Elasticity and its Application

Concept of ElasticityElasticity is used to describe the behavior of buyers and sellers in the market Elasticity is a measure of the quantity demanded or supplied to one of its determinants Elasticity of demand measures how much quantity demanded responds to change in one of its determinantsPrice elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good

Concept of ElasticityPrice e of demand= % change in quantity demanded/ % change in priceRemember price elasticity of demand is always negativePrice e of demand determines whether the demand curve is steep or flatDemand for a good is elastic if the quantity demanded responds substantially to changes in the priceDemand for a good is inelastic if the quantity demanded responds only slightly to changes in the price

Determinants of Price Elasticity of Demand Necessities (inelastic) versus luxuries (elastic)Availability of close substitutes (highly elastic)Definition of the market Time horizon

Computing Price Elasticity of Demand Using the midpoint methodThe midpoint method gives us the same price elasticity of demand between two points regardless of the direction of changeThe midpoint method computes a % change by dividing the change by midpoint of the initial and final levelsAlways use midpoint method to calculate elasticity between two points

Variety of Demand Curves Perfectly inelastic demand (e=0)Inelastic demand (e1)Perfectly elastic demand (e=infinity)The flatter the curve passing through a given point, the greater the elasticity of demand The steeper the curve passing through a given point, the smaller the elasticity of demand

Total revenue and the Price Elasticity of DemandTR= PxQTR changes as one moves along the demand curve due to changing price elasticity of demandThe slope of a linear demand curve is constant but its elasticity is not The following general rules apply:When demand is inelastic, a price increase raises TR, and a price decrease reduces TRWhen demand is elastic, a price increase reduces TR, and a price decrease raises TRIn case of unit elastic demand, a change in the price does not affect TR

Other Demand ElasticitiesIncome elasticity of demand =% change in quantity demanded/ % change in incomeNormal goods (positive income elasticity)Inferior goods (negative income elasticity)Necessities (small income elasticity)Luxuries (high income elasticity)Cross price elasticity of demand= % change in quantity demanded of good X/ % change in price of good Y Substitutes (positive cross-price elasticity)Complements (negative cross-price elasticity)

Elasticity of SupplyPrice elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that goodPrice elasticity of supply= % change in quantity supplied/ % change in priceDeterminants of elasticity of supply: Flexibility of sellers to change their production levelsTime period (short versus long)

Elasticity of SupplySupply of a good is elastic if the quantity supplied responds substantially to changes in priceSupply of a good is inelastic if the quantity supplied responds slightly to changes in priceComputing price elasticity of supply using midpoint method

(Change in quantity/midpoint of initial and final quantity) / (change in price/midpoint of initial and final price)

Variety of Supply Curves Perfectly inelastic supply (e=0)Inelastic supply (e1)Perfectly elastic supply (e=infinity)The flatter the curve passing through a given point, the greater the elasticity of supplyThe steeper the curve passing through a given point, the smaller the elasticity of supply

Variety of Supply Curves Price elasticity of supply varies over the supply curve in some markets. Why?

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Applications of supply, demand, and elasticity Impact of change in technology on market equilibriumCan good news for farming be bad news for farmers? Advanced technology results in a new market equilibrium with lower prices and larger quantity sold in the market. Behavior of supply and demand in the SR and LRWhy did OPEC fail to keep the price of oil high? In the SR supply and demand are inelastic and in the LR both of them are elastic

Applications of supply, demand, and elasticity Impact of policy on market equilibriumDoes drug interdiction policy increase or decrease drug-related crime? Drug related crime increases in the SR and decreases in the LRDrug education policy would reduce drug usage and drug- related crime in the SR.