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Notes on Chapter 4
ELASTICITY
ELASTICITY
Elasticity measures the degree of responsiveness of a dependent variable
to changes in any of the independent variables.
% ∆ the dependent var iable ( Y )
Elasticity = = Elasticity Coefficient
% ∆ the independent var iable ( X )
Elasticity coefficient includes a sign and a size. Interpret the sign and the
size of the coefficient.
Sign shows the direction of the relationship between the two variables. A
positive sign shows a direct relationship while a negative sign shows an
inverse relationship between the two variables.
Size illustrates the magnitude of this relationship. In other words, it shows
how large the response of the dependent variable to the change in the
independent variable. Large elasticity coefficient means that a small
change in the independent variable will result in a large change in the
dependent variable (the opposite is true).
In calculating the elasticity we use the percentage change rather than the
change to avoid the difficulty of comparing different measurement units.
Elasticity coefficient is a unit-free measure.
Elasticity is an important concept in economic theory. It is used to
measure the response of different variables to changes in prices, incomes,
costs, etc.
This chapter covers some of the important types of elasticities.
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
∆Q d Q2 − Q1 Q2 − Q1
% ∆Q d Qavg ( Q2 + Q1 ) / 2 Q2 + Q1 Q2 − Q1 P2 + P1 Q2 − Q1 P2 + P1
Ed = = = = = × = × =−
% ∆P ∆P P2 − P1 P2 − P1 Q2 + Q1 P2 − P1 P2 − P1 Q2 + Q1
Pavg ( P2 + P1 ) / 2 P2 + P1
Where,
Q1 = the original (the old) quantity demanded,
Q2 = the new quantity demanded
P1 = the original (the old) price,
P2 = the new price
Qavg = the average quantity,
Pavg = the average price
The formula yields a negative value, because price and quantity move in
opposite directions (law of demand). But it is the magnitude, or absolute
value, of the measure that reveals how responsive the quantity change has
been to a price change. Thus, we ignore the minus (negative) sign because
it simply represents the negative relationship between P and Qd
Example:
Suppose P1 = 7, P2 = 8, Q1 = 11, Q2 = 10, then
10 − 11 8 − 7
Ed = ÷ = −0.71
10 + 11 8 + 7
2 2
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
Now how to interpret the elasticity coefficient? What Ed= - 0.71 means?
It means that if the price of the good increases (decreases) by 1% the
quantity demanded of the good decreases (increases) by 0.71%
Example
If P1 = 15, P2 = 10, Q1 =30, Q2 = 50, then Ed = -1.25
Which means that if the price of the good changes by 1%, the quantity
demanded of that good will change in the opposite direction by 1.25%
Example
If P1 = 4, P2 = 5, Q1 = 25, Q2 = 20, then Ed = 1
If the price of the good changes by 1% the quantity demanded of that good
will change in the opposite direction by 1%
Example:
Price($) Qd(bushels of Wheat)
8 20
7 40
6 60
5 80
4 100
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
% ∆Q d
If E d = < 1 ⇒ % ∆ Qd < % ∆ P ⇒ demand is
% ∆P
inelastic.
D
Consumers are not very responsive to changes in P.
Qd
Demand Curve is steeper ⇒ 1% (or ) in P results
in a less than 1% (or) in Qd (if Ed = 0.70 that means if P by 1% Qd
by 0.7%.) or (if P by 10% Qd by 7%.)
Examples of inelastic goods: medicine, food, etc.
Thus, demand is perfectly inelastic when shifts of the supply curve results
in no change in quantity demanded.
If the price elasticity is between 0 and 1, demand is inelastic.
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
P D
5. Perfectly Inelastic Demand (Ed = 0) S1
S2
% ∆Q d
If E d = = 0 ⇒ demand is perfectly inelastic
% ∆P
⇒ a vertical demand curve ⇒ demand is completely
inelastic. Qd remains the same regardless of any Qd
Qd
change in price. Shifts in supply curve results in no
change in Qd. Examples: medicine of heart diseases or diabetes such as
insulin A good with a vertical demand curve has a demand with zero
elasticity.
We conclude from the five categories above that the more flatter is the
demand curve the more elastic is the demand and the more steeper is the
demand curve the more inelastic is the demand
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
1
Since the slope of straight-line demand curve is constant, is
slope
P
also constant Ö elasticity varies as a result of variation of ; i.e.
Qd
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
intersection points then their total revenue must increase. Total revenue
continues to rise as the firm moves away from the intersections until it
reaches a maximum at the midpoint.
For a price increase, total revenue rises when demand is inelastic and falls
when demand is elastic.
P
∞
Ed > 1
Ed = 1
*
P
Ed < 1
Q
0 0
TR
E=1
E>1
E<1
TR
0 Q
Q*
Examples
With a linear DC, TR increases and then decreases when P increases (or
when P decreases)
To max TR, set price at unitary elastic price
If a company wants to ↑ its TR when Ed = 0.75 , it should ↑ P
If a company wants to ↑ its TR when Ed = 1.5 , it should ↓ P
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
a. calculate Ed
b. When P increases what would happen to TR?
5 a
Ed = 1 and TR remains the same. b
4
The area (0-5-a-20) = the area (0-4-b-25) D
0 Qd
20 25
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
Example:
A buyer who likes Japanese cars and has relative preference for Toyota
products may have higher price elasticity of demand for Camry than the
price elasticity of demand for Toyota cars. His price elasticity of demand
for Toyota cars is higher than the price elasticity of demand for Japanese
cars. And his price elasticity of demand for Japanese cars is higher than
the price elasticity of demand for cars in general. Why?
Example:
Consider the relative price elasticity of demand for a good such as apples
compared to a good such as fruits. What is the difference between apples
and fruits? Apples are, of course, a fruit but so are lots of other goods as
well. Hence, more substitutes exist for apples than exist for the broader
category of fruits. We have already determined that as the number of
substitutes increase then so does that goods relative price elasticity of
demand.
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
Thus, the demand for high-priced goods such as cars tends to be more
price elastic than the demand for low-priced good such as bread or salt.
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
% ∆P ∆ P P2 − P1 P2 − P1 Q2 + Q1 P2 − P1
Pavg ( P2 + P1 ) / 2 P2 + P1
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
P P
P
S
S
D1
D1
D0 D0
Qs Qs Qs
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Dr. Mohammed Alwosabi Econ 140 - Ch.4
P
MS SS
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