -1 Ep absolute = 1 elastic (unitary elastic)

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Relationship between TR/TE, Ep and Change in P

P Q TR = P.Q=TE Ep absolute Comment

P1 =10 Q1 =20 200 0 (perfectly If Ep = 0, as P rises
inelastic) TR/TE rises and as
P2 =20 Q2 =20 400 P falls TR/TE falls

P Q TR = P.Q=TE Ep absolute Comment

P1 =10 Q1 =20 200 0.43 < 1 (inelastic) If Ep<1, as P rises
P2 =20 Q2 =15 300 TR/TE rises and as
P falls TR/TE falls

P Q TR = P.Q=TE Ep absolute Comment

P1 =10 Q1 =20 200 1 (elastic) If Ep=1, as P rises
P2 =20 Q2 =10 200 or falls TR/TE
remains the same

P Q TR = P.Q=TE Ep absolute Comment

P1 =10 Q1 =20 200 1.8 > 1 (elastic) If Ep>1, as P rises
P2 =20 Q2 =05 100 TR/TE falls and as
P falls TR/TE rises

P Q TR = P.Q=TE Ep absolute Comment

P1 =10 Q1 =20 200 ∞ > 1 perfectly If Ep=∞, as P rises
elastic) TR/TE falls and as
P2 =9.9999999999 Q2 =99999999999 ???????????? P falls TR/TE rises

Point Ep Again

Ep = (ΔQ/ΔP)(P/Q) ≈ (dQ/dP)(P/Q)

Q = 120 – 5P Calculate Ep when P = 4

Ep = (dQ/dP)(P/Q) = -5 (4/100) = -0.20 Ep absolute = 0.20 < 1 inelastic

Q = 120 – 5P2 Calculate Ep when P = 4

Ep = (dQ/dP)(P/Q) = -10P (4/40) = - 10(4) (4/40) = - 4.0 Ep absolute = 4.00 > 1 elastic

Income Elasticity

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Ey = percentage change in Q due to 1% change in Y (income), other things remaining the same.

Ey = (dQ/dY)(Y/Q)

Q = 120 + 0.5Y Calculate Ey when Y = 50

Ey = 0.5(50/145) = 0.17 < 1 inelastic

If income rises by 1%, Q will rise by 0.17% and vice versa ceteris paribus

In general, if

Ey = 0 Absolute necessity

Ey > 0 Normal good

0<Ey<1 Normal necessity

Ey≥1 Normal luxury

Ey < 0 Inferior good

Q = 120 - 5P + 0.5Y Calculate Ep and Ey when P = 4 and Y = 50

Ep = (∂Q/∂P) (P/Q) = - 5 (4/125) = - 0.16 Ep absolute = 0.16 < 1 inelastic

Ey = (∂Q/∂Y) (Y/Q) = 0.5 (50/125) = 0.20 < 1 normal necessity

Cross-Price Elasticity

E12 = percentage change in Q1 as P2 changes by 1%.

= (dQ1/dP2)(P2/Q1)

Q1 = 20 + 2P2 Calculate E12 when P2 = 3

E12 = 2 (3/26) = 0.23 > 0 (As the price of product 2 (P2) rises by 1%, demand for product 1 (Q1) rises by
0.23% and vice versa, ceteris paribus).

If E12 = 0No relationship between Q1 and Q2

If E12 > 0Q1 and Q2 are substitutes

If E12 < 0Q1 and Q2 are complements

Q1 = 120 - 5P1 + 2P2 + 0.5Y Calculate Ep1, E12 and Ey when P1 = 4, P2 = 3 and Y = 50

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Ep1 = (∂Q1/dP1)(P1/Q1) = -5(4/131) = - 0.15 Ep1 absolute = 0.15 < 1 inelastic

E12 = (∂Q1/dP2)(P2/Q1) = 2 (3/131) = 0.05 >0 Q1 and Q2 are substitutes (but not good ones)

Ey = (∂Q1/dY)(Y/Q1) = 0.5 (50/131) = 0.19 <1 Q1 Normal necessity