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MICROECONOMIC THEORY
BASIC PRINCIPLES AND EXTENSIONS
EIGHTH EDITION
WALTER NICHOLSON
Copyright 2002 by South-Western, a division of Thomson Learning. All rights reserved.
Elasticity
Suppose that a particular variable (B)
depends on another variable (A)
B = f(A)
We define the elasticity of B with respect
to A as
% change in B B / B B A
eB,A
% change in A A / A A B
The elasticity shows how B responds (ceteris
paribus) to a 1 percent change in A
Price Elasticity of Demand
The most important elasticity is the price
elasticity of demand
measures the change in quantity demanded
caused by a change in the price of the good
% change in Q Q / Q Q P
eQ,P
% change in P P / P P Q
eQ,P will generally be negative
except in cases of Giffens paradox
Distinguishing Values of eQ,P
% change in Q Q P'
eQ,P '
% change in P' P' Q
X PX X PX PX X X I
PX X PX X U constant
I I X
Slutsky Equation in Elasticities
A substitution elasticity shows how the
compensated demand for X responds to
proportional compensated price changes
it is the price elasticity of demand for
movement along the compensated demand
curve
X PX
e S
X ,PX
PX X U constant
Slutsky Equation in Elasticities
Thus, the Slutsky relationship can be
shown in elasticity form
e X ,PX e SX ,PX s X e X ,I
It shows how the price elasticity of
demand can be disaggregated into
substitution and income components
Note that the relative size of the income
component depends on the proportion of total
expenditures devoted to the good (sX)
Homogeneity
Remember that demand functions are
homogeneous of degree zero in all
prices and income
Eulers theorem for homogenous
functions shows that
X X X
PX PY I 0
PX PY I
Homogeneity
Dividing by X, we get
X PX X PY X I
0
PX X PY X I X
Using our definitions, this means that
e X ,PX e X ,PY e X ,I 0
eY ,PY 1 eY ,I 1 eY ,PY 1
Note that
PX X PYY
sX sY
I I
Cobb-Douglas Elasticities
Homogeneity can be shown for these elasticities
e X ,PX e X ,PY e X ,I 1 0 1 0
The elasticity version of the Slutsky equation can
also be used
e X ,PX e SX ,PX s X e X ,I
1 e SX ,PX (1)
e SX ,PX (1 - )
Cobb-Douglas Elasticities
The price elasticity of demand for this
compensated demand function is equal
to (minus) the expenditure share of the
other good
More generally
e S
X ,PX (1 - s X )
where is the elasticity of substitution
Linear Demand
Q = a + bP + cI + dP
where:
Q = quantity demanded
P = price of the good
I = income
P = price of other goods
a, b, c, d = various demand parameters
Linear Demand
Q = a + bP + cI + dP
Assume that:
Q/P = b 0 (no Giffens paradox)
Q/I = c 0 (the good is a normal good)
Q/P = d 0 (depending on whether
the other good is a gross substitute or
gross complement)
Linear Demand
If I and P are held constant at I* and
P*, the demand function can be written
Q = a + bP
where a = a + cI* + dP*
Note that this implies a linear demand
curve
Changes in I or P will alter a and shift the
demand curve
Linear Demand
Along a linear demand curve, the slope
(Q/P) is constant
the price elasticity of demand will not be
constant along the demand curve
Q P P
eQ,P b
P Q Q
As price rises and quantity falls, the
elasticity will become a larger negative
number (b < 0)
Linear Demand
P Demand becomes more
elastic at higher prices
-a/b eQ,P < -1
eQ,P = -1
eQ,P > -1
Q
a
Constant Elasticity Functions
If one wanted elasticities that were
constant over a range of prices, this
demand function can be used
Q = aPbIcPd
where a > 0, b 0, c 0, and d 0.
For particular values of I and P,
Q = aPb
where a = aIcPd
Constant Elasticity Functions
This equation can also be written as
ln Q = ln a + b ln P
Applying the definition of elasticity,
b 1
Q P ba' P P
eQ,P b
P Q a' P b