Elasticity and Its Application Chapter 5 1 1

Elasticity . . . … is a measure of how much buyers and sellers respond to changes in market conditions … allows us to analyze supply and demand with greater precision. 2 2

Price Elasticity of Demand Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price. It is a measure of how much the quantity demanded of a good responds to a change in the price of that good. 5 4

Computing the Price Elasticity of Demand The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. Price Elasticity = Percentage Change in Qd Of Demand Percentage Change in Price 10 16

Elasticity, Percentage Change and Slope Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve. But instead of looking at unit change, elasticity looks at percentage change. What do we mean by percentage change? Slope of demand curve = ∆p/∆q = 1/ ∆q/∆p On the other hand, the price elasticity of demand is concerned with relative changes in price and quantity, that is,Ep = ∆ q/q / ∆ p/p So elasticity = 1/ slope X p/ q 7 7

Computing the Price Elasticity of Demand Example: If the price of an ice cream cone increases from $2.00 to $2.20 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 Using the Midpoint Formula The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change. 10 16

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

Price Elasticity Regions along a Straight-Line Demand Curve Observation Price elasticity varies at every point along a straight-line demand curve b/2 a/2 a b Price Quantity NCCU 2006

Ranges of Elasticity Inelastic Demand Percentage change in price is greater than percentage change in quantity demand. Price elasticity of demand is less than one. (-1 < Ed < 0), Elastic Demand Percentage change in quantity demand is greater than percentage change in price. Price elasticity of demand is greater than one. ( -∞ < Ed < -1) perfectly inelastic changes in the price do not affect the quantity demanded for the good , Ed =0 unit (or unitary) elastic (Ed = -1), the percentage change in quantity demanded is equal to that in price perfectly elastic (Ed is − ∞), any increase in the price, no matter how small, will cause the quantity demanded for the good to drop to zero 6 5

Perfectly Inelastic Demand - Elasticity equals 0 Price Demand 100 $5 1. An increase in price... 4 Quantity 2. ...leaves the quantity demanded unchanged. 7 8

Inelastic Demand - Elasticity is less than 1 Price Demand $5 1. A 25% increase in price... 90 4 100 2. ...leads to a 10% decrease in quantity. Quantity 7 8

Unit Elastic Demand - Elasticity equals 1 Price Demand $5 1. A 25% increase in price... 75 4 100 2. ...leads to a 25% decrease in quantity. Quantity 7 8

Elastic Demand - Elasticity is greater than 1 Price Demand $5 1. A 25% increase in price... 50 4 100 2. ...leads to a 50% decrease in quantity. Quantity 7 8

Perfectly Elastic Demand - Elasticity equals infinity Price 1. At any price above $4, quantity demanded is zero. Demand $4 2. At exactly $4, consumers will buy any quantity. 3. At a price below $4, quantity demanded is infinite. Quantity 7 8

Determinants of Price Elasticity of Demand Necessities versus Luxuries: The more necessary a good is, the lower the elasticity, as people will attempt to buy it no matter the price, such as the case of insulin for those who need it Availability of Close Substitutes: The more and closer the substitutes available, the higher the elasticity is likely to be, as people can easily switch from one good to another if an even minor price change is made Level of income : as income level increase elasticity decrease as consumer will be careless for price change Percentage of income: The higher the percentage of the consumer's income that the product's price represents, the higher the elasticity tends to be, as people will pay more attention when purchasing the good because of its cost Time Horizon: For most goods, the longer a price change holds, the higher the elasticity is likely to be, as more and more consumers find they have the time and inclination to search for substitutes 8 13

Elasticity and Total Revenue Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold. TR = P x Q 15 21

Elasticity and Total Revenue Price $4 P x Q = $400 (total revenue) P Demand 100 Quantity Q 15 22

Generally any change in price will have two effects: The price effect: For inelastic goods, an increase in unit price will tend to increase revenue, while a decrease in price will tend to decrease revenue. (The effect is reversed for elastic goods.) The quantity effect: An increase in unit price will tend to lead to fewer units sold, while a decrease in unit price will tend to lead to more units sold.

