AN INTRODUCTION TO MICROECONOMICS Dr. Mohammed Migdad

Elasticity and Its Applications CHAPTER 3

Chapter 3 content: Chapter three is about elasticity and its applications. It includes:  Price elasticity of demand,  Point and arc elasticity,  Types of elasticity,  Factors affecting elasticity,  Elasticity and total revenue,  Income elasticity of demand,  Price elasticity of supply,  In addition to elasticity and tax.

3.1 Introduction Elasticity Is a general concept that can be used to quantify the response in one variable when another variable changes.

3.2 Price Elasticity of Demand

Example 1 Consider the market for sales of ice cream cones at a state fair. The table below gives the market quantity demanded with consideration in giving all the sellers the same price. Calculate the price elasticity of demand for the ice-cram.

Ice-Cream Demand Schedule Continue

You can calculate the market price elasticity of demand using the information contained in the table above. For instance, suppose you decided to calculate the price elasticity of demand at the price $2.00 by examining a price decrease from $2.00 to $1.50 per cone. Continue

In this case, the demand for ice cream will increase from 7 million cones to 10 million cones. You can use these figures to calculate the price elasticity of demand as follows: Continue

This implies the following: The price elasticity of demand for ice-cream cones at a price of $2.00, according to the demand schedule provided, is Continue

The sign here illustrates the negative relation between price and quantity demanded and that we deal here with the absolute number. So the value of the elasticity in this case equals This elasticity means that the % change in quantity is higher than the % change in price, which indicates that the demand here is an elastic demand.

Example 2 You are a cement producer. You wish to plot your firm's demand curve and to find the price elasticity of demand at various points along the demand curve. You decide to calculate elasticity by examining the effects of price declines from $50 to $40, $40 to $30, etc.

To calculate the price elasticity of demand between a price of $50 and $40 on the demand curve, divide the percentage change in quantity demanded by the percentage change in price. Continue

Cement Demand Schedule Continue

Similarly, you can find the elasticity between prices of $40 and $30, $30 and $20, and $20 and $10. To illustrate, here is what you will find when you calculate elasticity between $40 and $30: Continue

This is the equation of elasticity between $30 and $20: Continue

This is the equation for elasticity between $20 and $10 Continue

Notice that demand becomes increasingly less as prices fall. Intuitively, this makes sense; consumers can be expected to react much more dramatically to a change in price when prices are high than they are low.

3.3 Arc Elasticity

Arc Elasticity Supposing we want to measure the elasticity between point A and point B appearing on the same curve in figure (3.1), we assume that: P1 = 4, Qd1 = 12 P2 = 5, Qd2 = 9

If we intend to calculate the elasticity between the two points, A and B, starting from point B and using the elasticity formula as illustrated above, this is what we get:

If we intend to calculate the elasticity between the two points, A and B, starting from point A and using the elasticity formula as illustrated above, this is what we get:

We notice some differences in the results because the starting points were different. To avoid this difference in calculating the Arc Elasticity, calculating from the middle point between both points, A and B, could be the best way. This is known as the Midpoint Law which gives an average result.

3.4 Point Elasticity and Types of Demand Elasticity Point Elasticity >>> ….

3.4 Point Elasticity and Types of Demand Elasticity Types of Demand Elasticity

3.4.1 Types of Price Elasticity of Demand 1.Elastic Demand 2.Inelastic Demand 3.Unitary Elastic Demand 4.Perfectly Elastic Demand 5.Perfectly Inelastic Demand/The Zero Elasticity

Elastic Demand

Inelastic Demand

The Unitary-Elastic Demand

Perfectly Elastic Demand

Perfectly Inelastic Demand/The Zero Elasticity

3.4.2 Special Cases for the Negative Demand Elasticity Luxury cars, particularly at the higher end, like the Rolls-Royce Phantom pictured here, are often said to be desirable due to their price. As a result, it is argued that luxury cars are Veblen goods. In such cases, if we measure the demand elasticity, it will be positive with positive relationship between price and quantity demanded

3.5 Elasticity and Total Revenue Example Product X1 can be sold for $5. The seller decides to increase the price to $7 in order to earn more money, but finds that he earns less money. This is because he is selling fewer of the products due to the increased price. His/her total revenue is falling, as a result. The demand for this product must be elastic. The producer failed in achieving his/her aim due to the lack of knowledge about the elasticity of the good.

3.5.1The Relationship between (TR) and Elasticity, and (TE) and Elasticity If the demand on a product was as follows, the demand on this product will be elastic Table: Total Revenue when the Price Decreases in the Elastic Demand The demand on this product is elastic; therefore, the decrease in price causes an increase in total revenue (TR). The price decreases 20%, the quantity increases 30%, and total revenue increases 8.3%.

If the demand was unitary-elastic, total revenue remains constant no matter the price changes.

Total Revenue when the Price Decreases in the Unitary Elastic Demand The price decreases 20%, the quantity increases 20%, and total revenue remains constant.

