Chapter 5 Elasticity A. Price Elasticity of Demand 1. Elasticity the measure of responsiveness of one variable relative to another.

. We can do this for any variable, not just economic. 2. Price Elasticity of Demand Measures the percentage change in Qd relative to a change in percentage change in P. -It helps to give us a better idea of how price changes affect Qd . -Note: for our % formula we will use the midpoint method.
ED=%Q/%P= [(Q2-Q1)/Qave]/[(P2-P1)/Pave]

Note: we take absolute with this measure we could use a negative sign just as easily. Since demand follows law of demand [ as P Qd ] that is why we get a (-) sign. So we get P and Q moving in opposite directions. 3. Elasticity Measures: a. Inelastic when the responsiveness of Qd is less than the change in price. This is defined to be values of ED < 1, which can be written as:
ED = %Q/%P < 1 %Q < %P

Note: A perfectly inelastic curve is vertical. One can see that as P changes there are no change in Q. Graph 1: Perfectly Inelastic
P P1 P2

Q1

b. Elastic - when the responsiveness of Qd is greater than the change in price. This is defined to be values of ED > 1, which can be written as:

ED = %Q/%P < 1 %Q > %P

Note: A perfectly elastic curve is horizontal. One can see that as P changes the result is a complete drop in demand to 0. If price were raised to P2 then demand could be 0. Graph 2: Perfectly Elastic
P P2 P1

Q c. unit-elastic when the responsiveness of Qd is directly equal to the change in price. This is defined to be values of ED = 1, which can be written as:
ED = %Q/%P = 1 %Q = %P

4. Elasticity of Demand and Straight-Line Demand Curves a. The elasticity of demand changes as we move along a demand curve. It is not constant. As we move up the demand curve we get elastic measures and down the demand curve inelastic measures. This comes from the fact that at higher points P is greater (so the denominator is larger reducing the Ed measure) and at lower prices we get the exact opposite case. It is very important to note that elasticity is not slope. b. Graph 3: P Elastic

Inelastic

Q Intuition: This makes sense because at higher prices one would think that people would respond to price changes more than if they were considering whether to purchase a good at lower prices.

5. Determinants of Elasticity for Good a. Availability of Substitutes how many other goods can be used in place of the good. The increased prevalence of substitutes means that the relative elasticity measure should go up. This does not mean that the good is elastic, merely that the elasticity measure it greater than for goods with less subs. Note: (1) Goods that are necessities are generally more inelastic. (2) Goods where the time horizon is extended to find subs. also increase the elasticity measure. b. Importance/% of Buyers Budget The greater the percentage in budget the greater the elasticity measure as well. If it costs more you will consider more goods to use in place of it due to how expensive it is to you personally. c. Time As mentioned before, the more time one has the greater elasticity measure due to the increased ability to find another good to use in its place. d. How one defines the market the more narrowly defined the more inelastic the measure, the greater the market the increased availability of substitutes. e. Luxury vs. Necessity since a necessity generally has few substitutes it is generally less responsive. A luxury generally has more substitutes, so we would expect that if a good or service is a luxury it would have a greater elasticity measure. 6. Elasticity and Total Revenue Recall that Total Revenue (TR) total amount of dollars received for the purchase of a G/S. (a) Mathematically: TR = P*Q If we manipulate the above formula with the natural log and take derivatives we can note that: (b) %TR = %Q + %P (for this formula use midpoint) We can then use this formula to find out if the price change for an inelastic good or elastic good is a good idea or not. Inelastic: Recall that ED = %Q/%P < 1 %Q < %P for an inelastic good. So if we have a price increase we have: P = (+) Q = (-)

This is by law of demand. We can note that the change in P is greater so when we plug this into our previous equation we get: %TR = %Q + %P = (-) + (+) = overall (+) since we have %Q < %P . Since the percent change in TR is positive a price increase for an inelastic good is a good idea. Note: The opposite case is also true i.e. P for an inelastic good results in less TR and is therefore a bad idea. Elastic: Recall that ED = %Q/%P > 1 %Q > %P for an elastic good. So if we also have a price increase as before we have: P = (+) Q = (-) This is by law of demand. We can note that the change in P is greater so when we plug this into our previous equation we get: %TR = %Q + %P = (-) + (+) = overall (-) since we have %Q > %P . Since the percent change in TR is negative a price increase for an inelastic good is a bad idea. Note: The opposite case is also true i.e. P for an elastic good results in more TR and is therefore a good idea. Also, for a unit elastic good we get %Q = %P , so there is no change in TR. So, changing price results in no change in TR. B. Price Elasticity of Supply 1. Price Elasticity of Supply Measures the percentage change in Qs relative to a change in percentage change in P. -It helps to give us a better idea of how price changes affect Qs .
ES= %Qs/%P = [(Q2-Q1)/Qave]/[(P2-P1)/Pave ]

Note: (a) we dont need to take absolute with this measure this is due to the law of supply giving us both positive measures. To know that we are using supply rather than demand you must look at what info is given. Since supply follows law of supply [ as P Qs ] that is why we get a (+) sign. So we get P and Q moving in the same directions. (b) we can use the same ideas as before with elasticity of demand with the terms inelastic, elastic, and unit elastic here.

2. Influences on Price Elasticity of Supply a. Production Possibility if the G/S has a very flexible or constant OC, so these are more elastic. If G/S has a very fixed rate of production, then we would expect them to be more inelastic. Examples: paper and printing presses for textbooks and magazines have multiple uses and are therefore elastic. b. Time Elapse Since Price Change - as the time increases we find that once again that the elasticity measure increases because it allows suppliers more time to find alternate methods of production. c. Storage Possibility if the good can be stored it increases the elasticity measure. This makes intuitive sense because if the price swings to the disadvantage of the supplier, if they have storage options they would store it and supply the good at a more favorable price. Note that the cost of storage is a large determining factor with this variable. C. Other Elasticity Measures Recall: that elasticity in general measures responsiveness of one variable to changes in another. We dont simply need to look at P and Q. Just as we talked about other variables affecting demand of a good, we can also look at how altering these variables affect Qd. Note: Since we are dealing now with other variables besides price we are looking at how the demand curve shifts. When we get a shift in demand we are actually noting that D Qd at every price level or the opposite case. 1. Income Elasticity of Demand: Measures the percentage change in Qd caused by a 1% change in income. a. mathematically: EI = %Q/%I= [(Q2-Q1)/Qave]/[(I2-I1)/Iave] b. normal vs. inferior good normal good when EI > 0. This value is obtained from the fact that Income Demand [or Qd at every price ]. Inferior good when EI < 0. This value is obtained from the fact that Income Demand [or Qd at every price ].

c. Luxury or Necessity We can use the fact that we know that smaller measures of an elasticity mean less responsiveness to changes in the other variable to define economic luxuries and necessities. Economic necessity when 1 >EI > 0. This value is obtained from the fact that Income we dont have Qd changing a whole lot. This implies that even though income might change you still purchase the same amount of the good, which implies it is a necessity. Economic luxury when EI > 1. This value is obtained from the fact that Income we have Qd changing a whole lot. This implies that when income does change there is a large responsiveness, so it must be some type of luxury. 2. Cross (Price) Elasticity of Demand: measures how changing the price of a related good affects the demand of the good in question. a. mathematically: Exy = %Qx/%Py = [(Q2-Q1)/Qave]/[(P2-P1)/Pave] b. Substitute or Complement Recall the relationship we defined before for both subs and complements Substitute good when Psub D . So when Exy > 0 we define it to be a substitute good. Complement good - when Pcomp D . So when Exy < 0 we define it to be a complement good. Note: when the values are much greater than 0 then they are considered strongly related. For values that are around 0 they are much more weakly related.
3. Examples of Elasticity Measures: a. Example 1: Elasticity of Demand (i) Suppose we were looking at the demand for McDonalds Hamburgers at a particular location. When they had a p=$0.75 they had a Qd=1000 hamburgers per day. The owner of the McDonalds decided to raise price to p=$1.00 and found that demand dropped to Qd=900 per day. Calculate the elasticity of demand for hamburgers at this McDonalds. (ii). Is the good elastic or inelastic? (iii). Was the price change probably a good idea or not? Explain in terms of total revenue. i -Recall the formula for elasticity: Elasticity of demand = %Q / %P= [(Q 2-Q1) / Qave] / [(P2-P1) / Pave] Applying the above formula to the data given we get: [(900-1000)/950]/[(1.00-.75)/.875].368

ii - We obtain an answer with an elasticity of <1, so by definition we know the good is inelastic. An inelastic good implies that there is a greater change in P than there is in Q (i.e. the numerator change is less than the denominator). In this case a 1% change in price results in a .368% change in Q. iii - Since the price changes more than quantity, McDonalds should not expect the quantity demanded to drop off that much. Because of this fact, they should expect to earn more money with the price change even though there was some decrease in Qd. We can see this fact for sure b/c $.75*1000=$750 while $1.00*900=$900. So they should earn an extra $150 each day with the price increase. We can also obtain the same information using the formula: %TR = %Q + %P. In this case we get %TR = -.105 + .285 = .18. So %TR > 0 or positive, so it was a good idea. b. Example 2: Cross Price Elasticity and Income Elasticity (i). Suppose now that we were looking at how two fast-food locations affect one another. If we find that the change in price of taco bell tacos from $0.75 to $1.25 causes the McDonalds that is very near it to increase in Hamburger sales for the week from 15,000 to 17,000. Calculate the cross-price elasticity of demand and explain whether it is a substitute or complement based on your calculation. (ii). If you have an income increase of 15% and you purchase 3% more filet mignons as a results, find the income elasticity of the filets. 1. Is this a normal or inferior good? 2. How do you know? 3. Is this a luxury or necessity? i - Cross Price Elasticity of Demand = %Qx / %Py = [(Q 2-Q1)/Qave]/[(P2-P1)/Pave] Applying the above formula to the data given we get: [(17000-15000)/16000]/[(1.25-.75)/1.00] = .25 > 0 This tells us that there is a positive change in Qx as we change the price of y or as the price of taco bell goes up there is in increase in the quantity of McDonalds hamburgers purchased. This implies that the good are substitutes. As we get an increase in the price of one we get an increase demand for the other. ii - Income Elasticity of Demand = %Q / %I= 3/15= .2> 0 This tells us that there is a positive change in Q as we have an increase in income. 1. So, this is a normal good. 2. As income goes up we purchase more of the good. EI>0 3. Necessity. We know this because our value of 1> EI>0, which implies that even when our income went up we were already purchasing it to begin with. So our income going up has little affect on how we purchase the good and it must therefore be a necessity.