Economics Elasticity

Topic 3

The Elasticity of Demand
 Elasticity
A measure of the extent to which quantity demanded and quantity supplied respond to variations in determinants of demand such as price, income, and other factors.
Responsiveness to its own price change is called price elasticity
Responsiveness to income change is called income elasticity
Responsiveness to changes in price of substitutes or complement is called cross elasticity.

 Price elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price.

Percentage Change in Quantity Demanded
 Price elasticity of demand will always be negative (i.e., an inverse relationship between
price and quantity)
 For convenience we drop the negative sign and concentrate on absolute value.
Price Elasticity of Demand
Assume
The price of pork falls by 2% and the quantity demanded increases by 6%
Then the price elasticity of demand for pork 1

Extreme Cases
• When the price elasticity of demand is equal to zero, the demand is perfectly inelastic and is a vertical line.
•When the price elasticity of demand is infinite, the demand is perfectly elastic and is a horizontal line.

Price Elasticity of Demand
What is the elasticity of demand for pizza?
Originally
Price = $1/slice
Quantity demanded = 400 slices/day
New
Price = $0.97/slice
Quantity demanded = 404 slices/day, then
For small changes in price
ΔP/ P
ΔQ/ Q
Price elasticity
Where Q is the original quantity and P is the original price.
Applicable to a straight line demand curve. Please also note that even a straight line, elasticity differ
from point to point along the straight line.

The Midpoint Method
Because we use percentage changes in calculating the price elasticity of demand, the elasticity calculated by going from one point to another on a demand curve will be different from an elasticity calculated by going from the second point to the first.
This difference arises because the percentage changes are calculated using a different base.
A way around this problem is to use the midpoint method.

•Using the midpoint method involves calculating the percentage change in either price or quantity demanded by dividing the change in the variable by the midpoint between the initial and final levels rather than by the initial level itself.
•Example: the price rises from $4 to $6 and quantity demanded falls from 120 to 80.
Price elasticity= 1

Determinants of Price Elasticity of Demand
1.Substitution possibilities- the more substitutes the more elastic is the price of the product.
2.Budget share- big ticket items (car) tend to have higher price elasticities- incentive to look for substitutes
3.Time- the price elasticity for any goods and services will be higher in the long run than in the short run.
4.Necessities versus Luxuries: necessities are more price inelastic.
5.Definition of the market: narrowly defined markets (ice cream) have more elastic demand than broadly defined markets (food).
Total Expenditure = P x Q
Market demand measures the quantity (Q) at each price (P)

Total Expenditure = Total Revenue
Definition of total revenue: the amount paid by buyers and received by sellers of a good, computed as the price of the good times the quantity sold.
General Rule
A price increase will increase total revenue when the % change in P is greater than the % change in Q.
Price inelastic
Should a rock band raise or lower its price to increase total revenue?
Then
Total revenue = $20 x 5,000 = $100,000/week
If P is increased 10%, Q will decrease 30%
Total revenue = $22 x 3,500 = $77,000/week
If P is lowered 10%, Q will increase 30%
Total revenue = $18 x 6,500 = $177,000/week

Rule
When price elasticity is greater than 1, changes in price and changes in total expenditures always move in opposite directions. PTR; PTR decrease
When price elasticity is less than 1, changes in price and changes in total expenditures always move in the same direction. PTR; PTR increase
If demand is inelastic, the percentage change in price will be greater than the percentage change in quantity demanded.

•If price rises, quantity demanded falls, and total revenue will rise (because the increase in price will be larger than the decrease in quantity demanded).
• If price falls, quantity demanded rises, and total revenue will fall (because the fall in price will be larger than the increase in quantity demanded)
If demand is elastic, the percentage change in quantity demanded will be greater than the percentage change in price.

If price rises, quantity demanded falls, and total revenue will fall (because the increase in price will be smaller than the decrease in quantity demanded).
If price falls, quantity demanded rises, and total revenue will rise (because the fall in price will be smaller than the increase in quantity demanded).
If demand is unit elastic, the percentage change in price will be equal to the percentage change in quantity demanded.

•If price rises, quantity demanded falls, and total revenue will remain the same (because the increase in price will be equal to the decrease in quantity demanded).
• If price falls, quantity demanded rises, and total revenue will remain the same (because the fall in price will be equal to the increase in quantity demanded).
The slope of a linear demand curve is constant, but the elasticity is not.
At points with a low price and a high quantity demanded, demand is inelastic
At points with a high price and a low quantity demanded, demand is elastic.
Total revenue also varies at each point along the demand curve.

