Economics 9th Ed, R.A. Arnold Ch. 17 Elasticity Economics 9th Ed, R.A. Arnold

Elasticity The concept of elasticity is applied to situation swhere we are interested to study the percentage changes of two related variables e.g. P and Qd E.g. a seller may want to know, by what % the quantity demanded will increase if the price of a good decreases by 1 %? This answer is given by the price elasticity of demand

Price Elasticity of Demand, Ed E.g. a tea-seller reduces the price of tea by 10 % and observes that the quantity demanded has increased by 20% Therefore, %∆P = - 10 and %∆Qd = + 20 Ed = - 2 . But we always take the | absolute value | in price elasticity of demand Hence, |Ed| = | - 2 | = 2

Interpretation of our result in last slide: if the tea-seller reduces price by 1% the quantity demanded of tea will increase by 2% This is an example where the demand is elastic; occurs when %∆Qd > %∆P , Ed > 1 . Another example: A rice seller increases the price of rice by 15% and sees that the quantity demanded has fallen by 5 %. Here, %∆Qd = - 5 and %∆P = + 15 Using formula in last slide: | Ed | = |- 0.33 | = 0.33

Interpretation of result in last slide: if the price increases by 1% then the quantity demanded decreases by 0.33% Here, Ed < 1 (occurs when %∆Qd < %∆P) so we say the demand is inelastic If Ed = 1, (occurs when %∆Qd = %∆P). Then we say the demand is unit elastic

There are two other situations/possibilities: Price changes by a very small amount and the quantity demanded changes by a very large amount Using equation (1), Ed = ∞ Here the demand is perfectly elastic The demand is perfectly inelastic when a change in price does not affect the quantity demanded. Hence, % ∆ Qd = 0. Using equation (1) Ed = 0 The next slide summarizes the above discussions

In the next slide we look at the graphical representation of the different types of price elasticities of demand (above)

Application of Price Elasticity of Demand Total Revenue (TR) = Price (P) x Quantity (Q) If, Ed = 5 (elastic demand; Ed > 1), it means if P increases by 1% then Qd will decrease by 5%. Using above equation, TR will decrease. If, P decreases by 1% then Qd will increase by 5%. Using above equation, TR will increase. If, Ed < 1 then inelastic demand. If P increases by 1% then Qd decreases by less than 1%. TR increases. If, P decreases, TR decreases.

Determinants of Price Elasticity of Demand (Ed) Number of substitutes: If a good has many substitutes then Ed will be more as compared to a good which has fewer substitutes. Why? If there are more substitutes then buyers can easily shift to them when the price of a product increases hence Qd changes by a larger % and hence value of Ed will larger (demand more elastic). Necessities versus luxuries: If a good is a necessity (e.g. water), Ed will be less as compared to a good which is a luxury (e.g. grape juice). If the price of a necessity increases then Qd will fall by a small % hence Ed smaller and demand less elastic. Time: As more time passes after the price change, the higher will be the Ed **(End of Quiz 2 Syllabus)**

Other Elasticity Concepts  

P.S. Here we DO NOT take the absolute value because the sign (+ or -) gives us valuable info. In the example last slide, the quantity demanded of a good and the price of a substitute are directly (positively related). So, Ec > 0 i.e. positive for substitutes The higher the Ec, the closer the substitutes (the better the substitutes). Why? Think about this. And negative i.e. Ec < 0 for complements. The quantity demanded of a good and the price of complements are negatively related. If one increases the other decreases.

 

 

The Relationship Between Taxes and Elasticity

In figure, Gov is taxing $1 per DVD sold In figure, Gov is taxing $1 per DVD sold. Remember: If the demand is less elastic (more inelastic) the D curve will become steeper (more vertical). You should do the graphical analysis as an exercise. You will see that the consumer ends up paying more of the tax. When demand is perfectly inelastic the consumer/ buyer pays all of the tax.