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# Elasticity of Demand

## Price Elasticity of Demand

A measure of the responsiveness of quantity demanded to changes in price. Measured by dividing the percentage change in the quantity demanded of a good by the percentage change in its price. Economists compute price elasticity of demand using midpoints as the base values of changes in prices and quantities demanded.

## Computing Elasticity of Demand

We divide the change in quantity demanded by the average quantity demanded, all of which is then divided by the change in price divided by the average price.

## Computing the Price Elasticity of Demand

Price elasticity of demand Percentage change in quatity demanded Percentage change in price

Example: If the price of an ice cream cone increases from \$2.00 to \$2.20 and the amount you buy falls from 10 to 8 cones then your elasticity of demand would be calculated as:

## Computing the Arc Price Elasticity of Demand

The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.
(Q2 Q1 )/[(Q 2 Q1 )/2] Price Elasticity of Demand = (P2 P1 )/[(P2 P1 )/2]

## Computing the Arc Price Elasticity of Demand

(Q2 Q1 )/[(Q 2 Q1 )/2] Price Elasticity of Demand = (P2 P1 )/[(P2 P1 )/2]
Example: If the price of an ice cream cone increases from \$2.00 to \$2.20 and the amount you buy falls from 10 to 8 cones the your elasticity of demand, using the midpoint formula, would be calculated as:

(10 8) 22 percent (10 8) / 2 2.32 (2.20 2.00) 9.5 percent (2.00 2.20) / 2

Ranges of Elasticity
Inelastic Demand
Percentage change in price is greater than percentage change in quantity demand. Price elasticity of demand is less than one.

Elastic Demand
Percentage change in quantity demand is greater than percentage change in price. Price elasticity of demand is greater than one.

## Perfectly Inelastic Demand

- Elasticity equals 0
Price

Demand

\$5 1. An increase in price... 4

## Quantity 100 2. ...leaves the quantity demanded unchanged.

Inelastic Demand
- Elasticity is less than 1
Price

## Unit Elastic Demand

- Elasticity equals 1
Price

## Quantity 75 100 2. ...leads to a 25% decrease in quantity.

Elastic Demand
- Elasticity is greater than 1
Price

## Perfectly Elastic Demand

- Elasticity equals infinity
Price 1. At any price above \$4, quantity demanded is zero. \$4 2. At exactly \$4, consumers will buy any quantity. 3. At a price below \$4, quantity demanded is infinite. Quantity

Demand

Q&A
On Tuesday, price and quantity demanded are INR 7 and 120 units, respectively. Ten days later, price and quantity are INR 5 and 150 units, respectively. What is the price elasticity of demand between the price of INR 5 and INR 7? What does the price elasticity of demand calculated figure indicate?

## Determinants of Price Elasticity on Demand

Number of Substitutes: The more substitutes for a good, the higher the price elasticity of demand; the fewer substitutes for a good, the lower the price elasticity of demand. The more broadly defined the good, the fewer the substitutes; the more narrowly defined the good, the greater the substitutes. Necessities Versus Luxuries: The more that a good is considered a luxury rather than a necessity, the higher the price elasticity of demand.

## Determinants of Price Elasticity on Demand

Percentage of Ones Budget Spent on the Good: The greater the percentage of ones budget that goes to purchase a good, the higher the price elasticity of demand; the smaller the percentage of ones budget that goes to purchase a good, the lower the elasticity of demand. Time: The more time that passes, the higher the price elasticity of demand for the good; the less time that passes, the lower the price elasticity of demand for the good.

## Determinants of Price Elasticity of Demand

Demand tends to be more inelastic
If the good is a necessity. If the time period is shorter. Lesser the impact on the budget of the individual. The more broadly defined the market.

## Determinants of Price Elasticity of Demand

Demand tends to be more elastic :
if the good is a luxury. the longer the time period. Higher the impact on the budget of the individual. the more narrowly defined the market.

## Elasticity and 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

Price

\$4

P x Q = \$400
P

(total revenue)

Demand

100

Quantity

## Price Elasticity of Demand and Total Revenue

Total revenue may increase, decrease or remain constant.
If demand is elastic, a price rise decreases total revenue. If demand is elastic, a price fall increases total revenue. If demand is inelastic, a price fall decreases total revenue. If demand is unit elastic, a price fall will sell more goods while total revenue remains constant.

