Elasticity

Price Elasticity of Demand We know from the law of demand the when the price of a product falls, the QD of the product increases But the law of demand only tells firms that the demand curves for their products slope downward A more useful measure of responsiveness of the QD to a change in price is the price elasticity of demand

Measuring the Price Elasticity of Demand We might measure the price elasticity of demand using the slope of the demand curve because it tells us how much quantity changes as price changes Drawback: the measurement of slope is sensitive to the units chosen for quantity and price

Measuring the Price Elasticity of Demand To avoid confusion over units, economists use percentage changes when measuring the price elasticity of demand Percentage changes are not dependent on units No matter what units we use to measure the quantity of wheat, 10 % more wheat is 10% more wheat

Measuring the Price Elasticity of Demand Price Elasticity of Demand is measured by dividing the percentage change in the quantity demanded by the percentage change in the price It is important to note that the price elasticity of demand is not the same as the slope of the demand curve

Measuring the Price Elasticity of Demand If we calculate the price elasticity of demand for a price cut, the percentage change in price will be negative and the percentage change in quantity demanded will be positive If we calculate the price elasticity of demand for a price increase, the percentage change in price will be positive and the percentage change in quantity demanded will be negative

Measuring the Price Elasticity of Demand In comparing elasticities we are usually interested in their relative size Drop the minus sign and compare their absolute values

Elastic and Inelastic Demand If the QD is responsive to changes in price, the % change in QD with be greater than the % change in price The price elasticity of demand will be greater than 1 in absolute value Demand is elastic

Elastic and Inelastic Demand When the QD is not very responsive to price, however, the % change in QD will be less than the % change in price The price elasticity of demand will be less than 1 in absolute value Demand is inelastic

Elastic and Inelastic Demand In the special case in which the % change in QD is equal to the % change in price, the price elasticity of demand equals 1 Demand is unit-elastic

The Arc Midpoint Formula Used to ensure that we have only one value of the price elasticity of demand between the same two points on the same demand curve It uses the average of the initial and final quantity and the initial and final price

Demand Curves Remember elasticity is not the same thing as slope! Slope is calculated using changes in quantity and price, whereas elasticity is calculated using percentage changes

Demand Curves But it is true that when two demand curves intersect, the one with the smaller slope (in absolute value) – the flatter demand curve – is more elastic The one with the larger slope (in absolute value) – the steeper demand curve – is less elastic

Polar Cases of Price Elasticity Polar Cases of price elasticity do not occur often If a demand curve is a vertical line it is perfectly inelastic The QD is completely unresponsive to price and the price elasticity of demand = 0

Polar Cases of Price Elasticity If the demand curve is a horizontal line, it is perfectly elastic The QD is infinitely responsive to price, and the price elasticity of demand = infinity If a demand curve is perfectly elastic, an increase in price causes the QD to fall to zero

Straight Line Demand Curve

Determinants of Price Elasticity of Demand Time Horizon Availability of Substitutes (Market Definition) Necessities vs. Luxuries Importance of the good in relation to one’s budget

Determinants of the Price Elasticity of Supply Time horizon The short-run supply curve is inelastic In the long run, significant substitution is possible; the supply curve becomes very elastic Price elasticity of S depends on flexibility producers have to change the amount of good they produce In SR, hard for firms to open/close plants, hire/fire workers, etc. to make more/less good in response to price changes In the long run there are more options for changing production, so it is easier (less costly) for suppliers to subs into the production of another good: can open/close factories, new firms enter a market  The longer the run (time horizon), the greater the elasticity of S. The question: very elastic. Caveat: Suppliers produce goods, so we must take into account how easy (costly) it is to substitute for existing goods in production process and make more of them. We’ll be discussing this throughout the course.

Cross Price Elasticity When two goods are substitutes, cross elasticity of demand will be Positive When two goods are complements, cross elasticity of demand will be Negative E > 0 E < 0

Income Elasticity Income elasticity of demand will be Positive for normal goods Income elasticity of demand will be Negative for inferior goods

Elasticity and Total Revenue ** Inelastic – Price and TR move in the same direction** ** Elastic – Price and TR move in opposite directions** **Unit – TR does not change when price changes**