What do you think?
Could reducing the supply of illegal drugs cause an increase in drug-related burglaries?
This will depend on total expenditure/ revenue and not the quantity consumed.
Total revenue for drug traffickers increases, inducing to work harder.

Definition of cross-price elasticity of demand: a measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in the quantity demanded of the first good divided by the percentage change in the price of the second good.

Substitute Goods
When the cross-price elasticity of demand is positive
Complement Goods
When the cross-price elasticity of demand is negative

The price of apples rises from $1.00 per pound to $1.50 per pound. As a result, the quantity of oranges demanded rises from 8,000 per week to 9,500.
% change in quantity of oranges demanded = (9,500-8,000)/8,750 = 0.1714 = 17.14%
% change in price of apples = (1.50-1.00)/1.25 = 0.40 = 40%
cross-price elasticity = 17.14%/40% = 0.43
Because the cross-price elasticity is positive, the two goods are substitutes.

Definition of income elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in consumers’ income, computed as the percentage change in quantity demanded divided by the percentage change in income.

Income Elasticity of Demand
Normal Goods
Income elasticity is positive
Inferior Goods
Income elasticity is negative
Necessities tend to have small income elasticities,
Luxuries tend to have large income elasticities.

Definition of price elasticity of supply: a measure of how much the quantity supplied of a good responds to a change in the price of that good, computed as the percentage change in quantity supplied divided by the percentage change in price.

Example: the price of milk increases from $2.85 per gallon to $3.15 per gallon and the quantity supplied rises from 9,000 to 11,000 gallons per month.

% change in price = (3.15 – 2.85)/3.00 × 100% = 10%

% change in quantity supplied = (11,000 - 9,000)/10,000 × 100% = 20%

Price elasticity of supply = (20%)/(10%) = 2

In general, the flatter the supply curve that passes through a given point, the more elastic the supply.

Extreme Cases

When the elasticity is equal to zero, the supply is perfectly inelastic and is a vertical line.

When the elasticity is infinite, the supply is perfectly elastic and is a horizontal line.

Because firms often have a maximum capacity for production, the elasticity of supply may be very high at low levels of quantity supplied and very low at high levels of quantity supplied.

Determinants of Supply Elasticity

Flexibility of inputs-Flexibility of sellers: goods that are somewhat fixed in supply (beachfront property) have inelastic supplies.

Mobility of inputs- More mobile more elastic and vice versa.

Ability to produce substitute inputs

Time- Time horizon: supply is usually more inelastic in the short run than in the long run.

Three Applications of Supply, Demand, and Elasticity

A new hybrid of wheat is developed that is more productive than those used in the past. What happens?

Supply increases, price falls, and quantity demanded rises.

If demand is inelastic, the fall in price is greater than the increase in quantity demanded and total revenue falls.

If demand is elastic, the fall in price is smaller than the rise in quantity demanded and total revenue rises.

In practice, the demand for basic foodstuffs (like wheat) is usually inelastic.

a. This means less revenue for farmers.

b. Because farmers are price takers, they still have the incentive to adopt the new hybrid so that they can produce and sell more wheat.

C. This may help explain why the number of farms has declined so dramatically over the past two centuries.

d. This may also explain why some government policies encourage farmers to decrease the amount of crops planted.

The federal government increases the number of federal agents devoted to the war on drugs. What happens?

The supply of drugs decreases, which raises the price and leads to a reduction in quantity demanded. If demand is inelastic, total expenditure on drugs (equal to total revenue) will increase. If demand is elastic, total expenditure will fall.

 Thus, because the demand for drugs is likely to be inelastic, drug-related crime may rise.

The price elasticity of demand measures how much the quantity demanded responds to changes in the price.

Demand tends to be more elastic if close substitutes are available, if the good is a luxury rather than a necessity, if the market is narrowly defined, or if buyers have substantial time to react to a price change.

Keypoint

The price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price.

If the elasticity is less than one, so that quantity demanded moves proportionately less than the price, demand is said to be inelastic.

If the elasticity is greater than one, so that quantity demanded moves proportionately more than the price, demand is said to be elastic.

The price elasticity of supply measures how much the quantity supplied responds to changes in the price.

This elasticity often depends on the time horizon under consideration.

In most markets, supply is more elastic in the long run than in the short run.

The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price.

If the elasticity is less than one, so that quantity supplied moves proportionately less than the price, supply is said to be inelastic.

If the elasticity is greater than one, so that quantity supplied moves proportionately more than the price, supply is said to be elastic.