Chapter 5: ELASTICITY

Demand and Total Revenue due to Price Increase Q P gain loss gain loss Q P 00 Total Revenue Increases Total Revenue Decreases D D

Price Elasticity of Demand Price elasticity of demand measures the responsiveness of quantity demanded of a good to a change in its price. Its value is not affected by the choice of units in which quantity is measured Price elasticity of demand measures the responsiveness of quantity demanded of a good to a change in its price. Its value is not affected by the choice of units in which quantity is measured Price Elasticity formula: Price Elasticity formula: Note: By convention we use the average price and the average quantity. Percentage change in quantity demanded of good  XY = Percentage change in price

Calculating the Elasticity of Demand Prices: Original Price 1.00 Po New Price 2.00 P1 Change in price 1.00 dP= P1-Po Average Price 1.50 Pave = (Po+P1)/2 Percentage change in price 66% (dP/Pave)x100 Quantity: Original quantity demanded 10 Q0 New quantity demanded 8 Q1 Change in quantity demanded -2 dQ= Q1-Q0 Average quantity demanded 9 Qave = (Q0+Q1)/2 Percentage change in quantity demanded -22% (dQ/Qave)x100 Elasticity 0.33

Elastic and Inelastic Demand Inelastic : elasticity between zero and one Elastic : elasticity greater than one Unit Elastic : elasticity equal one Perfectly Elastic : elasticity is equal to infinity Perfectly Inelastic : elasticity is equal to zero Determinants of the Size of Elasticity u Substitutability: the ease with which one good can be substituted for another u The proportion of income spent on the good u The significance of price in total cost to the consumer u The amount of time elapsed since the price change

Time Frame of Demand u u Short-run Demand: when the price change is permanent, the quantity bought does not change much in short run. That is short run demand is inelastic. u u Long-run Demand: describes the response of buyers to a change in price after all possible adjustments have been made. Long-run demand is more elastic than short-run demand.

Income Elasticity Indicates the response of demand due to a change in income. Income elasticity of demand is the percentage change in the quantity demanded divided by the percentage change in income. Normal goods: whose income elasticity are positive. Inferior goods:whose income elasticity of demand are negative. Q Income Income elastic, E > 1 Income Q Income inelastic, 0<E < 1 Negative Income Elasticity Q Income

Income Elasticity u u Inelastic Demand Books and newspapers 0.38 Rail transport 0.39 Soft drinks 0.39 Confectionery 0.39 Beer 0.72 u u Elastic Demand Motor vehicles 1.03 Wine and spirits 1.08 Health services 1.20 Electric equipment 1.33 Air transport 1.84

Cross-elasticity of Demand è è It indicates the responsiveness of the quantity demanded of a particular good to the prices of its substitutes and complements. è è It is the percentage change in the quantity demanded of one good divided by the percentage change in the price of another good. Price Cross-Elasticity formula: Price Cross-Elasticity formula:   Percentage change in quantity demanded of one good  XY = Percentage change in price of another good è è The cross elasticity is negative w.r.t the price of a complement and positive w.r.t the price of substitute.

Elasticity of Supply u u It indicates the responsiveness of the quantity supplied to the price of the good. u u Elasticity of supply is the percentage change in the quantity supplied of a good divided by the percentage change in its price. Determinants of Supply Elasticity u The technological conditions governing the production u The amount of time elapsed since the price change

Time Frame for Supply The influence of time elapsed since a price change can be distinguished into: u u Momentary supply: shows the response of the quantity supplied immediately following a price change u u Short-run Supply: shows how the quantity supplied responds to a price change when only some of the technologically possible adjustments to production has been made u u Long-run Supply: shows the response of the quantity supplied to a change in price after all possible technological adjustments have been exploited

Supply Response Quantity P MS SS LS 0