Elasticity

Aims & Objectives

• After studying this lesson, you would be able to understand

• Elasticity of Demand & its practical application• Elasticity of Supply & its practical application

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Elasticity of Demand

Elasticity of demand

• This measures the responsiveness of quantity demanded of a good or a service by a consumer to change in factors like price, income, price of related products etc.

• The three main types of elasticity of demand are: Price elasticity Income elasticity Cross elasticity

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Price elasticity of demand• This measures the responsiveness of quantity demanded of

a good or service by a consumer to change in its own price.• It is defined as Ep = (% change in quantity demanded)/(% change in

price of the good or service) = [(ΔQ/Q) * 100]/[(ΔP/P )*100] Where, ΔQ denotes change in quantity ΔP denotes change in price Q denotes original quantity P denotes original price

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Arc vs Point elasticity• Arc elasticity measures the responsive of demand to large

changes in prices as measured over an arc of the demand curve. The formula for arc price elasticity is given as,

Ep = [(Q2-Q1)/1/2(Q2+Q1) /[(P2-P1)/1/2(P2+P1)

• Point elasticity measures the responsive of demand to very small changes in prices . The formula for arc price elasticity is given as,

Ep = [(ΔQ/Q) * 100]/[(ΔP/P )*100]

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Note: Price Elasticity of Demand Formula• Use percentages

Unit free measureCompare responsiveness across products

• Eliminate the minus signEasier to compare elasticities

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• Elastic demand - Products with price elasticity greater than one are said to be price elastic. This is usually the case for luxury goods. These areSensitive to price changesLarge change in quantity

• Inelastic demand - Products with price elasticity of demand less than 1 are said to be price inelastic. This usually the case of necessary goods. These are Insensitive to price changesSmall change in quantity

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Elastic vs Inelastic demand

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Interpretation of Elasticity of Demand

• Ed > 1 demand is elastic

• Ed = 1 demand is unit elastic

• Ed < 1 demand is inelastic

• Extreme cases Perfectly inelastic - when demand is unresponsiveness to changes in

price. Demand curve is vertical Perfectly elastic - when any quantity of the product can be sold at

a given price. Demand curve is horizontal Unit elasticity: When proportional change in quantity is exactly equal

to 1. Demand curve is rectangular hyperbolic in shape

• Normally, elasticity varies between 0 to infinity as one moves up along an demand curve with elasticity being 1 at the mid point of the demand curve

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Extreme Cases

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D1P

Perfectly inelastic demand

Perfectly inelastic demand(Ed = 0)

0

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Extreme Cases

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Perfectly elastic demand

P

D2

Perfectly elasticdemand(Ed = ∞)

0

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Application of price elasticity of demand: The Total Revenue test

• Total Revenue = Price X Quantity

• Inelastic demandP and TR move in the same direction

• Elastic demandP and TR move in opposite directions

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Total Revenue Test

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$3

2

1

0 10 20 30 40 Q

P

a

b

D1

• Lower price and elastic demand• Revenue gained = Blue area exceeds revenue lost = yellow area

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Total Revenue Test

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$4

3

2

1

0 10 20 Q

P

c

d

D2

• Lower price and inelastic demand• Revenue lost = Yellow area exceeds Revenue gained

= blue area

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Total Revenue Test

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$3

2

1

0 10 20 30 Q

P

e

f

D3

• Lower price and unit elastic demand• Revenue gained = Blue area equals Revenue lost = yellow area

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Elasticity and Total Revenue

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0 1 2 3 4 5 6 7 8

0 1 2 3 4 5 6 7 8

Quantity Demanded

Quantity Demanded

Pri

ceTo

tal R

even

ue

(Th

ou

san

ds

of

Do

llars

)

$201816141210

8642

$87654321

a

bc

de

fg

h

ElasticEd > 1

Unit ElasticEd = 1

InelasticEd < 1

D

TR

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Summary of Price Elasticity of Demand

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Price Elasticity of Demand: A Summary

Absolute Value of Elasticity Coefficient Demand Is: Description

Impact on Total Revenue of a:

Price Increase

Price Decrease

Greater than 1(Ed > 1)

Elastic or relatively elastic

Qd changes by a larger percentage than does price

Total Revenue decreases

Total Revenue increases

Equal to 1(Ed = 1)

Unit or unitary elastic

Qd changes by the same percentage as does price

Total revenue is unchanged

Total revenue is unchanged

Less than 1(Ed < 1)

Inelastic or relatively inelastic

Qd changes by a smaller percentage than does price

Total revenue increases

Total revenue decreases

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Elasticity and Pricing Power• Charge different prices based on price elasticities• Example:

Higher prices for Business air travelers

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Determinants of Elasticity of Demand

• Substitutability - More substitutes, demand is more elastic

• Proportion of Income - Higher proportion of income, demand is more elastic

• Luxuries vs. Necessities - Luxury goods, demand is more elastic

• Time - More time available, demand is more elastic

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Income elasticity of demand• This measures the responsiveness of quantity demanded of a

good or service to a change in the consumer’s income.• It is defined as EI = (% change in quantity demanded)/(% change in

income of the consumer) = [(ΔQ/Q) * 100]/[(ΔI/PI)*100]Where, ΔQ denotes change in quantity ΔI denotes change in price Q denotes original quantity I denotes original price

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Classification of goods on basis of income elasticity value• Inferior good: income elasticity of demand is negative• Normal good: income elasticity of demand is positive Necessities : income elasticity is less than 1 Luxuries: income elasticity is greater than 1

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Cross price elasticity of demand• This measures the responsiveness of quantity demanded of a

good or service to a change in price of a related good• It is defined as Exy = (% change in quantity demanded of X )/(%

change in price of Y) = [(ΔQx/Qx) * 100]/[(ΔPy/Py )*100]

Where, ΔQx denotes change in quantity of good X ΔPy denotes change in price of good Y Qx denotes original quantity of X Py denotes original price of Y

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Classification of goods on basis of cross elasticity value• Substitute goods: cross elasticity of demand is

positive• Complementary goods: cross elasticity of demand is

negative• Unrelated goods: cross elasticity of demand is zero

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Elasticity of Supply

Price Elasticity of Supply• Measures sellers’ responsiveness to price changes

Elastic supply, producers are responsive to price changes

Inelastic supply, producers are not responsive to price changes

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Price Elasticity of Supply• Formula to compute elasticity• Es > 1 supply is elastic

• Es < 1 supply is inelastic

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Percentage Change in QuantitySupplied of Product X

Percentage Change in Priceof Product X

Es =

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Price Elasticity of Supply• Time is primary determinant of elasticity of supply Time periods considered are

• Market period• Short Run• Long Run

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Elasticity of Supply: The Market Period

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P

Q

• Perfectly inelastic supply

D1

D2

Sm

Q0

Pm

P0

4-28

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Elasticity of Supply: The Short Run

LO3

• Supply is more elastic than in market period

P

Q

D1

D2

Ss

Q0

Ps

P0

Qs

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Elasticity of Supply: The Long Run

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• Supply is even more elastic than in the short run

P

Q

D1

D2

Sl

Q0

Pl

P0

Ql

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30

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Thank You