Week 3 Elasticity

Elasticity
Elasticity
 … allows us to analyze supply and demand

with greater precision.
 … is a measure of how much buyers and

sellers respond to changes in market
conditions
The Economic Concept of
Elasticity
 Elasticity: the percentage change in one
variable relative to a percentage change in
another.
percent change in A
Coefficien t of Elasticity 
percent change in B
The Price Elasticity of Demand
 Price elasticity of demand: The

percentage change in quantity demanded
caused by a 1 percent change in price.
% Quantity
Ep 
% Price
Elasticity
 Point Elasticity
 Arc Elasticity
1.Arc elasticity: Elasticity which is measured
over a discrete interval of a demand (or a
supply) curve.
Q2  Q1 P2  P1
Ep  
(Q1  Q2 ) / 2 ( P1  P2 ) / 2
 Ep = Coefficient of arc price elasticity
 Q1 = Original quantity demanded
 Q2 = New quantity demanded
 P1 = Original price
 P2 = New price
If a price of a product rises from $11 to
$12, causing a fall in the quantity
demanded from 7 to 6, the arc price
elasticity coefficient:
67 12  11
Ep  
(7  6) / 2 (11  12) / 2
 1.77
Computing the Price Elasticity of
Demand
Percentage change in quantity demanded
Price elasticity of demand =
Percentage change in price
 Example: If the price of Dunkin Doughnuts increases from RM2.00
to $RM2.20 and the amount you buy falls from 10 to 8 pieces, then
your elasticity of demand would be calculated as:
(10  8)
 100 20%
10  2
(2.20  2.00)
 100 10%
2.00
 Point elasticity: Elasticity measured at a

given point of a demand (or a supply)
curve.
dQ P1
εP = x
dP Q1
The point elasticity of a linear demand

function can be expressed as:
Q P1
p  
P Q1
The point elasticity of a linear demand
Q = 18 - P : If P = 12 and Q = 6
dQ P1
εP = x
dP Q1
12
 p  1 *
6
 2
The point elasticity of a non-linear
demand
Q = 100 - P2 : If P = 5 and Q = 75
dQ P1
εP = x
dP Q1
5
 p  2 P *
75
 0.67
 Some demand curves have constant
elasticity over the relevant range
 Such a curve would look like:
Q = aP-b
where –b is the elasticity coefficient
 This equation can be converted to linear
by expressing it in logarithms:
log Q = log a – b(log P)
 Categories of Elasticity
 Relative elasticity of demand: EP > 1
 Relative inelasticity of demand: 0 < EP < 1
 Unitary elasticity of demand: EP = 1
 Perfect elasticity: EP = ∞
 Perfect inelasticity: EP = 0
Elasticities
 Inelastic Demand
 Quantity demanded does not respond strongly
to price changes.
 Price elasticity of demand is less than one.
 Elastic Demand
 Quantity demanded responds strongly to
changes in price.
 Price elasticity of demand is greater than one.
 Factors affecting demand elasticity
 Ease of substitution
 Proportion of total expenditures
 Durability of product
 Possibility of postponing purchase
 Possibility of repair
 Used product market
 Length of time period

 Derived demand: The demand for

products or factors that are not directly
consumed, but go into the production of a
final product.
 The demand for such a product or factor
exists because there is demand for the
final product.
 The derived demand curve will be more
inelastic:
 the more essential is the component in question.
 the more inelastic is the demand curve for the final
product.
 the smaller is the fraction of total cost going to this
component.
 the more inelastic is the supply curve of cooperating
factors.
 A long-run demand curve
will generally be more
elastic than a short-run
curve.
 As the time period
lengthens consumers find
way to adjust to the price
change, via substitution
or shifting consumption
 There is a relationship between the price
elasticity of demand and revenue received.
 Because a demand curve is downward sloping, a
decrease in price will increase the quantity demanded
 If elasticity is greater than 1, the quantity effect is
stronger than the price effect, and total revenue will
increase
Demand Elastcity and Revenue
Price Qtt TR MR Arc (Ep)
$100 1 $100 $- Ep
90 2 180 80 -6.33
80 3 240 60 -3.40
70 4 280 40 -2.14
60 5 300 20 -1.44
50 6 300 0 -1.00
40 7 280 -20 -0.69
30 8 240 -40 -0.47
20 9 180 -60 -0.29
10 10 100 -80 -0.16