The Relationship between Elasticity and Total Revenue Elasticity of demand Inelastic demandUnitary-demandElastic demand Ed <1Ed = 1Ed > 1 Change in price Price increasesRevenue increasesRevenue constantRevenue decreases Price decreasesRevenue decreasesRevenue constantRevenue increases

The Relationship between Price and Total Revenue

3.6 The Relationship between Marginal Revenue, Price, and Elasticity Marginal revenue can be defined as "the change in total revenue caused by selling an additional new unit".

3.7 Elasticity and the Slop The Slope of the Infinity Elastic Demand Curve

The Slope of the Perfectly Inelastic Demand Curve

The Slope of the Normal Demand Curve

The Slope of the Unitary-Elastic Demand Curve

3.7.1 The Determinants of Price Elasticity of Demand (Factors that Affect Elasticity) The elasticity differs from one good to another depending on different factors as following: 1)The Availability of Substitutes 2)Necessity of a Product 3)Amount of Income Spent on the Good 4)Consumer Income (The Wealth of Consumers) 5)Time

3.8 Practical Applications to Price Elasticity of Demand The Effect of Decreasing Supply on Total Revenue

Monopoly ……

3.9 Cross Price Elasticity of Demand (CPED) CPED is the extent to which the quantity of good (y) is affected by the change in the price of good (x). Continue

The more precise equation in calculating cross price elasticity of demand is the mid-point law

3.10 Income Elasticity of Demand Income elasticity of demand could be measured through the following formula:

Example Measure the income elasticity of demand from the following data, and then illustrate the level of elasticity and type of the good. (Income increases from 100 to $150, as a result quantity increases from 90 to 110 units).

The income elasticity is positive and less than one that indicates a normal good with an inelastic demand

3.11 Price Elasticity of Supply Its formula is as follows:

Formula’s also include: The sign of "price elasticity of supply" is generally positive because there is a positive relationship between prices and quantity supplied.

Types of "Price Elasticity of Supply" 1) Perfectly Inelastic Supply (Zero Elastic Supply) 2)Infinity Elastic Supply 3)Unitary Elastic Supply 4)Elastic Supply 5)Inelastic Demand

1. Perfectly Inelastic Supply (Zero Elastic Supply)

2. Infinity Elastic Supply

3. Unitary Elastic Supply

4. Elastic Supply

5. Inelastic Demand

3.12 Supply Elasticity in the Short Run and the Long Run Economists usually differentiate between three time periods due to some conditions: 1)Market Period (Very Short Run) 2)The Short Run 3)The Long Run

The Supply Curve in the Very Short Run

Supply Curve in the Short Run

Supply Curve in the Long Run

3.12 Elasticity and Tax Incidence (Practical Cases) There are five different cases concerning both supply and demand elasticity First: Cases of Price Elasticity of Demand Second: Cases of Price Elasticity of Supply

First: Cases of Price Elasticity of Demand 1. If the demand for product (x) is perfectly inelastic and the government imposes ($1) tax on this product, the consumer bears the full burden of the imposed tax

First: Cases of Price Elasticity of Demand 2. If the demand for product (x) is infinity elastic and the government imposes ($1) tax on this product, the supplier bears the full burden of the imposed tax

First: Cases of Price Elasticity of Demand 3. If the demand on product (x) is unitary elastic and the government imposes ($1) tax on this product, the supplier bears half the burden of the imposed tax and the consumer bears the other half.

First: Cases of Price Elasticity of Demand 4. If the demand on product (x) is inelastic, and the government imposes ($1) tax on this product, the customer bears most of the burden of the imposed tax and the supplier bears the remaining few burden of tax.

First: Cases of Price Elasticity of Demand 5. If the demand on product (x) is elastic and the government imposes ($1) tax on this product, the supplier bears most of the burden of imposed tax and the customer bears the remaining few burden of tax.

Second: Cases of Price Elasticity of Supply 1.If the supply of product (x) is perfectly inelastic and the government imposes ($1) tax on this product, the supplier bears the full burden of imposed tax.

Second: Cases of Price Elasticity of Supply 2. If the supply of product (x) is infinity elastic, and the government imposes ($1) tax on this product, the consumer bears the full burden of imposed tax. In this case, the supplier is able to increase the prices to cover the burden of tax.

Second: Cases of Price Elasticity of Supply 3. If the supply of product (x) is unitary elastic and the government imposes ($1) tax on this product, the consumer bears half the burden of imposed tax and the supplier bares the remaining burden of tax. In this case, the suppliers are not able to increase the prices to cover the full burden of tax.

Second: Cases of Price Elasticity of Supply 4. If the supply of product (x) is inelastic and the government imposes ($1) tax on this product, the consumer bears less and the supplier bears more of the burden of imposed tax.

Second: Cases of Price Elasticity of Supply 5. If the supply of product (x) is elastic and the government imposes ($1) tax on this product, the consumer bears more and the supplier bears less of the burden of imposed tax.

THE END OF CHAPTER 3