concept of-elasticity-2015

ECON2: GEN . ECONOMICS WITH TARCONCEPT OF ELASTICITY

Elasticity . . .

• … allows us to analyze supply and demand with greater precision.

• … is a measure of how much buyers and sellers respond to changes in market conditions

THE ELASTICITY OF DEMAND

• Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

• Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.

Degree of Price Elasticity of Demand

• Elastic Demand• Quantity demanded responds strongly to changes in

price.• Price elasticity of demand is greater than one.

• Inelastic Demand• Quantity demanded does not respond strongly to

price changes.• Price elasticity of demand is less than one.

Degree of Price Elasticity of Demand• Unitary Elastic

• Quantity demanded changes by the same percentage as the price.

• This means that a change in price is equal to a change in quantity demanded

• Elasticity coefficient is equal to one

The Price Elasticity of Demand and Its Determinants

• Availability of Close Substitutes• Necessities versus Luxuries• Definition of the Market• Time Horizon

Availability of Close Substitutes

• Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others.

• For example, butter and margarine are easily susbtitutable.

Necessities versus Luxuries

• Necessities tend to have inelastic demands, whereas luxuries have elastic demands.

Definition of the Market

• Narrowly defined markets tend to have more elastic demand than broadly defined markets because it is easier to find close substitutes for narrowly defined goods

Time Horizon

• Goods tend to have more elastic demand over longer time horizons.

The Price Elasticity of Demand and Its Determinants

• Demand tends to be more elastic :• the larger the number of close substitutes.• if the good is a luxury.• the more narrowly defined the market.• the longer the time period.

Computing the Price Elasticity of Demand

• The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.

P rice e las tic ity o f d em an d = P ercen tag e ch an g e in q u an tity dem an d edP ercen tag e ch an g e in p rice

Computing the Price Elasticity of Demand

Where;Percentage change in qty. Demanded

=Q2-Q1/Q1Percentage change in Price

= P2-P1/P1Therefore;

ep=Q2-Q1/Q1/P2-P1/P1

• Example• Demand Schedule of Commodity X

• Price Qty. Demanded4 1005 60

Let: Q1=100 P1=4Q2=60 P2=5

• Computation• 60-100/100/5-4/4=-40/100/1/4=-0.4/0.25= -1.6

• Note: The mathematical presentation of price elasticity of demand has a negative sign. This is due to the inverse relationship of price and quantity demanded. Disregard sign.

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities

• The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.

P rice e las tic ity o f d em an d = ( ) / [( ) / ]( ) / [( ) / ]

Q Q Q QP P P P2 1 2 1

2 1 2 1

The Midpoint Method: A Better Way to Calculate Percentage Changes

and Elasticities• Example: If the price of

an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:

( )( ) /

( . . )( . . ) /

10 810 8 2

2 20 2 0 02 00 2 20 2

22 %9 5 %

Figure 1 The Price Elasticity of Demand

(a) Elastic Demand: Elasticity Is Greater Than 1

Demand

Quantity

1. A 22%increasein price . . .

2. . . . leads to a 67% decrease in quantity demanded.

(b) Inelastic Demand: Elasticity Is Less Than 1

Quantity0

Demand1. A 22%increasein price . . .

2. . . . leads to an 11% decrease in quantity demanded.

2. . . . leads to a 22% decrease in quantity demanded.

(c) Unit Elastic Demand: Elasticity Equals 1

Quantity

Demand

Total Revenue and the Price Elasticity of Demand

• Total revenue is the amount paid by buyers and received by sellers of a good.

• Computed as the price of the good times the quantity sold.

TR = P x Q

Price Elasticity & Total Revenue

Elastic

Quantity-effect dominates

Unitary elastic

No dominant effect

Inelastic

Price-effect dominates

Price risesPrice falls

TR falls

TR rises

No change in TR

TR rises

TR falls

Figure 2 Total Revenue

Demand

Quantity

P × Q = $400(revenue)

Elasticity and Total Revenue along a Linear Demand Curve

• With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases.

Figure 3 How Total Revenue Changes When Price Changes: Inelastic Demand

Demand

Quantity0

Revenue = $100

Quantity0

Revenue = $240

Demand$1

An Increase in price from $1 to $3 …

… leads to an Increase in total revenue from $100 to $240

Elasticity and Total Revenue along a Linear Demand Curve

• With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.

Figure 4 How Total Revenue Changes When Price Changes: Elastic Demand

Demand

Quantity0

Revenue = $200

Demand

Quantity0

Revenue = $100

An Increase in price from $4 to $5 …

… leads to an decrease in total revenue from $200 to $100

Income Elasticity of Demand

• Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income.

• It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

Computing Income Elasticity

In co m e e la stic ity o f dem an d =

P ercen tag e ch an ge in q u an tity d em an d ed

P ercen tag e ch an ge in in co m e

Computing Income Elasticity

• Percentage change in qty demanded/percentage change in the income

• Q2-Q1/Q1/I2-I1/I1• Example.• Let:

I1=1000 Q1=20I2= 2000 Q2=50

• Income elasticity• 50-20/20/2000-1000/1000= 1.5/1 = 1.5

• This means that for every one percent increase in the income of the consumer, the quantity demanded will increase by 1.5 percent

Income Elasticity

• Types of Goods• Normal Goods• Inferior Goods

• Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.

Income Elasticity

• Goods consumers regard as necessities tend to be income inelastic• Examples include food, fuel, clothing, utilities, and

medical services.• Goods consumers regard as luxuries tend to be

income elastic.• Examples include sports cars, furs, and expensive

foods.

THE ELASTICITY OF SUPPLY

• Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good.

• Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price.

Figure 6 The Price Elasticity of Supply

(a) Elastic Supply: Elasticity Is Greater Than 1

Quantity0

2. . . . leads to a 67% increase in quantity supplied.

Supply

(b) Inelastic Supply: Elasticity Is Less Than 1

Quantity0

Supply

(c) Unit Elastic Supply: Elasticity Equals 1

Quantity0

Supply

Determinants of Elasticity of Supply

• Ability of sellers to change the amount of the good they produce.• Beach-front land is inelastic.• Books, cars, or manufactured goods are elastic.

• Time period. • Supply is more elastic in the long run.

Computing the Price Elasticity of Supply

• The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price.

P rice e las tic ity o f sup p ly =

P ercen tag e ch an g e in q uan tity sup p lied

P ercen tage ch an g e in p rice

Computing the Price Elasticity of Supply

• Q2-Q1/Q1/P2-P1/P1

• Example: Let • P1=5 Qs1=10• P2=10 Qs2=40

• 40-10/10/10-5/5= 3/1=3

• Supply price elasticity =3 means that for every one percent increase in the price of commodity x, the quantity supplied will increase by 3 percent

Summary

• Price elasticity of demand measures how much the quantity demanded responds to changes in the price.

• Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price.

• If a demand curve is elastic, total revenue falls when the price rises.

• If it is inelastic, total revenue rises as the price rises.

Summary

• The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income.

• The price elasticity of supply measures how much the quantity supplied responds to changes in the price. .

Summary

• In most markets, supply is more elastic in the long run than in the short run.

• The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price.

• The tools of supply and demand can be applied in many different types of markets.

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