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5PART I INTRODUCTION TO ECONOMICS
Elasticity
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5PART I INTRODUCTION TO ECONOMICS
Elasticity
Price Elasticity of DemandSlope and ElasticityTypes of Elasticity
Calculating ElasticitiesCalculating Percentage ChangesElasticity Is a Ratio of PercentagesThe Midpoint FormulaElasticity Changes Along a Straight-Line Demand CurveElasticity and Total Revenue
The Determinants of Demand ElasticityAvailability of SubstitutesThe Importance of Being UnimportantThe Time Dimension
Other Important ElasticitiesIncome Elasticity of DemandCross-Price Elasticity of DemandElasticity of Supply
Looking Ahead
Appendix: Point Elasticity
CHAPTER OUTLINE
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Elasticity
elasticity A general concept used to quantify the response in one variable when another variable changes.
%elasticity of with respect to
%
AA B
B
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Price Elasticity of Demand
Slope and Elasticity
FIGURE 5.1 Slope Is Not a Useful Measure of ResponsivenessChanging the unit of measure from pounds to ounces changes the numerical value of the demand slope dramatically, but the behavior of buyers in the two diagrams is identical.
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Price Elasticity of Demand
price elasticity of demand The ratio of the percentage of change in quantity demanded to the percentage of change in price; measures the responsiveness of quantity demanded to changes in price.
pricein change %
demandedquantity in change % demand of elasticity price
Slope and Elasticity
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Price Elasticity of Demand
Types of Elasticity
TABLE 5.1 Hypothetical Demand Elasticities for Four Products
Product
% Change In Price
(% P)
% ChangeIn Quantity Demanded
(% QD)Elasticity
(% QD ÷ %P)
Insulin +10% 0% .0 Perfectly inelastic
Basic telephone service +10% -1% -.1 Inelastic
Beef +10% -10% -1.0 Unitarily elastic
Bananas +10% -30% -3.0 Elastic
perfectly inelastic demand Demand in which quantity demanded does not respond at all to a change in price.
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Price Elasticity of Demand
Types of Elasticity
FIGURE 5.2 Perfectly Inelastic and Perfectly Elastic Demand Curves
Figure 5.2(a) shows a perfectly inelastic demand curve for insulin. Price elasticity of demand is zero. Quantity demanded is fixed; it does not change at all when price changes.Figure 5.2(b) shows a perfectly elastic demand curve facing a wheat farmer. A tiny price increase drives the quantity demanded to zero. In essence, perfectly elastic demand implies that individual producers can sell all they want at the going market price but cannot charge a higher price.
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Price Elasticity of Demand
inelastic demand Demand that responds somewhat, but not a great deal, to changes in price. Inelastic demand always has a numerical value between zero and -1.
Types of Elasticity
A warning: You must be very careful about signs. Because it is generally understood that demand elasticities are negative (demand curves have a negative slope), they are often reported and discussed without the negative sign.
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Price Elasticity of Demand
Types of Elasticity
unitary elasticity A demand relationship in which the percentage change in quantity of a product demanded is the same as the percentage change in price in absolute value (a demand elasticity of -1).
elastic demand A demand relationship in which the percentage change in quantity demanded is larger than the percentage change in price in absolute value (a demand elasticity with an absolute value greater than 1).
perfectly elastic demand Demand in which quantity drops to zero at the slightest increase in price.
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Price Elasticity of Demand
Types of Elasticity
A good way to remember the difference between the two “perfect” elasticities is:
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Calculating Elasticities
%1
change in quantity demanded change in quantity demanded x 100%
Q
1
2 1 -
x 100%Q Q
Q
To calculate percentage change in quantity demanded using the initial value as the base, the following formula is used:
Calculating Percentage Changes
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Calculating Elasticities
Calculating Percentage Changes
We can calculate the percentage change in price in a similar way. Once again, let us use the initial value of P—that is, P1—as the base for calculating the percentage. By using P1 as the base, the formula for calculating the percentage of change in P is
1
change in price% change in price x 100%
P
2 1
1
- x 100%P P
P
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Calculating Elasticities
Elasticity Is a Ratio of Percentages
Once all the changes in quantity demanded and price have been converted to percentages, calculating elasticity is a matter of simple division. Recall the formal definition of elasticity:
% change in quantity demandedprice elasticity of demand
% change in price
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Calculating Elasticities
The Midpoint Formula
midpoint formula A more precise way of calculating percentages using the value halfway between P1 and P2 for the base in calculating the percentage change in price, and the value halfway between Q1 and Q2 as the base for calculating the percentage change in quantity demanded.
