1. ELASTICITY
Dr. Michelle Commosioung

2. Elasticity – the concept
The responsiveness of one variable to changes in another
When price rises, what happens to demand?
Demand falls
BUT!
How much does demand fall? 2

3. Elasticity – the concept
If price rises by 10% - what happens to demand?
We know demand will fall
By more than 10%?
By less than 10%?
Elasticity measures the extent to which demand will change 3

4. Importance of Elasticity
Relationship between changes in price and total revenue
Importance in determining what goods to tax (tax revenue)
Importance in analysing time lags in production
Influences the behaviour of a firm
This slide also has an automatic response with ten second gaps in between each point. At this stage we have tried to keep things as simple as possible but to introduce issues that will be dealt with later in the course. 4

5. Determinants of Elasticity
Number and closeness of substitutes – the greater the number of substitutes, the more elastic
The proportion of income taken up by the product – the smaller the proportion the more inelastic
Time period – the longer the time under consideration the more elastic a good is likely to be
Luxury or Necessity - for example, addictive drugs 5

6. Elasticity 4 basic types used: Price elasticity of demand
Price elasticity of supply
Income elasticity of demand
Cross price elasticity 6

7. Infinitely elastic demandP
Infinitely elastic demand a b P1 D Q2 O Q1 Q 7

8. Totally inelastic demandP
Totally inelastic demand D P2 b P1 a O Q1 Q 8

9. Unit elastic demand a b D P 20 100 8 O 40 Q This demand curve is known
as a rectangular hyperbola.
Notice that TR is the same at
points a and b (800) a 20 b
100 8 D O 40 Q 9

10. Elasticity Price (J$) Quantity Demanded
The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded.
Quantity Demanded 10

11. Elasticity Price Elasticity of Demand
The responsiveness of demand to changes in price
The Formula:
% Change in Quantity Demanded
Ped =
___________________________
% Change in Price 11

12. Where % change in demand is greater than % change in price – elastic
Where % change in demand is less than % change in price - inelastic

13. CALCULATING ELASTICITIES
CALCULATING PERCENTAGE CHANGES
To calculate percentage change in quantity demanded using the initial value as the base, the following formula is used:

14. CALCULATING ELASTICITIES
We can calculate the percentage change in price in a similar way. Once again, let us use the initial value of P—that is, P1—as the base for calculating the percentage. By using P1 as the base, the formula for calculating the percentage of change in P is simply:

15. CALCULATING ELASTICITIES
ELASTICITY IS A RATIO OF PERCENTAGES
Once all the changes in quantity demanded and price have been converted into percentages, calculating elasticity is a matter of simple division. Recall the formal definition of elasticity:

16. Product Price Elasticity of demand Food 0.21 Medical Services 0.22
Housing
Rental
Owner Occupied 1.20
Electricity
Cars
Beer
Wine
Cigarettes
Transatlantic air travel 1.30
Imports
Source: W.Nicholson, Microeconomic Theory:
Basic Principles and extensions, 7th edition, p.230 16

17. 17

18. 18

19. 19

20. Importance of Price Elasticity of Demand to Business Decision-Making
Total revenue is price x quantity sold. In this example, TR = $5 x 100,000 = $500,000.
This value is represented by the grey shaded rectangle.
The importance of elasticity is the information it provides on the effect on total revenue of changes in price. $5
Total Revenue D
100
Quantity Demanded (000s) 20

21. Elasticity D Total Revenue Price $5 $3 100 140
If the firm decides to decrease price to (say) $3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue. $5 $3
Total Revenue D
100
140
Quantity Demanded (000s) 21

22. Elasticity % Δ Price = 50% % Δ Quantity Demanded = 20%
Producer decides to lower price to attract sales 10
% Δ Price = 50%
% Δ Quantity Demanded = 20%
Ped = 0.4 (Inelastic)
Total Revenue would fall 5
Not a good move! D 5 6
Quantity Demanded 22

23. Elasticity Producer decides to reduce price to increase sales
% Δ in Price = 30%
% Δ in Demand = 300%
Ped = 10 (Elastic)
Total Revenue rises 10
Good Move! 7 D 5 20
Quantity Demanded 23

