Elasticity-CH6
Chapter 6: Elasticity and its Application
Introduction to Elasticity
Elasticity: A concept that measures responsiveness.
Key Insights:
Measures how strongly people respond to changes in prices and income.
Answers questions like:
Impact on museum attendance after a price increase.
Demand changes for products due to price variations.
Effects on demand when competitive product prices change.
Importance for Public Policy
Elasticity in Policy Making: Helps answer crucial economic questions.
Examples of applications:
Effects of increasing taxes on labor supply.
Implications of reducing fuel taxes on gasoline demand.
Impact of luxury taxes on item demand (yachts).
Forecasting: Accurate elasticity measurements are vital for predictions.
Case Study: Tennis Court Permits
Incident: Permit prices doubled from $100 to $200.
Outcome: Almost a 50% drop in sales from 2010 to 2012.
Economic Findings:
Expected revenue was $6.3 million; actual was only $1.1 million.
Higher fees led to decreased income suggesting elastic demand.
Practical Scenario in Business
Website Design: Changing the price from $200 to $250 per website.
Current sales: 12 websites per month.
Questions:
How many fewer will be sold?
Will overall revenue fall or potentially rise?
Understanding Elasticity
Definition: Elasticity measures the degree of response of quantity demanded (Qd) or supplied (Qs) to changes in determining factors.
Price Elasticity of Demand
Formula: Price elasticity of demand = Percentage change in Qd / Percentage change in P.
Significance: Measures price sensitivity of buyers.
Calculation Examples
Basic Example: If P rises by 10% and Q falls by 15%, then:
Price elasticity of demand = 15% / 10% = 1.5
Elasticity Sign: Generally presented as positive even though demand typically falls as price rises.
Percent Change Calculations
Standard Method:
Formula: (End Value - Start Value) / Start Value x 100%
Illustration: Price change from A ($200) to B ($250).
Conundrum in Elasticity Calculations
Issue: Elasticity values differ based on starting points.
Resolution: Use the midpoint formula for consistent results in calculations.
Using the Midpoint Method
Formula: (End Value - Start Value) / Midpoint x 100%
Example Calculation from A to B:
Price change: ($200 - $250) / $225 = -22.2%
Quantity change: (12 - 8) / 10 = 40.0%
Elasticity = 40 / -22.2 = 1.8
Determinants of Price Elasticity
Factors affecting price elasticity:
Availability of substitutes.
Whether the good is a necessity or luxury.
Broadness or narrowness of the good's definition.
Time horizon for consumer adjustment.
Examples of Goods
Rice Krispies vs Sunscreen: Close substitutes lead to higher elasticity for Rice Krispies.
Blue Jeans vs Clothing: Narrowly defined goods like blue jeans have higher elasticity.
Insulin vs Cruises: Necessities (insulin) have lower elasticity compared to luxuries (cruises).
Gasoline: Price elasticity affects short-term vs long-term consumer behavior.
Summary of Factors Influencing Elasticity
Price elasticity of demand varies based on:
Availability of substitutes
Necessity versus luxury classification
Definition breadth
Time consideration (long-run vs short-run)
Demand Curve Elasticity
Classification: Economists categorize demand curves by elasticity based on slope.
Elasticity Guidelines:
Flatter curves indicate greater elasticity.
Steeper curves indicate lower elasticity.
Types of Demand Elasticity
Perfectly Inelastic: Elasticity = 0 (no change in quantity demanded regardless of price).
Inelastic Demand: Elasticity < 1 (quantity changes less than price).
Unit Elastic Demand: Elasticity = 1 (proportional changes in quantity and price).
Elastic Demand: Elasticity > 1 (quantity changes more than price).
Perfectly Elastic Demand: Elasticity = ∞ (any price change results in infinity quantity change).
Price Elasticity and Total Revenue
Total Revenue = P x Q
Relationship between price increase and revenue depends on demand elasticity:
Elastic Demand: Price increase → Revenue decrease.
Inelastic Demand: Price increase → Revenue increase.
Summary of Price Elasticity Effects on Revenue
Elastic Demand: Higher price leads to significantly lower quantity sold, thus decreasing revenue.
Inelastic Demand: Higher price leads to minor decrease in quantity sold, thus increasing revenue.
Elasticity and Expenditure Revenue Examples
Insulin Price Increase: Total expenditure likely rises.
Cruise Price Decrease: Total revenue for cruise companies likely falls due to high elasticity.
Estimated Price Elasticities of Demand (Table 6-1)
Inelastic Demand Examples:
Gasoline (short-run): 0.09
Elastic Demand Examples:
College (out-of-state tuition): 1.5
Price Elasticity of Supply
Definition: Measures how Qs changes with price changes.
Formula: Price elasticity of supply = Percentage change in Qs / Percentage change in P.
Characteristics of Supply Curves
Classified based on elasticity similarly to demand curves:
Flatter = more elastic, steeper = less elastic.
Types of Supply Elasticity
Classification includes Perfectly Inelastic, Inelastic, Unit Elastic, Elastic, and Perfectly Elastic.
Determinants of Supply Elasticity
Availability of production inputs.
Time considerations impact supplier responsiveness.
Other Elasticities
Income Elasticity of Demand: Measures Qd change due to income change, varies for normal and inferior goods.
Cross-Price Elasticity of Demand: Measures demand change for one good in response to another good's price change, indicating substitution or complementary relationships.