Price Qtt Arc Elasticity Revenue
18 0 0
17 1 -35.0 17
16 2 -11.0 32
15 3 -6.2 45
14 4 -4.1 56
13 5 -3.0 65
12 6 -2.3 72
11 7 -1.8 77
10 8 -1.4 80
9 9 -1.1 81
8 10 -0.9 80
7 11 -0.7 77
6 12 -0.6 72
5 13 -0.4 65
4 14 -0.3 56
3 15 -0.2 45
2 16 -0.2 32
1 17 -0.1 17
0 18 0.0 0
 As price decreases
 Revenue rises when
demand is elastic.
 Revenue falls when it
is inelastic.
 Revenue reaches it
peak when elasticity of
demand equals 1.
 Marginal Revenue: The change in total

revenue resulting from changing quantity
by one unit.
Total Revenue
MR 
Quantity
 For a straight-line
demand curve the
marginal revenue
curve is twice as
steep as the demand.
 At the point where
marginal revenue
crosses the X-axis,
the demand curve is
unitary elastic and
total revenue reaches
a maximum.
 Some sample elasticities
 Coffee: short run -0.2, long run -0.33
 Kitchen and household appliances: -0.63
 Meals at restaurants: -2.27
 Airline travel in U.S.: -1.98
 Beer: -0.84, Wine: -0.55
The Cross-Elasticity of Demand
 Cross-elasticity of demand: The

percentage change in quantity consumed
of one product as a result of a 1 percent
change in the price of a related product.
% Q A
EX 
% PB
 Arc Elasticity
Q2 A  Q1 A P2 B  P1B
Ex  
(Q1 A  Q2 A ) / 2 ( P1B  P2 B ) / 2
 Point Elasticity
QA PB
EX  
QA PB
Cross Elasticity
 Substitutes: Related products for which a

price increase for one leads to an increase
in demand for another.
 Complements: Related products for which
a price increase for one leads to a
reduction in demand for the other
 The sign of cross-elasticity for substitutes
is positive.
 The sign of cross-elasticity for
complements is negative.
 Two products are considered good
substitutes or complements when the
coefficient is larger than 0.5.
Empirical Elasticity
 Cross elasticity of demand for electric

energy with respect to price of gas energy
Is about +0.13
 Aluminum with price of steel is +2.0
 Beef with price of chicken is +0.12
Income Elasticity
 Income Elasticity of Demand: The

percentage change in quantity demanded
caused by a 1 percent change in income.
 Y is shorthand for Income
%Q
EY 
%Y
Income Elasticity
 Arc Elasticity
Q2  Q1 Y2  Y1
EY  
(Q1  Q2 ) / 2 (Y1  Y2 ) / 2
Income Elasticity
 Categories of income
elasticity
 Superior goods: EY > 1
 Normal goods: 0 >EY >1
 Inferior goods – demand
decreases as income
increases: EY < 0
Empirical Elasticity
 Jewelry and watches to be 1.0

 Food expenditure to be 0.5
 Restaurant meal to be 1.6
 Air Travel between USA and Europe to be
1.9
Other Elasticity Measures
 Elasticity is encountered every time a
change in some variable affects
quantities.
 Advertising expenditure
 Interest rates
 Population size
Elasticity of Supply
 Price Elasticity of Supply: The
percentage change in quantity supplied as
a result of a 1 percent change in price.
% Quantity Supplied
ES 
% Price
 If the supply curve slopes upward and to
the right, the coefficient of supply
elasticity is a positive number.
 Arc elasticity
Q2  Q1 P2  P1
Es  
(Q1  Q2 ) / 2 ( P1  P2 ) / 2
 When the supply curve is more elastic, the

effect of a change in demand will be
greater on quantity than on the price of
the product.
 With a supply curve of low elasticity, a
change in demand will have a greater
effect on price than on quantity.
Try This
 Tots-R-Us operates the only day care center in
an exclusive neighborhood. Tots-R-Us is
making substantial economic profit, but the
owners know that new day-care centers will
soon learn from this highly profitable market
and attempt to enter the market. The owner
decide to begin spending immediately a rather
large sum of advertising designed to decrease
elasticity. Should they wait until new firms
actually enter?
Answer
 Tots-R-US should begin advertising
immediately in order to enhance brand
loyalty which will decrease elasticity of
demand. Also the less elastic is demand,
the greater the fall in price that results
when new firms enter. To the extent that
potential entrants consider post-entry
price, they will be less likely to enter the
more inelastic is demand.

Week 3 Elasticity

Uploaded by

Copyright:

Available Formats

Week 3 Elasticity

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Week 3 Elasticity

Uploaded by

Copyright:

Available Formats

Elasticity

 … allows us to analyze supply and demand

 … is a measure of how much buyers and

 Price elasticity of demand: The

 Point elasticity: Elasticity measured at a

The point elasticity of a linear demand

 Used product market

 Length of time period

 Derived demand: The demand for

40 7 280 -20 -0.69

30 8 240 -40 -0.47

20 9 180 -60 -0.29

10 10 100 -80 -0.16

 Marginal Revenue: The change in total

 Cross-elasticity of demand: The

 Substitutes: Related products for which a

 Cross elasticity of demand for electric

 Income Elasticity of Demand: The

 Jewelry and watches to be 1.0

 When the supply curve is more elastic, the

You might also like