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Elasticity and its Applications - Principles of Micro, Lecture...
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Elasticity and its ApplicationsPrinciples of Micro, Lecture 3
Petar Stankov
Sept. 2015
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 1 / 16
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Price and Income Elasticities of DemandDefining Elasticities
Which factors influenced demand?The general setting: Dx = f (px ,Y , pz ,Y , p
t+1x ,�, ...)
Demand elasticityA measure of how demand reacts to various changes in its factors.
Price elasticity of demandBy how much (in percentage points) the quantity demanded changes if theprice changes by 1 percent?
εDxpx = ∆Dx=?%
∆px=1%
Income elasticity of demandBy how much (in percentage points) the quantity demanded changes if theincome changes by 1 percent?
εDxY = ∆Dx=?%
∆Y=1%
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 2 / 16
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Price and Income Elasticities of DemandDefining Elasticities
Which factors influenced demand?The general setting: Dx = f (px ,Y , pz ,Y , p
t+1x ,�, ...)
Demand elasticityA measure of how demand reacts to various changes in its factors.
Price elasticity of demandBy how much (in percentage points) the quantity demanded changes if theprice changes by 1 percent?
εDxpx = ∆Dx=?%
∆px=1%
Income elasticity of demandBy how much (in percentage points) the quantity demanded changes if theincome changes by 1 percent?
εDxY = ∆Dx=?%
∆Y=1%
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 2 / 16
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Price and Income Elasticities of DemandDefining Elasticities
Which factors influenced demand?The general setting: Dx = f (px ,Y , pz ,Y , p
t+1x ,�, ...)
Demand elasticityA measure of how demand reacts to various changes in its factors.
Price elasticity of demandBy how much (in percentage points) the quantity demanded changes if theprice changes by 1 percent?
εDxpx = ∆Dx=?%
∆px=1%
Income elasticity of demandBy how much (in percentage points) the quantity demanded changes if theincome changes by 1 percent?
εDxY = ∆Dx=?%
∆Y=1%
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 2 / 16
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Price and Income Elasticities of DemandDefining Elasticities
Which factors influenced demand?The general setting: Dx = f (px ,Y , pz ,Y , p
t+1x ,�, ...)
Demand elasticityA measure of how demand reacts to various changes in its factors.
Price elasticity of demandBy how much (in percentage points) the quantity demanded changes if theprice changes by 1 percent?
εDxpx = ∆Dx=?%
∆px=1%
Income elasticity of demandBy how much (in percentage points) the quantity demanded changes if theincome changes by 1 percent?
εDxY = ∆Dx=?%
∆Y=1%
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 2 / 16
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Demand Elasticity w.r.t. Other FactorsDefining the Cross-Price Elasticity
Cross-price elasticity of demandBy how much (in percentage points) the quantity demanded of good Xchanges if the price of good Z changes by 1 percent?
εDxpz = ∆Dx=?%
∆pz=1%
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 3 / 16
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Types of GoodsWith respect to the elasticities of demand
W.r.t. the income elasticity of demand:
εDxY
< 0 - inferior goods(0; 1) - necessities> 1 - luxuries
What does the increase in income mean for your firm?
W.r.t. the cross-price elasticity of demand:
εDxpz
{< 0 - complements> 0 - substitutes
What does the increase in prices of related goods mean for your firm?1 on the inputs side of the market2 on the output side of the market
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 4 / 16
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Types of GoodsWith respect to the elasticities of demand
W.r.t. the income elasticity of demand:
εDxY
< 0 - inferior goods(0; 1) - necessities> 1 - luxuries
What does the increase in income mean for your firm?
W.r.t. the cross-price elasticity of demand:
εDxpz
{< 0 - complements> 0 - substitutes
What does the increase in prices of related goods mean for your firm?1 on the inputs side of the market2 on the output side of the market
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 4 / 16
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Own-Price Elasticity and Revenues of the Firm
How does your own price relate to the revenues of the firm?
|εDxpx |{< 1 lower price means lower revenues> 1 lower price means higher revenues
Exercise: Draw a graph relating demand, PED, and Revenues for the firm.
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 5 / 16
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Factors Affecting the Own-Price Elasticity of Demand
1 Advertising:
2 Availability of substitutes: Supertalents? Dinner at home and at therestaurant?
3 Share of income and expenditures the good occupies: food;toothpicks; aglets
4 Time-frame: food today; food in a monthP.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 6 / 16
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Various Demand CurvesPerfectly Inelastic Demand
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 7 / 16
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Various Demand CurvesInelastic Demand
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 8 / 16
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Various Demand CurvesElastic Demand
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 9 / 16
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Various Demand CurvesPerfectly Elastic Demand
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 10 / 16
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Elasticity and Market Equilibrium
How does the Equilibrium outcome depend on the own-price elasticity?
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 11 / 16
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Demand ElasticityThe Midpoint Formula
Recall the PED formula. Which way do you go: A to B or B to A? Are theelasticities the same? How to avoid the problem?
The midpoint formula:
εDxpx =
∆Q(Q1+Q2)/2
∆P(P1+P2)/2
Exercise: Design your own example by using the original formula and themidpoint formula. Notice the differences.
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 12 / 16
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Own-Price Elasticity of SupplyDefining supply elasticity
The general model: Sx = f (px ,E{px t+1}, pi ,T ,N, πalt , ...)
Supply elasticityA measure of how much supply reacts to changes in its factors
Price elasticity of supplyBy how much (in % points) does supply change if price changes by 1%
εSxpx = ∆Sx=?%∆px=1%
Factors influencing the PES:1 time period: short Vs. long2 spare capacity: small Vs. large3 the state of the economy: boom Vs. downturn4 the mobility of production factors5 ease of storing the product
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 13 / 16
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Own-Price Elasticity of SupplyDefining supply elasticity
The general model: Sx = f (px ,E{px t+1}, pi ,T ,N, πalt , ...)
Supply elasticityA measure of how much supply reacts to changes in its factors
Price elasticity of supplyBy how much (in % points) does supply change if price changes by 1%
εSxpx = ∆Sx=?%∆px=1%
Factors influencing the PES:1 time period: short Vs. long2 spare capacity: small Vs. large3 the state of the economy: boom Vs. downturn4 the mobility of production factors5 ease of storing the productP.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 13 / 16
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Supply elasticityTwo exercises
Based on your knowledge of PED, do the following:1 Use the midpoint formula to derive the PES for a given S curve.2 Draw the variety of supply curves based on their elasticity.
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 14 / 16
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Supply elasticityA graphical representation
Elastic supply
Inelastic supplyP.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 15 / 16
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Further Info
Reading:M-T, ch.4: 72-95
Do not miss:economist.com; wsj.com; cnbc.com
P.Stankov (UNWE, AUBG) Lecture 3 Sept. 2015 16 / 16