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Quantity Demanded
Elasticity
Price
Totalimportance
The revenue is of
price x
elasticity
quantity
is sold. In this
the information it
example, TR = £5 x 100,000
provides on the effect on
= £500,000.
total revenue of changes in
price.
This value is represented by
the grey shaded rectangle.
£5
Total Revenue
£3
Total Revenue
D
100 140 Quantity Demanded (000s)
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 inelastic:
elastic:
• Increasing price would increase
reduce TR
(%Δ Qd > % Δ P)
TR
• (%Δ
Reducing
Qd <price
% Δ would
P) increase TR
• Reducing
(%Δ Qd >price
% Δ would
P) reduce TR
(%Δ Qd < % Δ P)
Price Elasticity of Demand
Definition:
Law of demand tells us that consumers will respond to a price drop by buying more, but it does not tell us
how much more. The degree of sensitivity of consumers to a change in price is measured by the concept of
price elasticity of demand.
If the percentage change is not given in a problem, it can be computed using the following formula:
Percentage change in Qd = (Q1-Q2) / [1/2 (Q1+Q2)] where Q1 = initial Qd, and Q2 = new Qd.
Percentage change in P = (P1-P2) / [1/2 (P1 + P2)] where P1 = initial Price, and P2 = New Price.
Putting the two above equations together:
Ed = {(Q1-Q2) / [1/2 (Q1+Q2)] } / {(P1-P2) / [1/2 (P1 + P2)]}
Because of the inverse relationship between Qd and Price, the Ed coefficient will always be a negative
number. But, we focus on the magnitude of the change by neglecting the minus sign and use absolute
value
Examples:
1. If the price of Product A increased by 10%, the quantity demanded decreased by 20%. Then the
coefficient for price elasticity of the demand of Product A is:
Ed = percentage change in Qd / percentage change in Price = (20%) / (10%) = 2
2. If the quantity demanded of Product B has decreased from 1000 units to 900 units as price increased
from $2 to $4 per unit, the coefficient for Ed is:
Ed = {(Q1-Q2) / [1/2 (Q1+Q2)] } / {(P1-P2) / [1/2 (P1 + P2)]} = {(1000 - 900) / 1/2(1000 + 900)} / {(2 - 4) / 1/2
(2+4)} = - 0.16
Take the absolute value of - 0.16, Ed = 0.16
Elasticity
• 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
Elasticity
• Income Elasticity of Demand:
If the percentage change is not given in a problem, it can be computed using the following
formula:
Percentage change in Qx = (Q1-Q2) / [1/2 (Q1+Q2)] where Q1 = initial Qd, and Q2 = new Qd.
Percentage change in Y = (Y1-Y2) / [1/2 (Y1 + Y2)] where Y1 = initial Income, and Y2 = New
income.
Putting the two above equations together:
Ey = {(Q1-Q2) / [1/2 (Q1+Q2)] } / (Y1-Y2) / [1/2 (Y1 + Y2)]
Characteristics:
Ey > 1, Qd and income are directly related. This is a normal good and it is income elastic.
0< Ey<1, Qd and income are directly related. This is a normal good and it is income inelastic.
Ey < 0, Qd and income are inversely related. This is an inferior good.
Ey approaches 0, Qd stays the same as income changes, indicating a necessity.
Example:
If income increased by 10%, the quantity demanded of a product increases by 5 %. Then the
coefficient for the income elasticity of demand for this product is::
Ey = percentage change in Qx / percentage change in Y = (5%) / (10%) = 0.5 > 0, indicating
this is a normal good and it is income inelastic.
Elasticity
• For example:
• Yed = - 0.6: Good is an inferior good but inelastic –
a rise in income of 3% would lead to demand falling
by 1.8%
• Yed = + 0.4: Good is a normal good but inelastic –
a rise in incomes of 3% would lead to demand rising
by 1.2%
• Yed = + 1.6: Good is a normal good and elastic –
a rise in incomes of 3% would lead to demand rising
by 4.8%
• Yed = - 2.1: Good is an inferior good and elastic –
a rise in incomes of 3% would lead to a fall in demand
of 6.3%
Elasticity
• Cross Elasticity:
• The responsiveness of demand
of one good to changes in the price
of a related good – either
a substitute or a complement
% Δ Qd of good t
__________________
Xed =
% Δ Price of good y
Elasticity
• Goods which are complements:
– Cross Elasticity will have negative
sign (inverse relationship between the
two)
• Goods which are substitutes:
– Cross Elasticity will have a positive
sign (positive relationship between
the two)
Cross Elasticity of Demand
Definition:
Cross elasticity (Exy) tells us the relationship between two products. it measures the sensitivity of
quantity demand change of product X to a change in the price of product Y.
Formula: Exy = percentage change in Quantity demanded of X / percentage change in Price of Y.
If the percentage change is not given in a problem, it can be computed using the following
formula:
Percentage change in Qx = (Q1-Q2) / [1/2 (Q1+Q2)] where Q1 = initial Qd of X, and Q2 = new
Qd of X.
Percentage change in Py = (P1-P2) / [1/2 (P1 + P2)] where P1 = initial Price of Y, and P2 = New
Price of Y.
Putting the two above equations together:
Exy = {(Q1-Q2) / [1/2 (Q1+Q2)] } / {(P1-P2) / [1/2 (P1 + P2)]}
Characteristics:
Exy > 0, Qd of X and Price of Y are directly related. X and Y are substitutes.
Exy approaches 0, Qd of X stays the same as the Price of Y changes. X and Y are not related.
Exy < 0, Qd of X and Price of Y are inversely related. X and Y are complements.
Examples:
1. If the price of Product A increased by 10%, the quantity demanded of B increases by 15 %.
Then the coefficient for the cross elasticity of the A and B is :
Exy = percentage change in Qx / percentage change in Py = (15%) / (10%) = 1.5 > 0, indicating
A and B are substitutes.
2. If the quantity supplied of Product B has decreased from 1000 units to 200 units as
price decreases from $4 to $2 per unit, the coefficient for Es is:
Es = {(Q1-Q2) / [1/2 (Q1+Q2)] } / {(P1-P2) / [1/2 (P1 + P2)]} = {(1000 - 200) /
1/2(1000 + 200)} / {(4-2) / 1/2 (4+2)} = 2
Characteristics & Determinants
Characteristics:
Es approaches infinity, supply is perfectly elastic. Producers are very sensitive to price change.
Es > 1, supply is elastic. Producers are relatively responsive to price changes.
Es = 1, supply is unit elastic. Producers’ response and price change are in same proportion.
Es < 1, supply is inelastic. Producers are relatively unresponsive to price changes.
Es approaches 0, supply is perfectly inelastic. Producers are very insensitive to price change.
It is impossible to judge elasticity of a supply curve by its flatness or steepness. Along a linear
supply curve, its elasticity changes.
Determinants:
1. Time lag: How soon the cost of increasing production rises and the time elapsed since the
price change influence the Es. The more rapidly the production cost rises and the less time
elapses since a price change, the more inelastic the supply. The longer the time elapses, more
adjustments can be made to the production process, the more elastic the supply.
2. Storage possibilities: Products that cannot be stored will have a less elastic supply. For
example, produces usually have inelastic supply due to the limited shelf life of the vegetables
and fruits.
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 proportion of income taken up by the
product – the smaller the proportion the
more inelastic
• Luxury or Necessity - for example,
addictive drugs
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