Elasticity and Its Applications

(Quantitative Demand Analysis)

Outline
I. Introduction II. Elasticity of Demand
a) b) c)

d)

Definition (Price Elasticity of Demand) Degrees of Elasticity of Demand Relationship between Ed and Total Revenue Determinants of Elasticity of Demand Income Elasticity of Demand Cross Price Elasticity of Demand Elasticity of Supply

III. Other Elasticity

a) b) c)

Demand

We know, from the Law of Demand, that price and quantity demanded are inversely related. Now, we are going to get more specific in defining that relationship, allows us to analyze demand and supply with greater precision. We want to know just how much will quantity demanded change when price changes? That is what elasticity of demand measures. is a measure of how much buyers and sellers respond to changes in market conditions
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THE ELASTICITY OF DEMAND

Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.

Elasticity of Demand

Elasticity of Demand (Ed) measures the responsiveness of Qd of a good to a change in its P.

Price elasticity of demand = Percentage change in quantity demanded Percentage change in price

Ed = %D in Qd %D in P

(10 8) 100 20% 10 2 (2.20 2.00) 100 10% 2.00

Note that D means change Also note that the law of demand implies Ed is negative. We will ignore the negative sign only when discussing elasticity of demand.

How Do We Interpret Elasticity?

The number we get from computing the elasticity is a percentage - there are no units. We can read it as the percentage change in quantity for a 1% change in price Thus, if Ed = 2, that means in that part of the demand curve, a 1% change in price will cause a 2% change in quantity demanded. Or if we extrapolate, a 2% change in price will cause a 4% change in quantity demanded, and so on.
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Degrees of Ed

Perfectly Inelastic

Ed = %D in Qd %D in P Ed = 0 %D in P Ed = 0 it is also called zero elasticity

No matter how much price changes, consumers purchase the same amount of the good.

Example: Insulin

Elasticity
P
Perfectly Inelastic

Qd
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Degrees of Ed

Relatively Inelastic or Inelastic

Ed = %D in Qd %D in P Ed < 1 (in absolute value) % D in Qd < % D in P

For every 1% change in P, Qd changes by less than 1% Quantity demanded does not respond strongly to price changes.
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Degrees of Ed

Unitary Elastic

Ed = %D in Qd %D in P Ed = 1 (in absolute value) % D in Qd = % D in P

For every 1% change in P, Qd changes by 1% (in opposite direction) Quantity demanded responds strongly to changes in price.
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Degrees of Ed

Relatively Elastic or Elastic

Ed = %D in Qd %D in P Ed > 1 (in absolute value) % D in Qd > % D in P

For every 1% change in P, Qd changes by more than 1% (in opposite direction)

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Relatively Elastic Demand

(100 - 50)
Price $5 4 Demand

ED

(100 50)/2 (4.00 5.00)/2

(4.00 - 5.00)

67 percent -3 - 22 percent

50

100 Quantity

Demand is price elastic

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Degrees of Ed

Perfectly Elastic

Ed = %D in Qd %D in P Ed = %D in Qd 0 Ed =

The price of the good never changes, no matter how much consumers purchase of the good.
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Elasticity
P

Perfectly Elastic

Qd
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Generalizing about Elasticity

Notice that the vertical D curve has an elasticity of zero and the flat D curve has an elasticity of infinity. As the demand curve goes from vertical to horizontal the elasticity is going from 0 to infinity In other words, the flatter the demand curve, the greater the elasticity

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Elasticity
P
Relatively Inelastic

Relatively Elastic

Qd
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Elasticity of Demand and Its Determinants

Availability of Close Substitutes Necessities versus Luxuries Definition of the Market Time Horizon

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Elasticity of Demand and Its Determinants

Availability of Substitutes

As there are more substitutes, demand is more elastic (and vice versa)

Example:

Insulin has no substitutes if diabetic and demand is very inelastic. Kroger Brand Cola has many substitutes and hence, demand is very elastic
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Elasticity of Demand and Its Determinants

Amount of Consumers Budget

The less expensive a good is as a fraction of our total budget, the more inelastic the demand for the good is (and vice versa).

Example:

Price of cars go up 10% (from $20,000 to $22,000) Price of soda goes up 10% (from $0.50 to $0.55) Demand is more effected by the price of cars increasing.

