Chapter 6

Elasticity in Economics

General Definition

  • Elasticity in economics is a measure of how one economic variable responds to changes in another economic variable.

    • The primary economic variables discussed are:

    • Quantity (Quantity demanded, Q)

    • Price (P)

Price Elasticity of Demand (PED)

  • Price Elasticity of Demand (PED) is calculated using two formulas, which relate the percentage change in quantity demanded to the percentage change in price.

  • Definitions of PED:

    • If the absolute value of PED is greater than one ($|PED| > 1$), then demand is considered elastic.

    • If the absolute value of PED is less than one ($|PED| < 1$), then demand is considered inelastic.

    • If the absolute value of PED is equal to one ($|PED| = 1$), then demand is termed unit elastic.

Example of Price Elasticity of Demand Interpretation

  • Case Study:

    • Given: Percentage change in quantity demanded = 20%

    • Given: Percentage change in price = -30%

    • Calculation:

    • PED formula: PED=racextPercentagechangeinquantitydemandedextPercentagechangeinpricePED = rac{ ext{Percentage change in quantity demanded}}{ ext{Percentage change in price}}

    • Result: PED=rac20extextperthousand−30extextperthousand=−0.67ext(approximately)PED = rac{20 ext{ extperthousand}}{-30 ext{ extperthousand}} = -0.67 ext{ (approximately)}

    • Interpretation: The demand is inelastic since $|PED| < 1$.

Demand Curves: Steepness and Elasticity

  • When comparing two demand curves:

    • The steeper curve indicates more inelastic demand.

    • The flatter curve indicates more elastic demand.

    • Reasoning: The flatter curve has a greater change in quantity for a given change in price.

Formulas for PED

  • Standard Formula:

    1. PED=racext(Changeinquantitydemanded)ext(Changeinprice)PED = rac{ ext{(Change in quantity demanded)}}{ ext{(Change in price)}}

  • Midpoint Formula:

    1. PED<em>midpoint=rac(Q</em>2−Q<em>1)/((Q</em>2+Q<em>1)/2)(P</em>2−P<em>1)/((P</em>2+P1)/2)PED<em>{midpoint} = rac{(Q</em>2 - Q<em>1) / ((Q</em>2 + Q<em>1)/2)}{(P</em>2 - P<em>1) / ((P</em>2 + P_1)/2)}

    • This formula is advantageous since it gives a consistent value regardless of the direction of the change (A to B or B to A).

Application of Formulas

  • For exams:

    • If no formula is specified, assume to use the standard formula for PED unless otherwise instructed.

    • Be cautious with assumptions; wrong use will lead to different results.

Polar Cases

  • Polar Demand Cases:

    • Perfectly Elastic Demand: Horizontal demand line.

    • Perfectly Inelastic Demand: Vertical demand line.

Factors Determining Price Elasticity of Demand

1. Availability of Close Substitutes

  • Demand is more elastic when there are readily available close substitutes.

    • Example: If the price of coffee rises, consumers might switch to tea.

  • Demand is more inelastic when no close substitutes exist.

    • Example: Price increases for prescription medications with no alternatives.

2. Time Frame (Short Run vs. Long Run)

  • Short Run: Consumers exhibit inelastic behavior; habits are retained after price increase.

  • Long Run: Consumers adjust their purchasing habits; demand becomes more elastic as alternatives are explored.

3. Necessities vs. Luxuries

  • Necessities: Demand is inelastic (e.g., food, shelter).

  • Luxuries: Demand is elastic.

4. Definition of Market

  • Broad Market Definition: Less elastic; few substitutes (e.g., all cars).

  • Narrow Market Definition: More elastic; more substitutes (e.g., specific car models).

5. Share of Consumer Budget

  • Small Share of Budget: Inelastic demand (e.g., buying a magazine).

  • Large Share of Budget: Elastic demand (e.g., rent increase).

Total Revenue and Price Elasticity

  • Total Revenue (TR): Formula to calculate if price increases and how this affects quantity sold.
    TR=PimesQTR = P imes Q

  • Relationship between price changes and revenue:

    • For elastic demand, increasing the price leads to total revenue decreasing.

    • For inelastic demand, increasing the price leads to total revenue increasing.

  • Elasticity helps in decision-making about price changes to optimize revenue.

Implications for Business Decisions

  • Increasing Price for Elastic Demand:

    • Potential loss of total revenue as quantity demanded decreases more significantly than price rise.

  • Increasing Price for Inelastic Demand:

    • Increased revenue from higher prices because quantity reduction is less significant.

  • Price Decrease and Revenue:

    • For elastic demand, revenue can increase as quantity sold increases dramatically.

    • For inelastic demand, revenue may decrease if consumers aren't sensitive to price changes.

Price Elasticity of Supply

  • Definition: The percentage change in quantity supplied divided by the percentage change in price.

  • Price elasticity of supply is always positive because price increases lead to quantity supplied increases.

  • Supply Elasticity Categories:

    • Elastic ($|PES| > 1$)

    • Inelastic ($|PES| < 1$)

    • Unit Elastic ($|PES| = 1$)

  • Factors Determining Price Elasticity of Supply:

    • Time Frame:

    • Short Run: Often inelastic due to existing capacity constraints.

    • Long Run: More elastic as firms can adjust production levels effectively.

  • Examples of Supply Elasticity:

    • Perfectly inelastic supply (e.g., land for agriculture) does not change regardless of price.

Summary

  • Elasticity concepts are critical for businesses to determine pricing strategies.

  • Understanding these concepts allows better predictions of consumer behavior and market reactions to pricing changes.

  • Clarification on the differences between demand and supply elasticity is essential for economic analysis and business strategies.

Conclusion

  • The concepts of price elasticity of demand and supply have profound implications in real-world pricing and revenue strategies.