lecture w3 - chapter 5

8/6/2019 Lecture w3 - Chapter 5

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Elasticity of demand and supply

Sunil Kumar

School of Economics


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Key Concepts

Defining elasticity Explaining:

price elasticity of demand income elasticity of demand cross elasticity of demand

price elasticity of supply Understanding how a tax burden and elasticity are related


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The Concept of Elasticity Elasticity is the term used in economics to explain the sensitivity

or responsiveness of one variable to changes in another variable . Elasticity is useful for business decision-making (e.g. pricing,

marketing) and policymaking.


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Price Elasticity of Demand Price elasticity of demand measures the sensitivity of quantity

demanded by consumers to changes in price .

The formula for price elasticity of demand is:

E d = percentage change in quantity demanded

percentage change in price


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Price elasticity of demand (cont.) Example: A concert raises ticket prices from $25 to $30, and

the number of seats sold falls from 20,000 to 10,000.

2.525%50%

252530 00020

0002000010

%%

dE ==

=

= P

Q


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Price Elasticity of Demand

When we move along a demand curve between two points, weget different answers to elasticity depending on whether we aremoving up or down the demand curve.

When the price is lowered from $30 to $25, the elasticity iscalculated as follows:

6

9.517%

100%

3030-25

000100001000020

%%

dE ==

=

=

P

Q


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The Midpoint Formula for Elasticity

Recalculating our previous example yieldsEd = 3.7. Effectively it means price elasticity of

demand at the quantity of 15,000 and price of $27.50.

( )

( ) 2

2

21

12

21

12

/PPPP

/QQQQ

P%Q%

dE+

+

=

=


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Elastic Demand ( E d > 1)

Elastic demand indicates that the percentagechange in quantity demanded is greater than thepercentage change in price.

This means consumers are sensitive to the pricechange .


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Example of Elastic Demand A rock group decreases its prices from $30 to

$20, and quantity demanded rises from

10,000 to 30,000 tickets. Using the percentage change method:

9.517%

100%

30

30-2500010

0001000020

P%Q%

dE ==

=

=


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Example Calculations

Using the midpoint formula:

( )

( ) 2

2

21

12

21

12

/PPPP

/QQ

QQ

dE+

+

= ( )

( ) 220302030

21000030000

1000030000

/

/dE+

+

=

Ed = 2.5 demand is price elastic.


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Elastic Demand Coefficients


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Other Coefficients Inelastic: When the percentage change in the quantity

demanded is smaller than the percentage change in the price.

Consumers are not sensitive to the price change . Unitary elastic: When the percentage change in the quantity

demanded is equal to the percentage change in price.


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Other coefficients (cont.)

14


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The total revenue test

Total revenue is the revenue a firm earns fromsales it is equal to price multiplied by quantitydemanded.

Depending on the elasticity coefficient, a decreasein price may lead to: increase in total revenue (elastic) decrease in total revenue (inelastic)

no change in total revenue (unitary).


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Perfectly elastic demand & perfectly inelasticdemand

Perfectly elastic demand: a small percentage change in price brings about an

infinite percentage change in the quantitydemanded.

Perfectly inelastic demand: the quantity demanded does not change as the price

rises.


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Perfectly elastic demand & perfectly inelastic demand

17


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Variations along a straight-line demand curve

The price elasticity of demand varies as wemove along the demand curve. Any straight line demand curve has three

ranges: a price elastic range (at high prices) a unitary elastic point a price inelastic range (at low prices).


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Variations along a straight-line demand

curve (cont.)

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Notice how TR reflects the variation inelasticity along the demand curve.


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Determinants of price elasticity of demand

A number of factors influence the price elasticityof a good or service: the availability of substitutes the proportion of the consumers budget that

is spent on that product adjustments to price changes over time.


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Availability of substitutes

Demand is more price-elastic for goods that have close substitutesbecause consumers can switch to alternative products. Price elasticity depends upon how broadly (or narrowly) we

define the good or service. For example, the E d of Ford cars isgreater than the E d for cars in general.


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Share of budget spent on the product

Consumers are more sensitive to a price change, and thedemand curve is more elastic, when the good or servicetakes a larger proportion of their income .

This is because consumers think more carefully aboutalternatives when prices change.


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Adjustment to price change over time The longer consumers have to adjust , the more sensitive they are

to a price change, and the more elastic the demand curve.


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Other elasticity measures

Income elasticity of demand Cross price elasticity of demand


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Income elasticity of demand

The ratio of the percentage change in the quantity demandedof a good to a given percentage change in income:

percentage change in quantity demandedpercentage change in income

Ey =


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Income elasticity of demand (cont.)

Income increases from $1000 to $1250 per week. Ticket sales rise from 10,000 to 15,000

8.1.11.20

250100010001-2501

00015000100001000015

%%

Ey ==+

+

=

=

I

Q

Ticket sales are responsive to a change in income.


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Income Elasticity Coefficients

If the income elasticity coefficient is positive, then this is anormal good consumers purchase more when their incomerises.

If the income elasticity coefficient is negative, then this is aninferior good consumers purchase less when their income rises.


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Cross-price Elasticity of Demand

The ratio of the percentage change in quantitydemanded of a good to a given percentagechange in price of another good:

% change in quantity demanded of good A

% change in price of good B

Ex =


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Substitutes and Cross-elasticity

Cross-elasticity calculations reveal whether goodsare substitutes or complements in use. For example, if the price of Coke rose by 10%, the

quantity of Pepsi might rise 5%. Because the %change in Q is positive, Pepsi is a substitute forCoke.


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Complements and Cross-elasticity

Cross price elasticity calculations reveal whether goods aresubstitutes or complements in use. For example, if the price of motor oil rose by 50%, the quantity

of petrol might fall by 5%. Because the % change in Q is

negative, petrol and oil are complements in use.


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Price elasticity of supply

The ratio of the percentage change in the quantity suppliedof a product to the percentage change in its price.

percentage change in quantity suppliedpercentage change in price

Es =


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Coefficients of Elasticity of Supply

Supply is: elastic when E s > 1 perfectly elastic when E s = infinity

unit elastic when E s

= 1 inelastic when E s < 1

perfectly inelastic when E s = 0

32


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Coefficients of Elasticity of Supply

33


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Price elasticity and the impact of taxation

Taxes imposed on price inelastic goods are an importantsource of revenue for governments. Excise taxes are typically levied on goods such as petrol,

alcohol and cigarettes.

The study of the incidence of tax shows us who bears theburden .


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The incidence of a tax on petrol


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Taxes and Markets

Excise taxes raise revenue for government, and they can beput to good use.

They also distort markets and lead to an inefficient outcome.

lecture w3 - chapter 5

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