engineerin economics elasticity

7/29/2019 Engineerin Economics Elasticity

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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 = 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 < 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 = 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 > 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 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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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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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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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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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?

engineerin economics elasticity

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