ECO 202 Module 6: Elasticity

elasticity

measure of how much one economic variable responds to changes in another economic variable, basaed on percentage changes in the variable

price elasticity of demand

responsiveness of the quantity demanded to a change in price

• price elasticity of demand = (percentage change in quantity demanded) / (percentage change in price)

• this will be a negative number

price elasticity of demand and elastic/inelastic

if PED > 1, demand is elastic

if PED = 1, demand is unit elastic

if PED < 1, demand is inelastic

• a “large” value for PED means that quantity demanded changes a lot in response to a price change

calculating percentage change with the midpoint formula

percentage change = (A-B) / [(A+B) / 2]

• the difference between the numbers Q1-Q2 divided by the average between the numbers

we use the midpoint formula because calculating from A to B will result in a different number than from B to A

PED formula w midpoint formula = {(Q2-Q1) / [(Q1+Q2] / 2]} / {(P2-P1) / [(P1+P2] / 2]}

relationship between slip and elasticity

they are related but they are NOT the same

• if two demand curves go through the same point, the one with the higher slip also has the higher (more negative) elasticity

• vertical demand curve means that quantity demanded does not change as price changes, so elasticity is zero

  • vertical demand curve is perfectly inelastic

• a horizontal demand curve means quantity demanded in infinitely responsive to price changes. so elasticity is infinite

  • horiztonal demand curve is perfectly elastic

perfectly inelastic demand

the case where the quantity demanded is completely unresponsive to price and the price elasticity of demand equals 0

perfectly elastic demand

the case where the quantity demanded is infinitely responsive to price and the price elasticity of demand equals infinity

unit elastic

the case where a decrease in price results in the same percentage increase in quantity demanded

determinants of price elasticity of demand

1) availability of close substitutes

2) passage of time

3) whether the good is a luxury or a necessity

4) the definition of the market

5) the share of a good in a consumer’s budget

availability of subsitutes

if a product has more substitutes available, it will have more elastic demand

ex) there are few substitutes for gasoline, so its PED is low. there are many substitutes for Nike sneakers, so their PED is high

passage of time

elasticity is higher in the long run than in the short run. over time, people can adjust their buying habits

ex) in the long run, people can buy a more fuel-efficient car or move closer to work

whether the good is a luxury or a necessity

people are more flexible with luxuries so their PED is higher

ex) many people consider bread and milk necessities. they will buy them every week almost regardless of the price

definition of the market

the more narrowly defined the market, the more substitutes available, and hence the more elastic demand it

ex) you might believe there is no good substitue for jeans, so your demand for jeans is very inelastic. but if you consider different brands of jeans, you might be sensitive to the price of a particular brand

share of a good in a consumer’s budget

if a good is a small portion of your budget, you will likely not be very sensitive to its price

ex) you might buy table salt once a year or less. changes in the price of salt probably won’t affect how much of it you buy

total revenue

total amount of funds a seller receives from selling a good or service, calculate by multiplying price per unit by the number of units sold

total revenue and elasticity

• if demand is elastic, then an increase in price reduces revenue, because the decrease in quantity demanded is proportionally greater than the price increase

• if demand is inelastic, then an increase in price increases revenue because the decrease in the quantity demanded is proportionally smaller than the increase in price

• if demand is unit elastic, than an increase in price does not effect revenue because decrease in quantity demanded is proportionally the same as the increase in price

cross-price elasticity of demand

percentage change in the quantity demanded of one good divided by the percentage change in the price of another good

• measures the strength of substitute or compliment relationships between goods

• substitutes: goods and services that can be used for the same purpose

• complements: goods and services that are used together

• if the products are substitutes, then the XED will be positive

• if the products are complements, then the XED will be negative

• if the products are unrelated, then the XED will be zero

cross-price elasticity of demand formula

XED = percentage change in the quantity demanded of good A divided by the percentage change in the price of good B

XED = {(QA2-QA1) / [(QA1+QA2] / 2]} / {(PB2-PB1) / [(PB1+PB2] / 2]}

income elasticity of demand

a measure of the responsiveness of the quantity demanded to the changes in income, measured by the percentage change in the quantity demanded divided by the percentage change in income

• normal goods: goods and services for which quantity demanded increases as income increases

• inferior goods: goods and services for which quantity demanded decreases as income increases

• if IED is positive, but <1, than the good is normal and a necessity

• if IED is positive and >1, than the good is normal and a luxury

• if IED is negative, than the good is inferior

income elasticity of demand formula

IED = percentage change in quantity demanded / percentage change in income

{(Q2-Q1) / [(Q1+Q2] / 2]} / percentage change in income

price elasticity of supply

responsiveness of the quantity supplied to a change in price

PES = percent change in quantity supplied / percent change in price

midpoint formula still applies so really the formula is:

PES = {(Q_s2-Q_s1) / [(Q_s1+Q_s2] / 2]} / {(P2-P1) / [(P1+P2] / 2]}

• PEs depends on the ability and willingness of firms to alter the quantity they produce as price increases

• time period is critically important

if PES > 1, then supply is elastic

if PES < 1, then supply is inelastic

if PES = 1, then supply is unit elastic

using PES to predict changes in price

when demand increases, we know equilibrium price and quantity will increase, but if supply is inelastic, the quantity supplied cannot change much in response to the demand change, so the price will rise a lot. If supply is elastic, the price will rise much less