ELASTICITY & ITS APPLICATION
Chapter 5
THE ELASTICITY OF DEMAND
• a measure of the responsiveness of quantity demanded to one of its
determinants
• There are 3 elasticities of demand that we study
1. Price elasticity of Demand
2. Income elasticity of Demand
3. Cross Price elasticity of Demand
PRICE ELASTICITY OF DEMAND
• The 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, computed as
the percentage change in quantity demanded divided by the percentage change in
price.
• Demand for a good is said to be elastic if the quantity demanded responds
substantially to changes in the price.
• Demand is said to be inelastic if the quantity demanded responds only slightly to
changes in the price.
GENERAL RULES ABOUT WHAT DETERMINES
THE PRICE ELASTICITY OF DEMAND.
1. Necessities tend to have inelastic demands, whereas luxuries have elastic
demands.
2. 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
substitutable.
3. 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.
PRICE ELASTICITY OF DEMAND
• Economists compute the price elasticity of demand as the percentage change
in the quantity demanded divided by the percentage change in the price.
• For example, suppose that a 10-percent increase in the price of an ice-cream
cone causes the amount of ice cream you buy to fall by 20 percent. We
calculate your elasticity of demand as
• Price elasticity of demand = Percentage change in quantity Demanded
Percentage change in price
• Price elasticity of demand is 20/10 = 2
• Because the quantity demanded of a good is negatively related to its price, the
percentage change in quantity will always have the opposite sign
MID POINT METHOD TO CALCULATE
ELASTICITY
• calculating the price elasticity of demand between two points on a demand
curve, poses a problem i.e. The elasticity from point A to point B seems
different from the elasticity from point B to point A. For example, consider
these numbers:
Price at A = 4 Price at B = 6 Elasticity from
A to B= 0.66
Quantity at A= Quantity at B Elasticity from B
180 =120 to A = 1.5
• One way to avoid this problem is to use the midpoint method for calculating
elasticities. Rather than computing a percentage change using the standard way (by
dividing the change by the initial level), the midpoint method computes a percentage
change by dividing the change by the midpoint of the initial and final levels. For instance,
$5 is the midpoint of $4 and $6. Therefore, according to the midpoint method, a
change from $4 to $6 is considered a 40 percent rise, because (6 - 4) /5 X 100 = 40.
Similarly, a change from $6 to $4 is considered a 40 percent fall.
• In our example the mid point of A and B is
Price 5
Quantity 100
• According to the midpoint method, when going from point A to point B, the price rises
by 40 percent, and the quantity falls by 40 percent. Similarly, when going from point B
to point A, the price falls by 40 percent, and the quantity rises by 40 percent. In both
directions, the price elasticity of demand equals 1.
MID POINT METHOD FORMULA
• We can express the formula for calculating price elasticity by mid point
method between to point denoted as (Q1 , P1 ) & (Q2 , P2 )
(Q2 – Q1) / [(Q2 + Q1 )/2]
(P2 – P1) / [(P2 + P1 )/2]
THE VARIETY OF DEMAND CURVES
• Demand curves are classified according to their elasticity.
• Demand is elastic when the elasticity is greater than 1, so that quantity moves
proportionately more than the price.
• Demand is inelastic when the elasticity is less than 1, so that quantity moves
proportionately less than the price.
• If the elasticity is exactly 1, so that quantity moves the same amount proportionately
as price, demand is said to have unit elasticity.
• The flatter is the demand curve that passes through a given point, the greater
is the price elasticity of demand. The steeper is the demand curve that passes
through a given point, the smaller is the price elasticity of demand.
TOTAL REVENUE METHOD
• The total amount paid by buyers, and received as revenue by sellers, equals the
area of the box under the demand curve, P Q. Here, at a price of $4, the
quantity demanded is 100, and total revenue is $400.
INELASTIC DEMAND
• When a demand curve is inelastic (a price elasticity less than 1), a price
increase raises total revenue, and a price decrease reduces total revenue.
ELASTIC DEMAND CURVE
• When a demand curve is elastic (a price elasticity greater than 1), a price
increase reduces total revenue, and a price decrease raises total revenue.
