ELASTICITY

Objectives/Key Topics Upon completion of this unit, you should understand and be able to answer these questions: 1. How is the responsiveness of consumers to changes in various demand factors measured? 2. Elasticities – a.What are they? b.How are they calculated? c.What factors influence their values? d.How can they be used? 3. How is the responsiveness of producers to changes in supply factors measured?

Question Suppose your cumulative GPA increases from 3.00 to 3.30 after this semester. What was the ‘percentage increase’ in your cumulative GPA?

Answer

Question What is likely to happen to the quantity demanded of gasoline if it were to increase in price by 20%?

Elasticity of D Definition (Meaning) =A measure of responsiveness of D to changes in a factor that influences D Two components 1. Magnitude of change (number) 2. Direction of change (sign) =The number shows the magnitude of how much D will change due to a 1% change in a D factor The sign shows whether the D factor and D are changing in the same or opposite directions +  same direction -  opposite direction

Elasticities of Demand  E Q,F = %ΔQd x /%ΔF = %ΔQ/%ΔF Where, Qd x =the quantity demanded of X F=a factor that affects Qd x Notes: sign > 0  Qd x & F, ‘directly’ related sign < 0  Qd x & F, ‘indirectly’ related number > 1  %ΔQd, >%ΔF

Measures of Responsiveness of D to P Changes 1. Slope = unit ΔP/unit ΔQ d → can be used to show unit Δ Q d caused by 1 unit ΔP → a problem with slope is that it depends on the ‘units’ of measurement 2. Elasticity = % Δ Q d /% ΔP → shows % Δ Q d for each 1% ΔP → does NOT depend on ‘units’ of measurement

A lternative elasticity calculation ‘formulas’: 1.Point => calculate % changes as % of original values 2.Midpoint => Calculate % changes as % of average of original values and new values, = (original value + new value) / 2

Elasticity Calculation (point method)

Types of Elasticities TypeF E0E0 =own PPXPX ECEC =cross PPYPY EIEI =IncomeI EAEA =advertisingA

Elasticity Value Meanings (e.g.) E 0 = -2  for each 1%  Px,Qd for X will  by 2% in opposite direction E C = +1/2  for each 1%  PY,Qd for X will  by 1/2% in same direction E I = +.1  for each 1%  I,Qd for X will  by.1% in same direction

Own Price Elasticity of Demand Negative according to the ‘law of demand’

Perfectly Elastic & Inelastic Demand

E 0 Calculation (point formula)

E 0 Calculation (example)

E 0 and Linear D Curve P a 1/2a Q E 0 >1 E 0 =1 E 0 <1

Factors Affecting Own Price Elasticity Available Substitutes The more substitutes available for the good, the more elastic the demand. Time Demand tends to be more inelastic in the short term than in the long term. Time allows consumers to seek out available substitutes. Expenditure Share Goods that comprise a small share of consumer’s budgets tend to be more inelastic than goods for which consumers spend a large portion of their incomes.

Uses of E 0 Calculate % change in P needed to bring about desired % change in Q sold Calculate % change in Q sold that will result from a given % change in P Predict how TR will Δ due to given % ΔP

Elasticity Equation => Note: this is an equation with 3 variables => given values for 2 variables, can solve for value of 3 rd variable Example: %ΔQ = E 0 (%ΔP) Example: %ΔP = (%ΔQ)/E 0

Use of E 0 (Example) According to an FTC Report, AT&T’s own price elasticity of demand for long distance services is –8.64. If AT&T lowered price by 3 percent, what would happen to the volume of long distance telephone calls routed through AT&T?

Answer Calls would increase by percent!

Question If a firm wants to increase its dollar sales of a product, should it  P or  P?

Quote of the Day “Students of Economics need to be taught, in business, sometimes you should raise your price, and sometimes you should lower your price.” - CEO of Casey’s

E 0 and TR TR = P∙Q = total revenue (total $ sales) If E 0 elastic (# > 1)  little P   BIG Q    TR  little P   BIG Q    TR* (  P) If E 0 inelastic (# < 1)  BIG P   little Q    TR* (   P)  BIG P   little Q    TR

Max TR Maximum R will be generated at midpoint of linear, down-sloping D curve P Q P=5-.5Q Max TR

E 0 and TR (Example) Recall E 0 = -.25 at P=1 and Q=8 for P=5 -.5Q Given E 0 is inelastic  firm should be able to  TR by  P. PQdQd TR ($) * (= max TR)

Cross Price Elasticity of Demand +Substitutes - Complements

Income Elasticity +Normal Good -Inferior Good

Elasticity of Supply

Elasticity Summary Elasticities can be used to estimate: