Elasticity and Its...
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Elasticity and Its Application Sakib Bin Amin, Ph.D. Assistant Professor School of Business and Economics North South University
Transcript of Elasticity and Its...
Elasticity and Its
Application
Sakib Bin Amin, Ph.D.
Assistant Professor
School of Business and Economics
North South University
What is an Elasticity?
Measurement of the percentage change in
one variable that results from a 1%
change in another variable.
When the price rises by 1%, quantity
demanded might fall by 5%.
The price elasticity of demand is -5 in this
example.
Types of Elasticity
1.Elasticity of Demand
i) Price Elasticity of Demand
ii) Income Elasticity of Demand
iii) Cross Price Elasticity of Demand
2.Elasticity of Supply
Price Elasticity of Demand
Price elasticity of demand is the
percentage change in quantity demanded
given a percent change in the price.
It 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
Q
P
P
Q
PP
/
/
•The price elasticity of demand is always negative.
•Economists usually refer to the price elasticity of
demand by its absolute value (ignore the negative
sign).
Computing the Price Elasticity
of Demand
price inchange Percentage
demandedquatity inchange Percentagedemand of elasticityPrice
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:
2percent10
percent20
100002
002202
10010
810
.
)..(
)(
Example:
P0 = 8 P1 = 7
Q0 = 40 Q1 = 48
Step 1: Q = 48 - 40 = 8
P = 7 - 8 = -1
Step 2: Use the formula for Ed.
Example:
Step 3:
Ed = (Qd / P) * P0 / Q0
= (8 /-1) * (8/40) = - 1.6
Step 4:
This means that for every 1 % change in price that
there is a 1.6 % change in quantity demanded in the
opposite direction.
0 1 2 3 4 5 6
Inelastic
Unit elastic
Elastic
Price elasticity of demand
Demand is said to be: elastic when Ed > 1,
unit elastic when Ed = 1, and
inelastic when Ed < 1.
Inelastic Demand
Inelastic demand
The percentage change in quantity is less
than the percentage change in price.
Price elasticity of demand < 1
Inelastic Demand
- Elasticity is less than 1
Quantity
Price
4
$5 1. A 25% increase in price...
Demand
100 90 2. ...leads to a 10% decrease in quantity.
Elastic Demand
Elastic demand
The percentage change in quantity is greater
than the percentage change in price.
Price elasticity of demand > 1
Elastic Demand
- Elasticity is greater than 1
Quantity
Price
4
$5 1. A 25% increase in price...
Demand
100 50 2. ...leads to a 50% decrease in quantity.
Unit Elastic Demand
Unit elasticity
The percentage change in quantity equals the percentage change in price.
Price elasticity of demand = 1
Unit Elastic Demand
- Elasticity equals 1
Quantity
Price
4
$5 1. A 25% increase in price...
Demand
100 75 2. ...leads to a 25% decrease in quantity.
The flatter the demand curve, the more price elastic is the
demand.
P
Qd
P
Qd
flatter steeper
The flatter the demand
curve, the more room
there is for the quantity
to adjustment.
Hence, the flatter the
demand curve, the more
responsive is the quantity
to a price change.
Perfectly Elastic Demand
- Elasticity equals infinity
Quantity
Price
Demand $4
1. At any price above $4, quantity demanded is zero.
2. At exactly $4, consumers will buy any quantity.
3. At a price below $4, quantity demanded is infinite.
Perfectly Inelastic Demand
- Elasticity equals 0
Quantity
Price
4
$5
Demand
100 2. ...leaves the quantity demanded unchanged.
1. An increase in price...
Examples of Demand Elasticity
When the price of gasoline rises by 1% the
quantity demanded falls by 0.2%, so gasoline
demand is not very price sensitive.
Price elasticity of demand is -0.2 .
When the price of gold jewelry rises by 1% the
quantity demanded falls by 2.6%, so jewelry
demand is very price sensitive.
Price elasticity of demand is -2.6 .
Determinants of
Price Elasticity of Demand
Necessities versus Luxuries
Availability of Close Substitutes
Time Horizon
Factors That Influence
Elasticity
The Closeness of Substitutes.
The closer the substitutes, the more elastic the
demand – more elastic means a higher price elasticity (but not necessarily > 1)
Factors That Influence
Elasticity Proportion of Income Spent on the Good
The greater the proportion of income spent on food, the more elastic the demand
• Because of Income Effect of a price change
Factors That Influence
Elasticity
Time Elapsed Since Price Change
The longer the time, the more elastic the demand
• Short-run demand
• Long-run demand
Determinants of
Price Elasticity of Demand
Demand tends to be more elastic :
if the good is a luxury.
the longer the time period.
the larger the number of close
substitutes.
Determinants of Price
Elasticity of Demand
Demand tends to be more inelastic
If the good is a necessity.
If the time period is shorter.
The smaller the number of close substitutes.
Elasticity along a linear
demand curve
Computing the Price Elasticity of
Demand Using the Midpoint
Formula
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.
)/2]P)/[(PP(P
)/2]Q)/[(QQ(Q=Demand of Elasticity Price
1212
1212
Computing the Price Elasticity
of Demand
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:
32.25.9
22
2/)20.200.2(
)00.220.2(
2/)810(
)810(
percent
percent
)/2]P)/[(PP(P
)/2]Q)/[(QQ(Q=Demand of Elasticity Price
1212
1212
Arc elasticity measure
where:
Example
Suppose that quantity demanded falls from 60 to 40 when the price rises from $3 to $5. The arc elasticity measure is given by:
In this interval, demand is inelastic (since elasticity < 1).
Slope Compared to Elasticity
The slope measures the rate of change of one variable (P, say) in terms of another (Q, say).
The elasticity measures the percentage change of one variable (Q, say) in terms of another (P, say).
Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.
Elasticity: Mathematical Definition
slopeP
Q
1
slope
Q
P
elasticityP
Q slope
1
Exercise -- Linear Demand
Quantity Price
10 40
11 38
12 36
13 34
14 32
15 30
16 28
17 26
18 24
19 22
20 20
Compute the elasticity at the
point indicated in red on the
table (Q=18,P=24).
Slope = -2
1/Slope = -1/2
P/Q = 24/18 = 4/3
Elasticity = -2/3
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
$4
Demand
Quantity
P
0
Price
P x Q = $400
(total revenue)
100 Q
Elasticity and Total Revenue
Elasticity and Total Revenue
If demand is elastic in the relevant range of prices, price and total revenue vary inversely.
That is, a price increase will decrease total revenue.
An elastic demand means that the percentage change in quantity demanded is greater than the percentage change in price.
Hence, an increase in price will result in a more than offsetting percentage decrease in quantity taken.
Elastic: p q TR
Elasticity and Total Revenue
If demand is inelastic in the relevant range of prices, price and total revenue vary directly.
That is, a price increase will increase total revenue.
An inelastic demand means that the percentage change in quantity demanded is less than the percentage change in price.
Hence, an increase in price will result in a less than offsetting percentage decrease in quantity taken.
Inelastic:
p q TR
Elasticity and Total Revenue
If demand is unitary in the relevant range of prices, total revenue does not change in response to price changes. A unitary own-price elasticity of demand means that the
percentage change in quantity demanded is equal to the percentage change in price.
Hence, an increase in price will result in an offsetting percentage decrease in quantity taken.
Unitary:
p q TR
STAYS
The Total Revenue Test for
Elasticity
INELASTIC
DEMAND
ELASTIC
DEMAND
Decrease in
Price
ELASTIC
DEMAND
INELASTIC
DEMAND
Increase in
Price
Decrease in
Total Revenue
Increase in
Total Revenue
Price
Quantity
D
P2
Q2
P1
Q1
P1 x Q1 = A + B
P2 x Q2 = A + C
(P2 x Q2) - (P1 x Q1) =
(A + C) - (A + B) =
C - B
C
A B
Expenditure = Price x Quantity
Price
Quantity
D
P 2
Q1
Inelastic Demand: Area C > Area B
P1
Q2
C
A B
Price
Quantity
D
P
Q
2
2
P1
Elastic Demand: Area B > Area C
Q1
C
A B
Income Elasticity of Demand
Income elasticity of demand 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.
Computing Income Elasticity
Income Elasticity of Demand
Percentage Change in Quantity Demanded
Percentage Change in Income
=
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.
Income elasticity of demand
A good is a luxury good if income elasticity > 1.
A good is a necessity good if income elasticity < 1.
A good is a normal good if income elasticity > 0.
A good is an inferior good if income elasticity < 0.
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.
Cross-Price elasticity of demand
The cross-price elasticity of demand
between two goods j and k is defined as:
Cross-Price elasticity (cont.)
Cross-price elasticity is positive if and only if the goods
are substitutes
Cross-price elasticity is negative if and only if the
goods are complements.