1(
2
change in quantity demanded% change in quantity demanded x 100%
) / 2Q Q
2 1
1 2
- x 100%( ) / 2
Q Q
Q Q
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Calculating Elasticities
The Midpoint Formula
Using the point halfway between P1 and P2 as the base for calculating the percentage change in price, we get
1 2
change in price% change in price x 100%
( ) / 2P P
2 1
1 2
- x 100%( ) / 2
P P
P P
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Calculating Elasticities
The Midpoint Formula
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Calculating Elasticities
Elasticity Changes Along a Straight-Line Demand Curve
TABLE 5.3 Demand Schedule for Office Dining Room Lunches
Price(per
Lunch)
Quantity Demanded
(Lunches per Month)
$1110
9876543210
02468
10121416182022 FIGURE 5.3 Demand Curve for
Lunch at the Office Dining Room
Between points A and B, demand is quite elastic at -6.4.Between points C and D, demand is quite inelastic at -.294.
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Calculating Elasticities
Elasticity and Total Revenue
TR = P x Qtotal revenue = price x quantity
In any market, P x Q is total revenue (TR) received by producers:
When price (P) declines, quantity demanded (QD) increases. The two factors, P and QD move in opposite directions:
Effects of price changeson quantity demanded:
and
D
D
QP
QP
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Calculating Elasticities
Elasticity and Total Revenue
Because total revenue is the product of P and Q, whether TR rises or falls in response to a price increase depends on which is bigger: the percentage increase in price or the percentage decrease in quantity demanded.
If the percentage decline in quantity demanded following a price increase is larger than the percentage increase in price, total revenue will fall.
Effects of price increase ona product with inelastic demand: x D TRQP
Effects of price increase ona product with inelastic demand: x D TRQP
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Calculating Elasticities
Elasticity and Total Revenue
The opposite is true for a price cut. When demand is elastic, a cut in price increases total revenues:
When demand is inelastic, a cut in price reduces total revenues:
effect of price cut on a productwith elastic demand: x D TRQP
effect of price cut on a productwith inelastic demand: x D TRQP
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The Determinants of Demand Elasticity
Availability of Substitutes
Perhaps the most obvious factor affecting demand elasticity is the availability of substitutes.
The Importance of Being Unimportant
When an item represents a relatively small part of our total budget, we tend to pay little attention to its price.
The Time Dimension
The elasticity of demand in the short run may be very different from the elasticity of demand in the long run. In the longer run, demand is likely to become more elastic, or responsive, simply because households make adjustments over time and producers develop substitute goods.
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The Determinants of Demand Elasticity
Who Are the Elastic Smokers?
Bill aims to raise tax on cigarettes
Seattle Times
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The Determinants of Demand Elasticity
Elasticities at a Delicatessen in the Short Run and Long Run
The graph shows the expected relationship between long-run and short-run demand for Frank’s sandwiches. Notice if you raise prices above the current level, the expected quantity change read off the short-run curve is less than that from the long-run curve.
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Other Important Elasticities
Income Elasticity of Demand
income elasticity of demand A measure of the responsiveness of demand to changes in income.
incomein change %
demandedquantity in change % demand of elasticity income
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Other Important Elasticities
Cross-Price Elasticity Of Demand
cross-price elasticity of demand A measure of the response of the quantity of one good demanded to a change in the price of another good.
X
Y
of pricein change %
demanded ofquantity in change % demand of elasticity price-cross
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Other Important Elasticities
Elasticity Of Supply
elasticity of supply A measure of the response of quantity of a good supplied to a change in price of that good. Likely to be positive in output markets.
% change in quantity suppliedelasticity of supply
% change in price
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Other Important Elasticities
Elasticity Of Supply
elasticity of labor supply A measure of theresponse of labor supplied to a change in the price of labor.
rate wagein the change %
suppliedlabor ofquantity in change % supply labor of elasticity
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cross-price elasticity of demand
elastic demand
elasticity
elasticity of labor supply
elasticity of supply
income elasticity of demand
inelastic demand
midpoint formula
perfectly elastic demand
perfectly inelastic demand
price elasticity of demand
unitary elasticity
REVIEW TERMS AND CONCEPTS
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POINT ELASTICITY (OPTIONAL)
A P P E N D I X
Consider the straight-line demand curve in Figure 5A.1. We can write an expression for elasticity at point C as follows:
1
1
1
1 QQ
100
100 QQ
%
% elasticity
Q
P
P
Q
PP
PPP
Q
FIGURE 5A.1 Elasticity at a Point Along a Demand Curve
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POINT ELASTICITY (OPTIONAL)
A P P E N D I X
∆Q/∆P is the reciprocal of the slope of the curve. Slope in the diagram is constant along the curve, and it is negative. To calculate the reciprocal of the slope to plug into the previous electricity equation, we take Q1B, or M1, and divide by minus the length of line segment CQ1. Thus,
1
1 CQ
M
P
Q
Since the length of CQ1 is equal to P1, we can write:
1
1 P
M
P
Q
By substituting we get:
2
1
2
1
1
1
1
1
1
1 elasticityM
M
M
P
P
M
Q
P
P
M
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POINT ELASTICITY (OPTIONAL)
A P P E N D I X
FIGURE 5A.2 Point Elasticity Changes Along a Demand Curve