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Chapter 4 Elasticity

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Elasticity: The responsiveness of dependent variable to change in independent variable A measure of the extent to which quantity demanded and quantity supplied respond to variations in price, income, and other factors.

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Price Elasticity of Demand Definition: % change in Q d due to 1% change in P. Application: change in price on –total revenue for sellers –total expenditure for buyers –effectiveness of policy in influencing individual behaviors

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Exercise: 4.1, P.99 Known: –P=$400, Qd=10K; –P=$380, Qd=12K Solve for: Ed Is D elastic? Should P go down from $400 to $380?

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Elastic Demand |E d | > 1: (|E d | →∞) Elastic –price changes by 1%, quantity demanded changes by more than 1%. – price and total revenue are negatively related

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Inelastic Demand : |E d | < 1, (|E d | = 0) Inelastic –price changes by 1%, quantity demanded changes by less than 1% – price and total revenue are positively related

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Unit Elastic Demand |E d | = 1, Unit Elastic –price changes by 1%, quantity demanded also changes by 1% –total revenue is maximized

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Perfectly Elastic and Perfectly Inelastic Demand Curves Figure 4.8, P.106

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Mid-Point Method Change in Q = Q2 - Q1 Change in P = P2 - P1 E = {(Q2-Q1)/[(Q2+Q1)/2]} / {(P2-P1)/[(P2+P1)/2]}

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Example: 19981999 P$3.70$2.72 Qd1.74B1.9B

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Calculation Change in Qd = 1.9 – 1.74 = 0.16 Change in P = 2.72 – 3.70 = - 0.98 Average Qd = (1.74 + 1.9) / 2 = 1.82 Average P = (3.70 + 2.72) / 2 = 3.21 E = (0.16/1.82) / (-0.98/3.21) = - 0.29 TR1998 = 6.438, TR1999 = 5.168

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What does it mean? Elastic? (Ed = -0.29 absolute value < 1) Impact on TR when P decreases Possible type of good

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Factors Affecting Elasticity of Demand Substitutability Share in budget Necessity vs. Luxury Time span: short term vs. long term

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Price Elasticity of Demand Definition: % change in Q d due to 1% change in P. Formula:E d = %ΔQ d / %ΔP = (ΔQ d / Q d ) / (ΔP/P) = (Δ Q d /ΔP) x P/Q d Slope of DInitial position

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Determinants of Elasticity Slope of the demand curve at the price Position of the point (price level) on the demand curve

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Price Elasticity and the Steepness of the Demand Curve Figure 4.5, P.104

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Fig. 4.5, P.104 Elasticity affected by both slope and position – At (4,4) Ed on D1=1/2 Ed on D2=2 – On D2 Ed at (4,4) = 2 Ed at (1, 10) = 1/5

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Price Elasticity Regions along a Straight-Line Demand Curve Figure 4.7

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Conclusions: For Straight-line Demand Curves: Ed at mid-point = 1 –P > Pm Elastic –P < Pm Inelastic To increase TR –P > Pm: Lower P Higher TR –P < Pm: Higher P Higher TR

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Total Expenditure as a Function of Price Figure 4.12

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Cross-Price Elasticity Responsiveness of demand for one good to changes in the price of a related goods. E c = (Δ Q x / ΔP y ) x (P y /Q x ) E c > 0, substitutes E c < 0, complements

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Income Elasticity of Demand The responsiveness of demand to changes in consumer income % change in Q divided by % change in Y E m = (Δ Q/ ΔY) x (Y/Q)

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Income Elasticity of Demand 0 < E m < 1: (E m = 0) Income Inelastic Income changes by 1%, quantity demanded changes by less than 1%. E m > 1: Income Elastic Income changes by 1%, quantity demanded changes by more than 1%.

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Income Elasticity of Demand E m = 1: Income Unit Elastic Income changes by 1%, quantity demanded changes by 1%.

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Categories based on elasticity E m > 0: Normal goods –E m > 1: Luxury goods –E m < 1: Necessity E m < 0: Inferior goods

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Engel’s Law with a given set of tastes and preferences, as income rises, the proportion of income spent on food falls, even if actual expenditure on food rises the income elasticity of demand of food is less than 1 (necessity)

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Engel’s Coefficient % change in food expenditure / % change in total expenditure % change in food expenditure / % change in income –EC > 59%: absolutely poverty ( 绝对贫困 ); –50% < EC <59%: barely enough food and clothing （温饱） ; –40% < EC < 50%: moderately well-off （小康） –30%

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Summary: Elasticity of Demand Price ElasticityCross-Price Elasticity Income Elasticity %ΔQ d / %ΔP%ΔQ d (x)/ %ΔP(y)%ΔQ d / %ΔY Elastic (horizontal) Inelastic (vertical) Unitary elastic Complements Substitutes Normal vs. inferior Luxury vs.necessity Luxury/necessity Substitutability

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Price Elasticity of Supply Definition: % change in Q s due to 1% change in P. Formula:E s = %ΔQ s / %ΔP = (ΔQ s / Q s ) / (ΔP/P) = (Δ Q s /ΔP) x P/Q s

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Again: slope and position S’ Es at Point A: On S: (8/2)(1/2)=2 On S’: (14/2)(1/6)=7/6 Es on S: At A: (8/2)(1/2)=2 At B: (10/3)(1/2)=5/3 Conclusions: Es declines as Q increases Es declines faster if slope is steeper 14

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Special Case: fig.4.14, P.113 Es = 1 everywhere If S is straight and passes through origin

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Special cases: Perfectly inelastic and Perfectly elastic supply curves Fig.4.15, P. 113 Fig. 4.16, P.114

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Price Elasticity of Supply E s > 1: (E s →∞) Elastic price changes by 1%, quantity supplied changes by more than 1%. E s < 1, (E s = 0) Inelastic price changes by 1%, quantity supplied changes by less than 1%

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Unit Elastic Supply E s = 1, Unit Elastic price changes by 1%, quantity supplied also changes by 1%

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Factors Affecting Elasticity of Supply Availability of inputs: –Flexibility; mobility; substitute Length of production period Difficulty of production Technology

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Incidence of Excise Tax Who bears the real burden of tax, the buyer or the seller?

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Effect of an Excise Tax Levied on the Sales of Taxi Rides

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Effect of an Excise Tax Levied on Purchases of Taxi Rides

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The Revenue from an Excise Tax

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 5: Describing Demand and Supply: Elasticities Prepared by: Kevin Richter, Douglas College.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 5: Describing Demand and Supply: Elasticities Prepared by: Kevin Richter, Douglas College.

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