Elasticity Micro Economics ECO101

Elasticity Microeconomics

Objectives

By the end of the topic students should be able to understand

Application of demand and supply. Define elasticity and explain elasticity of

demand. The numerical interpretation of the

elasticity of demand.

Elasticity

Elasticity is a general concept that can be used to quantify the response in one variable when another variable changes.

e lastic ity o f A w ith resp ec t to BAB

%%

Elasticity – the concept

The responsiveness of one variable to changes in another

When price rises, what happens to demand?

Demand fallsBUT!How much does demand fall?

Elasticity – the concept

If price rises by 10% - what happens to demand?

We know demand will fallBy more than 10%?By less than 10%?Elasticity measures the extent to which

demand will change

Elasticity

Price Elasticity of DemandThe responsiveness of demand

to changes in priceWhere % change in demand

is greater than % change in price – elasticWhere % change in demand is less than %

change in price - inelastic

To calculate the price elasticity of demand:We express the change in price as a

percentage of the average price—the average of the initial and new price,

and we express the change in the quantity demanded as a percentage of the average quantity demanded—the average of the initial and new quantity.

Price Elasticity of Demand

Figure 4.2 calculates the price elasticity of demand for pizza.

The price initially is $20.50 and the quantity demanded is 9 pizzas an hour.


The price falls to $19.50 and the quantity demanded increases to 11 pizzas an hour.

The price falls by $1 and the quantity demanded increases by 2 pizzas an hour.


The average price is $20 and the average quantity demanded is 10 pizzas an hour.


The percentage change in quantity demanded, %Q, is calculated as Q/Q ave, which is 2/10 = 1/5.

The percentage change in price, %P, is calculated as P/Pave, which is $1/$20 = 1/20.


The price elasticity of demand is %Q/ %P = (1/5)/(1/20) = 20/5 = 4.


Elasticity

The Formula:

PED=% Change in Quantity Demanded___________________________

% Change in Price

If answer is between 0 and -1: the relationship is inelasticIf 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)


A popular measure of elasticity isA popular measure of elasticity is price price elasticity of demand elasticity of demand measures how measures how responsive consumers are to changes in responsive consumers are to changes in the price of a product.the price of a product.

price e las tic ity o f d em an d % ch an g e in q u an tity d em an d ed

ch an g e in p rice

%

• The value of demand elasticity is always negative, but it is stated in absolute terms.

Calculating Elasticities

Calculating percentage changes:

% ch ang e in q uan tity dem and ed x 1 00 %2Q QQ

1

1

% ch an ge in p rice x 1 0 0 %2P PP

1

1

Activity: Calculate the Elasticity of beans

Price of baked beans per tin

Market demand per week

40 pence 1000

30 pence 1500

Figure 1: Calculating Price Elasticity of Demand-- laptop computer demand

Quantity of Laptops

C

Price per Laptop

100,000 200,000 300,000 400,000 500,000 600,000

$3,500

3,000

2,500

2,000

1,500

1,000

B

A

D

D

Calculating Price Elasticity of Demand -- An Example

Now let’s calculate an elasticity of demand for laptop computers using data in Figure 1 from point A to point B

% 2.18or ,182.0000,550000,100

2)000,600000,500()000,600000,500( Q%

• Use percentage changes for price and quantity to calculate price elasticity of demand ( )

% 40.0or ,400.0250,1$

500$

2)000,1$500,1($)000,1$500,1($ P %

46.0400.0182.0

D

D


Elasticity is a ratio of percentages.

p rice e las tic ity o f d em an d

1 00 %33 3%

3 0.

.

• Using the values on the graph to compute elasticity, using percentage changes yields the following result:


A more accurate way of computing elasticity than percentage changes is the midpoint formula:

%%

( ) /

( ) /

QP

Q QQ QP PP P

d

2 1

1 2

2 1

1 2

2100 %

2

x

x 1 00 %

%%

( ) /

( ) /

. .QPd

1 0 55 1 0 2

1 0 0 %

2 33 2 2

57 5 1 6 7

x

x 1 0 0 %

x 1 0 0 %

-12 .5

x 1 0 0 % =

6 6 .7 %-4 0 .0 %


Here is how to interpret two different values of elasticity:

When = 0.2, a 10% increase in price leads to a 2% decrease in quantity demanded.

