ELASTICITY AND ITS APPLICATIONS

Overview Elasticity refers to the responsiveness of quantity demanded or quantity supplied. Elasticity is a critical analytical tool for businesses and policy analysts The most common elasticity measures are: Price elasticity of demand Price elasticity of supply Income elasticity Cross price elasticity 2

Price Elasticity of Demand Price elasticity of demand is a measure of how responsive the quantity demanded of a good is to a change in the price of that good The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. 4

Computing the Price Elasticity of Demand Example: Suppose the price of gas increases from $1.50 to $2.00. As a result, quantity demand decreases from 20,000 to 18,000. What is the price elasticity of demand for gas? 8

Computing the Price Elasticity of Demand One problem with the formula we just used is that the price elasticity of demand depends of the direction of the change in price. Example: Suppose the price of gas decreases from $2.00 to $1.50. As a result, quantity demand increases from 18,000 to 20,000. What is the price elasticity of demand for gas?

The Midpoint Method The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change. 17

Computing the Price Elasticity of Demand Using the Midpoint Formula Example: Suppose the price of gas increases from $1.50 to $2.00. As a result, quantity demand decreases from 20,000 to 18,000. What is the price elasticity of demand for gas?

Different Elasticities Elastic: If the price elasticity of demand is greater than one, demand is price elastic. A one percent increase in price results in a greater than one percent change in quantity demanded. Inelastic: If the price elasticity of demand is less than one, demand is price inelastic. A one percent increase in price results in less than a one percent change in quantity demanded. Unit Elastic: If the price elasticity of demand is equal to one, demand is unit elastic. A one percent increase in price results in a one percent change in quantity demanded.

Different Elasticities Demand is perfectly inelastic if the price elasticity of demand equals zero. When price changes, quantity demanded stays the same. A perfectly inelastic demand curve is vertical. Demand is perfectly elastic if the price elasticity of demand approaches infinity. In that case, small changes in price lead to huge changes in quantity demand. A perfectly elastic demand curve is horizontal.

The Price Elasticity of Demand and Demand Curves At any price above P1, quantity demanded is zero When price rises, quantity demanded doesn’t change P2 P2 Demand P1 P1 Q1 Quantity Quantity Perfectly Inelastic Perfectly Elastic

The Price Elasticity of Demand and Demand Curves When price rises, quantity demanded falls a lot When price rises, quantity demanded falls only slightly P2 P2 P1 P1 Demand Demand Q2 Q2 Q1 Q1 Quantity Quantity Inelastic Elastic

Determinants of Price Elasticity of Demand Whether demand is inelastic or elastic depends on several factors such as: Availability of Close Substitutes The larger the number of close substitutes the greater the price elasticity of demand Necessities versus Luxuries Necessities tend to be price inelastic while luxury goods tend to be price elastic Time Horizon The longer the time period, the greater the price elasticity of demand

Total Revenue and Price Elasticity of Demand If we know the price elasticity of demand for a good, we can determine how a change in price will affect a firm's total revenue. Total revenue is simply the price of a good multiplied by the quantity of the good sold. Total Revenue = P x Q

Total Revenue and Price Elasticity of Demand $5 TR = P x Q TR = $500 Demand 100 Quantity

Total Revenue and Price Elasticity of Demand “Should a Firm raise prices?” The answer depends on whether total revenue rises or falls when the firm raises prices. P P2 TR = P2 x Q2 P1 TR = P1 x Q1 Demand Q2 Q1 Q

Total Revenue and Price Elasticity of Demand With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases. With an elastic demand curve, an increase in price leads to a decrease in quantity that is proportionately larger. Thus, total revenue decreases. If demand is unit elastic, a change in price has no effect on total revenue.

Total Revenue and Price Elasticity of Demand

The Change in Total Revenue when Demand is Elastic P When demand is price elastic, an increase in price reduces total revenue P2 P1 D Q2 Q1 Q

The Change in Total Revenue when Demand is Inelastic P When demand is price inelastic, an increase in price increases total revenue P1 P0 D Q1 Q0 Q

Income Elasticity of Demand Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

Income Elasticity of Demand Types of Goods: Normal Goods: If a good is normal, quantity demanded increases when income increases For a normal good, the income elasticity of demand is positive Inferior Goods: If a good is inferior, quantity demanded decreases when income increases For an inferior good, the income elasticity of demand is negative

Income Elasticity of Demand Goods consumers regard as necessities tend to be income inelastic (income elasticity of demand less than one). Examples include food, fuel, clothing, utilities, and medical services. Goods consumers regard as luxuries tend to be income elastic (income elasticity of demand greater than one). Examples include sports cars, furs, and expensive foods.

Price Elasticity of Supply Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good. Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price.

The Price Elasticity of Supply At any price below P1, quantity supplied is zero When price rises, quantity supplied doesn’t change P2 Supply P1 P1 P2 Q1 Quantity Quantity Perfectly Inelastic Perfectly Elastic

The Price Elasticity of Supply When price falls, quantity supplied falls only slightly Price Supply Price When price fall, quantity supplied falls a lot Supply P1 P1 P2 P2 Q2 Q2 Q1 Q1 Quantity Quantity Inelastic Elastic

Determinants of Price Elasticity of Supply 1. Ability of sellers to change the amount of the good they produce. Beach-front land is inelastic. Books, cars, or manufactured goods are elastic. 2. Time period. Supply is more elastic in the long run.