the concept of elasticity. elasticity what is the concept and why do we need it? elasticity is used...

The Concept of Elasticity

Elasticity

What is the concept and why do we need it?

Elasticity is used to measure the effects of changes in economic variables

The Most Important Elasticity

• Price elasticity of demand

• A measure of the responsiveness of the quantity demanded of a good to a change in its price.

Demand: Gallons vs Litres Price($/g) Quant(g) Price($/L) Quant(L)

a 100 0 a' 25 0

b 50 25 b' 12.50 100

c 0 50 e' 0 200

Elasticity: A Units-Free Measure

Price elasticity ofdemand =

Percentage change in quantity demanded

Percentage change in price

Calculating Elasticity

P

Q

%

%

ave

ave

PP

QQ

/

/

Which is negative, but price elasticity ofdemand is given as a positive number

= (Q/P)(Pave/Qave)

Calculating Elasticity

• Negative sign is ignored

• The changes in price and quantity are expressed as percentages of the average price and average quantity.

Quantity (millions of chips per year)

Pri

ce (d

olla

rs p

er c

hip)

36 40 44

390

400

410

Da

Originalpoint

Newpoint

Calculating the Elasticity of Demand

Quantity (millions of chips per year)

Pri

ce (d

olla

rs p

er c

hip)

36 40 44

390

400

410

Da

= $20P

= 8Q

Originalpoint

Newpoint

Calculating the Elasticity of Demand

Quantity (millions of chips per year)

Pri

ce (d

olla

rs p

er c

hip)

36 40 44

390

400

410

Da

Originalpoint

Newpoint

Pave = $400

= $20P

= 8Q

Quantity (millions of chips per year)

Pri

ce (d

olla

rs p

er c

hip)

36 40 44

390

400

410

Da

Originalpoint

Newpoint

Pave = $400

Qave = 40

= $20P

= 8Q

Calculating the Elasticity of Demand

Calculating Elasticity

PavePQaveQ

//

400/2040/8 = 4

meaning, on average, each 1% price decreaseCauses a 4% increase inquantity demanded

Price elasticity

Some Interesting Characteristicsof

Linear Demand Curves(It is a straight Line)

Can be Deduced

Compute Elasticity for Gasoline (in Gallons) from Earlier Example

0 25 50 100 200

25

100

Pri

ce (

$/un

it)

Quant. (G)

Gallons: slope = -2

When:Price falls from $100/gal to $0/gal

50

|P/Q| = 100/50 = 2

Pavg = 100/2 (=50)Qavg = 50/2 (=25)Pavg/ Qavg = (100/2)/(50/2)

= 2

|P/Q| = 100/50 = 2

Pavg/ Qavg = (100/2)/(50/2)= 2

The ratio of midpoint Price and Quantity = The slope

But for elasticity we want |Q/P|, the reciprocal of demand curve slope

|Q/P| = 1/2

Elasticity = |Q/P| (Pavg/ Qavg) = (1/2)*2 =1

A Lesson: Elasticity on linear demand curves

0 25 50 100 200

25

100

Pri

ce (

$/un

it)

Quant. (G or L)

50 Elasticity = 1

For any Price-Quantity combinationElasticity > 1

Elasticity < 1

Three types of price elasticity of demand

• inelastic

• Unit elastic

• elastic

Inelastic Demand

• Inelastic demand

• The percentage change in quantity is less than the percentage change in price.

• Price elasticity of demand < 1

Extreme Case: Perfectly Inelastic Demand

6

12

Pri

ce

Quantity

D1Elasticity = 0 WHY?

(Q/P)(Pave/Qave) =

(0/P)(Pave/Qave) = 0

Because Q = 0

Elastic Demand

• Elastic demand

• The percentage change in quantity is greater than the percentage change in price.

• Price elasticity of demand > 1

Extreme Case:Perfectly Elastic Demand

6

12

Pri

ce

Quantity

D3

Elasticity =

(Q/P)(Pave/Qave) =

Because P = 0

(Q/0)(Pave/Qave) =

Unit Elastic Demand

• Unit elasticity

• The percentage change in quantity equals the percentage change in price.

• Price elasticity of demand = 1

Extreme Case:Unit Elastic Demand Everywhere

6

12

Pri

ce

Quantity

D2

1 2 3

Elasticity = 1

Unit Elasticity

Factors That Influence Elasticity

• The Closeness of Substitutes.

• The closer the substitutes, the more elastic the demand

•more elastic means a higher price elasticity (but not necessarily > 1)

Elasticity and Closeness of Substitutes

Quantity (pounds per week)

Pri

ce (d

olla

rs p

er p

ound

)

5

10

No close subs

1 2 3 4 7

Orange Roughy

Close subs

Factors That Influence Elasticity

• Proportion of Income Spent on the Good

• The greater the proportion of income spent on food, the more elastic the demand•Because of Income Effect of a price change

Factors That Influence Elasticity

• Time Elapsed Since Price Change

• The longer the time, the more elastic the demand•Short-run demand•Long-run demand

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Factors Affecting Price Elasticity of Demand

• Availability of substitutes

• The better & more numerous the substitutes for a good, the more elastic is demand

• Percentage of consumer’s budget

• The greater the percentage of the consumer’s budget spent on the good, the more elastic is demand

• Time period of adjustment

• The longer the time period consumers have to adjust to price changes, the more elastic is demand

29

Income Elasticity

• Income elasticity (EM) measures the

responsiveness of quantity demanded to changes in income, holding the price of the good & all other demand determinants constant

• Positive for a normal good

• Negative for an inferior goodd dM

d

% Q Q ME

% M M Q

30

Cross-Price Elasticity

• Cross-price elasticity (EXY) measures the

responsiveness of quantity demanded of good X to changes in the price of related good Y, holding the price of good X & all other demand determinants for good X constant

• Positive when the two goods are substitutes

• Negative when the two goods are complementsX X Y

XYY Y X

% Q Q PE

% P P Q