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Quantitative Demand Analysis

Elasticity

Question: If the price of EF3440A increases from $6300 to $63000, what happen to the quantity demanded of it? Drop, the Law of demand. By HOW MUCH? UNKOWN!

Elasticity

Law of Demand:

Price drops, Qd increases, vice versa Directional Change Magnitude is not given (it does not tell how much the Qd will response to a change in price) Dependent

Elasticity

variable

Independe Measures the responsiveness of one variable nt variable to changes in another variable. The percentage change in one variable that arises to a given percentage change in

Elasticity

Types of Elasticity 1. Price Elasticity of Demand 2. Income Elasticity of Demand 3. Cross-Price Elasticity of Demand

**Price Elasticity of Demand
**

The responsiveness of Qd to a change in price. The % change in Qd when price changes by 1% %∆Q Dependent variable Ed %∆P Independent variable Mathematically: =d (∆Qd/Qdold)x100% Ed = (∆P/Pold)x100 % ∆Qd Pold Ed = ∆P x Qdold

**Price Elasticity of Demand
**

Demand

Px

**Qdx = -10Px + 1500 100 150
**

0 500

Qdx

50 1000

0 1500

Q: What is the Ed if the price moves from $100 to $50? ∆Qd Pold

Ed = ∆P x Qdold (1000-500) x 100 Ed = (50-100) 50 0 Ed =-2

**Price Elasticity of Demand
**

Question: What does it mean by Ed = -2? The increase in Qd is 2% when price decreases by 1%. The decrease in Qd is 2% when price increases by 1%.

**Price Elasticity of Demand
**

Demand

Px

**Qdx = -10Px + 1500 100 150
**

0 500

Qdx

50 1000

0 1500

Q: Do you expect that if we go back from $50 to $100, the Ed is the same, -2? No!

∆Qd Pold Ed = ∆P x Qdold (500-1000) x 50 Ed = (100-50) 1000 Ed =-0.5

The “Old” point changed

**Price Elasticity of Demand
**

The value of an Ed depends on the direction of changes. There are two ways to remove this effect:

Arc price elasticity of demand ∆Qd Pold new+Pold)/2 x (P Edarc = ∆P (Qdold +Qdold)/2 Qd new Point price elasticity of demand

**Arc Price Elasticity of Demand
**

Px Qdx Px 150 100 75 50 A C B 500 750 1000 Demand Curve EdA ≠ EdB 150 0 100 500 50 1000 0 1500

1500

Qdx

**Price Elasticity of Demand
**

Question: What is the Sign of Ed, positive or negative? Negative

P ,Q P ,Q The Law of demand

**∆Qd Pold Ed = ∆P x Qdold
**

(-) (-)

Remark: as it must be negative, we usually ignore the sign and take the absolute

**Price Elasticity of Demand
**

Question: What is the Size of Ed? %∆Q Ed =d %∆P Depends on the magnitude of the change of Qd. 0 ∞

**Price Elasticity of Demand
**

According to the size, Ed can be divided into five types: 1.Elastic 2.Inelastic 3.Unitarily elastic 4.Perfectly elastic 5.Perfectly inelastic

Elastic

Definition:

% ∆ in Qd > % ∆ in P

10% 15% P Qd

%∆Q >1 Ed =d %∆P

When Ed > 1, the demand is elastic.

Elastic

Graphical representation of Elastic

Px

∆P ∆Qd D Qdx

Usually, we will use a flat demand curve to represent elastic.

Inelastic

Definition:

% ∆ in Qd < % ∆ in P

20% 10% P Qd

%∆Q <1 Ed =d %∆P

When Ed < 1, the demand is inelastic.

Inelastic

Graphical representation of Inelastic

Px

∆P ∆Qd D Qdx

Usually, we will use a steep demand curve to represent inelastic.

Unitarily elastic

Definition:

% ∆ in Qd = % ∆ in P

15% 15% P Qd

%∆Q =1 Ed =d %∆P

When Ed = 1, the demand is unitarily elastic.

Unitarily elastic

Graphical representation of Unitarily Elastic

Px

∆P ∆Qd

D Qdx

Usually, we will use a Rectangular Parabola demand curve to represent unitarily elastic.

