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Application

.

Elasticity – The concept

The responsiveness of one variable to

changes in another

When price rises what happens to

demand?

Demand falls

BUT!

How much does demand fall?

.

Elasticity – The concept

If price rises by 10% - what happens to

demand?

We know demand will fall

By more than 10%?

By less than 10%?

Elasticity measures the extent to which

demand will change

.

Elasticity . . .

sellers respond to changes in market

conditions

demand with greater precision.

.

Price Elasticity of Demand

percentage change in quantity demanded

given a percent change in the price.

demanded of a good responds to a change

in the price of that good.

.

Determinants of Elasticity

Time period – the longer the time under

consideration the more elastic a good is likely

to be.

Number and closeness of substitutes –

the greater the number of substitutes,

the more elastic the demand.

The proportion of income taken up by the product

– the smaller the proportion the more inelastic

Luxury or Necessity – necessary goods have

inelastic demand vs. luxury goods have elastic

demand. E.g. Salt vs. luxury cars.

.

Determinants of

Price Elasticity of Demand

Demand tends to be more elastic :

if the good is a luxury.

the longer the time period.

the larger the number of close

substitutes.

If the consumer is spending large portion

of his income on the product.

.

Computing the Price Elasticity

of Demand

The price elasticity of demand is computed

as the percentage change in the quantity

demanded divided by the percentage

change in price. Percentage Change

in Quantity Demanded

Price Elasticity of Demand =

Percentage Change

in Price

.

Computing the Price Elasticity

of Demand

Percentage change in quatity demanded

Price elasticity of demand

Percentage change in price

Example: If the price of an ice cream increases from

2.00 to 2.20 and the amount you buy falls from 10 to 8

then your elasticity of demand would be calculated as:

(10 8 )

100

10 20 percent

2

( 2.20 2.00 )

100 10 percent

2.00

.

Ranges of Elasticity

Perfectly Inelastic

Quantity demanded does not respond at

all to price changes.

Inelastic Demand

Quantity demanded does not respond

strongly to price changes.

Price elasticity of demand is less than one.

.

Ranges of Elasticity

Unit Elastic

Quantity demanded changes by the same

percentage as the price.

Elastic Demand

Quantity demanded responds strongly to

changes in price.

Price elasticity of demand is greater than one.

Perfectly Elastic

Quantity demanded changes infinitely with any

change in price.

.

A Variety of Demand Curves

demand measures how much

quantity demanded responds to the

price, it is closely related to the

slope of the demand curve.

.

Perfectly Inelastic Demand

- Elasticity equals 0

Price Demand

1. An 5

increase

in price... 4

100 Quantity

2. ...leaves the quantity demanded unchanged.

.

Inelastic Demand

- Elasticity is less than 1

Price

5

1. A 25%

increase

in price... 4

90100 Quantity

2. ...leads to a 10% decrease in quantity.

.

Unit Elastic Demand

- Elasticity equals 1

Price

1. A 25% 5

increase

in price... 4

75 100 Quantity

2. ...leads to a 25% decrease in quantity.

.

Elastic Demand

- Elasticity is greater than 1

Price

1. A 25%

increase 5

in price...

4

50 100 Quantity

2. ...leads to a 50% decrease in quantity.

.

Perfectly Elastic Demand

- Elasticity equals infinity

Price

1. At any price

above 4, quantity

demanded is zero.

4 Demand

2. At exactly 4,

consumers will

buy any quantity.

quantity demanded is infinite.

.

Computing the Price Elasticity

of Demand ( Other methods)

Price elasticity of demand can also be

calculated by a few other methods. These

methods are :

Total Outlay Method

Midpoint Formula

Geometric Method

.

Total Outlay Method

This method, measures the change on

expenditure on commodities due to a change in

price.

If a given change does not cause any change in

the total amount spent on the commodity, the

demand is said to be unitary elastic.

If the total expenditure increases due to fall in

price, the demand is said to be elastic and vice

versa.

.

Demand is Unitary elastic

Price ( in Rs.) Quantity demanded Total expenditure

4.50 4 18

4.00 4.5 18

3.00 6 18

But the total outlay remains constant.

Hence, elasticity of demand is equal to unity.

.

Demand is Elastic

Price ( in Rs.) Quantity demanded Total expenditure

4.50 6 27

4 7 28

3 10 30

And the total outlay also increases.

Hence, demand is elastic. ( Greater than unity)

.

Demand is inelastic

Price ( in Rs.) Quantity demanded Total expenditure

4.50 4 18

4 4.25 17

3 5 15

but the total outlay decreases.

Hence, demand is inelastic. ( Lesser than unity)

.

Midpoint Formula

calculating the price elasticity of demand

because it gives the same answer regardless

of the direction of the change.

