1. Topic 3 Elasticity Topic 3 Elasticity

2. Elasticity a Fancy Term  Elasticity is a fancy term for a simple concept  Whenever you see the word elasticity, you can conveniently replace it with responsiveness or sensitivity  Recall the law of demand  It stated, when price rises quantity demanded falls and vice versa  But, by how much the quantity demanded falls?  Elasticity deals with this how much (magnitude) question 2

3. Elasticity of Demand  For the purpose of elasticity, you may think of  Law of demand as a cause and effect relationship, where,  Price as the cause  Quantity demanded as the effect  Therefore, one can ask,  Is the effect responsive to the cause?  Is the quantity demanded responsive to price change?  Is the quantity demanded elastic to price change? 3

4. Elasticity of Demand  Consider that  Price rises 5%. As a result Quantity Demanded falls (the law of demand, here) by 10%.  In this case, decline in Quantity demanded is larger than increase in price in percentage term.  Which means, effect (response) is higher than the cause.  This makes the demand very responsive  We call it demand is elastic 4

5. Elasticity of Supply  Again consider that  Price rises 5%. As a result Quantity Supplied rises (the law of supply, here) by 4%.  In this case, rise in Quantity Supplied is smaller than increase in price in percentage term.  Which means, effect (response) is smaller than the cause.  This makes the supply very irresponsive  We call it supply is Inelastic 5

6. Elasticity Coefficient  Elasticity is computed using simple formula  Take the demand for example. We have:  Elasticity of Demand formula is: E d = % change in quantity demanded % change in price = -10/5 (% △ effect / % △ cause) = -2 6 Change in Price (Cause) Percentage change in Quantity Demanded (Effect) 5%10%

7. Elasticity of Demand  E d = -2 is called Price elasticity of Demand  Note, this is not same as Slope (rise over run) of the demand curve  How about elastic or Inelastic?  We already know demand is elastic. Quantity response is larger than price change in percentage term.  This is clear from the value of E d  E d = -2, means that change in quantity demanded (response) is twice as large as price change (cause) in percentage terms 7

8. Elasticity of Demand  Assume that E d = 1  Is it Elastic or Inelastic?  What can we say about the cause and effect in this case?  Recall Elasticity = % △ effect / % △ cause E d = % △ Quantity demanded / % △ Price =>1 = % △ Quantity demanded / % △ Price => % △ Price= % △ Quantity demanded => We call the demand is Unit Elastic 8

9. Elasticity of Demand  What if the E d =.8  Is it Elastic or Inelastic?  What can we say about the cause and effect in this case?  Recall Elasticity = % △ effect / % △ cause E d = % △ Quantity demanded / % △ Price => 8/10 = % △ Quantity demanded / % △ Price => 10% △ Price => 8% △ Quantity demanded => We call the demand is Inelastic 9

10. Elasticity of Demand  Rule for assigning elasticity: Here |E d | is the Absolute value of E d  The Absolute value takes care of the  Negative sign for demand or  Positive sign for supply curve  The signs convey important information about the relationship. But nothing about determining elastic or inelastic 10 Value of |E d |ElasticityReason More than 1ElasticEffect is larger than Cause Equal to 1Unit ElasticEffect is equal Cause Less than 1InelasticEffect is smaller than Cause

11. Elasticity of Demand How to compute % change  We will use midpoint formula. The elasticity computed using this formula is called ARC elasticity  Consider following data  Compute percentage in price and quantity demanded 11 PriceQuantity Demanded P 1 = 6Q 1 = 100 P 2 = 2Q 2 = 500

12. How to Compute Price Elasticity  According to the midpoint formula: % △ in Q d = [ △ Q d / Average Q d ]*100 % △ in Price = [ △ P / Average P]*100 % △ in Q d = [(500-100)/300]*100 = (4/3)*100 % △ in Price = [(2-6)/4]*100 = (-4/4)*100 E d = % △ Quantity demanded / % △ Price = (4/3)*100/-(4/4)*100 = (4/3)/-(1) = -4/3 12 PriceQuantity Demanded P 1 = 6Q 1 = 100 P 2 = 2Q 2 = 500

13. How to Compute Price Elasticity To compute price elasticity of demand,  Find the absolute values of E d or |E d |  If |E d | is more than 1, the demand is Elastic  If |E d | is less than 1, the demand is Inelastic  If |E d | is equal to 1, the demand is Unit elastic 13

14. Elasticity and Total Revenue  Total Revenue is price times number of output sold or TR = P * Q  when P rises TR also rises, ceteris paribus  However, P and Q are negatively related through the law of demand  Therefore, when P rises, there is no guarantee that TR will also rise  What will happen to TR depends on whether increase in P is larger or smaller than decrease in Q in percentage terms 14