When = 2.0, a 10% increase in price leads to a 20% decrease in quantity demanded.

0

2

4

6

8

10

0 10 20 30 40 50

PRICE

QUANTITY

As P increases, Q falls, elasticity gets bigger

| ED | > 1

elastic

| ED | = 1

Unit elastic

| ED | < 1

inelastic

2525

55

Slope and Elasticity

The value of the slope of the demand curve and the value of elasticity are not the same.

Unlike the value of the slope, the value of elasticity is a useful measure of responsiveness.

Slope and Elasticity

Changing the units of measure yields a very different value of the slope, yet the behavior of buyers in both diagrams is identical.

2 3 1slope10 5 5

2 3 1slope

160 80 80

Elasticity Changes along a Straight-Line Demand Curve

Along the elastic range, elasticity values are greater than one.

6.4

.29 • Along the inelastic range, elasticity values are less than one.

Types of Elasticity

Hypothetical Demand Elasticities for Four Products

PRODUCT

% CHANGE IN PRICE

(%P)

% CHANGE IN QUANTITY

DEMANDED (%QD)ELASTICITY(%QD %P)

Insulin +10% 0% 0.0 Perfectly inelastic

Basic telephone service

+10% -1% -0.1 Inelastic

Beef +10% -10% -1.0 Unitarily elastic

Bananas +10% -30% -3.0 Elastic

Price Elasticity of Demand -- Categorize GoodsInelastic Demand

Price elasticity of demand between 0 and -11.0

P%Q % Demand Inelastic

|% Change in Quantity Demanded| < |% Change in Price|

• Extreme Case: Perfectly Inelastic Demand– Price elasticity of demand equal to 0

Elasticity Along a Straight-Line Demand CurveFigure 4.4 shows

how demand becomes less elastic as the price falls along a linear demand curve.


At prices above the mid-point of the demand curve, demand is elastic.

At prices below the mid-point of the demand curve, demand is inelastic.


For example, if the price falls from $25 to $15, the quantity demanded increases from 0 to 20 pizzas an hour.

The average price is $20 and the average quantity is 10 pizzas.

The price elasticity of demand is (20/10)/(10/20), which equals 4.


If the price falls from $10 to $0, the quantity demanded increases from 30 to 50 pizzas an hour.

The average price is $5 and the average quantity is 40 pizzas.

The price elasticity is (20/40)/(10/5), which equals 1/4.


If the price falls from $15 to $10, the quantity demanded increases from 20 to 30 pizzas an hour.

The average price is $12.50 and the average quantity is 25 pizzas.

The price elasticity is (10/25)/(5/12.5), which equals 1.


Categorizing Goods by Elasticity

• Elastic Demand– Price elasticity of demand with absolute value > 1

|% Change in Quantity Demanded| > |% Change in Price|

• Extreme Case: Perfectly (infinitely) Elastic Demand– Price elasticity of demand approaching minus infinity

• Another Special Case: Unitary Elastic Demand– Price elasticity of demand equal to -1

1 P %Q % Demand Elastic

Pricing strategies for substitutes:

If a competitor cuts the price of a rival product, firms use estimates of cross-price elasticity to predict the effect on the quantity demanded and total revenue of their own product. For example, two or more airlines competing with each other on a given route will have to consider how one airline might react to its competitor’s price change. Will many consumers switch? Will they have the capacity to meet an expected rise in demand? Will the other firm match a price rise? Will it follow a price fall?