The Total Revenue Test for Elasticity Increase in Total Revenue Decrease in Total Revenue Increase in Price INELASTIC DEMAND ELASTIC DEMAND Decrease in Price ELASTIC DEMAND INELASTIC DEMAND

The relation between marginal revenue and elasticity:

Monopoly market and elasticity: For monopoly producer it more profitable to produce until point of unit elasticity as total revenue reach its maximum , but that at case cost is zero. But as we get cost into analysis to maximize profit marginal revenue must be equal marginal cost and that happen at elastic erea , as if we choice to produce at unit elastic point MC will be higher than MR, that mean firm achieve loss.

Income Elasticity of Demand Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income. 19 29

Computing Income Elasticity of Demand Percentage Change in Quantity Demanded in Income = 20 31

Income Elasticity - Types of Goods - Normal Goods Income Elasticity is positive. Inferior Goods Income Elasticity is negative. Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. 21 32

Cross Price Elasticity of Demand Elasticity measure that looks at the impact a change in the price of one good has on the demand of another good. % change in demand Q1/% change in price of Q2. Positive-Substitutes Negative-Complements.

What is Elasticity of Supply? Price elasticity of supply measures the relationship between change in quantity supplied and a change in price. In other words, it measures the amount supply changes when price changes. If it is said to be INELASTIC, there will be a small change in supply due to a large price change. Supply does not change much when the price changes. If it is said to be ELASTIC, there will be a large change in supply due to a small price change. Supply changes a lot when price changes.

Factors That Determine Elasticity of Supply Spare Capacity Stocks Ease of Factor Substitution Time Period SPARE CAPACITY How much spare capacity a firm has - if there is plenty of spare capacity, the firm should be able to increase output quite quickly without a rise in costs and therefore supply will be elastic STOCKS The level of stocks or inventories - if stocks of raw materials, components and finished products are high then the firm is able to respond to a change in demand quickly by supplying these stocks onto the market - supply will be elastic EASE OF FACTOR SUBSTITUTION Consider the sudden and dramatic increase in demand for petrol canisters during the recent fuel shortage. Could manufacturers of cool-boxes or producers of other types of canister have switched their production processes quickly and easily to meet the high demand for fuel containers? If capital and labour resources are occupationally mobile then the elasticity of supply for a product is likely to be higher than if capital equipment and labour cannot easily be switched and the production process is fairly inflexible in response to changes in the pattern of demand for goods and services. TIME PERIOD Supply is likely to be more elastic, the longer the time period a firm has to adjust its production. In the short run, the firm may not be able to change its factor inputs. In some agricultural industries the supply is fixed and determined by planting decisions made months before, and climatic conditions, which affect the production, yield. Economists sometimes refer to the momentary time period - a time period that is short enough for supply to be fixed i.e. supply cannot respond at all to a change in demand.

So how do I know if it is Elastic or Inelastic? Economists use a formula to determine the elasticity of supply Percentage change in quantity supplied Percentage change in price = X If X>1, the product is elastic, meaning the If X<1, the product is inelastic, meaning the In graphical terms it would mean…

Elastic Graph of Supply Price $$ Supply 5 4 20 50 Quantity of Supply

Inelastic Graph of Supply Price $$ 10 5 10 12

Examples of Inelastic Petrol (gas) – The amount of petrol supplied would not change much when the price of petrol changes, therefore it is inelastic. Tickets (to a concert/sports match) – Tickets are printed in a fixed amount (there are only so many seats available), so no matter how much the price changes, the amount supplied should always stay the same. Tickets would be inelastic.

Elastic Products Clothes – If the price of certain clothes drop, then the production (and therefore supply) of those clothes will drop too. Clothes would be elastic. Electronic goods (games, cameras, etc.) – If the price of a certain electronic, say, a games console were to drop, then production of the games console would drop too. Electronic goods = elastic.