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ELASTICITY

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7/23/2012

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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

20

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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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7/23/2012

**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

7/23/2012

Xd = %DQdx / %DPy = Qx1-Qx0/(Qx1+Qx0)

Py1-Py0/(Py1+Py0)

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