Perfectly Elastic

Definition: =∞ % ∆ in Qd > % ∆ in P

10%

∞

P Qd

%∆Q =∞ Ed =d %∆P

When Ed = ∞, the demand is perfectly elastic.

Perfectly Elastic

Graphical representation of Perfectly Elastic

Px

P1

∆P = 0

D

Qdx

Usually, we will use a horizontal demand curve to represent perfectly elastic. Implication: Price must set at P1

Perfectly Inelastic

Definition:

=0

% ∆ in Qd < % ∆ in P

10% 0 P Qd

%∆Q =0 Ed =d %∆P

When Ed = 0, the demand is perfectly inelastic.

Perfectly Inelastic

Graphical representation of Perfectly Px D inelastic

∆Qd = 0

Q1

Qdx

Usually, we will use a vertical demand curve to represent perfectly elastic. Implication: Quantity will not response according to a price change.

**Elasticity vs Total Revenue
**

When price increases, what happen to the producer’s total revenue?

P

P2 P1 Q2 Q1 D Q At P1, TR = (P1 x Q1) =

At P2, TR = (P2 x Q2) =

Unknown, unless we know Ed. Remark: If P and Qd go to opposite direction, Ed is essential for the

Total Revenue (Ed >1)

If Ed >1 (% ∆ in Qd > % ∆ in P)

P At P1, TR = (P1 x Q1) = Los s Q2 Q1 D Q

P2 Gai P n

1

At P2, TR = (P2 x Q2) =

P increases, TR drops (Gain < Loss) P decreases, TR rises (Gain > Loss)

Total Revenue (Ed >1)

Another way to shows this result Ed >1 (% ∆ in Qd > % ∆ in P)

(% in Qd > % Price increases TR = P x Q Price decreases(% in Qd > % in P)

in P)

TR = P x Q

Total Revenue (Ed <1)

If Ed <1 (% ∆ in Qd < % ∆ in P)

P P2 Gai P1 n At P1, TR = (P1 x Q1) = D Q

At P2, TR = (P2 x Q2) =

P increases, TR rises (Gain > Loss) P decreases, TR drops (Gain < Loss)

Los s Q2 Q1

Total Revenue (Ed <1)

Another way to shows this result Ed <1 (% ∆ in Qd < % ∆ in P)

(% in Qd < % Price increases TR = P x Q Price decreases(% in Qd < % in P)

in P)

TR = P x Q

Application of Elasticity

What happen to producers’ expenditure under the minimum wage law?

P

wagemin wage

S

Q2 Q1

D

Q

Price increases, Qt decreases TE is uncertain (lower if Ed <1)

Application of Elasticity

Government set a per unit tax = t Supply shifts up vertically by “t” P Results:

Price rises Quantity drops Government tax revenue = t x Q2 How much is shared by Consumers / Producers P2 tax P1 revenue

S2

t S1

D

Q2 Q1 Q

Application of Elasticity

Total tax burden

Tax x Qnew t x Q2

S2 P t S1

P2 CB Consumer burden (CB)P1 PB P0 Price increase x Qnew (P2 – P1) x Q2

D Q2 Q1

Producer burden (PB)

Total tax burden – CB (P1 – P0) x Q2

Q

Application of Elasticity

Which situation will the consumers pay more than producers?

Consumers with smaller Ed tend to pay more tax. S2 S2 P P t S1 t S1

P2 CB P1 PB P0 D Q2 Q1 Q Q2Q1 P2 CB

P1 PB P0

D Q

Application of Elasticity

Question: In April 2009, HK Government announced to raise the tobacco tax by 50%. Do you expect the smokers or the producers to pay more? Smokers!

Smoker’s Ed is low

Determinants of Ed

1. When there is no close substitute for a good, demand for it tends to be less price elastic.

eg. MTR

**2. When a good is necessity, demand for it tends to be less elastic.
**

eg. Drugs

3. When the expenditure on a good is large (either in absolute terms or relative to total expenditure), demand tends to be more price elastic.

eg. Rent

**Ed along a Linear Demand Curve
**

The slope of a demand curve is just an approximation of Ed. %∆Q ∆Qd Ed =d %∆P 1/slope = ∆P For one demand curve, different points will give different Ed. ∆Qd Pold Ed = ∆P x Qdold

**Ed of Linear Demand Curve
**

What is the Ed of A, B, C, D and E?