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Elasticity of Demand and Its Determinants

Time

The longer the time frame is, the more elastic the demand for a good is (and vice versa).

Example - Price of Gasoline Increases

Immediately: cant do much, still need to get to work, school, etc. Short-run: find a car pool, ride bike, etc. Long-run: next car you buy uses less gas.

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Elasticity of Demand and Its Determinants

Necessities vs. Luxuries

The more necessary a good is, the more inelastic the demand for the good (and vice versa).

Example: Insulin

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Total Revenue

Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold. TR = P x Q

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Total Revenue
Price of Pen (P) Quantity Demanded (Q) T. Expenditures or Revenue (PxQ) Total Expenditures or Revenue (PxQ) E >1

5.00 4.75

30 40

150 190

4.50
4.25 4.00 3.75 3.50 3.25

50
60 75 80 84 87

225
255 300 300 294 282.75

E>1
E>1 E>1 E=1 E<1 E<1
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Summary

When IEpI < 1 , an increase in price will rise TR and a decrease in price will decrease TR. When IEpI > 1 , an increase in price will decrease TR and a decrease in price will increase TR. When IEpI = 1 , a change in price does not effect the TR.
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Income Elasticity of Demand

Income elasticity of demand (EdY) measures how much the quantity demanded of a good responds to a change in consumers income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

EdY = %D in Qd %D in Y
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Normal Goods

Typically, if our income rises, we buy more and visa versa. These types of goods are called normal goods. EdY > 0 - normal good Normal Goods can be split into two categories: Luxury and Necessity Goods
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Necessity Goods

A necessity good is a good whose quantity demanded is not very sensitive to income changes In other words, we buy it no matter what happens to our income. If a goods elasticity is 0 < EdY < 1 then it is a necessity good.

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Luxury Goods

A luxury good is one that we buy a lot of when our income goes up and we cut back on significantly when our income goes down. If a goods elasticity is EdY > 1, then it is a luxury good.

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Inferior Goods

There are some good we buy less of as our income grows and more of as our income falls. For instance, in college you probably eat Macaroni & Cheese. But when you get a well-paying job (as all Miami grads do) you will probably buy less Mac and Cheese. If a goods elasticity is EdY < 0 it is an inferior good
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Cross Price Elasticity of Demand

Another type of elasticity is the Cross Price Elasticity. This gets at how changes in price of one good can effect the demand of another Cross Price Elasticity of Demand (E1,2) - measures the responsiveness of quantity demanded of good one when the price of good 2 changes.
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Cross Price Elasticity of Demand

E1,2 = % in Qd of Good 1 % in P of Good 2 Note that the sign DOES matter for this elasticity also!

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Substitute Goods

Consider Coke and Pepsi. If the price of Coke goes up, what would you expect to happen to the quantity demanded of Pepsi?

It will rise, since people will buy less Coke and more Pepsi. Thus the Demand for Pepsi will rise.

So the bottom of the elasticity fraction is positive and top of the elasticity fraction is positive.

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Substitute Goods
This relationship is called substitutes and can be seen when E1,2 > 0.

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Complement goods

Consider Washing Machines and Dryers. If the price of Washing Machines goes up, what would you expect to happen to the quantity demanded of Dryers?

It will fall, since people will buy less washers at the new price, they will need less dryers.

So the bottom of the elasticity fraction is positive and top of the elasticity fraction is negative.
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Complement Goods
This relationship is called complements and can be seen when E1,2 < 0

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Elasticity of Supply

This one is just same as price elasticity of demand, except we substitute the word supply for demand. It measures the same inelastic, elastic, and unitary elastic supply. Elasticity of Supply (Es) - measures the responsiveness of quantity supplied to changes in price of the good. or Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price
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Elasticity of Supply
Es = %D in Qs %D in P

Law of Supply tells us this number is generally positive.

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Determinants of Elasticity of Supply

If supply is getting more (or less) elastic, we are saying that the firms can change supply in larger (or smaller) quantities when price changes. Generally, anything that can effect a firms ability to change production easily will effect the elasticity of supply.

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Determinants of Elasticity of Supply

For instance: more time, a change in technology, etc. To consider: what would the supply curve of Picasso paintings look like?

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