Intro to Elasticity Several components Price Elasticity- the buying and selling responses of consumers and producers to price changes; that is, how MUCH change occurs. Cross Elasticity- the buying response of consumers of one product when the price of another product changes.

Intro Third: Income Elasticity- the buying response of consumers when incomes change. And we will look at markets in which government set prices rule. Although we have talked about this briefly, we will look a little more closely.

Elasticity Definition: a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants Price elasticity of demand: A measure of how much the QD of a good responds to a change in price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price.

Elasticity Since the law of demand states that a decrease in the price of a good raises the quantity demanded, we have a qualitative tool. To have a quantitative tool elasticity is invoked. Price elasticity of demand measures how much quantity demanded responds to a change in price.

continued Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in price. Demand is said to be inelastic if the quantity demanded responds only slightly to changes in price. Elasticity is, then, a measure of how willing consumers are to move away from a good as its price rises. So elasticity reflects more than just economic forces shaping tastes.

Determinants of Price Elasticity of Demand Availability of close substitutes: goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others. Examples: butter and margarine

Determinants of Price Elasticity of Demand Necessities versus Luxuries: Necessities tend to have inelastic demand curves, whereas luxuries have elastic demand curves. We will look at some examples. Also it is important to remember that whether a good is a necessity or luxury is buyer dependent. Doctor visits and sailboats

Determinants of Price Elasticity of Demand Definition of the Market: The elasticity of demand in any market depends on how the boundaries of the market are perceived. Narrowly defined markets tend to have more elastic demand than broadly defined markets. This is because, generally, it is easier to find substitutes for narrowly defined goods. Food as a broad category, ice cream as a narrow category.

Determinants of Price Elasticity of Demand Time Horizon: Goods tend to have more elastic demand over longer time horizons. This is true in many cases, but we will look at gasoline to examine this determinant. Gasoline tends to be relatively inelastic in the short run. If the price of gasoline increases, short run QD decreases relatively little. However, over time consumers will move away from using gasoline, so the QD will fall more quickly as time goes on and Ceteris Paribus.

Formulae Coefficient Ed defined as % change in QD of product ________________________ % change in price of product or

continued Ed= ∆ in QD of product original QD of product Divided by ∆ in Price of product Original Price of product

COntinued Because of the confusion that results from positive and negative signs in the co-efficient equations, economists tend to use absolute value. So will we. Using the Mid Point Formula: Because using the coefficient formula will deliver results that appear contradictory, the mid point formula has been developed to smooth out possible errata in calculation of elasticity.

Mid Point formula Ed= Change in Q divided by Change in Price sum of quantities/2 sum of prices/2

Outcomes Perfectly Inelastic demand: elasticity =0 An increase in price leaves the qd unchanged Inelastic demand: elasticity is less than 1 An increase in price lead to an decrease in qd of less than an equal percentage but greater than 0

Outcomes Unit Elastic Demand: an increase in price leads to the exact same percentage decrease in QD. In other words elastiticy = 1 Elastic Demand: Elasticity is greater than 1. An increase in price leads to a decrease in QD by greater than than 1x’s the percentage increase in price.

Outcomes Perfectly elastic demand. Elasticity equal infinity. At any price above the horizontal demand curve QD is zero. At any price on the horizontal demand curve, consumers will buy any quantity. At any price below the horizontal demand curve, consumers QD is infinite.

Total Revenue Test One way to study elasticity is from the perspective of revenue. The variable, Total Revenue, which is the amount paid by buyers and received by sellers of the good. In any market total revenue is P x Q (price of the good times quantity of good sold.) So, does total revenue change as movement occurs along a demand curve?

Total Revenue Test The answer is dependent on the elasticity of demand If demand is inelastic then an increase in P causes an increase in total revenue. This is due to the fact that by definition the percentage increase in P is GREATER than the percentage decrease in Q. If demand is elastic, then an increase in P will cause a decrease in total revenue. This is also due to the fact that by definition, the percentage increase in P is SMALLER than the percentage decrease in Q.

General Assumptions TRevenue When demand is inelastic (price elasticity coefficient less than 1) price and total revenue move in the same direction When demand is elastic ( price elasticity coefficient is more than 1) price and total revenue move in opposite directions. If demand is unit elastic (price elasticity coefficient is exactly equal to 1) total revenue is constant when price changes.

Total Revenue and the linear demand curve While the slope of a linear curve is constant, the elasticity is not. Remember, the slope is the ratio of changes in the two variables (p and q) while elasticity is the ratio of percentage changes in the two variables (p and q).

Cross Elasticity of Demand This measures how the quantity demanded of one good changes as the price of another good changes. It is calculated as the % change in QD of good 1 divided by the % change in the P of good 2. (Confused yet?) Cross-price Elasticity of Demand= %change in quantity demanded of good 1 % change in price of good 2

So what the heck does this mean? IF cross elasticity of demand is positive- meaning that sales of good 1 move in the direction of price of good 2, this indicates good 1 and 2 are SUBSTITUTE goods. The larger the cross-elasticity coefficient the greater the substitutability of the two goods. As you can see this gives us a much deeper insight into the determination of demand change.

Continued: what the heck? When cross-elasticity of demand is negative (you will notice that we are NOT using absolute value in cross elasticity) we know that goods 1 and 2 are complementary. The larger the negative coefficient, the more complementary the two goods must be. This is called, and I kid you not, the complementarity of the two goods.

What the heck? Independent goods would be connoted by a zero or near zero coefficient cross elasticity of demand. These are goods where there is no expectation that a change in price of one would cause any change in Q of the other. Cross elastiticy- substitutability is important to business. How does the price change of one brand affect another? Government may also use this to assess mergers. If cross elasticity is high, and substitutability is there, mergers would be less likely.

What? More Heck! Income Elasticity of Demand: measures how the quantity demanded changes as consumer income changes. (This is another determinant of simple demand as I am sure you have already gathered.) It is calculated as the % change in QD divided by the % change in income. Income elasticity of demand= Percentage change in quantity demanded Percentage change in income

Why income elasticity of demand? And I do mean, why? For most goods the income elasticity coefficient Ei is positive, meaning more of them are demanded as incomes rise. Such goods are called normal or superior goods. However, the value of Ei varies greatly among normal goods. Farm products have fairly low values and manufactured goods have relatively high values.

More yet again A negative income elasticity of demand coefficient designates an inferior good. Consumers decrease purchase of these goods as incomes increase, This income elasticity may help to explain the growth and contraction of industries. Growth will tend to go towards highly positive coefficient goods and not towards low coefficient goods.

Supply Elasticity Elasticity in supply will examine the same thing as in demand, that is, the quantitative changes brought about in quantity supplied by change in price. Price elasticity of supply measures this response. Supply of a good is said to be elastic if the QS responds substantially to changes in the P. Supply is said to be inelastic if the QS responds only slightly to changes in P.

Supply elasticity Price elasticity of supply depends on the flexibility of sellers to change the amount of the good they produce. Some goods are relatively inelastic in supply, such as beachfront property. By contrast, manufactured goods tend to have elastic supplies because firms that produce them can run plants longer in response to a higher price. In most markets a key determinant to price elasticity of supply is the TIME PERIOD being considered.

Price Elasticity of Supply In the long run supply is usually more elastic than in the short run. Firms cannot easily change the size of factories or make more or less of a good in the short run. Thus in the short run the quantity supplied is not very responsive to price. In the long run firms can make these changes and supply more, so the quantity supplied can respond more substantially to price change in the long run

P Elasticity of S formulae Pe of S= % ∆ in QS/ % ∆ in P Milk P ↑ from $2.85 to $3.15 per gallon Milk QS ↑ from 9,000 to 11,000 gallons % ∆ in P (3.15-2.85)/3.00 (using midpoint method) x100 = 10 % % ∆ in QS= (11,000-9,000)/10,000 (midpoint method) x 100= 20% Pe of S = 20%/10% =2 so QS moves 2 times as quickly as P increases

From Perfectly Inelastic to Perfectly Elastic Price Elasticity of Supply Perfectly Inelastic Supply: AN increase in price leaves the quantity supplied unchanged. There is a vertical supply curve Inelastic supply: Elasticity coefficient is less than 1. A % change in P leads to a smaller % change in QS Unit Elastic Supply: Elasticity equals exactly 1. A certain % change in P leads to the same % change in QS

Supply Elasticities Elastic Supply: Elasticity is greater than 1. A % increase in P leads to a % increase in QS greater than that of change in price Perfectly Elastic Supply: Elasticity equals infinity. At any price above the supply curve, QS is infinite. At exactly the price of the horizontal supply curve, producers will supply any quantity. At a price below the horizontal supply curve, quantity supplied is zero.

Some other notes about Price Elasticity of Supply Elasticity of the supply curve may or may not be constant depending on the market. For low levels of QS elasticity is usually high or elastic because firms have idle capacity and can respond quickly with more production as a small increase in price makes it profitable to do so. As QS rises, firms reach capacity. Once capacity is fully engaged, increasing production further requires significant outlays to construct new plants. To induce this, price must rise substantially for a reduced increase in QS thus the supply curve becomes more inelastic.