Elasticity & case studies

1- Price elasticity of demand

1- What is Ed? 2- How to calculate Ed? 3- Different values of Ed & shapes of

Demand curves. 4- Relation between changes in price,

changes in revenues & Ed. 5- What determines Ed?

What is Ed? It is a measure that shows how the %

change in quantity demanded of a product RESPONDS to the % change in the price of

the product itself, other factors being constant.

How to measure Ed? Ed= % change in Qdx / % change in Px Ed=change in Q/change in P . P/Q Example: If the quantity demanded of a

certain product increased by 80% when its price fell by 20%, calculate Ed. What does the value show?

Ed=+80%/-20%= -4(every 1% change in P yields 4% in Q , in the inverse direction)

Another example Calculate Ed from the following table using the

point elasticity of demand, the original situation was ( A):

P Q A)100 100 B)90 140 Ed= 40/-10 . 100/100=-4( notice that addressing

the absolute value, Ed is more than unity, ie % change in Q RESPONDS GREATLY to % change in P.

3-Different values of Ed & shapes of demand curves 1-Ed might be Zero.Demand is PERFECTLY

INELASTIC Meaning: Qd does not respond whatsoever to P

changes. The Qd remains constant , regardless of price changes.

Example: Vital necessities with no substitutes. Demand curve is vertical as seen in the following

diagram:

Shape of PERFECTLY INELASTIC Demand curve:It is vertical:

2-Ed= infinity Demand for the product is perfectly elastic. Meaning: consumers are ready to buy an infinite

quantity at a certain price & none at all at a slightly higher price.

Example: Very luxurious products with endless number of substitutes( the product is not important whatsoever for the consumer

Demand curve will be horizontal as follows:

Shape of a perfectly elastic demand curve. It is horizontal:

3-Ed=1 Demand is of unit elasticity. Meaning:% change in Qd =% change in P Demand curve takes shape of a

rectangular hyperbola( area under the curve which reflects REVENUE is always constant) as follows:

A demand curve of unit elasticity Revenues are always constant under the

curve:

4- Ed is more than unity(Demand is elastic) Meaning: % change in Q exceeds % change in P Example: when price rises by 10%, Quantity falls

& responds greatly , by 50%( Ed =- 5, as an absolute value Ed is more than 1.

It is the case of a product that has many substitutes & is not important to the consumer.

Demand curve is relatively flat( versus the following fifth last case). The diagram is as follows:

A relatively elastic demand curve

5-Ed is less than unity.Demand is inelastic Meaning: % change in Q is less than the %

change in P. Example: When price rises by 10%, Quantity

demanded falls slightly by 2%. Thus the value of Ed is - 0.5 ( less than one, as an absolute value).

Real case study: it might be a necessary product to the consumer, & it had few substitutes. The demand curve will be relatively steep versus the previous case.

Demand curve that is relatively inelastic:

5- Relation between changes in price, changes in revenues & Ed. Definitely total revenue is just equal to total

spending ( P . Q) If demand for the product is elastic( eg. When

price falls by 10%, quantity demanded increases greatly , by 50% for instance, thus offsetting the decrease in price & total revenue increases. Thus if demand is elastic, seller should lower the price to boost revenues.

This can be seen from the following diagram:

If demand for the product is inelastic ( eg when price rises by 20% , quantity demanded falls slightly by 5% , for instance, thus price change offsets quantity change & total revenues increase.

Thus, if demand is inelastic it is for the benefit of the seller to increase the price to receive more of a revenue.

The following diagram shows the previous case;

If demand for the product is of unit elasticity( eg. A fall in price by 10% is offset by an increase in quantity by 10%, thus leaving revenues constant.) This can be seen in the following diagram:

The diagram shows that the total revenue ( Or total spending from consumer’s side is constant regardless of price changes.

5- What determines Ed?

Main determinants are: The more important & necessary the product is ,

the less the elasticity .( demand is inelastic for necessities & elastic for products that are not important for the consumer).

The more the number of substitutes , the more the elasticity( the demand is elastic for a product with many substitutes & inelastic in case of few substitutes).

The longer the time period , the more the elasticity.

Cases to comment on: 1- TWA company was seeking to maximize

revenues. Top managers advised the company to increase the prices of the VIP class & to decrease the prices of the economy class on the same flight.

2-Directly after the October War in 1973, many Arab countries were able to maximize petroleum revenues as the price per barrel increased by 4 fold. However, afterwards, the foreign importing

countries set strategies to confront the unfavorable supply shock.

3- The prices of some goods seem to fluctuate more than others as a result of a decrease in supply, prove that the price elasticity of demand is behind such price fluctuations.

HINT : the less the elasticity the more the price fluctuations.

Price Elasticity of Supply 1- What is Es? 2- How to measure Es? 3- different values of Es & shapes of

Supply curves. 4- what determines Es?

1-What is Es? Es is a measure that shows how % change

in quantity supplied of the product RESPONDS to the % change in the price of the product, other factors being constant.

2-How to measure Es?

Es= % change in Qs/ % change in price. Es= change in Qs/change in P . P/Q Eg. Calculate Es if you know that the

quantity supplied of a product increased by 40% when its price increased by 10%.

Answer: Es = =40%/=10%=4( every 1% change in price yields 4% changes in qs( in the same direction)

Calculate Es from the following table using point elasticity of supply Assume that A) is the original situation: P Qs A) 10 100 B) 60 900 Es= 800/50.10/100= 1.6( more than 1,

thus supply is elastic)

3- Different values of Es & shapes of Supply curves 1- Es= zero ( Supply is perfectly inelastic) Meaning: Qs is constant regardless of

price changes , eg. Crop with no inventories in the very short run.

Supply curve is vertical as following:

Supply curve that is perfectly inelastic:

2- Es= infinity( supply is perfectly elastic) Meaning EG. Suppliers supply all they can

at a certain price & none at a slightly lower price.

Supply curve is horizontal as following:

3-Es=1 ( supply is of unit elasticity) Meaning :% change in Qs=% change in P Supply curve originates from the origin ( or

its extension starts from the origin) as:

4- ES is more than 1( supply is elastic) Meaning :% change in Qs exceeds %

change in P. The supply curve is relatively flat versus the coming last case, it intersects the horizontal axis) as:

5- Es is less than 1( supply is inelastic) Meaning: % change in Qs is less than %

change in P. Supplier CANNOT respond GREATLY to the price signals. Supply curve is relatively steep versus the previous case , it intersects the horizontal axis as:

4- what determines Es? 1- The more

efficient & sufficient the resources are the more the elasticity.

2- The longer the period of time, elasticity usually increases