ELASTICITY Dr. Michelle Commosioung

Elasticity – the concept The responsiveness of one variable to changes in another When price rises, what happens to demand? Demand falls BUT! How much does demand fall? 2

Elasticity – the concept If price rises by 10% - what happens to demand? We know demand will fall By more than 10%? By less than 10%? Elasticity measures the extent to which demand will change 3

Importance of Elasticity Relationship between changes in price and total revenue Importance in determining what goods to tax (tax revenue) Importance in analysing time lags in production Influences the behaviour of a firm This slide also has an automatic response with ten second gaps in between each point. At this stage we have tried to keep things as simple as possible but to introduce issues that will be dealt with later in the course. 4

Determinants of Elasticity Number and closeness of substitutes – the greater the number of substitutes, the more elastic The proportion of income taken up by the product – the smaller the proportion the more inelastic Time period – the longer the time under consideration the more elastic a good is likely to be Luxury or Necessity - for example, addictive drugs 5

Elasticity 4 basic types used: Price elasticity of demand Price elasticity of supply Income elasticity of demand Cross price elasticity 6

Infinitely elastic demand P Infinitely elastic demand a b P1 D Q2 O Q1 Q 7

Totally inelastic demand P Totally inelastic demand D P2 b P1 a O Q1 Q 8

Unit elastic demand a b D P 20 100 8 O 40 Q This demand curve is known as a rectangular hyperbola. Notice that TR is the same at points a and b (800) a 20 b 100 8 D O 40 Q 9

Elasticity Price (J$) Quantity Demanded The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded. Quantity Demanded 10

Elasticity Price Elasticity of Demand The responsiveness of demand to changes in price The Formula: % Change in Quantity Demanded Ped = ___________________________ % Change in Price 11

Where % change in demand is greater than % change in price – elastic Where % change in demand is less than % change in price - inelastic

CALCULATING ELASTICITIES CALCULATING PERCENTAGE CHANGES To calculate percentage change in quantity demanded using the initial value as the base, the following formula is used:

CALCULATING ELASTICITIES We can calculate the percentage change in price in a similar way. Once again, let us use the initial value of P—that is, P1—as the base for calculating the percentage. By using P1 as the base, the formula for calculating the percentage of change in P is simply:

CALCULATING ELASTICITIES ELASTICITY IS A RATIO OF PERCENTAGES Once all the changes in quantity demanded and price have been converted into percentages, calculating elasticity is a matter of simple division. Recall the formal definition of elasticity:

Product Price Elasticity of demand Food 0.21 Medical Services 0.22 Housing Rental 0.18 Owner Occupied 1.20 Electricity 1.14 Cars 1.20 Beer 0.26 Wine 0.88 Cigarettes 0.35 Transatlantic air travel 1.30 Imports 0.58 Source: W.Nicholson, Microeconomic Theory: Basic Principles and extensions, 7th edition, p.230 16

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Importance of Price Elasticity of Demand to Business Decision-Making Total revenue is price x quantity sold. In this example, TR = $5 x 100,000 = $500,000. This value is represented by the grey shaded rectangle. The importance of elasticity is the information it provides on the effect on total revenue of changes in price. $5 Total Revenue D 100 Quantity Demanded (000s) 20

Elasticity D Total Revenue Price $5 $3 100 140 If the firm decides to decrease price to (say) $3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue. $5 $3 Total Revenue D 100 140 Quantity Demanded (000s) 21

Elasticity % Δ Price = 50% % Δ Quantity Demanded = 20% Producer decides to lower price to attract sales 10 % Δ Price = 50% % Δ Quantity Demanded = 20% Ped = 0.4 (Inelastic) Total Revenue would fall 5 Not a good move! D 5 6 Quantity Demanded 22

Elasticity Producer decides to reduce price to increase sales % Δ in Price = 30% % Δ in Demand = 300% Ped = 10 (Elastic) Total Revenue rises 10 Good Move! 7 D 5 20 Quantity Demanded 23

