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Elasticity
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Definition
Elasticity measures the sensitivity of either
demand or supply to a change in any of their
determinants.
Elasticity measures how responsive or
unresponsive the quantity demanded (or
supplied) is to changes in a given factor.
Elasticity allows you to predict how a price
change will affect the behavior of buyers or
sellers.
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Types of Elasticity
Price elasticity of demand.
Price elasticity of supply.
Income elasticity of demand.
Cross Price elasticity.
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Factors Affecting Demand
Elasticity
Percent of consumers budget
spent on item
The smaller the percent, the
more inelastic
Nature of the good
necessities more inelastic
than non-necessities
durable goods more elastic
than for nondurable goods
Length of time period over
which elasticity is measured
short run more inelastic than
long-run
Availability of substitutes:
Number and closeness of
substitutes--more and closer
means greater elasticity
A related factor is how
widely, or narrowly, a market
is defined:
Demand for food is much
more inelastic than demand
for cereal because of the
relative number ofsubstitutes
in each case
Demand for a product is more
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The Price Elasticity of Demand
Measures the response of the quantity
demanded to a change in price.
How responsive do you think is the quantity
demanded of prescription drugs to a change
in price?
How responsive do you think is the quantity
demanded of bananas to a change in price?
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The Elasticity Formula
e
d
=
Percentage Change in Quantity Demanded
Percentage Change in price
e
s
=
%Change in Quantity Supply
%Change in Price
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The Elasticity Formula
e
d
=
Qd2-Qd1/ Qd1
P2-P1/P1
e
s
=
Qs2- Qs1/Qs1
P2-P1/P1
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1. Compute elasticity of demand
for 2002
PRICE QUANTITY
2001 : PY 3 4
2002 CY 2 12
2003 1 20
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The Elasticity Formula
e
d
=
12-4/ 4
2-3/3
e
d
=
8/4
1/3
e
d
= 2/.33 =- 6.06, 6.-6.06
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For every 1% inc. in Price, Qd
dec. by 6.06%
For every 1% dec. in Price, Qd
inc. by 6.06%
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The Price Elasticity of Demand
Measures the responsiveness of the
quantity demanded to a change in
price.
There is a negative relationship
between the price and the quantity
demanded.
The price elasticity of demand is
ALWAYS NEGATIVE.
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Price elasticity of demand is
ALWAYS NEGATIVE
e
p
d
=
Change in Quantity / Average Quantity
Change in Price / Average Price
Always write a negative
sign in front!
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Five Types of Elasticities
Consider only the absolute value of the
elasticity: |E|
The absolute value of the elasticity can be
|e|>1
|e|=1
|e|<1
/e/=0
/e/=
InElastic
Unitarily Elastic
Elastic
Perfectly Inelastic
Perfectly Elastic
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Sensitive Demands are Elastic
Demands (e > 1)
e
p
d
=
Percentage Change in Quantity Demanded
Percentage Change in price
A relatively small change in price causes a
relatively large change in quantity demanded.
If the numerator (DQ%) is larger than the
denominator (DP%) then e
p
d
is greater than one.
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Example
It has been observed that a 5%
increase in the price, caused a 10%
reduction in the quantity demanded.
Elasticity of Demand is greater than one:
Elastic
e
p
d
= 10% / 5% = - 2
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Insensitive Demands are
Inelastic Demands (e < 1)
e
p
d
=
Percentage Change in Quantity Demanded
Percentage Change in price
A relatively large change in price causes a
relatively small change in quantity demanded.
If the numerator (DQ%) is smaller than the
denominator (DP%), then e
p
d
is less than one.
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Example
It has been observed that a 20%
decrease in the price of good X, caused
a 5% increase in the quantity
demanded of X.
Elasticity of Demand is less than one:
Inelastic
e
p
d
= 5% / 20% = - 0.25
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The Elasticity Changes Along the
Demand Curve
|e| < 1
|e| > 1
|e| = 1
Midpoint
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Perfectly Elastic Demand
When the elasticity is a
very large number
(close to infinity)
demand is said to be
perfectly elastic.
A perfectly elastic
demand would show
that at the slightest
increase in the price,
the quantity demanded
would drop to zero.
0.6
100 Units
0.61
0 Units
|e| =
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Perfectly Inelastic Demand
When the elasticity is a
very small number
(close to zero) demand
is said to be perfectly
inelastic.
A perfectly inelastic
demand would show
that even after a large
change in the price the
quantity demanded
would not change at all.
0.6
100 Units
1.20
|e| = 0
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What Determines the Elasticity?
The number of substitutes available.
The Definition of the market.
The length of time consumers have to
react to a price change.
Necessities tend to have inelastic
demands, whereas luxuries have elastic
demands.
Example: Doctor visits, sailboats.
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The number of Substitutes
Available.
The more
substitutes
exist for a
given good, the
easier it would
be for
consumers to
switch.
The more
sensitive
(elastic)
demand would
be to price
changes
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2. Which product will be less
elastic? Why?
a) Cars
b) Convertibles
c) Imported Convertibles
d) Imported, red convertibles
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The amount of time to react
The longer the time allowed, the easier
it is for consumers to find an alternative
or modify their behavior.
Goods have more elastic demands over
longer time horizons.
Example: Gasoline.
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The Price Elasticity of Demand
and Revenues
Total Revenues = Price x Quantity
An increase in price will increase TR
only if the quantity demanded does not
fall too much.
If the increase in price is larger than the
drop in quantities, TR will increase.
3. This is precisely what happens if
demand is _____________
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Elasticity and Total Revenues
TR = P x Q
This is the case when |e| > 1.
TR = P x Q
This is the case when |e| < 1.
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If a company increases prices
and as a result:
Total Revenues
Decrease.
We can conclude
that the rise in
revenues due to
higher prices, was
completely offset by
the drop in
quantities sold.
Total Revenues
Increase.
We can conclude
that the quantities
sold did not drop
enough to offset the
rise in revenues due
to higher prices
Demand is
Elastic
Demand is
Inelastic
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|e| = 1
Midpoint
Decrease
Price to
Increase TR
Increase Price
to Increase
TR
If demand is UNIT elastic an
increase/decrease in price
would leave TR unchanged
Total Revenues, Changes in prices
and Elasticity
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Cross Elasticity
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% change in Q to %
change in price of some
other good
Measures closeness of
substitutes and
complements
positive for substitute
commodities
negative for complements
EX can be calculated
X
d
= %DQ
d
x
/ %DP
y
= Q
x
1
-Q
x
0
/(Q
x
1
+Q
x
0
)
P
y
1
-P
y
0
/(P
y
1
+P
y
0
)
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