ch5 : elasticity asst. prof. dr. serdar ayan. the concept of elasticity how large is the response of...
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CH5 :CH5 :ElasticityElasticity
Asst. Prof. Dr. Serdar AYAN
The Concept of Elasticity
How large is the response of producers and consumers to changes in price? Before business firms and the government decide to change prices and taxes, they must anticipate the magnitude of response by those affected.
Elasticity is a measure of the responsiveness of people to changes in economic variables.
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Elasticity
elasticity A general concept used to quantify the response in one variable when another variable changes.
%elasticity of with respect to
%
AA B
B
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Price Elasticity of Demand
price elasticity of demand The ratio of the percentage of change in quantity demanded to the percentage of change in price; measures the responsiveness of quantity demanded to changes in price.
pricein change %
demandedquantity in change % demand of elasticity price
Slope and Elasticity
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Price Elasticity of Demand
Types of Elasticity
TABLE 5.1 Hypothetical Demand Elasticities for Four Products
Product
% Change In Price
(% P)
% ChangeIn Quantity Demanded
(% QD)Elasticity
(% QD ÷ %P)
Insulin +10% 0% .0 Perfectly inelastic
Basic telephone service +10% -1% -.1 Inelastic
Beef +10% -10% -1.0 Unitarily elastic
Bananas +10% -30% -3.0 Elastic
perfectly inelastic demand Demand in which quantity demanded does not respond at all to a change in price.
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Price Elasticity of Demand
inelastic demand Demand that responds somewhat, but not a great deal, to changes in price. Inelastic demand always has a numerical value between zero and -1.
Types of Elasticity
A warning: You must be very careful about signs. Because it is generally understood that demand elasticities are negative (demand curves have a negative slope), they are often reported and discussed without the negative sign.
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Price Elasticity of Demand
Types of Elasticityunitary elasticity A demand relationship in which the percentage change in quantity of a product demanded is the same as the percentage change in price in absolute value (a demand elasticity of -1).
elastic demand A demand relationship in which the percentage change in quantity demanded is larger than the percentage change in price in absolute value (a demand elasticity with an absolute value greater than 1).
perfectly elastic demand Demand in which quantity drops to zero at the slightest increase in price.
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Price Elasticity of Demand
Types of Elasticity
FIGURE 5.2 Perfectly Inelastic and Perfectly Elastic Demand Curves
Figure 5.2(a) shows a perfectly inelastic demand curve for insulin. Price elasticity of demand is zero. Quantity demanded is fixed; it does not change at all when price changes.Figure 5.2(b) shows a perfectly elastic demand curve facing a wheat farmer. A tiny price increase drives the quantity demanded to zero. In essence, perfectly elastic demand implies that individual producers can sell all they want at the going market price but cannot charge a higher price.
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Price Elasticity of Demand
Types of Elasticity
A good way to remember the difference between the two “perfect” elasticities is:
Interpreting the Value of Elasticity
Response to Price
Changes
Responsive
Unresponsive
Proportional
Value of
Elasticity
Ed > 1
Ed < 1
Ed = 1
Demand Elasticity
Elastic
Inelastic
Unitary elastic
Magnitudes of Change
%QD > %P
%QD < %P
%QD = %PType of
Elasticity
Elastic
Inelastic
Substitutes Available
Many
Few
The main determinant of demand elasticity is the availability of substitutes for the good in question.
Interpreting the Value of Elasticity
The price elasticity for water (0.20) suggests that a 10% increase in the price of water would decrease the quantity demanded by only 2%.
The elasticity for specific brands of coffee (5.6) suggests that a 10% increase in the price of a specific brand would decrease its quantity demanded by 56%.
Estimated price elasticities of demand for selected products
ProductPrice elasticity
of demandSalt 0.1
Water 0.2
Coffee 0.3
Cigarettes 0.3
Shoes and footwear 0.7
Housing 1.0
Automobiles 1.2
Foreign travel 1.8
Restaurant meals 2.3
Air travel 2.4
Motion pictures 3.7
Specific brands of coffee 5.6
Example: If the price of an ice cream cone increases from 2.00TL to 2.20TL and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as:
Computing the Price Elasticity of Demand
P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed
P ercen tag e ch an g e in p rice
( )
( . . ).
1 0 81 0
1 0 0
2 2 0 2 0 02 0 0
1 0 0
2 0 %
1 0 %2
Computing Price Elasticity of Demand
E d p ercentage change in q uantity d em and ed
p ercentage change in p r ice
% .Q
8 5 1 0 0
1 0 0
1 5
1 0 00 1 5 o r 1 5 %
%$ 2. $ 2 .
$ 2 .
$ 0.
$ 2 .P
2 0 0 0
0 0
2 0
0 010%
%
%.
