Elasticity

Elasticity measures how sensitive one variable is to a change in another variable. –Measured in terms of percentage changes, elasticity tells us if a change in one variable causes a lesser, equal, or greater change in another variable.

Elasticity of Demand Elasticity of demand is a measure of responsiveness between quantity demanded and the price of the good. –It is defined as: e = % Change in Quantity Demanded % Change in Price e = (Q 1 - Q 2 )/((Q 1 + Q 2 )/2) (P 1 - P 2 )/((P 1 + P 2 )/2)

Elasticity of Demand P P Q 0 D a b What is the elasticity of demand? (50-30)/((50+30)/2) (10-12)/((10+12)/2) (20/80)/(-2/22) 0.25/ = = =

Types of Elasticity Demand may be elastic, inelastic, or unit elastic. –When demand is inelastic, a 1% change in price causes a change in quantity demanded that is less than 1%. –When demand is elastic, a 1% change in price causes a change in quantity demanded that is greater than 1%. –When demand is unit elastic, a 1% change in price causes a change in quantity demanded that is equal to 1%.

Types of Elasticity Elastic Demand Inelastic Demand Unit Elastic Demand PPP QQQ e > 1e = 1e < 1 000

Importance of Elasticity The concept of demand elasticity is important to businesses because depending on the elasticity of demand, total revenue can rise, fall or remain constant when firms change prices.

Total Revenue and the Law of Demand The law of demand states that as price rises quantity demanded falls and as price falls quantity demanded rises. –An increase in price increases total revenue if price rises by more than quantity demanded falls. –A decrease in price decreases total revenue if price falls by more than quantity demanded rises.

Elasticity and Total Revenue Case 1: Unit Elasticity –A 1% change in price causes a 1% change in quantity demanded. Price increases by 1% quantity demanded decreases by 1% total revenue does not change. Price decreases by 1% quantity demanded increases by 1% total revenue does not change. When demand is unit elastic, changes in price do not change total revenue.

Elasticity and Total Revenue Case 1: Inelastic Demand –A 1% change in price causes a less than 1% change in quantity demanded. Price increases by 1% quantity demanded decreases by less than 1% total revenue increases Price decreases by 1% quantity demanded increases by less than 1% total revenue decreases. –When demand inelastic, total revenue and price change in the same direction.

Elasticity and Total Revenue Case 1: Elastic Demand –A 1% change in price causes a greater than 1% change in quantity demanded. Price increases by 1% quantity demanded decreases by more than 1% total revenue decreases. Price decreases by 1% quantity demanded increases by more than 1% total revenue increases. When demand is elastic, total revenue and price change in opposite directions.

Determinants of Demand Elasticity Nature of the goods –Necessities tend to be inelastic. Luxuries tend to be elastic. Availability of good substitutes –As the quantity and quality of substitutes increase, elasticity increases. The price of the good relative to income. –Goods with low (high) prices relative to income tend to be inelastic (elastic). Time –Elasticity increases over time.

Elasticity of Supply Elasticity of supply is a measure of responsiveness between quantity supplied and the price of the good. –It is defined as: e = % Change in Quantity Supplied % Change in Price e = Q 1 – Q 2 /((Q 1 + Q 2 )/2) P 1 – P 2 /((P 1 + P 2 )/2)

Types of Elasticity Supply may be elastic, inelastic or unit elastic. –When supply is inelastic, a 1% change in price causes a change in quantity supplied that is less than 1%. –When supply is elastic, a 1% change in price causes a change in quantity supplied that is greater than 1%. –When supply is unit elastic, a 1% change in price causes a change in quantity supplied that is equal to 1%.

Types of Elasticity Unit Elastic Elastic Inelastic PPP QQQ e = 1e < 1e > 1 000

Determinants of Supply Elasticity Substitutability of resources –The greater (smaller) the degree of substitutability, the larger (smaller) the potential increase in quantity supplied, and the greater (smaller) the supply elasticity. An increase in price leads to an increase in quantity supplied. –An increase in quantity supplied requires more resources. –If it is easy to shift resources from other uses, quantity supplied can increase by larger amounts.

Determinants of Supply Elasticity Time –As time passes, more resources can be shifted from one activity to another. –This greater access to resources increases quantity supplied and the elasticity of supply.