Elasticity

1. A definition & determinants of elasticity
• Price elasticity

2. Elasticity & consumer expenditure 3. Measurement of elasticity
• Arc method • Point method

4. Other measures of elasticity

1. Definitions and determinants
 If price rises, demand will fall
• By how much?

• Responsiveness of demand – elasticity
 Definitions

‘the responsiveness of demand and supply to changes in price’ Price elasticity of demand (P∈d):
• ‘The responsiveness of quantity demanded to a change in price’

Market supply and demand
S1

Price

a
P1

D
O Q2
fig

Q1 Quantity

Market supply and demand
S2 S1 b
Price
P2

a
P1

D
O Q2 Q1 Quantity

Market supply and demand
S2 S1 b
Price
P2

c
P3 P1

a D'

D
O Q3 Q2
fig

Q1 Quantity

Determinants of P∈d

Why does the price elasticity vary?
• 1. number and closeness of substitute goods

The larger the number of substitute goods (that satisfy the same need), the greater (P∈d) will be E.g. holidays v. electricity

• 2. the proportion of income spent on the good

If this is high, a price rise will force a substantial reduction in demand

• 3. Time
  

Time to adjust spending patterns Short run – inelastic Long run - elastic

2. Elasticity and consumer expenditure

Total expenditure (TE)
=PxQ = Total Revenue (TR) See figure

4

Total expenditure

3

2

P(£)
1

0 0

Consumers’ total expenditure = firms’ total revenue = 1£2 x 3m2= £6m 3

D
4 5

Q (millions of units per period of time)

Elasticity & consumer expenditure
 What happens to TE (and TR) as price

changes?

A) elastic demand
• P↑, Q↓ proportionately more (TE↓) • P ↓, Q ↑ proportionately more (TE ↑)

Elastic demand between two points

P(£)

4

a D

0

20 Q (millions of units per period of time)

Elastic demand between two points
Expenditure falls as price rises
P(£) 5 4

b a D

0

10

20

Q (millions of units per period of time)

Elasticity & consumer expenditure

B) inelastic demand
• P↑, Q↓ proportionately less (TE ↑) • P ↓, Q ↑ proportionately less (TE ↓)

Inelastic demand between two points

P(£)

4

a

D
0 20 Q (millions of units per period of time)

Inelastic demand between two points
Expenditure rises as price rises
8 P(£)

c

4

a

D
0 15 20

Q (millions of units per period of time)

P

Totally inelastic demand (P∈D = 0)
D

P2

b

P1

a

O

Q1

Q

P

Infinitely elastic demand (P∈D = ∞)

a
P1

b

D

O

Q1

Q2

Q

P

Unit elastic demand (P∈D = -1)

20

a

8

b D
40 100

O

Q

3. Measurement of elasticity

Elasticity varies along the demand ( & supply) curve
  

Price-elastic (>1) price-inelastic(0-1) unitary (=1) price elasticity of demand: ∆ Q/Q ÷ ∆ P/P using the average or 'mid-point' method
∀ ∆ Q/average Q ÷ ∆ P/average P

(1) arc method (between two points on D)
 

10

Measuring elasticity using the arc method

d

=

∆Q
mid Q

8

m n

÷ mid P

∆P

6

P (£)
4

2

Demand

0 0 10 20 30 40 50

Q (000s)

Measuring elasticity using the arc method 10

8
d

= =

∆Q
10 15

m n
= = =

mid Q

÷ mid P ÷
− 2 7

∆P

10/15 x − 7/2 − 70/30 − 7/3 = − 2.33

6

P (£)
4

2

Demand

0 0 10 20 30 40 50

Q (000s)

Measurement of elasticity
 (2) The Point Method
• Price elasticity of demand

dQ / dP x P / Q

• ‘d’ – infinitesimally small change (see calculus) • dQ / dP – rate of change of quantity demanded with respect to price

Measuring elasticity at a point
50 Pε
d

= (1 / slope) x P/Q

30 P

r

D

0

40 Q

100

Measuring elasticity at a point
50 Pε d = (1 / slope) x P/Q = dQ/dP i.e. invert dP/dQ (-50/100) = − 100/50 =-2 = − (30/40) 2 = -2 (0.75) = −1.5

30 P

r

D

0

40 Q

100

4. Other measures of elasticity

Income elasticity of demand

‘…the responsiveness of demand to a change in consumer income, Y.’
• Luxuries (>1), necessities (0-1),inferior goods(<0)

Cross-price elasticity of demand

‘…responsiveness of demand for one product to a change in the price of another product.’ Substitutes or complements

Price elasticity of supply

Definition & determinants?