Elasticity and its Application

Concept of Elasticity

Elasticity is used to describe the behavior of buyers and sellers in the market

Elasticity is a measure of the quantity demanded or supplied to one of its determinants

Elasticity of demand measures how much quantity demanded responds to change in one of its determinants

Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good

Concept of Elasticity

Price e of demand= % change in quantity demanded/ % change in price Remember price elasticity of demand is

always negative Price e of demand determines whether the

demand curve is steep or flat Demand for a good is elastic if the quantity

demanded responds substantially to changes in the price

Demand for a good is inelastic if the quantity demanded responds only slightly to changes in the price

Determinants of Price Elasticity of Demand

Necessities (inelastic) versus luxuries (elastic)

Availability of close substitutes (highly elastic)

Definition of the market Time horizon

Computing Price Elasticity of Demand

Using the midpoint method The midpoint method gives us the same

price elasticity of demand between two points regardless of the direction of change

The midpoint method computes a % change by dividing the change by midpoint of the initial and final levels

Always use midpoint method to calculate elasticity between two points

Variety of Demand Curves

Perfectly inelastic demand (e=0) Inelastic demand (e<1) Unit elastic demand (e=1) Elastic demand (e>1) Perfectly elastic demand (e=infinity) The flatter the curve passing through a given

point, the greater the elasticity of demand The steeper the curve passing through a given

point, the smaller the elasticity of demand

Total revenue and the Price Elasticity of Demand

TR= PxQ TR changes as one moves along the demand

curve due to changing price elasticity of demand The slope of a linear demand curve is constant

but its elasticity is not The following general rules apply:

When demand is inelastic, a price increase raises TR, and a price decrease reduces TR

When demand is elastic, a price increase reduces TR, and a price decrease raises TR

In case of unit elastic demand, a change in the price does not affect TR

Other Demand Elasticities

Income elasticity of demand =% change in quantity demanded/ % change in income Normal goods (positive income elasticity) Inferior goods (negative income elasticity) Necessities (small income elasticity) Luxuries (high income elasticity)

Cross price elasticity of demand= % change in quantity demanded of good X/ % change in price of good Y Substitutes (positive cross-price elasticity) Complements (negative cross-price elasticity)

Elasticity of Supply

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=

% change in quantity supplied/ % change in price Determinants of elasticity of supply:

Flexibility of sellers to change their production levels

Time period (short versus long)

Elasticity of Supply

Supply of a good is elastic if the quantity supplied responds substantially to changes in price

Supply of a good is inelastic if the quantity supplied responds slightly to changes in price

Computing price elasticity of supply using midpoint method

(Change in quantity/midpoint of initial and final quantity) / (change in price/midpoint of initial and final price)

Variety of Supply Curves

Perfectly inelastic supply (e=0) Inelastic supply (e<1) Unit elastic supply (e=1) Elastic supply (e>1) Perfectly elastic supply (e=infinity) The flatter the curve passing through a given

point, the greater the elasticity of supply The steeper the curve passing through a given

point, the smaller the elasticity of supply

Variety of Supply Curves

Price elasticity of supply varies over the supply curve in some markets. Why?

QS

Pricee<1

e>1

Applications of supply, demand, and elasticity

Impact of change in technology on market equilibrium Can good news for farming be bad news for farmers?

Advanced technology results in a new market equilibrium with lower prices and larger quantity sold in the market.

Behavior of supply and demand in the SR and LR Why did OPEC fail to keep the price of oil high?

In the SR supply and demand are inelastic and in the LR both of them are elastic

Applications of supply, demand, and elasticity

Impact of policy on market equilibrium Does drug interdiction policy increase or

decrease drug-related crime? Drug related crime increases in the SR and

decreases in the LR Drug education policy would reduce drug usage

and drug- related crime in the SR.