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**MARKET DEMAND AND
**

ELASTICITY

MICROECONOMIC THEORY

BASIC PRINCIPLES AND EXTENSIONS

EIGHTH EDITION

WALTER NICHOLSON

Copyright ©2002 by South-Western, a division of Thomson Learning. All rights reserved.

Elasticity

• Suppose that a particular variable (B)

depends on another variable (A)

B = f(A…)

• We define the elasticity of B with respect

to A as

% change in B B / B B A

eB,A

% change in A A / A A B

– The elasticity shows how B responds (ceteris

paribus) to a 1 percent change in A

**Price Elasticity of Demand
**

• The most important elasticity is the price

elasticity of demand

– measures the change in quantity demanded

caused by a change in the price of the good

% change in Q Q / Q Q P

eQ,P

% change in P P / P P Q

• eQ,P will generally be negative

– except in cases of Giffen’s paradox

Distinguishing Values of eQ.P > -1 Inelastic .P < -1 Elastic eQ.P Value of eQ.P at a Point Classification of Elasticity at This Point eQ.P = -1 Unit Elastic eQ.

we can determine how total expenditure changes when the price of a good changes . Price Elasticity and Total Expenditure • Total expenditure on any good is equal to total expenditure = PQ • Using elasticity.

Price Elasticity and Total Expenditure • Differentiating total expenditure with respect to P yields PQ Q QP P P • Dividing both sides by Q.P Q P Q . we get PQ / P Q P 1 1 eQ.

demand is elastic and price and total expenditures move in opposite directions .P is greater or less than -1 – If eQ.P < -1.P > -1. demand is inelastic and price and total expenditures move in the same direction – If eQ. Price Elasticity and Total Expenditure PQ / P Q P 1 1 eQ.P Q P Q • Note that the sign of PQ/P depends on whether eQ.

Price Elasticity and Total Expenditure Responses of PQ Demand Price Increase Price Decrease Elastic Falls Rises Unit Elastic No Change No Change Inelastic Rises Falls .

I > 0 – Luxury goods eQ.I) measures the relationship between income changes and quantity changes % change in Q Q I eQ.I % change in I I Q • Normal goods eQ.Income Elasticity of Demand • The income elasticity of demand (eQ.I < 0 .I > 1 • Inferior goods eQ.

P’) measures the relationship between changes in the price of one good and and quantity changes in another % change in Q Q P' eQ. Cross-Price Elasticity of Demand • The cross-price elasticity of demand (eQ.P ' % change in P' P' Q • Gross substitutes eQ.P’ > 0 • Gross complements eQ.P’ < 0 .

PY.PY.I) .I) Y = dY(PX. Relationships Among Elasticities • Suppose that there are only two goods (X and Y) so that the budget constraint is given by PXX + PYY = I • The individual’s demand functions are X = dX(PX.

Relationships Among Elasticities • Differentiation of the budget constraint with respect to I yields X Y PX PY 1 I I • Multiplying each item by 1 PX X X I PY Y Y I 1 I I X I I Y .

I + sYeY. Relationships Among Elasticities • Since (PX · X)/I is the proportion of income spent on X and (PY · Y)/I is the proportion of income spent on Y.I = 1 • For every good that has an income elasticity of demand less than 1. sXeX. there must be goods that have income elasticities greater than 1 .

Slutsky Equation in Elasticities • The Slutsky equation shows how an individual’s demand for a good responds to a change in price X X X X PX PX U constant I • Multiplying by PX /X yields X PX X PX X 1 PX X PX X PX X U constant I X .

Slutsky Equation in Elasticities • Multiplying the final term by I/I yields X PX X PX PX X X I PX X PX X U constant I I X .

PX PX X U constant .Slutsky Equation in Elasticities • A substitution elasticity shows how the compensated demand for X responds to proportional compensated price changes – it is the price elasticity of demand for movement along the compensated demand curve X PX e S X .

PX e SX .I • It shows how the price elasticity of demand can be disaggregated into substitution and income components – Note that the relative size of the income component depends on the proportion of total expenditures devoted to the good (sX) . the Slutsky relationship can be shown in elasticity form e X .PX s X e X .Slutsky Equation in Elasticities • Thus.