Pricing strategies for complementary goods:

For example, popcorn, soft drinks and cinema tickets have a high negative value for cross elasticity– they are strong complements. Popcorn has a high mark up i.e. pop corn costs pennies to make but sells for more than a pound. If firms have a reliable estimate for C ped they can estimate the effect, say, of a two-for-one cinema ticket offer on the demand for popcorn. The additional profit from extra popcorn sales may more than compensate for the lower cost of entry into the cinema.

Advertising and marketing: In highly competitive markets where brand names carry

substantial value, many businesses spend huge amounts of money every year on persuasive advertising and marketing. There are many aims behind this, including attempting to shift out the demand curve for a product (or product range) and also build consumer loyalty to a brand. When consumers become habitual purchasers of a product, the cross price elasticity of demand against rival products will decrease. This reduces the size of the substitution effect following a price change and makes demand less sensitive to price. The result is that firms may be able to charge a higher price, increase their total revenue and turn

consumer surplus into higher profit.

income elasticity of demand

Income elasticity of demand measures the relationship between a change in quantity demanded for good X and a change in real income.

The formula for calculating income elasticity: % change in demand divided by the % change in income

Normal necessities vs Luxuries

Normal necessities have an income elasticity of demand of between 0 and +1 for example, if income increases by 10% and the demand for fresh fruit increases by 4% then the income elasticity is +0.4. Demand is rising less than proportionately to income.

Luxuries have an income elasticity of demand > +1 i.e. the demand rises more than proportionate to a change in income – for example a 8% increase in income might lead to a 16% rise in the demand for restaurant meals. The income elasticity of demand in this example is +2.0. Demand is highly sensitive to (increases or decreases in) income.

Inferior Goods

Inferior goods have a negative income elasticity of demand. Demand falls as income rises. Typically inferior goods or services tend to be products where there are superior goods available if the consumer has the money to be able to buy it. Examples include the demand for cigarettes, low-priced own label foods in supermarkets and the demand for council-owned properties.

Figure 2: Extreme Cases of Demand

D

Perfectly Inelastic Demand

(a)

Quantity

Price per

Unit

1

2

3

$4

20 40 60 80 100

(b)

D

Quantity20 40 60 80 100

1

2

3

$4

Price per

Unit

Perfectly Elastic Demand

What Affects Elasticity? -- 1. Availability of Substitutes

Demand is more elasticIf close substitutes are easy to find and buyers

can cut back on purchases of the good in question

Demand is less elastic If close substitutes are difficult to find and

buyers can not cut back on purchases of the good in question

What Affects Elasticity? -- 3.Necessities vs. Luxuries

The more “necessary” we regard an item, the harder it is to find a substituteExpect it to be less price elastic

The less “necessary” (luxurious) we regard an item, the easier it can be substitutedExpect it to be more price elastic

Example?

What Affects Elasticity? -- 4. Time Horizon

Short-run elasticityMeasured a short time after a price change

Long-run elasticityMeasured a year or more after a price change

Usually easier to find substitutes for an item in the long run than in the short runTherefore, demand tends to be more elastic in the long

run than in the short run

What Affects Elasticity? -- 5. Importance in the Buyer’s Budget

The more of their total budgets that households spend on an itemThe more elastic is demand for that item

The less of their total budgets that households spend on an itemThe less elastic is demand for that item

Figure 6 Some Short-Run Price Elasticities of Demand

Specific Brands Narrow Categories Broad Categories

T ide Detergent – 2.7 9 Transatlantic A ir Trave l – 1.3 0 Recreation – 1.09 Tourism in Thailand – 1.2 0

Pepsi – 2.08 G round Beef – 1.02 C lothing – 0.89 C oke – 1.7 1 Pork – 0.7 8 Food – 0.6 7

M ilk – 0.5 4 Im ports – 0.5 8 C igarettes – 0.45 Transportation – 0.5 6 E lectricity – 0.40 to – 0.5 0 Beer – 0.2 6 Eggs – 0.2 6 G asoline – 0.2 0 O il – 0.1 5

inelastic

elastic

Economy & Finance

Elasticity Micro Economics ECO101