Elasticity

1

Elasticity measures 
What  Why

are they?

± Responsiveness measures

introduce them?

± Demand and supply responsiveness clearly matters for lots of market analyses. 
Why

not just look at slope?

± ± ± ±

Want to compare across markets: inter market Want to compare within markets: intra market slope can be misleading want a unit free measure
2

Why Economists Use Elasticity
elasticity is a unit-free measure.  By comparing markets using elasticities it does not matter how we measure the price or the quantity in the two markets.  Elasticities allow economists to quantify the differences among markets without standardizing the units of measurement. 
An
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What is an Elasticity?
of the percentage change in one variable that results from a 1% change in another variable.  Can come up with many elasticities.  We will introduce four. 
Measurement

± three from the demand function ± one from the supply function

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 Price elasticity of supply: how sensitive is the quantity supplied to a change in the price of the good. 5 .  Often referred to as ³own´ price elasticities.2 VIP Elasticities  Price elasticity of demand: how sensitive is the quantity demanded to a change in the price of the good.

6 . ± Price elasticity of demand is -2.Examples of Own Price Demand Elasticities the price of gasoline rises by 1% the quantity demanded falls by 0. so jewelry demand is very price sensitive. ± Price elasticity of demand is -0.6%. so gasoline demand is not very price sensitive.  When the price of gold jewelry rises by 1% the quantity demanded falls by 2.  When 6 .2 .2%.

± Price elasticity of supply is 0. so beef supply is very price sensitive.Examples of Own Price Supply Elasticities the price of DaVinci paintings increases by 1% the quantity supplied doesn¶t change at all.  When the price of beef increases by 1% the quantity supplied increases by 5%. so the quantity supplied of DaVinci paintings is completely insensitive to the price.  When 7 . ± Price elasticity of supply is 5.

8 . ± We compare the demand elasticities of -0.Examples of Unit-free Comparisons  Gasoline and jewelry ± It doesn¶t matter that gas is sold by the gallon for about $1.6 (gold jewelry).2 (gas) and -2. ± Gold jewelry demand is more price sensitive.09 and gold is sold by the ounce for about $290.

± We compare the supply elasticities of 0 (classical paintings) and 5 (beef). ± Beef supply is more price sensitive. 9 .Examples of Unit-free Comparisons  Paintings and meat ± It doesn¶t matter that classical paintings are sold by the canvas for millions of dollars each while beef is sold by the pound for about $1.50.

± Inelastic supply means that the quantity supplied is not very sensitive to the price. 10 . ± Inelastic demand means that the quantity demanded is not very sensitive to the price. we call the relation that it describes inelastic.Inelastic Economic Relations  When an elasticity is small (between 0 and 1 in absolute value).

± Elastic demand means that the quantity demanded is sensitive to the price. 11 .Elastic Economic Relations  When an elasticity is large (greater than 1 in absolute value). we call the relation that it describes elastic. ± Elastic supply means that the quantity supplied is sensitive to the price.

Size of Price Elasticities Unit elastic Inelastic 0 1 2 3 4 5 Elastic 6  Unit elastic: own price elasticity equal to 1 own price elasticity less than 1 own price elasticity greater than 1 12  Inelastic:  Elastic: .

General Formula for own price elasticity of demand P = Current price of good X  XD = Quantity demanded at that price  (P = Small change in the current price  (XD= Resulting change in quantity demanded Percentage Change in Quantity Demanded Elasticity ! Percentage Change in Price 13 .

67 in the second. we would say the elasticity of demand is 1.5 in the first example and 0.  So.Note: own price elasticity of demand is always negative.  Economists usually refer to the own price elasticity of demand by its absolute value (ignore the negative sign).  The 14 . even though the formula says that the own price elasticity of demand is negative.

 Need two points to perform the calculation.Arc Formula for Elasticity General the exact formula for calculating an elasticity is useful for theory.  You are really approximating the elasticity between two points.  Although 15 . in practice economists usually calculate an approximation called the arc elasticity.

