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Elasticity
and Its Applications(Quantitative Demand Analysis)
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Outline
I. Introduction
II. Elasticity of Demand
a) Definition (Price Elasticity of Demand)
b) Degrees of Elasticity of Demandc) Relationship between Edand Total Revenue
d) Determinants of Elasticity of Demand
III. Other Elasticity
a) Income Elasticity of Demandb) Cross Price Elasticity of Demand
c) Elasticity of Supply
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Demand
We know, from the Law of Demand, that priceand quantity demanded are inversely related.
Now, we are going to get more specific in
defining that relationship, allows us toanalyze demand and supply with greaterprecision.
We want to know just how much will quantity
demanded change when price changes? That iswhat elasticity of demand measures.
is a measure of how much buyers and sellers
respond to changes in market conditions
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THE ELASTICITY OF DEMAND
Price elasticity of demandis a measure ofhow much the quantity demanded of agood responds to a change in the price of
that good.
Price elasticity of demand is thepercentage change in quantity demanded
given a percent change in the price.
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Elasticity of Demand
Elasticity of Demand (Ed) measures theresponsiveness of Qd of a good to a changein its P.
Ed = %D in Qd%D in P
Note thatD
means change Also note that the law of demand implies Ed is
negative. We will ignore the negative sign onlywhen discussing elasticity of demand.
Price elasticity of demand =Percentage change in quantity demanded
Percentage change in price
( )
( . . )
.
10 8
10100
2 20 2 00
2 00100
20%
10%2
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How Do We Interpret Elasticity?
The number we get from computing theelasticity is a percentage - there are no units.
We can read it as the percentage change inquantity for a 1% change in price
Thus, if Ed = 2, that means in that part of thedemand curve, a 1% change in price willcause a 2% change in quantity demanded. Orif we extrapolate, a 2% change in price willcause a 4% change in quantity demanded,and so on.
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Degrees of Ed
Perfectly Inelastic
Ed = %D in Qd%D in P
Ed = 0 %D in P
Ed = 0 it is also called zero elasticity
No matter how much price changes,consumers purchase the same amount of thegood.
Example: Insulin
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Elasticity
P
Qd
Perfectly
Inelastic
0
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Degrees of Ed
Relatively Inelastic or Inelastic
Ed = %D in Qd%D in P
Ed < 1 (in absolute value)
% D in Qd < % D in P
For every 1% change in P, Qd changes
by less than 1% Quantity demanded does not respond
strongly to price changes.
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Degrees of Ed
Unitary Elastic
Ed = %D in Qd%D in P
Ed = 1 (in absolute value) % D in Qd = % D in P
For every 1% change in P, Qd changesby 1% (in opposite direction)
Quantity demanded responds strongly to
changes in price.
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Degrees of Ed
Relatively Elastic or Elastic
Ed = %D in Qd%D in P
Ed > 1 (in absolute value)
% D in Qd > % D in P
For every 1% change in P, Qd changesby more than 1% (in opposite direction)
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Relatively Elastic Demand
Demand is price elastic
$54
Demand
Quantity1000 50
-3percent22-
percent67
5.00)/2(4.00
5.00)-(4.00
50)/2(10050)-(100
ED
Price
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Degrees of Ed
Perfectly Elastic
Ed = %D in Qd%D in P
Ed = %D in Qd0
Ed =
The price of the good never changes, no matterhow much consumers purchase of the good.
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Elasticity
P
Qd
Perfectly
Elastic
0
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Generalizing about Elasticity
Notice that the vertical D curve has anelasticity of zero and the flat D curve hasan elasticity of infinity.
As the demand curve goes from verticalto horizontal the elasticity is going from0 to infinity
In other words, the flatter the demandcurve, the greater the elasticity
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Elasticity
P
Qd
Relatively
Elastic
0
Relatively
Inelastic
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Elasticity of Demand and Its Determinants
Availability of Close Substitutes
Necessities versus Luxuries
Definition of the Market
Time Horizon
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Elasticity of Demand and Its Determinants
Availability of Substitutes
As there are more substitutes, demand ismore elastic (and vice versa)
Example:
Insulin has no substitutes if diabetic and
demand is very inelastic. Kroger Brand Cola has many substitutes
and hence, demand is very elastic
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Elasticity of Demand and Its Determinants
Amount of Consumers Budget
The less expensive a good is as a fraction of ourtotal budget, the more inelastic the demand for
the good is (and vice versa).
Example: Price of cars go up 10% (from $20,000 to $22,000)
Price of soda goes up 10% (from $0.50 to $0.55)
Demand is more effected by the price of cars
increasing.