(Q 2 Q 1 )/[(Q 2 Q 1 )/2 ]

P rice E la sticity o f D e m a n d =

(P 2 P1 )/[(P 2 P1 )/2 ]

.

Geometric method

Elasticity at a point on a straight line demand curve

can be calculated as follows :

--------------------------------------------------

Length of the upper segment

At all points above the midpoint e >1

At all points below the midpoint e < 1

.

Geometric Method

At the point M,

Price Elasticity > 1

the demand curve

Elasticity = 1

is unit elastic. M is

the midpoint of

this linear demand

curve

Elasticity < 1

Above M, demand M

is elastic,

Below M, demand

is inelastic

Quantity

.

Income elasticity of Demand

=

demand Percentage change in income

.

Income elasticity of Demand

Income Elasticity of Demand:

The responsiveness of demand to changes in

incomes.

Normal Good – demand rises as income

rises and vice versa

Inferior Good – demand falls as income

rises and vice versa

.

Cross Elasticity of Demand

Cross Elasticity:

The responsiveness of demand of one

good to changes in the price of a related

good – either a substitute or a

complement

Percentage Change

in Quantit y Demanded

in Quantity of good X

Demanded

PriceElas

Cross Elasticity

ticity of of Demand

Demand = =

Percentage Change

in Price of good Y

.

Price elasticity of Supply

Responsiveness of supply to a given

change in the price.

Percentage Change

in Quantity Demanded

Supplied

Price Elasticity of Demand

Supply =

Percentage Change

in Price

.

Ranges of Price Elasticity of

Supply

Perfectly inelastic Supply – Quantity supplied

does not change at all with a given change in

price.

Relatively Inelastic Supply – Quantity supplied

does not respond strongly to a given change in

price.

Unitary elastic supply – The change is quantity

supplied is as much as the change in price.

.

Ranges of Price Elasticity of

Supply

Relatively Elastic Supply – Quantity

supplied respond strongly to a given

change in price.

Perfectly elastic supply - Quantity

supplied changes infinitely with a

given change in price.

.

Perfectly Inelastic Supply

Elasticity equals 0

Price Supply

1. An 5

increase

in price... 4

100 Quantity

2. ...leaves the quantity supplied unchanged.

.

Inelastic Supply

Elasticity is less than 1

Price

1. A 25% 5

increase

in price... 4

leads to a 10% increase in Supply

.

Unit Elastic Supply

Elasticity equals 1

Price

1. A 25% 5

increase

in price... 4

leads to a 25% increase in Supply

.

Elastic Supply

Elasticity is greater than 1

Price

1. A 25% 5

increase

in price... 4

Leads to a 50% increase in quantity supplied

.

Perfectly Elastic Supply

Elasticity equals infinity

Price

1. At any price

above 4, quantity

supplied is infinite.

4 Supply

2. At exactly 4,

Producers will sell any quantity.

quantity supplied is zero.

.

Total revenue is The importance of

price x quantity elasticity is the

Elasticity sold. In this

example, TR = 5 x

information it

provides on the

Price 100 = 500. effect on total

This value is revenue of

represented by the changes in price.

shaded rectangle.

Total Revenue

.

If the firm decides

to decrease price

Elasticity to (say) 3, the

Price degree of price

elasticity of the

demand curve

would determine

the extent of the

5 increase in

demand and the

change therefore

in total revenue.

3

Total Revenue

D

100 140 Quantity Demanded

.

Elasticity

Price

Producer decides to lower price to attract sales

10 % Δ Price = -50%

% Δ Quantity Demanded = +20%

Ped = -0.4 (Inelastic)

5 Total Revenue would fall

Not a good move!

D

5 6

Quantity Demanded

.

Elasticity

Price (£)

Producer decides to reduce price to increase sales

% Δ in Price = - 30%

% Δ in Demand = + 300%

Ped = - 10 (Elastic)

Total Revenue rises

10

Good Move!

7

D

5 Quantity Demanded 20

.

Elasticity

If demand is price If demand is price

elastic: inelastic:

Increasing price Increasing price

would reduce TR would increase TR

(%Δ Qd > % Δ P) (%Δ Qd < % Δ P)

Reducing price Reducing price

would increase TR would reduce TR

(%Δ Qd > % Δ P) (%Δ Qd < % Δ P)

.

Importance of Elasticity

Relationship between changes in price

and total revenue

Importance in determining what goods to

tax (tax revenue)

Importance in analysing time lags in

production

Influences the behaviour of a firm

.

Importance of Elasticity

Concepts

For a Businessman : If a businessman

finds that the demand is inelastic, he is

free to increase prices.

In case if the demand is elastic, by

slightly reducing the price, the demand

will increase sharply and hence the total

revenue will also increase.

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