Methods of Economic Analysis

EC115 - Methods of Economic Analysis
Spring Term - Lecture 1

Elasticity
Renshaw - Chapter 9
University of Essex - Department of Economics
Week 16
Domenico Tabasso (University of Essex - Department of Economics) Lecture 1 - Spring Term Week 16 1 / 26
Hello!
Domenico Tabasso
Room 5.408 (5th oor, Economics building)
Oce Hour: Wednesday 2-3pm
E-mail: dtabas@essex.ac.uk
Reminder: Mid-Term Test, Thursday 19 February 2009
Main Topics for this Term
1
Elasticity (last topic for functions of one variable)
2
Functions of two variables:
Denition
Dierentiation
Maximisation
Economic Examples
3
Constrained Optimization
Introduction
Our starting point is a simple function y = f (x).
The elasticity of a function is a way to measure the relation
between a proportionate change in x and the resulting
proportionate change in y.
The word proportionate is extremely important.
Absolute, proportionate and percentage change - 1
Our initial weekly income is Y
0
= 200. Then the income
goes up to Y
1
= 240. We can then dene three types of
changes:
1
Absolute Change:
Y Y
1
Y
0
= 240 200 = 40 per week;
2
Proportionate Change:
Y
Y
0
=
40
200
=
1
5
(= 0.2);
3
Percentage Change:
Prop. Change100 =
Y
Y
0
100 =
1
5
100
Absolute, proportionate and percentage change - 2
In general, the proportionate change is more informative
than the absolute one.
Important note: the proportionate change is pure number,
it does not depend on the units in which the variable
experiencing the change is measured.
Rule: If any variable y changes by a nite amount y, the
proportionate change in y is measured by
y
y
0
where y
0
is
the initial value of y.
The elasticity of supply
Consider a supply function of the form: q = f (p). The
question that we would like to answer is:
How is the quantity supplied by the producers going to
change when there is a change in the price they receive?
The elasticity will answer this question in terms of
responsiveness of the supplied quantity to the change in
price.
We will discuss two dierent denitions of elasticity:
Arc elasticity;
Point elasticity.
The elasticity of supply - The arc elasticity - 1
The arc elasticity of supply (denoted as
s
) is dened as:
s
=
percentage change in quantity supplied
percentage change in price
(1)
Playing a bit with this equation we can get:
s
=
proportionate change in quantity supplied 100
proportionate change in price 100
(2)
Since the 100 in the numerator and in the denominator
cancel out we can write the previous equation as:
s
=
q/q
0
p/p
0
(3)
Since:
s
=
q/q
0
p/p
0
(4)
is the ratio of two proportionate changes we call it the ratio of
proportionate change of y and measures the proportionate change in
q per unit of proportionate change in p.
Example: the price of beer is p
0
= 2 and the suppliers sell 500
millions pints. The price then rises to p
1
= 2.5. After this change
there is an increase in production of 50 millions pints. Can we
calculate the elasticity of the supply (i.e. the rate of proportionate
change in q)?
s
=
q/q
0
p/p
0
=
50, 000, 000/500, 000, 000
0.5/2
=
0.1
0.25
= 0.4 (5)
The elasticity of supply - The arc elasticity - 3 - A graph
0
D
A
p0
C
q0 q1
q
p1
p
E
F
G H
The arc elasticity of supply is
B
FG AB
AD GH
p p
q q
S
=
0
0
In eq. 4 we dened the elasticity of supply as
s
=
q/q
0
p/p
0
.
This equation can be rewritten as :
s
=
q
q
0
p
0
p
. (6)
This formulation is more useful when we try to compare the
arc elasticity with the point elasticity.
The elasticity of supply - The point elasticity
In general the arc elasticity is not a very precise method for
measuring proportionate changes (unless the function were
dealing with is linear). Hence in economics we tend to rely
more on the point elasticity, that we dene as:
s
= lim
p0
q
q
0
p
0
p

