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ElasticityElasticity

1. A definition & determinants of elasticity1. A definition & determinants of elasticity Price elasticityPrice elasticity

2. Elasticity & consumer expenditure2. Elasticity & consumer expenditure

3. Measurement of elasticity3. Measurement of elasticity Arc methodArc method

Point methodPoint method

4. Other measures of elasticity4. Other measures of elasticity

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1. Definitions and determinants1. Definitions and determinants

If price rises, demand will fallIf price rises, demand will fall By how much?By how much?

Responsiveness of demand elasticityResponsiveness of demand elasticity

DefinitionsDefinitions thethe responsivenessresponsiveness of demand andof demand and

supply to changes in pricesupply to changes in price

Price elasticity of demandPrice elasticity of demand ((PPdd))::

The responsiveness of quantity demandedThe responsiveness of quantity demanded

to a change in priceto a change in price

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figfigQuantity

P

ric

e

O Q2

Q1

P1

S1

D

a

Market supply and demandMarket supply and demand

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Determinants ofDeterminants ofPPdd

Why does the price elasticity vary?Why does the price elasticity vary?

1. number and closeness of substitute goods1. number and closeness of substitute goods

The larger the number of substitute goods (that satisfy theThe larger the number of substitute goods (that satisfy the

same need), the greater (same need), the greater (PPdd) will be) will be

E.g. holidays v. electricityE.g. holidays v. electricity

2.2. the proportion of income spent on the goodthe proportion of income spent on the good

If this is high, a price rise will force a substantial reduction inIf this is high, a price rise will force a substantial reduction in

demanddemand

3. Time3. Time

Time to adjust spending patternsTime to adjust spending patterns

Short run inelasticShort run inelastic

Long run - elasticLong run - elastic

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2. Elasticity and consumer expenditure2. Elasticity and consumer expenditure

Total expenditure (TE)Total expenditure (TE)

== P x QP x Q

= Total Revenue (TR)= Total Revenue (TR)

See figureSee figure

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Consumers total expenditureConsumers total expenditure

==

firms total revenuefirms total revenue

==

2 x 3m = 6m2 x 3m = 6m

P()

Q (millions of units per period of time)

D0

1

2

3

4

0 1 2 3 4 5

Total expenditureTotal expenditure

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Elasticity & consumer expenditureElasticity & consumer expenditure

What happens to TE (and TR) as priceWhat happens to TE (and TR) as price

changes?changes?

A) elastic demandA) elastic demand

PP, Q, Qproportionately more (TEproportionately more (TE))

PP , Q, Q proportionately more (TEproportionately more (TE ))

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P()

Q (millions of units per period of time)

0

aD

4

20

Elastic demand between two pointsElastic demand between two points

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Elasticity & consumer expenditureElasticity & consumer expenditure

B) inelastic demandB) inelastic demand

PP, Q, Qproportionately less (TEproportionately less (TE )) PP , Q, Q proportionately less (TEproportionately less (TE ))

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Inelastic demand between two pointsInelastic demand between two points

P()

Q (millions of units per period of time)

0

a

D

4

20

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P

QO Q1

P1

P2

D

b

a

Totally inelastic demand (Totally inelastic demand (PPDD= 0)= 0)

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P

QO Q1

P1

Q2

D

ba

Infinitely elastic demand (PD= )Infinitely elastic demand (PD= )

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P

QO 40

20

100

D8

a

b

Unit elastic demand (Unit elastic demand (PPDD= -1)= -1)

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3. Measurement of elasticity3. Measurement of elasticity

Elasticity varies along the demand ( & supply)Elasticity varies along the demand ( & supply)

curvecurve Price-elastic (>1)Price-elastic (>1)

price-inelastic(0-1)price-inelastic(0-1)

unitary (=1)unitary (=1) (1) arc method (between two points on D)(1) arc method (between two points on D)

price elasticity of demand:price elasticity of demand: Q/QQ/Q P/PP/P

using the average or 'mid-point' methodusing the average or 'mid-point' method Q/average QQ/average Q P/average PP/average P

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0

2

4

6

8

1 0

0 1 0 2 0 3 0 4 0 5 0

P()

Q (000s)

m

n

Q P

mid Q mid PP d =

Demand

Measuring elasticity using the arc methodMeasuring elasticity using the arc method

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Measurement of elasticityMeasurement of elasticity

(2) The Point Method(2) The Point Method Price elasticity of demandPrice elasticity of demand

dQ / dP x P / QdQ / dP x P / Q

d infinitesimally small change (see calculus)d infinitesimally small change (see calculus)

dQ / dP rate of change of quantity demandeddQ / dP rate of change of quantity demanded

with respect to pricewith respect to price

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P

Q

50

30

0 40 100

D

r

P d = (1 / slope) x P/Q

Measuring elasticity at a pointMeasuring elasticity at a point

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4. Other measures of elasticity4. Other measures of elasticity

Income elasticity of demandIncome elasticity of demand

the responsiveness of demand to a change inthe responsiveness of demand to a change in

consumer income, Y.consumer income, Y.

Luxuries (>1), necessities (0-1),inferior goods(1), necessities (0-1),inferior goods(