Price, Income and Cross Elasticity

Gaurav Guleria 100908034 ME-2

Elasticity the concept

The responsiveness of one variable to changes in another When price rises, what happens to demand? Demand falls BUT! How much does demand fall?

Elasticity the concept

If price rises by 10% - what happens to demand? We know demand will fall By more than 10%? By less than 10%? Elasticity measures the extent to which demand will change

Elasticity
4 basic types used: Price elasticity of demand Price elasticity of supply Income elasticity of demand Cross elasticity

Elasticity
Price Elasticity of Demand
The responsiveness of demand to changes in price Where % change in demand is greater than % change in price elastic Where % change in demand is less than % change in price - inelastic

Elasticity
The Formula:
PED = % Change in Quantity Demanded ___________________________ % Change in Price

If answer is between 0 and -1: the relationship is inelastic If the answer is between -1 and infinity: the relationship is elastic Note: PED has sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

Elasticity
Price (Rs)
The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded.

Quantity Demanded

Elasticity
Price
Total revenue is of price x The importance elasticity quantity sold. In this is the information it example, TR =Rs5 x 100 provides on the effect on = Rs500. total revenue of changes in

price. This value is represented by the shaded rectangle.

Rs5

Total Revenue

D 100

Elasticity
If the firm decides to decrease price to (say) Rs3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue.

Rs5

Rs3

Total Revenue
D
100 140 Quantity Demanded

Elasticity
Price (Rs) 10

Producer decides to lower price to attract sales

% Price = -50% % Quantity Demanded = +20% Ped = -0.4 (Inelastic) Total Revenue would fall

Not a good move

D
5 6
Quantity Demanded

Elasticity
Price (Rs)

Producer decides to reduce price to increase sales % in Price = - 30% % in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises Good Move
D

10 7

Elasticity
If demand is price elastic: Increasing price would reduce TR (% Qd > % P) Reducing price would increase TR (% Qd > % P)

Elasticity
If demand is price inelastic: Increasing price would increase TR (% Qd < % P) Reducing price would reduce TR (% Qd < % P)

Elasticity
Income Elasticity of Demand:
The responsiveness of demand to changes in incomes

Normal Good demand rises as income rises and vice versa Inferior Good demand falls as income rises and vice versa

Elasticity
Income Elasticity of Demand:
A positive sign denotes a normal good A negative sign denotes an inferior good

Elasticity
Cross Elasticity: The responsiveness of demand of one good to changes in the price of a related good either a substitute or a complement
Xed =
% Qd of good t __________________ % Price of good y

Elasticity
Goods which are complements:
Cross Elasticity will have negative sign (inverse relationship between the two)

Goods which are substitutes:

Cross Elasticity will have a positive sign (positive relationship between the two)

Elasticity
Price Elasticity of Supply:
The responsiveness of supply to changes in price If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price If Pes is elastic supply can react quickly to changes in price
Pes =
% Quantity Supplied ____________________ % Price

Determinants of Elasticity
Time period the longer the time under consideration the more elastic a good is likely to be Number and closeness of substitutes the greater the number of substitutes, the more elastic The proportion of income taken up by the product the smaller the proportion the more inelastic Luxury or Necessity - for example, racing cars

Importance of Elasticity
Relationship between changes in price and total revenue Importance in determining what goods to tax (tax revenue) Importance in analysing time lags in production Influences the behaviour of a firm

Application of Elasticity:

Does Drug Interdiction Increase or Decrease DrugRelated Crime?

One side effect of illegal drug use is crime: Users often turn to crime to finance their habit. We examine two policies designed to reduce illegal drug use and see what effects they have on drug-related crime. For simplicity, we assume the total dollar value of drug-related crime equals total expenditure on drugs. Demand for illegal drugs is inelastic, due to addiction issues.

Policy 1: Interdiction
Interdiction reduces the supply of drugs. Since demand for drugs is inelastic, P rises proportionally more than Q falls.
Price of Drugs new value of drugrelated crime S2 D1

S1

P2
P1 initial value of drugrelated crime

Result: an increase in total spending on drugs, and in drug-related crime

Q2 Q1

Quantity of Drugs

Policy 2: Education
Education reduces the demand for drugs. P and Q fall. Result: A decrease in total spending on drugs, and in drug-related crime.
P1 P2 Price of Drugs new value of drugrelated crime D2 D1 S initial value of drugrelated crime

Q2 Q1

Quantity of Drugs