Q
P
1 5 %
1 0 %1 5 0
Elasticity Along a Linear Demand Curve
Price elasticity of demand decreases as we move downward along a linear demand curve
Demand is elastic on the upper part of the demand curve and inelastic on the lower part.
Percentage decrease in price
Percentage increase in quantity
Elasticity
Point r to point s 4/80 = 5% 2/10 = 20% 20%/5% = 4.0
Point t to point u 4/50 = 8% 2/25 = 8% 8%/8% = 1
Point v to point w 4/20 = 20% 2/40 = 5% 5%/20% = 0.25
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Calculating Elasticities
Elasticity and Total Revenue
TR = P x Qtotal revenue = price x quantity
In any market, P x Q is total revenue (TR) received by producers:
When price (P) declines, quantity demanded (QD) increases. The two factors, P and QD move in opposite directions:
Effects of price changeson quantity demanded:
and
D
D
QP
QP
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Calculating Elasticities
Elasticity and Total Revenue
Because total revenue is the product of P and Q, whether TR rises or falls in response to a price increase depends on which is bigger: the percentage increase in price or the percentage decrease in quantity demanded.
If the percentage decline in quantity demanded following a price increase is larger than the percentage increase in price, total revenue will fall.
Effects of price increase ona product with inelastic demand: x D TRQP
Effects of price increase ona product with elastic demand: x D TRQP
Predicting Changes in Total Revenue
Elasticity and Total Revenue
Type of demand Value of Ed
Change in quantity versus change in price
Effect of an increase in price on total revenue
Effect of a decrease in price on total revenue
Elastic Greater than 1.0
Larger percentage change in quantity
Total revenue decreases
Total revenue increases
Inelastic Less than 1.0 Smaller percentage change in quantity
Total revenue increases
Total revenue decreases
Unitary elastic
Equal to 1.0 Same percentage change in quantity and price
Total revenue does not change
Total revenue does not change
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Calculating Elasticities
Elasticity and Total Revenue
The opposite is true for a price cut. When demand is elastic, a cut in price increases total revenues:
When demand is inelastic, a cut in price reduces total revenues:
effect of price cut on a productwith elastic demand: x D TRQP
effect of price cut on a productwith inelastic demand: x D TRQP
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The Determinants of Demand Elasticity
Availability of Substitutes
Perhaps the most obvious factor affecting demand elasticity is the availability of substitutes.
The Importance of Being UnimportantWhen an item represents a relatively small part of our total budget, we tend to pay little attention to its price.
The Time DimensionThe elasticity of demand in the short run may be very different from the elasticity of demand in the long run. In the longer run, demand is likely to become more elastic, or responsive, simply because households make adjustments over time and producers develop substitute goods.
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Other Important Elasticities
Income Elasticity of Demand
income elasticity of demand A measure of the responsiveness of demand to changes in income.
incomein change %
demandedquantity in change % demand of elasticity income
Income Elasticity
E i > 0 Normal Income QD E i < 0 Inferior Income QD E i > 1 Luxury % QD > % I E i < 1 Necessity % QD < % I
Income Elasticity
Type of Good Responsiveness
Classification of Goods According to Income Elasticity
E = p ercentage change in q uantity d emand ed
p ercentage change in inco mei
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Other Important Elasticities
Cross-Price Elasticity Of Demand
cross-price elasticity of demand A measure of the response of the quantity of one good demanded to a change in the price of another good.
X
Y
of pricein change %
demanded ofquantity in change % demand of elasticity price-cross
Exy > 0 Substitutes Py Qx
Cross Elasticity of Demand
Exy < 0 Complements Py Qx
Classification of Goods According to Cross ElasticityCross Elasticity
Responsiveness
Type of Good
E = p ercentage change in q uantity o f X d emand ed
p ercentage change in p r ice o f Yxy
Price Elasticity of Supply
Price elasticity of supply is a measure of the responsiveness in quantity supplied to changes in price.
E s p ercentage change in q uantity sup p lied
p ercentage change in p r ice
Computing Price Elasticity of Supply
E s p ercentage change in q uantity sup p lied
p ercentage change in p r ice
% Q s
1 2 0 1 0 0
1 0 0
2 0
1 0 02 0 %
%$ 2. $ 2 .
$ 2 .
$ 0.
$ 2 .P
2 0 0 0
0 0
2 0
0 01 0 %
EQ
Pss
%
%.
2 0 %
1 0 %2 0
Supply Elasticity and Time
Supply becomes more elastic over time.
The increase in quantity supplied as a response to an increase in price is greater when supply is more elastic.
Higher market prices give business firms an incentive to expand production and output. As time goes by, the ability of firms to expand productive capacity is greater, and supply becomes more elastic.