ECO L 8

Overview of Elasticity in Economics

Learning Objectives
  • Understand the different types of elasticity.
  • Grasp why elasticity is crucial in economics (full details in future lectures).
Key Concepts
Supply and Demand
  • Supply and demand determine market equilibrium.
  • Changes in supply or demand affect equilibrium price and quantity.
Equilibrium Price and Quantity
  • An example from New Zealand's market for "Snake oil":
    • Equilibrium price: $16
    • Equilibrium quantity: 120 litres
Changes in Equilibrium
  1. Identify if Supply, Demand, or both are changing.
  2. Determine the direction of the change (left or right shift).
  3. Assess how it affects equilibrium price (P) and quantity (Q).
Change in Demand
  • Example: A heatwave increases demand for ice cream.
    • Shift: Demand curve shifts right.
    • Outcome: Higher price (P1 to P2) and higher quantity (Q1 to Q2).
Change in Supply
  • Example: A fire destroys ice cream shops, reducing supply.
    • Shift: Supply curve shifts left.
    • Outcome: Higher price (P1 to P2) and lower quantity (Q1 to Q2).
Simultaneous Changes in Demand and Supply
  • Two potential outcomes:
    1. Demand change dominates, leading to increase in both price and quantity.
    2. Supply change dominates, leading to higher price but lower quantity.
Role of Prices in Resource Allocation
  • Increased demand pushes up prices, signaling suppliers to produce more.
  • This mechanism eliminates the need for central planning in resource allocation.
Understanding Elasticity
  • Price Elasticity of Demand (PED): Measures responsiveness of quantity demanded to changes in price.
  • Defined mathematically as:
    • Pε = Percentage change in Qd / Percentage change in P
  • Relationships:
    • Inversely proportional: As price increases, quantity demanded usually decreases (law of demand).
Point Elasticity of Demand
  • Evaluating elasticity at a specific point on the demand curve:
    • Pε = (Change in Qd) / (Qd) / (Change in P) / (P)
    • Example with specific values shows how to calculate elasticity at defined prices and quantities.
Arc Elasticity
  • Takes an average of two points to calculate elasticity:
    • Pε = (Q2 - Q1) / [(Q2 + Q1) / 2] / (P2 - P1) / [(P2 + P1) / 2]
  • Offers consistent results regardless of direction of movement between points A and B.
Types of Elasticity
  • Elastic Demand (Pε > 1): Small change in price results in large change in quantity demanded.
  • Inelastic Demand (Pε < 1): Changes in price have little effect on quantity demanded.
  • Unit Elastic (Pε = 1): Percentage change in price leads to an equal percentage change in quantity demanded.
Future Topics
  • Factors that determine elasticity.
  • Relationship between elasticity and total revenue for sellers.
  • Other forms of elasticity: income elasticity, cross-price elasticity, and price elasticity of supply.
Application Questions
  • Consider scenarios where increasing prices may not benefit firms.
  • Evaluate price adjustments for events (e.g., sports event ticket prices, responding to demand surges).