Lecture 3Elasticity

General Concept

• Elasticity means responsiveness. It shows how responsive one variable is due to the change in another variable.

• In economics, elasticity is the measurement of how changing one economic variable affects others. For example:

• "If I lower the price of my product, how much more will I sell?“

• Or, "If I raise the price, how much less will I sell?”

General Formula

• Suppose, X is the independent variable and Y is the dependent variable. So when X changes it leads to a change in Y. Elasticity shows how responsive Y is to the change of X.

• How to calculate elasticity?• Elasticity is the percentage change in Y due to

1% percentage change in X. • Formula:• Elasticity =

ΔY/Y ΔX/X

Types of Elasticity

There are two broad type of elasticity1) Price Elasticity2) Income Elasticity Price elasticity can be classified as:a) Own price elasticityb) Cross price elasticity

Own Price Elasticity

a) Own Price Elasticity: Here we consider how a change in the price of a good affects the quantity ( demanded or supplied) of that good.

Definition: It is the percentage change of quantity due to the 1% change in its own price.

Formula:Own Price Elasticity=

ΔQ1/Q1 ΔP1/P1

Cross Price Elasticity b) Cross Price Elasticity: Here we consider how a change in the price of a

good affects the quantity ( demanded or supplied) of another good.Definition: It is the percentage change of quantity of a good due to the 1%

change in the price of another good. Formula:Cross Price Elasticity= Where, P1 is the price of good 1 and Q1 is the quantity of good 1P2 is the price of good2 and Q2 is the quantity of good 2

• If the two goods are substitute goods then the elasticity will be positive.• If the two goods are complementary goods then the elasticity will be

negative.

ΔQ2/Q2 ΔP1/P1

Income Elasticity

• It shows how a change in income of a consumer affects the quantity demanded of a good.

• Definition: It is the percentage change of quantity demanded of a good due to the 1% change in the income of a consumer.

Formula:Income Elasticity= Here m is income

ΔQ/Q Δm/m

Value and Sign of ElasticityPrice Elasticity of Demand: Own Price elasticity of demand is always

negative (sign). Why?- Because of negative relationship between price and quantity

demanded.- The range of value of price elasticity of demand is from 0 to negative

infinity. Price Elasticity of Supply: Own Price elasticity of supply is always

positive (Sign). Why?- Because of positive relationship between price and quantity supplied.

- The range of value of price elasticity of supply is from 0 to positive infinity.

• Elastic Demand: It means that 1% increase in price leads to a decrease in quantity demanded by more than 1%.

The value of elastic demand is between -1 and negative infinity.

• Inelastic Demand: It means that 1% increase in price leads to a decrease in quantity demanded by less than 1%.

The value of inelastic demand is in between 0 and -1.

• Unit Elastic Demand: It means that 1% increase in price leads to a decrease in quantity demanded by exactly 1%.

The value of inelastic demand is exactly -1.

• Elastic Supply: It means that 1% increase in price leads to an increase in quantity supplied by more than 1%.

The value of elastic supply is between 1 and positive infinity. • Inelastic Supply: It means that 1% increase in price leads to an increase in quantity

supplied by less than 1%.

The value of elastic supply is in between 0 and 1.

• Unit Elastic Supply: It means that 1% increase in price leads to an increase in quantity supplied by exactly 1%.

The value of unit elastic supply is exactly 1.

The Price Elasticity of Demand

(a) Perfectly Inelastic Demand: Elasticity Equals 0

$5

4

Quantity

Demand

1000

1. Anincreasein price . . .

2. . . . leaves the quantity demanded unchanged.

Price

The Price Elasticity of Demand

(b) Perfectly Elastic Demand: Elasticity Equals Infinity

Quantity0

Price

$4 Demand

2. At exactly $4,consumers willbuy any quantity.

1. At any priceabove $4, quantitydemanded is zero.

3. At a price below $4,quantity demanded is infinite.

Exercise

Period Price Toyota Quantity Demanded Toyota

1st 20 802nd 30 20

Find Elasticity and interpret (whether you have elastic, inelastic or unit elastic demand/ supply)

Own Price Elasticity of DemandExample: 1

Period Price Toyota Quantity Supplied Toyota

1st 10 20

2nd 20 60

Own Price Elasticity of SupplyExample: 2

Period Price of Honda Quantity Demanded Toyota

1st 20 202nd 40 80

Period Price of sugar Quantity Demanded Tea1st 10 202nd 30 10

Cross Price ElasticityExample: 3 and 4

Period Income Quantity Demanded Toyota

1st 100 302nd 200 90

Income Elasticity:Example: 5