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8/8/2019 EoM3 Elasticity of Demand by kuldeep ghanghas
1/18
S&N, Ch. 4Mw, Ch. 5
Sr, pp. 85-95
8/8/2019 EoM3 Elasticity of Demand by kuldeep ghanghas
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` When price rises, what happensto demand?
` Demand falls
` BUT!` How much does demand fall
` Elasticity measures the extent to which
demand will change
8/8/2019 EoM3 Elasticity of Demand by kuldeep ghanghas
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Types of Elasticity
Priceelasticity
of demand
Priceelasticity
ofsupply
Incomeelasticity
of demand
Cross
elasticity
8/8/2019 EoM3 Elasticity of Demand by kuldeep ghanghas
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Price elasticity of demand (EDP ) measures how much the quantitydemanded responds to a change in price
EDP is normally negative, but we can ignore the negative sign
EDP =
Percentage change in quantity
demandedPercentage change in price
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` At P1= $90, Q1 =240 units are demanded
` At P2 = $110, Q2 =160 units are demanded
` % change in quantity is (Q/Qave) 100%
` Q = Q2 - Q1 =160 240 = - 80` Qave = (Q1 + Q2) / 2= (240 +160 ) / 2=200
` % change in Q = (-80 / 200) 100% = - 40%
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` % change in price is (P/Pave) 100%
` P=P2 - P1 =110 90 =20
` Pave = (P1 +P2) / 2= (90 +110 ) / 2=100
` % change in price is (20/100) 100% =20%` EDP = - 40 / 20 = - 2
` (We can ignore the minus sign)
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When EDP is greater than 1,demand is elastic(flatter demand
curve)
Relative change in demand islarger than the relative change in theprice
With elastic demand raising prices
lowers total revenue (revenue =P Q)
P
Q
D
D
Q
P
D
D
When EDP is lesser than 1,demand is inelastic(steeper
demand curve)
Relative change in demand islesser than the relative change in theprice
With inelastic demand raising
prices increases total revenue(revenue =P Q)
8/8/2019 EoM3 Elasticity of Demand by kuldeep ghanghas
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P
Q
P
Q
D
D P
Q
D
EDP= 0 is perfectly
inelastic demand (avertical demandcurve demanddoes not change withprice)
EDP=1 is unit elastic
demand (raisingprices does not
change revenues)
EDP= is perfectly
elastic demand (ahorizontal demand
curve )
D
D
D
8/8/2019 EoM3 Elasticity of Demand by kuldeep ghanghas
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ncomeel ticit of emand ( I )measures owmuch the uantit demandedresponds toachange inconsumers income.
I ispositive fornormal good
EDI isnegative for inferiorgood
EDI =
Percentagechange in uantitdemanded
Percentagechange in income
8/8/2019 EoM3 Elasticity of Demand by kuldeep ghanghas
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Normalgoods havepositive EDI,
e.g. as income
rises people gofor morevacations
Inferiorgoods have
negativeEDI,
e.g. as incomesrise people
switch frombuses to usingautos and taxis,
or buy cars
Necessitiesusually have
small EDI,
like food
Luxuriesusually have
large EDI,
like jewelry andcars
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Cross-price elasticity of demand (EDC) measures how much the quantitydemanded in one good responds to a change in the price of another good
EDC can have either sign
EDC =
Percentage change in quantitydemanded of good 1
Percentage change in price of good 2
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If the two goodsare substitutes
EDC is positive
E.g. hot dogs andhamburgers are
substitutes. If theprice of hot dogs goesup, people buy
hamburgers instead
If two goods arecomplements
EDC is negative
E.g. If the price oftrousers goes uppeople buy fewer
trousers and fewerbelts
8/8/2019 EoM3 Elasticity of Demand by kuldeep ghanghas
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rice, potatoes and pasta tape players, CD players, MP3 players ballpoint pens, fountain pens, felt-tip
pens
Substitutes aregoods that canreplace others
With substitutes an increase in the price of one leads toan increase in the demand for the other
Where substitutes exist demand will be more elastic-Ifthe price of potatoes rises and the price of pasta doesnot, people switch from eating potatoes to eating pasta
8/8/2019 EoM3 Elasticity of Demand by kuldeep ghanghas
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trousersand elts computers, software internetconnections
ginand tonicwater
Complementsaregoods that
areused
together
With complementsan increase in thepriceofone leads toadecrease indemand for the
other
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Time period
the longer thetime under
consideration themore elastic a
good is likely tobe
Number andcloseness ofsubstitutes
the greater thenumber of
substitutes, themore elastic
Theproportion ofincome taken
up by theproduct
the smaller theproportion themore inelastic
Luxury orNecessity
the more theluxurious, themore elastic
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Price elasticity of supply (ESP) measures how much thequantity supplied responds to a change in price
If ESP is inelastic - it will be difficult for suppliers toreact swiftly to changes in price
If ESP is elastic supply can react quickly to changesin price
ESP =Percentage change in quantitysupplied
Percentage change in price
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Relationship between changes in price and totalrevenue
Importance in determining what goods to tax(tax revenue)
Importance in analysing time lags in production
Influences the behaviour of a firm
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` Theory of the consumer S&N, Ch 5,Appendix 5
Mw, pp.137-142