What is Elasticity?

A term economists use to describe sensitivity

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How do we measure the Price Elasticity of Demand?

The percentage change in quantity demanded divided by the percentage change in price
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Price Elasticity of Demand

Ed
=

% change in Q % change in P

Notes on Ed
Ed negative, but ignore negative use of % change-not affected by units of measurement

Classifying Ed
Ed = 1 Unitary elasticity Ed > 1 Elastic demand Ed < 1 Inelastic demand

Extreme elasticities
Ed = 0 Perfectly inelastic (vertical demand curve) Ed = Perfectly elastic (horizontal demand curve)

Perfectly inelastic demand

P
D

Perfectly elastic demand

Q
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When consumers are very sensitive to a price change what does the demand curve look like?
Very horizontal
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When consumers are less sensitive to a price change what does the demand curve look like?
Very vertical
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Problem - When we move along a demand curve between two points, we get different answers to elasticity depending if we are moving up or down the demand curve
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If there is an increase from 3 units to 5, what is the percentage increase?

2/3 = 66%
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If there is a decrease from 5 units to 3, what is the percentage decrease?

2/5 = 40%
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If we go from 3 to 5, the percentage change is 2/3 , but if we go from 5 to 3, the percentage change is 2/5 , so the elasticities are different
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The answer to this problem is to work with averages ...

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Price elasticity equals the

change in quantity demanded sum of quantities/2

divided by
change in price sum of prices/2
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Quantity
Bananas Oranges 200

Price
$20 $18 $40

240 400 280

$70
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What is the Price Elasticity of Demand for bananas?

2 40 = 220 19 40 X 19 760 = 440 2 220

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= 1.727

What is the Price Elasticity of Demand for oranges? 120 30 = 340 55 120 X 55 6,600 = 10,200 30 340
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= .647

Practice: calculating Ed
You usually buy 4 cds per month at a price of $14, but when the price rises to $18, you purchase only 3 per month. What is your elasticity of demand for cds over this range of prices?
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Elasticity and Total Revenue (TR)

TR = PQ, price times quantity Ed
=

% change in Q % change in P

2 0

When price increases, what two things happen?

more money per unit fewer units are sold

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If total revenue does not change when price increases, the demand curve is unitary elastic, value equals 1
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If price increases and the revenue gained is less than the revenue lost, the demand curve is price elastic, > 1
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If price increases and the revenue gained is greater than the revenue lost, the demand curve is price inelastic, < 1
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Summary, elasticity, price changes, and total revenue

Price increase Total revenue same Price Decrease Total revenue same

Ed = 1

Ed > 1 Ed < 1

Total revenue falls

Total revenue rises 2 5

Total revenue rises

Total revenue falls

What factors influence Demand Sensitivity (elasticity)? Number and closeness of Substitute goods % of income a good makes up Basic goods or needs Time to adjust
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What do substitutes have to do with sensitivity?

The more substitutes a good has, the more sensitive consumers are to a price change
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A
D

B
D

Which demand curve is for spark plugs and which for Coca-Cola?
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What does % of income a good makes up have with sensitivity?

The lower the % of ones budget a good is, the less sensitive consumers are to a price change
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What do basic goods have to do with sensitivity?

The greater the need a good has to the consumer, the less sensitive the consumer is to a price change
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What does time have to do with sensitivity?

The more time to adjust, the more sensitive consumers are to a price change

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If a college raises tuition, what happens to revenue?

If demand is elastic revenue goes down If demand is inelastic revenue goes up
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What strategies do Coca-Cola and Pepsi use to make the demand for their products less elastic?
http://www.cocacola.com

http://www.pepsi.com
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What is Cross Elasticity of Demand?

The percentage change in the quantity demanded of one commodity resulting from a 1 percent change in price of another commodity
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E c = % Quantity of X % Price of Y

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If negative - complements (steak & steak sauce) If positive - substitutes (butter & margarine) Unrelated goods should have a cross elasticity close to zero
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What is Income Elasticity of Demand?

The ratio of the percentage change in quantity demanded to the percentage change in income
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E i = % Quantity % Income
E i > 0 Normal goods E i < 0 Inferior goods

E i > 1 Luxury goods

0 < E i < 1 Necessities

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When does a good face an income elastic demand curve?

A 1% change in income generates a greater than 1% change quantity demanded

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When does a good face an income inelastic demand curve?

A 1% change in income generates a less than 1% change quantity demanded

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What is an Inferior Good?

Something that people will buy less of as their incomes increase

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What is a Normal Good?

Something that people will buy more of as their incomes increase

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What is Price Elasticity of Supply?

The ratio of the percentage change in quantity supplied to the percentage change in price

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E s = % Q supplied % Price
E s = 1 Unitary E s > 1 Elastic E s < 1 Inelastic

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Extreme cases of E s
E s = 0, perfectly inelastic (vertical supply curve E s = , perfectly elastic (horizontal supply curve)

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Does time effect Supply Elasticities?

Yes! The more time,

the more elastic the supply curve
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Applications of Elasticity
The farm problem Illegal drugs The volunteer army Tax incidence

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The Farm Problem

Inelastic demand for many farm goods Low income elasticity of demand also

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P
P1 P2 D

S
S1

Q Q1 Q2

Since farmers face volatile supply, with inelastic demand, % change in Price is greater than % change in quantity, making for more fluctuating of incomes 4 9

Recall with inelastic demand, lower prices do not increase quantity by the same %, leading to lower revenue, yet costs are higher due to increased quantity, resulting in lower farm profits.

Low income elasticity means that farming is not a growth industry, as our incomes rise we tend to allocate that income to other goods, not as much to food products.
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P
P1 P2

S (illegal)
S1 (legal)

D inelastic Q Q1 Q2

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Which type of good would be best to tax to raise the most revenue?
Goods that face a price inelastic demand curve will generate the most revenue

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 What factors influence Demand Sensitivity? What is Elasticity?

How do we measure the Price Elasticity of Demand? What is Cross Elasticity of Demand? What is Income5 Elasticity of
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END
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