dq
dp
p
0
q
0
(7)
which can also be expressed as:
dq/dp
q
0
/p
0
Relations between arc and point elasticity - A graph
Relations between arc and point elasticity - 2
Summarising:
1
Arc elasticity:
s
=
q
q
0
p
0
p
.
2
Point elasticity:
s
=
dq
dp
p
0
q
0
Note that in the case of linear equations, the two formulas
are identical since
q
p
and
dq
dp
coincide.
The point elasticity should only be used in case of small
changes in p. Nonetheless, in economics the point elasticity
is the most commonly used measure of elasticity, becuase
its generally easier to calculate that the arc elasticity.
An example
Given the supply function: q = 10p
3
1000
1
nd the arc elasticity when p increases from 10 to 11;
2
nd the point elasticity when p = 10
Since p
0
= 10 from the equation we obtain:
q
0
= 10, 000 1, 000 = 9, 000.
Furthermore, p
1
= 11, hence q
1
= 12310 and so: p = 11 10 = 1
and q = 12310 9000 = 3310.
We have all the elements for calculating the arc elasticity:
s
=
q
q
0
p
0
p
=
3310
9000
10
1
= 3.678
An example - 2
How about the point elasticity?
Given q = 10p
3
1000 we have
dq
dp
= 3 10 p
31
= 30p
2
.
So, following the denition, when p = 10 we have:
s
=
dq
dp
p
0
q
0
= (30 (10)
2
)

dq/dp
p
0
/q
0

10
9000
= 3.333
The elasticity of demand - The arc elasticity
Given a generic demand function q = g(p), the elasticity of
demand measure the responsiveness of the quantity of good
demanded by buyers to a change in the price they have to
pay. Just as for the supply function we dene the arc
elasticity of demand as:
d
=
q
q
0
p
0
p
=
proportionate change in quantity demanded
proportionate change in price
(8)
or equivalently we can write:
d
=
q
p
p
0
q
0
The elasticity of demand - The arc elasticity - A graph
The elasticity of demand - The arc elasticity - 2
Note: The elasticity of demand is usually negative (if the
price of a good goes up, the quantity demanded should go
down). Very often economist prefer to express the elasticity
as a positive number so that they redene it either with an
extra minus sign in front or expressing it in absolute values.
Value of arc Implied absolute Terminology
elasticity,
d
elasticity,

d
< 1

> 1 Demand is elastic
d
> 1

< 1 Demand is inelastic
d
= 1

= 1 Demand is of
unit elasticity
The elasticity of demand - The point elasticity
Just as for the case of the supply function we can also
dene the point elasticity of the demand function, which is
of course given by:
s
=
dq
dp
p
0
q
0
(9)
or alternatively:
s
=
dq/dp
q
0
/p
0
The point elasticity is more commonly used than the arc
elasticity and it is the denition we will refer to when we
talk about elasticity.
The elasticity of demand - A graph
The elasticity of demand - An important clarication
It is tempting to assume that the elasticity of demand of a
linear function is constant. This is wrong!
25 25
||=
Elastic
| |
20
||>1
Elastic
15
||=1
10
||=0
||<1
Inelastic
5
||=0
5
0
0 1 2 3 4 5 6 7 8 9 10
The relationship between the elasticity of demand and
marginal revenue
Rule:
Given a certain demand function p = f (q) the following
relation between marginal revenue and the elasticity of
demand function can be established:
MR = p
1 +
1
(10)
Furthermore it can be proved that:
1
If marginal revenue is positive, than the demand is
elastic
2
If the demand is elastic, then the marginal revenue is
positive
Note that proving just condition (1) is not enough to prove
condition (2) and viceversa.
The relationship between the elasticity of demand and
marginal revenue - A graph
The elasticity of demand under perfect competition
So far we have assumed that the demand is sloped downward. In case
of perfect competition, though, the demand is horizontal at the level
of the market price, p. In this case the slope of the function is
dp
dq
= 0, and
dq
dp
does not exist, so calculating the elasticity seems to
be impossible. Nonetheless, using the limits we can still say that as
dp
dq
0 then
dq
dp
and
D
. Note that this implies that
in perfect competition:
MR = p
1 +
1
= p
1 +
1
= p (1 0) = p
which is the standard result we always obtain in perfect competition
Elasticity - Generalisations
We have focused on the elasticity of demand and supply.
Nonetheless the concept of elasticity can be applied to any
function. In general the rule is:
For any function y = f (x) the elasticity of y with respect
to x is:
y,x
=
dy
dx
x
y
.
So for example the elasticity of the total cost function TC = f (q) will
be:
TC
=
dTC
dq
q
TC
Furthermore it is useful to note (but we dont prove it!)
that:
y,x
=
dy
dx
x
y
=
d ln(y)
d ln(y)

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EC115 - Methods of Economic Analysis

Spring Term - Lecture 1

> 1 Demand is elastic

< 1 Demand is inelastic

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