Elasticity Lecture Notes

ELASTICITY

Definition of Elasticity

  • Elasticity: A measure of the responsiveness of buyers and sellers to changes in price or income.

    • Usefulness: It helps determine how much buyers and sellers change their behavior when prices or income change.

Key Concepts of Elasticity

  1. Price Elasticity of Demand

    • Definition: A measure of the responsiveness of quantity demanded to a change in price.

      • Example: If the price of a Snickers bar increases by 25%, we assess how this impacts the purchase of Snickers bars.

      • Example: If gasoline prices increase by 25%, evaluation of how this affects driving habits is required.

      • Example: If the price of houses increases by 25%, understanding the impact on the development of new houses is crucial.

  2. Price Elasticity of Supply

    • Definition: Similar responsiveness regarding supply to changes in price.

  3. Impact of Income and Prices of Other Goods on Elasticity

    • Changes in income and related goods' prices influence elasticity.

Expected Skills from Unit Completion

  • Ability to:

    • Calculate price elasticity of demand, elasticity of supply, income elasticity, and cross-price elasticity.

    • Predict total revenue impact due to price changes, utilizing elasticity knowledge.

CALCULATING ELASTICITY OF DEMAND

  • Elasticity of Demand (ED) Formula: ED = rac{ ext{Percentage Change in Quantity Demanded}}{ ext{Percentage Change in Price}}

    • Example Calculation: If the price of apples increases by 10% and consumers reduce their purchases by 30%, then:
      ED = rac{-30 ext{%}}{10 ext{%}} = -3

    • Interpretation: Consumers of apples are three times as responsive as the price change.

    • Elasticity of demand is negative due to the law of demand (inverse relationship between price and quantity demanded).

MIDPOINT FORMULA FOR ELASTICITY

  • Issue with Percent Change Formula:

    • Different percentage changes result when moving along a demand curve.

    • Example:

    • Price decreases from $5 to $4 results in a 20% change.

    • Price increases from $4 to $5 results in a 25% change.

  • Midpoint Method:

    • Corrects the problem of varying percentage changes by yielding a single estimate regardless of the direction of price change.

ELASTICITY CATEGORIES

Perfectly Elastic Demand

  • Definition: If |ED| = ext{∞}, demand is perfectly elastic.

    • Market Example: Highly competitive markets with identical products (e.g., wheat).

    • Behavior: Price increase results in quantity demanded equal to zero.

Elastic Demand

  • Definition: If ∞ > |ED| > 1, demand is elastic.

    • Characteristics: Products with many good substitutes (e.g., candy bars).

    • Behavior: A 25% increase in price leads to more than a 25% decrease in quantity demanded, showing high consumer sensitivity.

Unit Elastic Demand

  • Definition: If |ED| = 1, then demand is unit elastic.

    • Characteristics: Purchases involving a fixed expenditure budget.

    • Example: Spending fixed amounts on computers results in a proportional response, such as a 25% price increase leading to a 25% decrease in quantity demanded.

Inelastic Demand

  • Definition: If 1 > |ED| > 0, demand is inelastic.

    • Characteristics: Few substitutes available (e.g., gasoline, baby formula).

    • Example: A 25% price increase results in less than a 25% decrease in quantity demanded, indicating low sensitivity.

Perfectly Inelastic Demand

  • Definition: If |ED| = 0, demand is perfectly inelastic.

    • Characteristics: No adequate substitutes available (e.g., insulin).

    • Behavior: A 25% increase in price leads to no change in quantity demanded.

SUMMARY CHART OF ELASTICITY OF DEMAND

DEMAND IS:

ELASTICITY OF DEMAND

QUANTITY DEMANDED IS:

Perfectly Elastic

|ED|=∞

Extremely Responsive

Elastic

∞>|ED|>1

Very Responsive

Unit Elastic

|ED|=1

Equally Responsive

Inelastic

1>|ED|>0

Not Very Responsive

Perfectly Inelastic

|ED|=0

Not At All Responsive

DETERMINANTS OF ELASTICITY

  1. Availability of Substitutes:

    • More Substitutes Available: Increases elasticity of demand (e.g., Vidal Sassoon shampoo, Wheaties cereal).

    • Fewer Substitutes Available: Decreases elasticity of demand (e.g., gasoline).

  2. Luxuries vs. Necessities:

    • Necessities: Relatively inelastic demand; consumers cannot easily reduce quantity demanded (e.g., milk, medicine).

    • Luxuries: Relatively elastic demand; consumers can easily reduce quantity demanded (e.g., vacations, jewelry).

  3. Proportion of Income Expended:

    • If a larger portion of income is spent on a product, consumers are more sensitive to price changes (e.g., housing vs. table salt).

  4. Time:

    • Longer time frames allow consumers to adjust their quantity demanded more effectively (e.g., change habits over time when gasoline prices increase).

RELATIONSHIP BETWEEN ELASTICITY OF DEMAND & TOTAL REVENUE

  1. Inelastic Demand:

    • If price increases, total revenue increases (e.g., TR1 < TR2 when comparing revenue at different price points).

    • If price decreases, total revenue decreases.

  2. Elastic Demand:

    • If price increases, total revenue decreases.

    • If price decreases, total revenue increases.

  3. Unit Elastic Demand:

    • Total revenue remains unchanged regardless of price changes (e.g., total revenue is constant whether prices go up or down).

MEMORY DEVICE FOR ELASTICITY CURVES

  • For distinguishing between perfectly inelastic and perfectly elastic demand curves, focus on the first letter of each word:

    • Perfectly Inelastic: Vertical curve.

    • Perfectly Elastic: Horizontal curve.