elasticity edited

Elasticity Basics

  • Elasticity Definition: Elasticity measures the responsiveness of one variable to changes in another variable.

    • Specifically, it quantifies how much the quantity demanded (Qd) or quantity supplied (Qs) changes in response to changes in price (P), income, or the price of related goods.

Chapter Overview

  • Key Questions:

    • What is elasticity and what issues can it clarify?

    • What is the price elasticity of demand?

      • Relationship to the demand curve

      • Impact on revenue and expenditure.

    • What is the price elasticity of supply?

      • Relationship to the supply curve

    • What are income and cross-price elasticities of demand?

Elasticity in Action: A Scenario

  • Business Example:

    • Website designer charges $200 per site and sells 12 sites monthly.

    • Considering raising prices to $250 due to rising costs.

    • Implications of price increase on demand and revenue.

Elasticity Concepts

  • Basic Idea: Elasticity captures how much quantity demanded/supplied shifts due to price changes.

  • Elasticity Formula:

    • Price Elasticity of Demand (PED) = Percentage Change in Qd / Percentage Change in P

  • Understanding Qd response to price changes:

    • If price rises, it typically leads to a decrease in demand.

Price Elasticity of Demand

  • Definition: Measures the responsiveness of Qd to changes in P.

    • Formula: PED = (Percentage change in Qd) / (Percentage change in P)

Calculating Price Elasticity of Demand

  • Example Calculation:

    • If P rises by 10% and Q falls by 15%, then

    • PED = 15% / 10% = 1.5

    • Indicates price-sensitive demand.

Demand Curve Behavior

  • Along a demand curve:

    • Price (P) and Quantity (Q) move inversely.

    • Price elasticity is reported as a positive number by convention.

Percentage Change Calculations

  • Standard Method:

    • Percentage Change = (End Value - Start Value) / Start Value x 100%

  • Example:

    • From $200 to $250: % change in price = (($250 - $200) / $200) x 100% = 25%

    • From 12 to 8 websites: % change in quantity = (($12 - 8) / 12) x 100% = -33%

  • Discrepancy in standard method highlights the need for the midpoint method.

Midpoint Method for Elasticity Calculation

  • Midpoint Formula helps standardize percentage calculations, allowing consistent results regardless of direction in change.

    • Formula: % Change in Q = (Q2 - Q1) / [(Q1 + Q2) / 2] * 100%

    • Formula: % Change in P = (P2 - P1) / [(P1 + P2) / 2] * 100%

Determinants of Price Elasticity of Demand

  • Different goods show varying elasticities based on:

    • Availability of substitutes: More substitutes = More elasticity

    • Necessity vs. luxury: Luxuries are more elastic

    • Scope of goods: Narrowly defined goods are more elastic

    • Time frame: Generally, more elastic in the long run than in the short run.

Categorizing Demand Elasticity

  • Perfectly Inelastic Demand: Consumers do not change Qd with price changes.

    • Example Situation: Life-saving medications.

  • Inelastic Demand: Qd increases less than proportional to price increases (< 1).

  • Unit Elastic Demand: Qd changes are proportional to price changes (1).

  • Elastic Demand: Qd increases more than proportional to price increases (> 1).

  • Perfectly Elastic Demand: Any price increase causes Qd to drop to zero (infinity).

Total Revenue and Price Elasticity Relationship

  • Price changes affect revenue depending on elasticity:

    • Elastic Demand (< 1): Total revenue drops with price increases.

    • Inelastic Demand (> 1): Total revenue increases with price increases.

    • Unit Elastic: Total revenue remains constant when prices change.

Price Elasticity of Supply

  • Definition: Measures how much Qs responds to changes in P.

    • Formula: Price Elasticity of Supply = Percentage change in Qs / Percentage change in P

Classifying Supply Elasticity

  • Similar to demand, supply curves can be classified based on elasticity:

    • Perfectly Inelastic Supply: Sellers cannot change output regardless of price.

    • Inelastic Supply: Sellers increase Qs less than proportional to price increases (< 1).

    • Unit Elastic Supply: Proportional increase in Qs to price increases (1).

    • Elastic Supply: Qs increases more than proportional (> 1).

    • Perfectly Elastic Supply: Infinite response to price change (infinity).

Income Elasticity of Demand

  • Measures the responsiveness of Qd to changes in consumer income.

    • Formula: Income Elasticity = Percentage change in Qd / Percentage change in income

    • Normal Goods: Income elasticity > 0

    • Inferior Goods: Income elasticity < 0

Cross-Price Elasticity of Demand

  • Measures demand response for one good due to price changes in another good.

    • Formula: Cross-price elasticity = % change in Qd of Good 1 / % change in price of Good 2

    • Substitutes: Cross-price elasticity > 0 (e.g., Coke and Pepsi)

    • Complements: Cross-price elasticity < 0 (e.g., printers and ink).

Chapter Summary

  • Elasticity indicates quantity response to various determinants.

  • PED = % change in Qd / % change in P; < 1 is inelastic, > 1 is elastic.

  • Demand characteristics influencing elasticity:

    • Short-run demand is less elastic.

    • Necessities and broadly defined goods exhibit less elasticity.