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Elasticity of Demand and Its Determinants
Time
The longer the time frame is, the more elasticthe demand for a good is (and vice versa).
Example - Price of Gasoline Increases
Immediately: cant do much, still need to get towork, school, etc.
Short-run: find a car pool, ride bike, etc. Long-run: next car you buy uses less gas.
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Elasticity of Demand and Its Determinants
Necessities vs. Luxuries
The more necessary a good is, themore inelastic the demand for the good
(and vice versa).
Example: Insulin
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Total Revenue
Total revenue is the amount paid bybuyers and received by sellers of a good.
Computed as the price of the good timesthe quantity sold.
TR = P x Q
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Total Revenue
Price of Pen (P) QuantityDemanded (Q)
T. Expendituresor Revenue
(PxQ)
TotalExpendituresor Revenue
(PxQ)
5.00 30 150 -
4.75 40 190 E >1
4.50 50 225 E>1
4.25 60 255 E>1
4.00 75 300 E>1
3.75 80 300 E=1
3.50 84 294 E
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Summary
When IEpI < 1 , an increase inprice will rise TR and a decrease inprice will decrease TR.
When IEpI > 1 , an increase inprice will decrease TR and adecrease in price will increase TR.
When IEpI = 1 , a change in pricedoes not effect the TR.
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Income Elasticity of Demand
Income elasticity of demand(EdY)
measures how much the quantitydemanded of a good responds to a
change in consumers income. It is computed as the percentage change
in the quantity demanded divided by thepercentage change in income.
EdY = %D in Qd
%D in Y
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Normal Goods
Typically, if our income rises, webuy more and visa versa. Thesetypes of goods are called normalgoods.
EdY > 0 - normal good
Normal Goods can be split into two
categories: Luxury and NecessityGoods
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Necessity Goods
A necessity good is a good whosequantity demanded is not verysensitive to income changes
In other words, we buy it no matterwhat happens to our income.
If a goods elasticity is 0 < EdY < 1
then it is a necessity good.
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Luxury Goods
A luxury good is one that we buy alot of when our income goes up andwe cut back on significantly whenour income goes down.
If a goods elasticity is EdY > 1, then
it is a luxury good.
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Inferior Goods
There are some good we buy less of as
our income grows and more of as our
income falls.
For instance, in college you probably eat
Macaroni & Cheese. But when you get a
well-paying job (as all Miami grads do) you
will probably buy less Mac and Cheese. If a goods elasticity is Ed
Y < 0 it is an
inferior good
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Cross Price Elasticity of Demand
Another type of elasticity is the CrossPrice Elasticity. This gets at how
changes in price of one good caneffect the demand of another
Cross Price Elasticity of Demand (E1,2)
- measures the responsiveness ofquantity demanded of good one whenthe price of good 2 changes.
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Cross Price Elasticity of Demand
E1,2 = % in Qd of Good 1
% in P of Good 2
Note that the sign DOES matter for this
elasticity also!
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Substitute Goods
Consider Coke and Pepsi. If the price of
Coke goes up, what would you expect to
happen to the quantity demanded of Pepsi?
It will rise, since people will buy less Coke andmore Pepsi. Thus the Demand for Pepsi will rise.
So the bottom of the elasticity fraction is
positive and top of the elasticity fraction is
positive.
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Substitute Goods
This relationship is called substitutes and can
be seen when E1,2 > 0.
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Complement goods
Consider Washing Machines and Dryers. If
the price of Washing Machines goes up, what
would you expect to happen to the quantity
demanded of Dryers? It will fall, since people will buy less washers at
the new price, they will need less dryers.
So the bottom of the elasticity fraction is
positive and top of the elasticity fraction isnegative.
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Complement Goods
This relationship is called complements and
can be seen when E1,2 < 0
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Elasticity of Supply
This one is just same as price elasticity of demand,
except we substitute the word supply for demand. It
measures the same inelastic, elastic, and unitary
elastic supply.
Elasticity of Supply (Es) - measures the
responsiveness of quantity supplied to changes in
price of the good. or
Price elasticity of supply is the percentagechange in quantity supplied resulting from apercent change in price
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Elasticity of Supply
Es = %D in Qs
%D in P
Law of Supply tells us this number isgenerally positive.
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Determinants of Elasticity of
Supply
If supply is getting more (or less) elastic, we
are saying that the firms can change supply
in larger (or smaller) quantities when price
changes.
Generally, anythingthat can effect a firms
ability to change production easily will effect
the elasticity of supply.
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Determinants of Elasticity of
Supply
For instance: more time, a changein technology, etc.
To consider: what would the supplycurve of Picasso paintings look like?