15. Elasticity and Total Revenue  For example, if price is increased by 5% and as a result quantity demanded falls by 10%, we know that demand is elastic  What will happen to TR in this case?  You are right, TR will fall  This is because, impact of quantity decline dominates the impact of price increase forcing TR to fall  In summary,  If P↑ and demand is elastic TR↓  If P↑ and TR↓ demand is elastic 15

16. Elasticity and Total Revenue  Consider another example, if price is increased by 5% and as a result quantity demanded falls by 2%, we know that demand is inelastic  What will happen to TR in this case?  You are right, TR will rise  This is because, impact of price increase dominates the impact of quantity decline forcing TR to rise  In summary,  If P↑ and demand is inelastic TR↑  If P↑ and TR↑ demand is inelastic 16

17. Price Elastic An increase in price... reduces total revenue. A reduction in price... Increases total revenue. Total revenue moves in the direction of quantity change Price Inelastic An increase in price… Increases total revenue. A reduction in price… Reduces total revenue. Total revenue moves in the direction of price change Unit price Elastic An increase in price… No change in total revenue. A reduction in price… No change in total revenue. Total revenue does not change with price Price Elasticity of Demand and Changes in Total Revenue

18. Responsiveness and Demand A B Movement from Point A to B Price falls by $.10 Quantity rises by 20,000 rides Movement from Point A to B Price falls by $.10 Quantity rises by 20,000 rides 18 TR before (.8 * 40,000) 16,000 TR after (.7 * 60,000) 42,000 TR is rising with Price TR before (.8 * 40,000) 16,000 TR after (.7 * 60,000) 42,000 TR is rising with Price Is the Demand elastic or inelastic in this region? Elastic

19. Responsiveness and Demand A B Movement from Point A to B Price falls by $.10 Quantity rises by 20,000 rides Movement from Point A to B Price falls by $.10 Quantity rises by 20,000 rides 19 TR before (.4 * 120,000) 48,000 TR after (.3 * 140,000) 42,000 TR is falling with Price TR before (.4 * 120,000) 48,000 TR after (.3 * 140,000) 42,000 TR is falling with Price Is the Demand elastic or inelastic in this region? Inelastic

20. Price Elasticity Along a Linear Demand Curve e D = -.33 e D = -1.00 e D = -3.00 20

21. Elasticity and the TR Curve 012345678 012345678 Quantity Demanded Price Total Revenue (Thousands of Dollars) $20 18 16 14 12 10 8 6 4 2 $8 7 6 5 4 3 2 1 a b c d e f g h Elastic E d > 1 Unit Elastic E d = 1 Inelastic E d < 1 D TR

22. Constant Price Elasticity of Demand Curves  Perfectly Inelastic (Insensitive to price changes) Refers to a situation in which the price elasticity of demand is zero |E d | = 0  Perfectly Elastic (Sensitive to price changes) Refers to a situation in which the price elasticity of demand is infinite |E d | = ∞ 22

23. Demand Curves with Constant Price Elasticity E d =0 E d =∞ E d =-1 E d =-.5

24. Determinants of the Price Elasticity of Demand  Availability of substitutes  If there are lots of close substitute goods to choose from consumers can switch easily  Importance in household budgets  Price of good relative to income  Luxuries versus Necessity  Luxuries are more elastic  Time  In the short run it is often difficult to find substitutes.

25. Income Elasticity of Demand  Income elasticity of demand is the percentage change in quantity demanded at a specific price divided by the percentage change in income that produced the demand change, all other things unchanged. 25

26. Normal Good (DVD’s) An increase in income… Increases demand. A decrease in income… Decreases demand. Inferior Good (Used clothing) An increase in income… Decreases demand. A decrease in income… Increases demand. Income Elasticity of Demand

27. Price Elasticity of Supply  Price elasticity of Supply is the ratio of the percentage change in quantity supplied of a good or service to the percentage change in its price, all other things unchanged. 27

28. Cross Price Elasticity of Demand  Cross price elasticity of demand is the percentage change in the quantity demanded of one good or service at a specific price divided by the percentage change in the price of a related good or service. 28

29. Time: An Important Determinant of the Elasticity of Supply  In the short run supply is likely to be inelastic  In the long run supply is likely to be more elastic 29

30. Price Elasticity of Supply In Short Run, supply tends to be Inelastic P Q D1D1 D2D2 SsSs Q0Q0 P1P1 P0P0 Q1Q1 % △ Q < % △ P → Inelastic P Q D1D1 D2D2 SlSl Q0Q0 PlPl P0P0 QlQl In Long Run, supply tends to be more Elastic % △ Q > % △ P → Elastic

31. Selected Elasticity Estimates 31

32. Selected Elasticity Estimates 32