Px a A Ed = ∞ B Ed > 1

As Price increases, Ed gets higher

a/2

Ed = 1 C

Ed < 1 D Ed = 0 E Qd x b

b/2

**Ed of Linear Demand Curve
**

Question As the prices of the following two goods drop by 50%, which one do you care more?

$2 $1

$1000 0 $500 0

**Income Elasticity of Demand
**

The responsiveness of Qd to a change in Income (Y). The % change in Qd when income changes by 1% Mathematically: %∆Q EY = d %∆Y (∆Qd/Qdold)x100% EY = (∆Y/Yold)x100 % ∆Qd Yold EY = ∆Y x Qdold

**Income Elasticity of Demand
**

Y Qdx 1000 0 2000 500 3000 1000 4000 1500

**Q: What is the EY if the income rises from $2000 to $3000? ∆Qd Yold EY= ∆Y x Qdold
**

(1000-500) x 2000 EY = (3000500 2000)

EY = 2

**Income Elasticity of Demand
**

Question: What does it mean by EY = 2? When income decreases by 1%, Qd increase by 2%. When income increases by 1%, Qd decreases by 2%.

**Income Elasticity of Demand
**

Question: What is the Sign of EY, positive or Positive negative? Negative

Y ,Q

Normal (Superior) Good

Y ,Q

Inferior Good

Remark: EY can be either “+” or “–”, depends on whether it is Normal or Inferior Good.

**Income Elasticity of Demand
**

Question: What is the Size of EY? %∆Q EY = d %∆Y Depends on the magnitude of the change of Qd. -∞ ∞

**Income Elasticity of Demand
**

Less will be consumed with More will be consumed with higher income. higher income. Inferior Normal Good Good

-∞

∞ Income NecessityLuxury

0 1

Neutral Good The same quantity will be consumed even with higher income.

**Income Elasticity of Demand
**

Is Sushi a normal, inferior or income neutral?

**Income Elasticity of Demand
**

Is a cheeseburger a normal, inferior or income neutral?

**Income Elasticity of Demand
**

Is a toilet paper a normal, inferior or income neutral?

The responsiveness of Qd of good x to a change in Price of good y (EPy). The % change in Qdx when Py changes by 1% %∆Qdx Mathematically: EPy = %∆P y (∆Qdx/Qdxold)x100 EPy =%(∆P / P old)x100% y y ∆Qdx Py old EPy = ∆P x Qdxold y

Cross-Price Elasticity of Demand

**Cross-Price Elasticity of Demand
**

Question: What is the Sign of EPy, positive or Positive negative? Negative

Py , Qx

Substitutes

Py , Qx

Complements

Remark: EPy can be either “+” or “–”, depends on whether the goods are

**Cross-Price Elasticity of Demand
**

Question: What is the Size of EPy? %∆Qdx EPy = %∆P y Depends on the magnitude of the change of Qdx. -∞ ∞

**Cross-Price Elasticity of Demand
**

Complements Substitutes

-∞

0

∞

Increasing degree of Substitutability

**Cross-Price Elasticity of Demand
**

Question Which pair of goods give a larger EPy?

**Price Elasticity of Supply
**

The responsiveness of Qs to a change in price. The % change in Qs when price changes by 1% %∆Q Es Mathematically: = s%∆P (∆Qs/Qsold)x100% Es = (∆P/Pold)x100 % ∆Qs Pold Es = ∆P x Qsold

**Price Elasticity of Supply
**

Question: What is the Sign of Es, positive or negative? Positive

P ,Q P ,Q The Law of supply

**∆Qs Pold Ed = ∆P x Qsold
**

(+) (+)

Remark: Es must be positive

**Price Elasticity of Supply
**

According to the size, Es can be divided into five types: Flat 1.Elastic % ∆ in Qs > % ∆ in P Es >1 2.Inelastic % ∆ in Qs < % ∆ in P Es <1

S

Steep S

3.Unitarily % ∆ in Qs = % ∆ in P elastic

S

Es =1

0

**Price Elasticity of Supply
**

4. Perfectly % ∆ in Qs = ∞ Es = ∞ elastic

Horizontal S

5. Perfectly % ∆ in Qs = 0 inelastic

vertical S

Es = 0

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