Elasticity If demand is price elastic: Increasing price would reduce TR Reducing price would increase TR If demand is price inelastic: Increasing price would increase TR Reducing price would reduce TR 24

Elasticity Income Elasticity of Demand: Measures the responsiveness of demand to changes in income 25

EM= % Qd = 60 % = 1.8 % M 33.3% E>1 normal good E E<1 inferior good 26

Income elasticity of demand is an important concept to firms considering the future size of the market for their product (e.g. if national income rises or if the economy moves into recession) 27

Product Income Elasticity of demand Food 0.28 Medical Services 0.22 Housing Rental 1.00 Owner Occupied 1.20 Electricity 0.61 Cars 3.00 Beer 0.38 Wine 0.97 Cigarettes 0.50 Transatlantic air travel 1.40 Imports 2.73 Source: W.Nicholson, Microeconomic Theory: Basic Principles and extensions, 7th edition, p.230 28

Elasticity Cross-price (or simply Cross Elasticity): Measures the responsiveness of demand of one good to changes in the price of a related good – either a substitute or a complement % Δ Qd of good t __________________ Xed = % Δ Price of good y 29

In other words, cross-price elasticity enables us to predict how much demand for one product will shift when the price of a second product changes (e.g. the cross price elasticity of demand for Coca-Cola to the price of Pepsi) 30

Elasticity Goods which are complements: Goods which are substitutes: Cross Elasticity will have negative sign (inverse relationship between the two) Goods which are substitutes: Cross Elasticity will have a positive sign (positive relationship between the two) 31

Elasticity Price Elasticity of Supply: Measures the responsiveness of supply to changes in price If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price If Pes is elastic – supply can react quickly to changes in price % Δ Quantity Supplied ____________________ Pes = % Δ Price 32

(in millions of bars per day) Price of a chocolate bar P(in cents) 40 80 120 160 200 240 10 20 30 50 60 70 100% A G S 66/% Quantity of chocolate bars supplied Q (in millions of bars per day) s 33

E Q P 100% 66 6% 1 5  % .  s Price Elasticity of Supply is Elastic 100% 66 6% 1 5  % .  Price Elasticity of Supply is Elastic 34

Supply is Elastic if firms have: Plenty of spare capacity Can readily get extra supplies of raw materials Can switch away from producing one good to the next

Price Elasticity of Supply is affected by: The amount that costs rise as output rises Hence, the cheaper it is to produce additional output, the more firms will be encouraged to produce for a given price rise, that is, Supply will become more Elastic. Time period Both consumers and producers take time to respond to a change in price. The longer the time period, the greater the response, that is, the greater the elasticity of supply or demand.

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The Time Dimension of Market Adjustment Short-run and long-run price adjustment short and long-run demand and supply curves 13 38

Supply in different time periods a D1 O Q1 Q 39

Supply in different time periods a D2 D1 O Q1 Q 40

Supply in different time periods Si b P2 P1 a D2 D1 O Q1 Q 41

Supply in different time periods Si SS b P2 c P3 Q3 P1 a D2 D1 O Q1 Q 42

Supply in different time periods Si SS b P2 c SL P3 d P4 Q4 P1 a D2 D1 O Q1 Q3 Q 43

Response of demand to an increase in supply Q1 Q 44

Response of demand to an increase in supply Q1 Q 45

Response of demand to an increase in supply b D short-run O Q1 Q2 Q 46

Response of demand to an increase in supply Demand is more elastic in the long run. P1 c P3 P2 b D long-run D short-run Q1 Q2 Q3 O Q 47

PRICE ELASTICITY OF DEMAND A good way to remember the difference between the two “perfect” elasticities is:

Applications to business importance of perceptions of the product repositioning a product effects of changes in competitors' pricing strategy strategies to make a product less cross-price elastic 11 49

Elasticity – Mind Map