Homogeneity • Remember that demand functions are homogeneous of degree zero in all prices and income • Euler’s theorem for homogenous functions shows that X X X PX PY I 0 PX PY I .

I 0 • An equal percentage change in all prices and income will leave the quantity of X demanded unchanged .PY e X . this means that e X . we get X PX X PY X I 0 PX X PY X I X • Using our definitions. Homogeneity • Dividing by X.PX e X .

Cobb-Douglas Elasticities • The Cobb-Douglas utility function is U(X.PX 2 1 PX X PX X PX I PX .Y) = XY • The demand functions for X and Y are I I X Y PX PY • The elasticities can be calculated X PX I PX I 1 e X .

PY 1 • Note that PX X PYY sX sY I I . Cobb-Douglas Elasticities • Similar calculations show e X .PY 1 eY .PY 0 eY .I 1 eY .I 1 e X .

PX s X e X .PX (1) e SX .I 1 0 1 0 • The elasticity version of the Slutsky equation can also be used e X .PY e X .I 1 e SX .PX e X .PX (1 . ) .PX e SX . Cobb-Douglas Elasticities • Homogeneity can be shown for these elasticities e X .

s X ) where is the elasticity of substitution .PX (1 . Cobb-Douglas Elasticities • The price elasticity of demand for this compensated demand function is equal to (minus) the expenditure share of the other good • More generally e S X .

c. Linear Demand Q = a + bP + cI + dP’ where: Q = quantity demanded P = price of the good I = income P’ = price of other goods a. d = various demand parameters . b.

Linear Demand Q = a + bP + cI + dP’ • Assume that: Q/P = b 0 (no Giffen’s paradox) Q/I = c 0 (the good is a normal good) Q/P’ = d ⋛ 0 (depending on whether the other good is a gross substitute or gross complement) .

Linear Demand • If I and P’ are held constant at I* and P’*. the demand function can be written Q = a’ + bP where a’ = a + cI* + dP’* – Note that this implies a linear demand curve – Changes in I or P’ will alter a’ and shift the demand curve .

the elasticity will become a larger negative number (b < 0) . Linear Demand • Along a linear demand curve.P b P Q Q • As price rises and quantity falls. the slope (Q/P) is constant – the price elasticity of demand will not be constant along the demand curve Q P P eQ.

P < -1 eQ.P > -1 Q a’ .P = -1 eQ. Linear Demand P Demand becomes more elastic at higher prices -a’/b eQ.

b 0. Q = a’Pb where a’ = aIcP’d . this demand function can be used Q = aPbIcP’d where a > 0. • For particular values of I and P’. and d ⋛ 0.Constant Elasticity Functions • If one wanted elasticities that were constant over a range of prices. c 0.

b 1 Q P ba' P P eQ.P b P Q a' P b • The price elasticity of demand is equal to the exponent on P .Constant Elasticity Functions • This equation can also be written as ln Q = ln a’ + b ln P • Applying the definition of elasticity.

Important Points to Note: • The market demand curve is negatively sloped on the assumption that most individuals will buy more of a good when the price falls – it is assumed that Giffen’s paradox does not occur • Effects of movements along the demand curve are measured by the price elasticity of demand (eQ.P) – % change in quantity from a 1% change in price .

price and total expenditures move in the same direction – if demand is elastic (eQ.P < -1) . price and total expenditures move in opposite directions .P > -1) . Important Points to Note: • Changes in total expenditures on a good caused by changes in price can be predicted from the price elasticity of demand – if demand is inelastic (0 > eQ.

I) measures the effect of changes in income on quantity demanded – the cross-price elasticity (eQ. income. the market demand curve will shift – the income elasticity (eQ.P’) measures the effect of changes in another good’s price on quantity demanded . Important Points to Note: • If other factors that enter the demand function (prices of other goods. preferences) change.

Important Points to Note: • There are a number of relationships among the various demand elasticities – the Slutsky equation shows the relationship between uncompensated and compensated price elasticities – homogeneity is reflected in the fact that the sum of the elasticities of demand for all of the arguments in the demand function is zero .

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