CH5 : Elasticity Asst. Prof. Dr. Serdar AYAN

The Concept of Elasticity How large is the response of producers and consumers to changes in price? Before business firms and the government decide to change prices and taxes, they must anticipate the magnitude of response by those affected.  Elasticity is a measure of the responsiveness of people to changes in economic variables.

3 of 31 Elasticity elasticity A general concept used to quantify the response in one variable when another variable changes.

4 of 31 Price Elasticity of Demand price elasticity of demand The ratio of the percentage of change in quantity demanded to the percentage of change in price; measures the responsiveness of quantity demanded to changes in price. Slope and Elasticity

5 of 31 Price Elasticity of Demand Types of Elasticity TABLE 5.1 Hypothetical Demand Elasticities for Four Products Product % Change In Price (%  P) % Change In Quantity Demanded (%  Q D ) Elasticity (%  Q D ÷ %  P) Insulin+10%0%.0Perfectly inelastic Basic telephone service+10%-1% -.1Inelastic Beef+10%-10%Unitarily elastic Bananas+10%-30%-3.0Elastic perfectly inelastic demand Demand in which quantity demanded does not respond at all to a change in price.

6 of 31 Price Elasticity of Demand inelastic demand Demand that responds somewhat, but not a great deal, to changes in price. Inelastic demand always has a numerical value between zero and -1. Types of Elasticity A warning: You must be very careful about signs. Because it is generally understood that demand elasticities are negative (demand curves have a negative slope), they are often reported and discussed without the negative sign.

7 of 31 Price Elasticity of Demand Types of Elasticity unitary elasticity A demand relationship in which the percentage change in quantity of a product demanded is the same as the percentage change in price in absolute value (a demand elasticity of -1). elastic demand A demand relationship in which the percentage change in quantity demanded is larger than the percentage change in price in absolute value (a demand elasticity with an absolute value greater than 1). perfectly elastic demand Demand in which quantity drops to zero at the slightest increase in price.

8 of 31 Price Elasticity of Demand Types of Elasticity  FIGURE 5.2 Perfectly Inelastic and Perfectly Elastic Demand Curves Figure 5.2(a) shows a perfectly inelastic demand curve for insulin. Price elasticity of demand is zero. Quantity demanded is fixed; it does not change at all when price changes. Figure 5.2(b) shows a perfectly elastic demand curve facing a wheat farmer. A tiny price increase drives the quantity demanded to zero. In essence, perfectly elastic demand implies that individual producers can sell all they want at the going market price but cannot charge a higher price.

9 of 31 Price Elasticity of Demand Types of Elasticity A good way to remember the difference between the two “perfect” elasticities is:

Interpreting the Value of Elasticity Response to Price Changes Responsive Unresponsive Proportional Value of Elasticity E d > 1 E d < 1 E d = 1 Demand Elasticity Elastic Inelastic Unitary elastic Magnitudes of Change %  Q D > %  P %  Q D < %  P %  Q D = %  P Type of Elasticity Elastic Inelastic Substitutes Available Many Few The main determinant of demand elasticity is the availability of substitutes for the good in question.

Interpreting the Value of Elasticity  The price elasticity for water (0.20) suggests that a 10% increase in the price of water would decrease the quantity demanded by only 2%.  The elasticity for specific brands of coffee (5.6) suggests that a 10% increase in the price of a specific brand would decrease its quantity demanded by 56%. Estimated price elasticities of demand for selected products Product Price elasticity of demand Salt0.1 Water0.2 Coffee0.3 Cigarettes0.3 Shoes and footwear0.7 Housing1.0 Automobiles1.2 Foreign travel1.8 Restaurant meals2.3 Air travel2.4 Motion pictures3.7 Specific brands of coffee5.6

Example: If the price of an ice cream cone increases from 2.00TL to 2.20TL and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as: Computing the Price Elasticity of Demand

Computing Price Elasticity of Demand

Elasticity Along a Linear Demand Curve Price elasticity of demand decreases as we move downward along a linear demand curve  Demand is elastic on the upper part of the demand curve and inelastic on the lower part. Percentage decrease in price Percentage increase in quantity Elasticity Point r to point s4/80 = 5%2/10 = 20%20%/5% = 4.0 Point t to point u4/50 = 8%2/25 = 8%8%/8% = 1 Point v to point w4/20 = 20%2/40 = 5%5%/20% = 0.25

15 of 31 Calculating Elasticities Elasticity and Total Revenue TR = P x Q total revenue = price x quantity In any market, P x Q is total revenue (TR) received by producers: When price (P) declines, quantity demanded (Q D ) increases. The two factors, P and Q D move in opposite directions: Effects of price changes on quantity demanded:

16 of 31 Calculating Elasticities Elasticity and Total Revenue Because total revenue is the product of P and Q, whether TR rises or falls in response to a price increase depends on which is bigger: the percentage increase in price or the percentage decrease in quantity demanded. If the percentage decline in quantity demanded following a price increase is larger than the percentage increase in price, total revenue will fall. Effects of price increase on a product with inelastic demand: Effects of price increase on a product with elastic demand:

Predicting Changes in Total Revenue Elasticity and Total Revenue Type of deman dValue of E d Change in quantity versus change in price Effect of an increase in price on total revenue Effect of a decrease in price on total revenue ElasticGreater than 1.0 Larger percentage change in quantity Total revenue decreases Total revenue increases InelasticLess than 1.0Smaller percentage change in quantity Total revenue increases Total revenue decreases Unitary elastic Equal to 1.0Same percentage change in quantity and price Total revenue does not change

18 of 31 Calculating Elasticities Elasticity and Total Revenue The opposite is true for a price cut. When demand is elastic, a cut in price increases total revenues: When demand is inelastic, a cut in price reduces total revenues: effect of price cut on a product with elastic demand: effect of price cut on a product with inelastic demand:

19 of 31 The Determinants of Demand Elasticity Availability of Substitutes Perhaps the most obvious factor affecting demand elasticity is the availability of substitutes. The Importance of Being Unimportant When an item represents a relatively small part of our total budget, we tend to pay little attention to its price. The Time Dimension The elasticity of demand in the short run may be very different from the elasticity of demand in the long run. In the longer run, demand is likely to become more elastic, or responsive, simply because households make adjustments over time and producers develop substitute goods.

20 of 31 Other Important Elasticities Income Elasticity of Demand income elasticity of demand A measure of the responsiveness of demand to changes in income.

Income Elasticity E i > 0 Normal E i < 0 Inferior E i > 1 Luxury %  Q D > %  I E i < 1 Necessity %  Q D < %  I Income Elasticity Type of GoodResponsiveness Classification of Goods According to Income Elasticity

22 of 31 Other Important Elasticities Cross-Price Elasticity Of Demand cross-price elasticity of demand A measure of the response of the quantity of one good demanded to a change in the price of another good.

Exy > 0 Substitutes  Py   Qx Cross Elasticity of Demand Exy < 0Complements  Py   Qx Classification of Goods According to Cross Elasticity Cross ElasticityResponsivenessType of Good

Price Elasticity of Supply Price elasticity of supply is a measure of the responsiveness in quantity supplied to changes in price.

Computing Price Elasticity of Supply

Supply Elasticity and Time Supply becomes more elastic over time. The increase in quantity supplied as a response to an increase in price is greater when supply is more elastic. Higher market prices give business firms an incentive to expand production and output. As time goes by, the ability of firms to expand productive capacity is greater, and supply becomes more elastic.