The Concept of Elasticity

Elasticity What is the concept and why do we need it? Elasticity is used to measure the effects of changes in economic variables

The Most Important Elasticity Price elasticity of demand A measure of the responsiveness of the quantity demanded of a good to a change in its price.

Demand: Gallons vs Litres Price($/g) Quant(g) Price($/L) Quant(L) a100 0 a' 25 0 b b' c 0 50 e' 0 200

Elasticity: A Units-Free Measure Price elasticity of demand = Percentage change in quantity demanded Percentage change in price

Calculating Elasticity Which is negative, but price elasticity of demand is given as a positive number = (  Q/  P)(P ave /Q ave )

Calculating Elasticity Negative sign is ignored The changes in price and quantity are expressed as percentages of the average price and average quantity.

Quantity (millions of chips per year) Price (dollars per chip) DaDa Original point New point Calculating the Elasticity of Demand

Quantity (millions of chips per year) Price (dollars per chip) DaDa = $ 20 = 8 Original point New point Calculating the Elasticity of Demand

Quantity (millions of chips per year) Price (dollars per chip) DaDa Original point New point P ave = $400 = $20 = 8

Quantity (millions of chips per year) Price (dollars per chip) DaDa Original point New point P ave = $400 Q ave = 40 = $20 = 8 Calculating the Elasticity of Demand

Calculating Elasticity = 4 meaning, on average, each 1% price decrease Causes a 4% increase in quantity demanded Price elasticity

Some Interesting Characteristics of Linear Demand Curves (It is a straight Line) Can be Deduced

Compute Elasticity for Gasoline (in Gallons) from Earlier Example Price ($/unit) Quant. (G) Gallons: slope = -2 When: Price falls from $100/gal to $0/gal 50 |  P/  Q| = 100/50 = 2 P avg = 100/2 (=50) Q avg = 50/2 (=25) P avg / Q avg = (100/2)/(50/2) = 2

|  P/  Q| = 100/50 = 2 P avg / Q avg = (100/2)/(50/2)= 2 The ratio of midpoint Price and Quantity = The slope But for elasticity we want |  Q/  P|, the reciprocal of demand curve slope |  Q/  P| = 1/2 Elasticity = |  Q/  P| (P avg / Q avg ) = (1/2)*2 =1

A Lesson: Elasticity on linear demand curves Price ($/unit) Quant. (G or L) 50 Elasticity = 1 For any Price-Quantity combination Elasticity > 1 Elasticity < 1

Three types of price elasticity of demand inelastic Unit elastic elastic

Inelastic Demand Inelastic demand The percentage change in quantity is less than the percentage change in price. Price elasticity of demand < 1

Extreme Case: Perfectly Inelastic Demand 6 12 Price Quantity D1D1 Elasticity = 0 WHY? (  Q/  P)(P ave /Q ave ) = ( 0/  P)(P ave /Q ave ) = 0 Because  Q = 0

Elastic Demand Elastic demand The percentage change in quantity is greater than the percentage change in price. Price elasticity of demand > 1

Extreme Case: Perfectly Elastic Demand 6 12 Price Quantity D3D3 Elasticity = (  Q/  P)(P ave /Q ave ) = Because  P = 0 (  Q/0)(P ave /Q ave ) =

Unit Elastic Demand Unit elasticity The percentage change in quantity equals the percentage change in price. Price elasticity of demand = 1

Extreme Case: Unit Elastic Demand Everywhere 6 12 Price Quantity D2D Elasticity = 1 Unit Elasticity

Factors That Influence Elasticity The Closeness of Substitutes. The closer the substitutes, the more elastic the demand more elastic means a higher price elasticity (but not necessarily > 1)

Elasticity and Closeness of Substitutes Quantity (pounds per week) Price (dollars per pound) 5 10 No close subs Orange Roughy Close subs

Factors That Influence Elasticity Proportion of Income Spent on the Good The greater the proportion of income spent on food, the more elastic the demand Because of Income Effect of a price change

Factors That Influence Elasticity Time Elapsed Since Price Change The longer the time, the more elastic the demand Short-run demand Long-run demand

28 Factors Affecting Price Elasticity of Demand Availability of substitutes The better & more numerous the substitutes for a good, the more elastic is demand Percentage of consumer’s budget The greater the percentage of the consumer’s budget spent on the good, the more elastic is demand Time period of adjustment The longer the time period consumers have to adjust to price changes, the more elastic is demand

29 Income Elasticity Income elasticity ( E M ) measures the responsiveness of quantity demanded to changes in income, holding the price of the good & all other demand determinants constant Positive for a normal good Negative for an inferior good

30 Cross-Price Elasticity Cross-price elasticity ( E XY ) measures the responsiveness of quantity demanded of good X to changes in the price of related good Y, holding the price of good X & all other demand determinants for good X constant Positive when the two goods are substitutes Negative when the two goods are complements