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Elasticity

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Definition

Elasticity measures the sensitivity of either demand or supply to a change in any of their determinants. Elasticity measures how responsive or unresponsive the quantity demanded (or supplied) is to changes in a given factor. Elasticity allows you to predict how a price change will affect the behavior of buyers or sellers.
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Types of Elasticity
Price elasticity of demand.  Price elasticity of supply.  Income elasticity of demand.  Cross Price elasticity.

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Factors Affecting Demand Elasticity

Percent of consumer’s budget spent on item – The smaller the percent, the more inelastic Nature of the good – necessities more inelastic than non-necessities – durable goods more elastic than for nondurable goods Length of time period over which elasticity is measured – short run more inelastic than long-run

Availability of substitutes: – Number and closeness of substitutes--more and closer means greater elasticity – A related factor is how widely, or narrowly, a market is defined: Demand for “food” is much more inelastic than demand for cereal because of the relative number ofsubstitutes in each case • Demand for a product is more

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The Price Elasticity of Demand
 

Measures the response of the quantity demanded to a change in price. How responsive do you think is the quantity demanded of prescription drugs to a change in price? How responsive do you think is the quantity demanded of bananas to a change in price?

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The Elasticity Formula
Percentage Change in Quantity Demanded

ed =

Percentage Change in price
%Change in Quantity Supply

es=

%Change in Price

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The Elasticity Formula
Qd2-Qd1/ Qd1

ed =

P2-P1/P1
Qs2- Qs1/Qs1

es=

P2-P1/P1

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1. Compute elasticity of demand for 2002
PRICE QUANTITY

2001 : PY

3

4

2002 CY

2

12

2003

1

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The Elasticity Formula
12-4/ 4

ed =

2-3/3
8/4

ed=

1/3

ed= 2/.33 =- 6.06, 6.-6.06
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For every 1% inc. in Price, Qd dec. by 6.06% For every 1% dec. in Price, Qd inc. by 6.06%

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The Price Elasticity of Demand
Measures the responsiveness of the quantity demanded to a change in price.  There is a negative relationship between the price and the quantity demanded.  The price elasticity of demand is ALWAYS NEGATIVE.

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Price elasticity of demand is ALWAYS NEGATIVE
Always write a negative sign in front!

epd =

Change in Quantity / Average Quantity Change in Price / Average Price

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Three Types of Elasticities
Consider only the absolute value of the elasticity: |E| The absolute value of the elasticity can be  |e|>1 Elastic  |e|=1 Unitarily Elastic  |e|<1 Inelastic  /e/=0 Perfectly Inelastic  /e/=∞
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Perfectly Elastic

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Sensitive Demands are Elastic Demands (e > 1)
Percentage Change in Quantity Demanded

epd =

Percentage Change in price

If the numerator (DQ%) is larger than the denominator (DP%) then epd is greater than one. A relatively small change in price causes a relatively large change in quantity demanded.
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Example
It has been observed that a 5% increase in the price, caused a 10% reduction in the quantity demanded.

epd = 10% / 5% = - 2
Elasticity of Demand is greater than one: Elastic
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Insensitive Demands are Inelastic Demands (e < 1)
Percentage Change in Quantity Demanded

epd =

Percentage Change in price

If the numerator (DQ%) is smaller than the denominator (DP%), then epd is less than one. A relatively large change in price causes a relatively small change in quantity demanded.
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Example
It has been observed that a 20% decrease in the price of good X, caused a 5% increase in the quantity demanded of X.

ep = 5% / 20% = - 0.25
d
Elasticity of Demand is less than one: Inelastic
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The Elasticity Changes Along the Demand Curve

|e| > 1

|e| = 1 |e| < 1

Midpoint
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Perfectly Elastic Demand

When the elasticity is a very large number (close to infinity) demand is said to be 0.61 perfectly elastic. 0.6 A perfectly elastic demand would show that at the slightest increase in the price, the quantity demanded would drop to zero. 0 Units

|e| =

100 Units
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Perfectly Inelastic Demand

When the elasticity is a very small number 1.20 (close to zero) demand is said to be perfectly inelastic. A perfectly inelastic demand would show that even after a large 0.6 change in the price the quantity demanded would not change at all.

|e| = 0
100 Units
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What Determines the Elasticity?
The number of substitutes available.  The Definition of the market.  The length of time consumers have to react to a price change.  Necessities tend to have inelastic demands, whereas luxuries have elastic demands.


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Example: Doctor visits, sailboats.
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The number of Substitutes Available.
The more substitutes exist for a given good, the easier it would be for consumers to switch.
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The more sensitive (elastic) demand would be to price changes
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2. Which product will be less elastic? Why?
a) b)

c)
d)
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Cars Convertibles Imported Convertibles Imported, red convertibles
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The amount of time to react
The longer the time allowed, the easier it is for consumers to find an alternative or modify their behavior.  Goods have more elastic demands over longer time horizons. Example: Gasoline.

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The Price Elasticity of Demand and Revenues
Total Revenues = Price x Quantity  An increase in price will increase TR only if the quantity demanded does not fall “too much”.  If the increase in price is larger than the drop in quantities, TR will increase. 3. This is precisely what happens if demand is _____________

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Elasticity and Total Revenues
Px Q This is the case when |e| > 1.

TR =

This is the case when |e| < 1.
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TR = P x

Q

If a company increases prices and as a result:
 

Total Revenues Decrease. We can conclude that the rise in revenues due to Demand is higher prices, was Elastic completely offset by the drop in quantities sold.

 

Total Revenues Increase. We can conclude that the quantities sold did not drop enough to offset the Demand is rise in revenues due Inelastic to higher prices
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Total Revenues, Changes in prices and Elasticity
Decrease Price to Increase TR

|e| = 1
If demand is UNIT elastic an increase/decrease in price would leave TR unchanged

Increase Price to Increase TR Midpoint
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Cross Elasticity 􀀗
% change in Q to % change in price of some other good 􀀗 Measures closeness of substitutes and complements – positive for substitute commodities – negative for complements 􀀗 EX can be calculated
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Xd = %DQdx / %DPy = Qx1-Qx0/(Qx1+Qx0)

Py1-Py0/(Py1+Py0)

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