Elasticity

Chapter 5
by M. Nabeel Tahir, Siyu Liu and Alfonso Izquierdo

Imagine!

Wheat Farmer Higher harvest = higher income A major discovery A new form of hybrid wheat

To use or not to use?

The yield will increase by 20% per hectare of land Should you use it? Is it a good alternative? Will it cost more?

Will demand increase?

Basic rule of Supply and Demand

The quantity of a product supplied and demanded reacts to changes in price Can you measure this reaction? Elasticity

What is Elasticity?

A measure of how much buyers and sellers respond to changes in markets conditions.

Determining the direction of effect

The quantitative value of the effect

Price Elasticity of Demand

Percentage change in quantity demanded divided by the percentage change in price Suppose price decreases by 25% Demand increases by 100% Elasticity = 100/25 = 4
50 100 Price

4 3

Quantity

Price Elasticity of Demand

Now if price increases

Price

% increase in price is 33.33%

Demand decreases by 50% Elasticity = 50/33.33 = 1.5 So value of E changes according to price increase of decrease
4 3

50

100

Quantity

Solution

The Midpoint Method: Divide the change in value by the median price. Price on average = (43)/3.5 = 28.57% Quantity on average = (100-50)/75 = 66.67% PE = 66.67/28.57 = 2.33
50 Price

4 3.5 3

75
100 Quantity

The Variety of Demand Curves

Inelastic Demand

Quantity demanded does not respond strongly to price changes. Price elasticity of demand is less than one.

Elastic Demand
Quantity demanded responds strongly to changes in price. Price elasticity of demand is greater than one.

The Variety of Demand Curves

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Demand is elastic !
0 50 100

The Variety of Demand Curves

Because the price elasticity of demand
measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.

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slope = (y1-y2)/(x1-x2)

The Variety of Demand Curves

In extreme cases...

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Perfectly Inelastic

Quantity demanded stays the same regardless the price.

Perfectly Elastic

Quantity demanded changes infinitely with any change in price.

Unit Elastic

Quantity demanded changes by the same percentage as the price.

The Variety of Demand Curves

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The price elasticity of demand determines whether the demand curve is steep or flat. Note that all percentage changes are calculated using the midpoint method.

The Variety of Demand Curves

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The Variety of Demand Curves

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The Variety of Demand Curves

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The Variety of Demand Curves

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Total Revenue and the Price Elasticity of Demand

Total Revenue = PQ

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The amount paid by buyers and received by sellers of the good

Total Revenue and Price Elasticity of Demand

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Inelastic Demand

An increase in the price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increase.

Total Revenue and Price Elasticity of Demand

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Elastic Demand

An increase in the price leads to a decrease in quantity that is proportionately larger. Thus, total revenue decreases.

Total Revenue and Price Elasticity of Demand

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Inelastic Demand

Price and total revenue move in the same direction

Elastic Demand

Price and total revenue move in opposite direction

Unit Elastic Demand

Total revenue remains constant when the price changes

Elasticity and Total Revenue along a linear Demand Curve

Price USD Quantity Total Revenue USD Percent change in price Percent change in quantity Price elasticity Quantity description 7 6 5 4 3 2 1 0 0 2 4 6 8 10 12 14 0 12 20 24 24 20 10 0 15 18 22 29 40 67 200 200 67 40 29 22 18 15 13 3.7 1.8 1.0 0.6 0.3 0.1 Elastic Elastic Elastic Unit elastic inelastic inelastic inelastic

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Other Elasticities Income Elasticity of Demand

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Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

Other Elasticities Income Elasticity of Demand

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Income elasticty of demand =

Percentage change in quantity demanded Percentage change in income

Other Elasticities Income Elasticity of Demand

Types of Goods

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Normal Goods Inferior Goods

Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.

Other Elasticities Income Elasticity of Demand

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Other Elasticities Income Elasticity of Demand

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Goods consumers regard as necessities tend to be income inelastic

Goods consumers regard as luxuries tend to be income elastic.

Other Elasticities The Cross-Price Elasticity of Demand

The Cross-Price elasticity of Demand measures the response of demand for one good to changes in the price of another good

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Cross-price elasticity of demand =

Percentage change in quantity demanded of good 1 Percentage change in the price of good 2

Other Elasticities The Cross-Price Elasticity of Demand

For substitutes, cross-price elasticity > 0 (e.g., an increase in price of beef causes an increase in demand for chicken) For complements, cross-price elasticity < 0 (e.g., an increase in price of computers causes decrease in demand for software)

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The Elasticity of Supply

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Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good. Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price.

The Elasticity of Supply

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Price elasticity of supply =

Percentage change in quantity supplied Percentage change in price

The Elasticity of Supply

Example:
Price elasticity of supply equals
16% = 2.0 8%
P P rises P2 by 8% P1 Q S

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Q1 Q rises by 16%

Q2

Variety of Supply Curves

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Variety of Supply Curves

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Variety of Supply Curves

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Variety of Supply Curves

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Variety of Supply Curves

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How the Price Elasticity of Supply Can Vary

P
$15 12

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S elasticity <1

elasticity >1
4 $3 100 200 500 525

Supply often becomes less elastic as Q rises, due to capacity limits.

Q

ELASTICITY AND ITS APPLICATION

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Thank you