Chapter 3 - Elasticity

Chapter 3: Elasticity

3.1 Types of Elasticity

  • Price Elasticity of Demand

  • Income Elasticity of Demand

  • Cross-Price Elasticity of Demand

  • Price Elasticity of Supply

3.2 Price Elasticity of Demand

  • Definition:

    • Measures the responsiveness of quantity demanded to changes in price.

    • Calculated as the percentage change in quantity demanded divided by the percentage change in price.

    • Formula:

      • [ Ed = \frac{(Q1 - Q0) / Q0}{(P1 - P0) / P0} \times 100 ]

3.3 Example Calculation

  • Example:

    • If the price of an ice cream cone increases from $2.00 to $2.20 and demand decreases from 10 to 8 cones:

      • [ Ed = \frac{(8 - 10) / 10}{(2.20 - 2.00) / 2.00} = \frac{-0.2}{0.1} = -2 ]

    • Negative sign ignored (indicates law of demand).

3.4 Degrees of Price Elasticity of Demand

  • Elastic Demand (Ed > 1):

    • Percentage change in quantity demanded is greater than percentage change in price.

    • Example: Goods with close substitutes (e.g., toothpaste brands).

  • Inelastic Demand (Ed < 1):

    • Percentage change in quantity demanded is less than percentage change in price.

    • Example: Necessities like petrol and rice.

  • Perfectly Elastic Demand (Ed = ∞):

    • Consumers buy any quantity at P0, none above P0.

  • Perfectly Inelastic Demand (Ed = 0):

    • Quantity demanded does not change regardless of price.

    • Example: Insulin for diabetics.

  • Unitary Elastic Demand (Ed = 1):

    • Percentage changes in price and quantity demanded are equal.

3.5 Determinants of Price Elasticity of Demand

  • Substitutes Available:

    • More substitutes = more elastic demand.

    • Example: An increase in Coca Cola's price leads to higher demand for Pepsi.

  • Necessity vs. Luxury Goods:

    • Necessity goods tend to have inelastic demand while luxury goods are more elastic.

  • Time Horizon:

    • Elasticity can increase over time as consumers find alternatives.

  • Proportion of Income Spent:

    • Larger expenditure proportion leads to more elastic demand (e.g., cars).

  • Consumer Habits:

    • Habituated goods tend to display inelastic demand.

  • Joint Demand:

    • Goods that are used together may show similar elasticity shifts.

  • Income Levels:

    • Higher income = inelastic demand generally; lower income yields elastic demand.

3.6 Relationship Between Price Elasticity of Demand and Total Revenue (TR)

  • TR Formula:

    • [ TR = Price \times Quantity ]

  • Implications:

    • If demand is elastic: Decrease price to boost TR.

    • If demand is inelastic: Increase price to boost TR.

    • Unitary elastic demand: Change in price does not affect TR.

3.7 Cross Elasticity of Demand

  • Measures responsiveness of demand for one good relative to the price change of another good.

  • Calculation Formula:

    • [ Ec = \frac{(Q1x - Q0x) / Q0x}{(P1y - P0y) / P0y} \times 100 ]

  • Possibilities:

    • If Ec is positive: Goods are substitutes.

    • If Ec is negative: Goods are complements.

    • If Ec is zero: No relationship between goods.

3.8 Income Elasticity of Demand

  • Measures responsiveness of demand to changes in consumer income.

  • Calculation Formula:

    • [ Ey = \frac{(Q1 - Q0) / Q0}{(Y1 - Y0) / Y0} \times 100 ]

  • Categories:

    • Luxury goods (Ey ≥ 1) = positive income elasticity.

    • Normal goods (0 < Ey < 1) = positive income elasticity.

    • Inferior goods (Ey < 0) = negative income elasticity.

3.9 Price Elasticity of Supply

  • Definition:

    • Measures quantity supplied responsiveness to price changes.

  • Calculation: Similar to price elasticity of demand.

  • Degrees of Elasticity:

    • Elastic Supply (Es > 1), Inelastic Supply (Es < 1), Unitary Elastic Supply (Es = 1), Perfectly Inelastic Supply (Es = 0), Perfectly Elastic Supply (Es = ∞)

3.10 Determinants of Price Elasticity of Supply

  • Factors include producer flexibility, time period, factor mobility, technology, and perishability.