 Consider PA and XA and PB and XB from the demand relationship.  Note: we¶ll take absolute value  Get elasticity (X ! (P A A  X  P B B ) / Xavg ) / Pavg 16 .Arc Formula for Own Price Elasticity of Demand two points of the demand curve: Points A and B.

 Note: we¶ll take absolute value  The elasticity P ! X A A ¨ (X ¸ © ¹ atA © (P ¹ ª º D 17 .Point Formula for Own Price Elasticity of Demand exact formula for calculating an elasticity at the point A on the demand curve.

 slope = (P/ (X = (X/ (P Price Demand (P slope ! (X (P (X P P+ (P  1/slope X X + (X Quantity 18 .Slope of the Demand Curve  (P is the change in price. ((P<0)  (X is the change in quantity.

say).  The 19 . say) in terms of another (P. say) in terms of another (X. say).  The elasticity measures the percentage change of one variable (X.Slope Compared to Elasticity slope measures the rate of change of one variable (P.

5 Linear Demand Curve 42 41 40 39 38 Price 37 36 35 34 33 32 31 30 10 11 A 12 13 14 Quantity 20 .Example: Elasticity Calculation at ³A´       Slope = (40-32)/(10-14)=-2 1/slope = -1/2 P/X = 36/12 = 3 at point A P/X x 1/slope = -1.5 Elasticity of demand = -1.5 Absolute value of the elasticity = 1.

Linear Demand  Compute the elasticity at the point indicated in red on the table (X=18.Exercise -.  Slope = -2  1/Slope = -1/2  P/X = 24/18 = 4/3  Elasticity = -2/3 Qua 10 11 12 13 14 15 16 17 18 19 20 r ce 40 38 36 34 32 30 28 26 24 22 20 21 .P=24).

5000 -1. This is illustrated in the linear demand curve table above.8750 -0.Elasticities and Linear Demand Linear Demand Exact Elasticity -1.5 -0.5   The elasticity varies along a linear demand (or supply) curve.7647 -0.5 -0.5 -0.5 -0.5 -0.5 -0.0000 -0.7273 -1.3077 -1.6667 -0.5 -0. Note: Usually we would report last column as absolute value 22 .5 -0.1429 -1.5789 Quantity 10 11 12 13 14 15 16 17 18 19 20 Price 40 38 36 34 32 30 28 26 24 22 20 Slope -2 -2 -2 -2 -2 -2 -2 -2 -2 1/Slope -0.

Supply Elasticities price elasticity of supply is always positive.  Economists refer to the price elasticity of supply by its actual value.  Exactly the same type of point and arc formulas are used to compute and estimate supply elasticities as for demand elasticities.  The 23 .

 Perfectly elastic means the quantity (demanded or supplied) is as price sensitive as possible. 24 .  Perfectly inelastic means that the quantity (demanded or supplied) has no price sensitivity at all.Some Technical Definitions For Extreme Elasticity Values  Economists use the terms ³perfectly elastic´ and ³perfectly inelastic´ to describe extreme values of price elasticities.

Perfectly Elastic Demand  We say that demand is perfectly elastic when a 1% change in the price would result in an infinite change in quantity demanded. Price Perfectly Elastic Demand (elasticity = g) Quantity 25 .

Price Perfectly Inelastic Demand (elasticity = 0) Quantity 26 .Perfectly Inelastic Demand  We say that demand is perfectly inelastic when a 1% change in the price would result in no change in quantity demanded.

Price Perfectly Elastic Supply (elasticity = g) Quantity 27 .Perfectly Elastic Supply  We say that supply is perfectly elastic when a 1% change in the price would result in an infinite change in quantity supplied.

Perfectly Inelastic Supply  We say that supply is perfectly inelastic when a 1% change in the price would result in no change in quantity supplied. Price Perfectly Inelastic Supply (elasticity = 0) Quantity 28 .

 What is a major determinant of the own price elasticity of supply? ± Availability of alternatives in production. 29 .Determinants of elasticity  What is a major determinant of the own price elasticity of demand? ± Availability of substitutes in consumption.