24. Elasticity If demand is price elastic:
Increasing price would reduce TR
Reducing price would increase TR
If demand is price inelastic:
Increasing price would increase TR
Reducing price would reduce TR 24

25. Elasticity Income Elasticity of Demand:
Measures the responsiveness of demand to changes in income 25

26. EM= % Qd = 60 % = 1.8 % M 33.3% E>1 normal good E E<1
inferior good 26

27. Income elasticity of demand is an important concept to firms considering the future size of the market for their product
(e.g. if national income rises or if the economy moves into recession) 27

28. Product Income Elasticity of demand Food 0.28 Medical Services 0.22
Housing
Rental
Owner Occupied 1.20
Electricity
Cars
Beer
Wine
Cigarettes
Transatlantic air travel 1.40
Imports
Source: W.Nicholson, Microeconomic Theory:
Basic Principles and extensions, 7th edition, p.230 28

29. Elasticity Cross-price (or simply Cross Elasticity):
Measures the responsiveness of demand of one good to changes in the price of a related good – either a substitute or a complement
% Δ Qd of good t
__________________
Xed =
% Δ Price of good y 29

30. In other words, cross-price elasticity enables us to predict how much demand for one product will shift when the price of a second product changes
(e.g. the cross price elasticity of demand for Coca-Cola to the price of Pepsi) 30

31. Elasticity Goods which are complements: Goods which are substitutes:
Cross Elasticity will have negative sign (inverse relationship between the two)
Goods which are substitutes:
Cross Elasticity will have a positive sign (positive relationship between the two) 31

32. Elasticity Price Elasticity of Supply:
Measures the responsiveness of supply to changes in price
If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price
If Pes is elastic – supply can react quickly to changes in price
% Δ Quantity Supplied
____________________
Pes =
% Δ Price 32

33. (in millions of bars per day)
Price of a
chocolate bar
P(in cents) 40 80
120
160
200
240 10 20 30 50 60 70
100% A G S
66/%
Quantity of chocolate
bars supplied Q
(in millions of bars per day) s 33

34. E Q P 100% 66 6% 1 5  % .  s Price Elasticity of Supply is Elastic
100% 66 6% 1 5  % . 
Price Elasticity of Supply is Elastic 34

35. Supply is Elastic if firms have:
Plenty of spare capacity
Can readily get extra supplies of raw materials
Can switch away from producing one good to the next

36. Price Elasticity of Supply is affected by:
The amount that costs rise as output rises
Hence, the cheaper it is to produce additional output, the more firms will be encouraged to produce for a given price rise, that is, Supply will become more Elastic.
Time period
Both consumers and producers take time to respond to a change in price. The longer the time period, the greater the response, that is, the greater the elasticity of supply or demand.

37. 37

38. The Time Dimension of Market Adjustment
Short-run and long-run price adjustment
short and long-run demand and supply curves 13 38

39. Supply in different time periodsa D1 O Q1 Q 39

40. Supply in different time periodsa D2 D1 O Q1 Q 40

41. Supply in different time periodsSi b P2 P1 a D2 D1 O Q1 Q 41

42. Supply in different time periodsSi SS b P2 c P3 Q3 P1 a D2 D1 O Q1 Q 42

43. Supply in different time periodsSi SS b P2 c SL P3 d P4 Q4 P1 a D2 D1 O Q1 Q3 Q 43

44. Response of demand to an increase in supplyQ1 Q 44

45. Response of demand to an increase in supplyQ1 Q 45

46. Response of demand to an increase in supplyb
D short-run O Q1 Q2 Q 46

47. Response of demand to an increase in supply
Demand is more elastic in the long run. P1 c P3 P2 b
D long-run
D short-run Q1 Q2 Q3 O Q 47

48. PRICE ELASTICITY OF DEMAND
A good way to remember the difference between the two “perfect” elasticities is:

49. Applications to business
importance of perceptions of the product
repositioning a product
effects of changes in competitors' pricing strategy
strategies to make a product less cross-price elastic 11 49

50. Elasticity – Mind Map