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Elasticity!Boingy, boingy, boingy!
Price, Income and Cross Elasticity
Elasticity – the concept The responsiveness of one variable to
changes in another
When price rises what happens to quantity demanded?• Demand falls
• BUT!
• How much does demand fall?
Elasticity – the concept If price rises by 10% - what happens to
Qd?
• We know Qd will fall
• By more than 10%?
• By less than 10%?
Elasticity measures the extent to which quantity demanded will change
Elasticity 4 basic types used:
• Price elasticity of demand – PED
• Price elasticity of supply – PES
• Income elasticity of demand – YED
• Cross elasticity – Cross ED or XED
Elasticity Price Elasticity of Demand
• The responsivenessresponsiveness of quantity demanded to changes in price
• Where % change in Qd is greater than % change in price – elastic
• Where % change in Qd is less than % change in price - inelastic
Elasticity
The Formula:
Ped =% Change in Quantity Demanded___________________________
% Change in Price
If answer is between 0 and -1: the relationship is inelastic
If the answer is between -1 and infinity: the relationship is elastic
Note: PED has – sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)
Elasticity
Price (£)
Quantity Demanded
The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded.
Elasticity
Price
Quantity Demanded (000s)
D
The importance of elasticity is the information it provides on the effect on total revenue of changes in price.
£5
100
Total revenue is price x quantity sold. In this example, TR = £5 x 100,000 = £500,000.
This value is represented by the grey shaded rectangle.
Total Revenue
ElasticityPrice
Quantity Demanded (000s)
D
If the firm decides to decrease price to (say) £3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue.£5
100
£3
140
Total Revenue
Elasticity
Price (£)
Quantity Demanded
10
D
5
5
6
% Δ Price = -50%
% Δ Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
Total Revenue would fall
Producer decides to lower price to attract sales
Not a good move!
Elasticity
Price (£)
Quantity Demanded
D
10
5 20
Producer decides to reduce price to increase sales
7
% Δ in Price = - 30%
% Δ in Demand = + 300%
Ped = - 10 (Elastic)Total Revenue rises
Good Move!
Elasticity If demand is price
elastic: Increasing price
would reduce TR (%Δ Qd > % Δ P)
Reducing price would increase TR (%Δ Qd > % Δ P)
If demand is price inelastic:
Increasing price would increase TR
(%Δ Qd < % Δ P) Reducing price
would reduce TR (%Δ Qd < % Δ P)
Elasticity Versus Slope
Elasticity of demand describes the shape of a demand curve, but it is not the same as slope.
Slope measures the rise or fall in a curve divided by its horizontal run.
Elasticity measures the horizontal run by the rise or fall.
Task #1 – Calculating PEDCalculate the price elasticity of demand in each of the following
examples: The change in demand is 5%, the change in price is 7%
The change in demand is 12%, the change in price is 3%
The change in demand is 9%, the change in price is 4%
The change in demand is 13%, the change in price is 25%
The change in demand is 6%, the change in price is 8%
In each case say whether the price elasticity is inelastic or elastic.
Spending and Elasticity
If demand is inelastic, buyers spend more on the good when its price is higher.
If demand is elastic, buyers spend less on the good when its price is higher.
If demand is unit-elastic, buyers spend the same amount on the good when its price is higher.
Determinants of Elasticity Time period – the longer the time under consideration
the more elastic a good is likely to be
Number and closeness of substitutes – the greater the number of substitutes the more elastic
The proportion of income taken up by the product – the smaller the proportion the more inelastic
Luxury or Necessity - for example, addictive drugs
Factors Affecting Elasticity of Demand
Availability of Substitutes Demand for a good is more elastic when
close substitutes for it are available to buyers.
Factors Affecting Elasticity of Demand
Fraction of Income Spent on the GoodAs people spend higher fractions of their
incomes on a good, their demand for the good becomes more elastic.
As they spend smaller fractions of their income on a good, their demand for it
becomes less elastic.
Factors Affecting Elasticity of Demand
Adjustment TimeDemand is more elastic when people have
more time available to adjust to a change in price.
Other Types of Elasticity
Explain how to calculate Income Elasticity of Demand
(YED), Cross-Price Elasticity of Demand (XED) and Price Elasticity of Supply (PES)
Elasticity – YED Income Elasticity of Demand (YED):
• The responsiveness of demand to changes in incomes
Normal Good – demand rises as income rises and vice versa
Inferior Good – demand falls as income rises and vice versa
Elasticity – YED
Income Elasticity of Demand: A positive sign denotes a normal good A negative sign denotes an inferior good
Elasticity – YED For example:
Yed = - 0.6: Good is an inferior good but inelastic – a rise in income of 3% would lead to demand falling by 1.8%• WHY? Use your YED formula and plug it in:• (x/0.03)=-0.6• (-0.6)(0.03)=x• -0.018=x, or -1.8%
Yed = + 0.4: Good is a normal good but inelastic – a rise in incomes of 3% would lead to demand rising by 1.2%
Yed = + 1.6: Good is a normal good and elastic – a rise in incomes of 3% would lead to demand rising by 4.8%
Yed = - 2.1: Good is an inferior good and elastic – a rise in incomes of 3% would lead to a fall in demand of 6.3%
YED Video
Elasticity – XED Cross Elasticity: The responsiveness of demand of one
good to changes in the price of a related good – either a substitute or a complement
XED = % Δ Qd of good t__________________% Δ Price of good y
Elasticity – XED Goods which are complements:
• Cross Elasticity will have negative sign (inverse relationship between the two)
Goods which are substitutes:• Cross Elasticity will have a positive sign
(positive relationship between the two)
Practice! Is the following graph
showing a situation where the goods are complements or substitutes? How can you tell?
Substitutes. As the P for good B
increases, the Qd for good A increases (XED>0).
XED video
Elasticity Price Elasticity of Supply:
• The responsiveness of supply to changes in price
• If PES is inelastic - it will be difficult for suppliers to react swiftly to changes in price
• If PES is elastic – supply can react quickly to changes in price
PES = % Δ Quantity Supplied____________________
% Δ Price
PES: determinants—length of time
PES Video
Importance of Elasticity Relationship between changes in price
and total revenue Importance in determining what goods to
tax (tax revenue) Importance in analyzing time lags in
production Influences the behavior of a firm
As you go back to read/review Think about how to solve for each: equations,
plugging in, what changes might occur given certain values
Think about what the graphs would look like for each
Think about determinants of each, and how that might affect how the graph looks
Think about substitutes, complements, inferior, superior, normal and luxury goods and how they apply to each