UNITARY ELASTIC DEMAND
• In the special case of unit elastic demand (a price elasticity exactly equal to 1),
a change in the price does not affect total revenue.
ELASTICITY AND TOTAL REVENUE ALONG
A LINEAR DEMAND CURVE
QUICK QUESTION
1. Two drivers—Tom and Jerry—each drive up to a gas station. Before looking
at the price, each places an order. Tom says, “I’d like 10 gallons of gas.” Jerry
says, “I’d like $10 worth of gas.” What is each driver’s price elasticity of
demand?
INCOME ELASTICITY OF DEMAND
• income elasticity of demand: a measure how the quantity demanded
changes as consumer income changes. The income elasticity is the percentage
change in quantity demanded divided by the percentage change in income
Percentage change in quantity Demanded
Percentage change in income
• In mostly all goods higher income raises quantity demanded. Because quantity
demanded and income move in the same direction, normal goods have positive
income elasticities.
• For few goods, higher income lowers the quantity demanded. Because quantity
demanded and income move in opposite directions, inferior goods have
negative income elasticities.
CROSS PRICE ELASTICITY
• cross price elasticity of demand is a of measure how the quantity
demanded of one good changes as the price of another good changes. It is
calculated as the percentage change in quantity demanded of good 1 divided by
the percentage change in the price of good 2.
Percentage change in quantity Demanded of good 1
Percentage change in price of good 2
PRICE ELASTICITY OF SUPPLY
• The price elasticity of supply is a measure of how much the quantity supply of a good responds to a
change in the price of that good, computed as the percentage change in quantity supplied divided by the
percentage change in price.
• Supply for a good is said to be elastic if the quantity supplied responds substantially to changes in the
price. (>1)
• Supply is said to be inelastic if the quantity supplied responds only slightly to changes in the price.(<1)
• The price elasticity of supply depends on the flexibility of sellers to change the amount of the good they
produce.
• In most markets, a key determinant of the price elasticity of supply is the time period being considered.
Supply is usually more elastic in the long run than in the short run
MEASUREMENT OF PRICE ELASTICITY OF
SUPPLY
Percentage change in quantity Supplied
Percentage change in price
eg: assume that a surge of 40% in pizza price resulted in an increase in the supply
of pizza by 25%
Price elasticity in this case would be 25/40 = 0.625
The price elasticity of supply is inelastic in this case
DIFFERENT SHAPES OF SUPPLY CURVE
ELASTICITY IS NOT CONSTANT ALONG
A SUPPLY CURVE
• Calculations:
• When the price rises from $3 to $4 (a 29 percent increase),the quantity supplied
rises from 100 to 200 (a 67 percent increase). Because quantity supplied moves
proportionately more than the price, the supply curve has elasticity greater than 1.
• By contrast, when the price rises from $12 to $15 (a 22 percent increase), the
quantity supplied rises from 500 to 525 (a 5 percent increase). In this case, quantity
supplied moves proportionately less than the price, so the elasticity is less than 1.
APPLICATIONS
1. CAN GOOD NEWS FOR FARMING BE
BAD NEWS FOR FARMERS?
• hybrid increases the amount of wheat that can
be produced on each acre of land.
• The supply curve shifts to the right
• As the supply increases the prices fall
• As the demand for agriculture goods is inelastic
a decrease in price leads to fall in the total
revenue and makes the farmers worse-off
A REDUCTION IN SUPPLY IN THE WORLD
MARKET FOR OIL
• When the supply of oil falls, the
response depends on the time horizon.
• In the short run, supply and demand
are relatively inelastic, as in panel
(a)Thus, when the supply curve shifts
from S1 to S2, the price rises
substantially.
• By contrast, in the long run, supply and
demand are relative elastic, as in panel
(b). In this case, the same size shift in
the supply curve (S1 to S2) causes a
smaller increase in the price.
DOES DRUG INTERDICTION INCREASE
OR DECREASE DRUG-RELATED CRIME?
QUICK QUESTION
SOLUTION