Elasticity & case studies 1- Price elasticity of demand

 1- What is Ed?  2- How to calculate Ed?  3- Different values of Ed & shapes of Demand curves.  4- Relation between changes in price, changes in revenues & Ed.  5- What determines Ed?

What is Ed?  It is a measure that shows how the % change in quantity demanded of a product RESPONDS to the % change in the price of the product itself, other factors being constant.

How to measure Ed?  Ed= % change in Qdx / % change in Px  Ed=change in Q/change in P. P/Q  Example: If the quantity demanded of a certain product increased by 80% when its price fell by 20%, calculate Ed. What does the value show?  Ed=+80%/-20%= -4(every 1% change in P yields 4% in Q, in the inverse direction)

Another example  Calculate Ed from the following table using the point elasticity of demand, the original situation was ( A):  P Q  A)  B)  Ed= 40/ /100=-4( notice that addressing the absolute value, Ed is more than unity, ie % change in Q RESPONDS GREATLY to % change in P.

3-Different values of Ed & shapes of demand curves  1-Ed might be Zero.Demand is PERFECTLY INELASTIC  Meaning: Qd does not respond whatsoever to P changes. The Qd remains constant, regardless of price changes.  Example: Vital necessities with no substitutes.  Demand curve is vertical as seen in the following diagram:

Shape of PERFECTLY INELASTIC Demand curve: It is vertical:

2-Ed= infinity  Demand for the product is perfectly elastic.  Meaning: consumers are ready to buy an infinite quantity at a certain price & none at all at a slightly higher price.  Example: Very luxurious products with endless number of substitutes( the product is not important whatsoever for the consumer  Demand curve will be horizontal as follows:

Shape of a perfectly elastic demand curve.  It is horizontal:

3-Ed=1  Demand is of unit elasticity.  Meaning:% change in Qd =% change in P  Demand curve takes shape of a rectangular hyperbola( area under the curve which reflects REVENUE is always constant) as follows:

A demand curve of unit elasticity  Revenues are always constant under the curve:

4- Ed is more than unity(Demand is elastic)  Meaning: % change in Q exceeds % change in P  Example: when price rises by 10%, Quantity falls & responds greatly, by 50%( Ed =- 5, as an absolute value Ed is more than 1.  It is the case of a product that has many substitutes & is not important to the consumer.  Demand curve is relatively flat( versus the following fifth last case). The diagram is as follows:

A relatively elastic demand curve

5-Ed is less than unity. Demand is inelastic  Meaning: % change in Q is less than the % change in P.  Example: When price rises by 10%, Quantity demanded falls slightly by 2%. Thus the value of Ed is ( less than one, as an absolute value).  Real case study: it might be a necessary product to the consumer, & it had few substitutes. The demand curve will be relatively steep versus the previous case.

Demand curve that is relatively inelastic:

5- Relation between changes in price, changes in revenues & Ed.  Definitely total revenue is just equal to total spending ( P. Q)  If demand for the product is elastic( eg. When price falls by 10%, quantity demanded increases greatly, by 50% for instance, thus offsetting the decrease in price & total revenue increases. Thus if demand is elastic, seller should lower the price to boost revenues.

 This can be seen from the following diagram:

 If demand for the product is inelastic ( eg when price rises by 20%, quantity demanded falls slightly by 5%, for instance, thus price change offsets quantity change & total revenues increase.  Thus, if demand is inelastic it is for the benefit of the seller to increase the price to receive more of a revenue.

 The following diagram shows the previous case;

 If demand for the product is of unit elasticity( eg. A fall in price by 10% is offset by an increase in quantity by 10%, thus leaving revenues constant.) This can be seen in the following diagram:

 The diagram shows that the total revenue ( Or total spending from consumer’s side is constant regardless of price changes.

5- What determines Ed?  Main determinants are:  The more important & necessary the product is, the less the elasticity.( demand is inelastic for necessities & elastic for products that are not important for the consumer).  The more the number of substitutes, the more the elasticity( the demand is elastic for a product with many substitutes & inelastic in case of few substitutes).  The longer the time period, the more the elasticity.

Cases to comment on:  1- TWA company was seeking to maximize revenues. Top managers advised the company to increase the prices of the VIP class & to decrease the prices of the economy class on the same flight.  2-Directly after the October War in 1973, many Arab countries were able to maximize petroleum revenues as the price per barrel increased by 4 fold. However, afterwards, the foreign importing  countries set strategies to confront the unfavorable supply shock.

 3- The prices of some goods seem to fluctuate more than others as a result of a decrease in supply, prove that the price elasticity of demand is behind such price fluctuations.  HINT : the less the elasticity the more the price fluctuations.

Price Elasticity of Supply  1- What is Es?  2- How to measure Es?  3- different values of Es & shapes of Supply curves.  4- what determines Es?

1-What is Es?  Es is a measure that shows how % change in quantity supplied of the product RESPONDS to the % change in the price of the product, other factors being constant.

2-How to measure Es?  Es= % change in Qs/ % change in price.  Es= change in Qs/change in P. P/Q  Eg. Calculate Es if you know that the quantity supplied of a product increased by 40% when its price increased by 10%.  Answer: Es = =40%/=10%=4( every 1% change in price yields 4% changes in qs( in the same direction)

Calculate Es from the following table using point elasticity of supply  Assume that A) is the original situation:  P Qs  A)  B)  Es= 800/50.10/100= 1.6( more than 1, thus supply is elastic)

3- Different values of Es & shapes of Supply curves  1- Es= zero ( Supply is perfectly inelastic)  Meaning: Qs is constant regardless of price changes, eg. Crop with no inventories in the very short run.  Supply curve is vertical as following:

 Supply curve that is perfectly inelastic:

2- Es= infinity( supply is perfectly elastic)  Meaning EG. Suppliers supply all they can at a certain price & none at a slightly lower price.  Supply curve is horizontal as following:

3-Es=1 ( supply is of unit elasticity)  Meaning :% change in Qs=% change in P  Supply curve originates from the origin ( or its extension starts from the origin) as:

4- ES is more than 1( supply is elastic)  Meaning :% change in Qs exceeds % change in P. The supply curve is relatively flat versus the coming last case, it intersects the horizontal axis) as:

5- Es is less than 1( supply is inelastic)  Meaning: % change in Qs is less than % change in P. Supplier CANNOT respond GREATLY to the price signals. Supply curve is relatively steep versus the previous case, it intersects the horizontal axis as:

4- what determines Es?  1- The more efficient & sufficient the resources are the more the elasticity.  2- The longer the period of time, elasticity usually increases