## Bridge Toll Example

Current toll for the George Washington Bridge is \$2.00/trip. Suppose the quantity demanded at \$2.00/trip is 100,000 trips/hour. If the price elasticity of demand for bridge trips is 2.0, what is the effect of a 10% toll increase?

## Bridge Toll: Elastic Demand

Price elasticity of demand = 2.0 Toll increase of 10% implies a 20% decline in the quantity demanded. Trips fall to 80,000/hour. Total expenditure falls to \$176,000/hour (= 80,000 x \$2.20). \$176,000 < \$200,000, the revenue from a \$2.00 toll.

## Bridge Toll Example, Part 2

Now suppose the elasticity of demand for bridge trips is 0.5. How would the number of trips and the expenditure on tolls be affected by a 10% increase in the toll?

## Bridge Toll: Inelastic Demand

Price elasticity of demand = 0.5 Toll increase of 10% implies a 5% decline in the quantity demanded. Trips fall to 95,000/hour. Total expenditure rises to \$209,000/hour (= 95,000 x \$2.20). \$209,000 > \$200,000, the revenue from a \$2.00 toll.

## Cross Elasticity of Demand

Measures the responsiveness in the quantity demanded of one good to changes in the price of another good. Defined as the percentage change in the quantity demanded of one good divided by the percentage change in the price of another good. This concept is often used to determine whether two goods are substitutes or complements and the degree to which one good is a complement to or substitute for another.

## Cross Price Elasticity of Demand

Elasticity measure that looks at the impact a change in the price of one good has on the demand of another good. % change in demand Q1/% change in price of Q2. Positive-Substitutes Negative-Complements.

## Income Elasticity of Demand

Measures the responsiveness of quantity demanded to changes in income. Define as the percentage change in quantity demanded of a good divided by the percentage change in income. Income elasticity of demand is positive (Ey > 0) for a normal good. The demand for an inferior good decreases as income increases.

## Computing Income Elasticity

Percentage Change in Quantity Demanded Percentage Change in Income

## Income Elasticity = of Demand

Income Elasticity
- Types of Goods Normal Goods Income Elasticity is positive. Inferior Goods Income Elasticity is negative.
Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.

## Price Elasticity of Supply

Measures the responsiveness of quantity supplied to changes in price. Defined as the percentage change in quantity supplied of a good divided by the percentage change in the price of the good. Supply can be classified as elastic, inelastic, unit elastic, perfectly elastic, or perfectly inelastic.

## FACTORS THAT DETERMINE ELASTICITY OF SUPPLY

CAPACITY How much spare capacity a firm has - if there is plenty of spare capacity, the firm should be able to increase output quite quickly without a rise in costs and therefore supply will be elastic STOCKS The level of stocks or inventories - if stocks of raw materials, components and finished products are high then the firm is able to respond to a change in demand quickly by supplying these stocks onto the market - supply will be elastic

## FACTORS THAT DETERMINE ELASTICITY OF SUPPLY

FACTOR SUBSTITUTION
If capital and labour resources are occupationally mobile and substitutable then the elasticity of supply for a product is likely to be higher than if capital equipment and labour cannot easily be switched and the production process is fairly inflexible in response to changes in the pattern of demand for goods and services. TIME PERIOD Supply is likely to be more elastic, the longer the time period a firm has to adjust its production. In the short run, the firm may not be able to change its factor inputs.

## Summary of the Four Elasticity Concepts

A tax placed on the sellers of VCR tapes shifts the supply curve from S1 to S2 and raises the equilibrium price from \$8 to \$8.50. Part of the tax is paid by buyers through a higher price paid, and part of the tax is paid by sellers through a lower price kept. Tax revenues are maximized by placing the tax on the seller who faces the more inelastic demand curve.

## Different Elasticities and Who Pays the Tax

Q&A
Why will government raise more tax revenue if it applies a tax to a good with inelastic demand than if it applies the tax to a good with elastic demand? Under what condition would a per-unit tax placed on the sellers of computers be fully paid by the buyers of computers?