Reminders  Value of own price elasticity usually changes along a demand curve ± there are many interesting intra elasticity applications  Can also compare elasticities across markets ± there are interesting inter elasticity questions 30 .

we must measure the measure the price elasticity of demand to answer the question.Using Demand Elasticity: Total Expenditures  Do the total expenditures on a product go up or down when the price increases?  The price increase means more spent for each unit.  So. quantity demanded declines as price rises.  But. 31 .

0.00/trip.  If the price elasticity of demand for bridge trips is 2.  Suppose the quantity demanded at $2.Bridge Toll Example  Current toll for the George Washington Bridge is $2. what is the effect of a 10% toll increase? 32 .000 trips/hour.00/trip is 100.

the revenue from a $2. 33 .000/hour (= 80.Bridge Toll: Elastic Demand  Price elasticity of demand = 2.0  Toll increase of 10% implies a 20% decline in the quantity demanded.00 toll.000/hour.000 x $2.  $176.000 < $200.  Trips fall to 80.  Total expenditure falls to $176.000.20).

 How would the number of trips and the expenditure on tolls be affected by a 10% increase in the toll?  Now 34 .Bridge Toll Example.5. Part 2 suppose the elasticity of demand for bridge trips is 0.

000 x $2.Bridge Toll: Inelastic Demand  Price elasticity of demand = 0.5  Toll increase of 10% implies a 5% decline in the quantity demanded.000 > $200.000/hour (= 95. the revenue from a $2.000.  Trips fall to 95.000/hour. 35 .00 toll.  $209.  Total expenditure rises to $209.20).

± Elastic demand A 36 . the price elasticity of demand is greater than 1 in absolute value (less than -1). and only if. and only if.Elasticity and Total Expenditures price increase will increase total expenditures if. the price elasticity of demand is less than 1 in absolute value (between -1 and zero) ± Inelastic demand  A price reduction will increase total expenditures if.

demand is inelastic. Total expenditure is maximized at the point M.Elasticity and Total Expenditure (Graph)     At the point M. the demand curve is unit elastic. price increase reduces it. so total expenditure falls as the price rises Below M. where the elasticity = 1. Elasticity = 1: Total expenditure is at a maximum Elasticity < 1: Price reduction reduces total expenditure. Price Elasticity > 1: Price reduction increases total expenditure. so total expenditure falls as price falls. M Quantity 37 . price increase increases it. M is the midpoint of this linear demand curve Above M. demand is elastic.

New (price. quantity) is (P. Since the point (P.Q*). quantity) is (P*. So. Expenditures increase if G is bigger than E.Q) is above the midpoint of the linear demand curve.Q*). we know that total expenditures will increase at the lower price (P*. Price P E P* F G Demand Q Q* Quantity 38 . E must be smaller than G.Change in Expenditure Components     Old (price.Q).

Two real world examples  Gas taxes in Washington DC plates in Virginia  Vanity 39 .

When the price of software rises the quantity demanded of computers falls. ± Example (from last week) software is complementary with computers. 40 .Other Price Elasticities: CrossPrice Elasticity of Demand  Elasticity of demand with respect to the price of a complementary good (cross-price elasticity) ± This elasticity is negative because as the price of a complementary good rises. the quantity demanded of the good itself falls. ± Cross-price elasticity quantifies this effect.

± Example (from last week) hockey is substitute for basketball. the quantity demanded of the good itself rises. 41 .Other Price Elasticities: Cross Price Elasticity of Demand  Elasticity of demand with respect to the price of a substitute good (also a cross-price elasticity) ± This elasticity is positive because as the price of a substitute good rises. When the price of hockey tickets rises the quantity demanded of basketball tickets rises. ± Cross-price elasticity quantifies this effect.

consumers increase their purchases of the good more than proportionate to the income increase (e. consumers increase their purchases of the good as their incomes rise (e. clothing). potatoes).Other Elasticities: Income Elasticity of Demand  The elasticity of demand with respect to a consumer¶s income is called the income elasticity. 42 . ± When the income elasticity of demand is greater than 1 (luxury good).g.g. automobiles. ski vacations). ± When the income elasticity of demand is positive (normal good).g. ± When the income elasticity of demand is negative (inferior good). consumers reduce their purchases of the good as their incomes rise (e.

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