Topic 3 Elasticity Topic 3 Elasticity. Elasticity a Fancy Term Elasticity is a fancy term for a...
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Transcript of Topic 3 Elasticity Topic 3 Elasticity. Elasticity a Fancy Term Elasticity is a fancy term for a...
Topic 3ElasticityTopic 3
Elasticity
Elasticity a Fancy Term
Elasticity is a fancy term for a simple concept
Whenever you see the word elasticity, you can conveniently replace it with responsiveness or sensitivity
Recall the law of demand It stated, when price rises quantity demanded falls and vice versa
But, by how much the quantity demanded falls?
Elasticity deals with this how much (magnitude) question 2
Elasticity of Demand
For the purpose of elasticity, you may think of Law of demand as a cause and effect relationship, where,
Price as the cause Quantity demanded as the effect
Therefore, one can ask, Is the effect responsive to the cause? Is the quantity demanded responsive to price change?
Is the quantity demanded elastic to price change?
3
Elasticity of Demand
Consider that Price rises 5%. As a result Quantity Demanded falls (the law of demand, here) by 10%.
In this case, decline in Quantity demanded is larger than increase in price in percentage term.
Which means, effect (response) is higher than the cause.
This makes the demand very responsive We call it demand is elastic
4
Elasticity of Supply
Again consider that Price rises 5%. As a result Quantity Supplied rises (the law of supply, here) by 4%.
In this case, rise in Quantity Supplied is smaller than increase in price in percentage term.
Which means, effect (response) is smaller than the cause.
This makes the supply very irresponsive We call it supply is Inelastic
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Elasticity Coefficient
Elasticity is computed using simple formula
Take the demand for example. We have:
Elasticity of Demand formula is:Ed = % change in quantity demanded
% change in price= -10/5 (% △ effect / % △ cause)= -2
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Change in Price (Cause)
Percentage change in Quantity Demanded
(Effect)
5% 10%
Elasticity of Demand
Ed = -2 is called Price elasticity of Demand
Note, this is not same as Slope (rise over run) of the demand curve
How about elastic or Inelastic? We already know demand is elastic. Quantity response is larger than price change in percentage term.
This is clear from the value of Ed
Ed = -2, means that change in quantity demanded (response) is twice as large as price change (cause) in percentage terms
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Elasticity of Demand
Assume that Ed = 1 Is it Elastic or Inelastic? What can we say about the cause and effect in this case?
Recall Elasticity = % △ effect / % △ cause
Ed = % △ Quantity demanded / % △ Price
=> 1 = % △ Quantity demanded / % △ Price
=> % △ Price= % △ Quantity demanded => We call the demand is Unit Elastic
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Elasticity of Demand
What if the Ed = .8 Is it Elastic or Inelastic? What can we say about the cause and effect in this case?
Recall Elasticity = % △ effect / % △ cause
Ed = % △ Quantity demanded / % △ Price
=> 8/10 = % △ Quantity demanded / % △ Price
=> 10% △ Price => 8% △ Quantity demanded => We call the demand is Inelastic
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Elasticity of Demand
Rule for assigning elasticity:
Here |Ed| is the Absolute value of Ed
The Absolute value takes care of the Negative sign for demand or Positive sign for supply curve The signs convey important information about the relationship. But nothing about determining elastic or inelastic
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Value of |Ed| Elasticity Reason
More than 1 Elastic Effect is larger than Cause
Equal to 1 Unit Elastic Effect is equal Cause
Less than 1 Inelastic Effect is smaller than Cause
Elasticity of Demand
How to compute % change We will use midpoint formula. The elasticity computed using this formula is called ARC elasticity
Consider following data
Compute percentage in price and quantity demanded
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Price Quantity Demanded
P1 = 6 Q1 = 100
P2 = 2 Q2 = 500
How to Compute Price Elasticity
According to the midpoint formula:% △ in Qd = [△ Qd / Average Qd]*100
% △ in Price = [△ P / Average P]*100% △ in Qd = [(500-100)/300]*100 = (4/3)*100
% △ in Price = [(2-6)/4]*100 = (-4/4)*100
Ed = % △ Quantity demanded / % △ Price
= (4/3)*100/-(4/4)*100 = (4/3)/-(1) = -4/3
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Price Quantity Demanded
P1 = 6 Q1 = 100
P2 = 2 Q2 = 500
How to Compute Price Elasticity
To compute price elasticity of demand, Find the absolute values of Ed or |Ed|
If |Ed| is more than 1, the demand is Elastic
If |Ed| is less than 1, the demand is Inelastic
If |Ed| is equal to 1, the demand is Unit elastic
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Elasticity and Total Revenue
Total Revenue is price times number of output sold or TR = P * Q
when P rises TR also rises, ceteris paribus However, P and Q are negatively related through the law of demand
Therefore, when P rises, there is no guarantee that TR will also rise
What will happen to TR depends on whether increase in P is larger or smaller than decrease in Q in percentage terms
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Elasticity and Total Revenue
For example, if price is increased by 5% and as a result quantity demanded falls by 10%, we know that demand is elastic
What will happen to TR in this case? You are right, TR will fall This is because, impact of quantity decline dominates the impact of price increase forcing TR to fall
In summary, If P↑ and demand is elastic TR↓ If P↑ and TR↓ demand is elastic 15
Elasticity and Total Revenue Consider another example, if price is increased by 5% and as a result quantity demanded falls by 2%, we know that demand is inelastic
What will happen to TR in this case? You are right, TR will rise This is because, impact of price increase dominates the impact of quantity decline forcing TR to rise
In summary, If P↑ and demand is inelastic TR↑ If P↑ and TR↑ demand is inelastic
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Price Elastic
An increase in price ...
reduces total revenue.
A reduction in price...
Increases total revenue.
Total revenue moves in the direction of quantity change
Price Inelastic
An increase in price… Increases total revenue.
A reduction in price… Reduces total revenue.
Total revenue moves in the direction of price change
Unit price Elastic
An increase in price… No change in total revenue.
A reduction in price… No change in total revenue.
Total revenue does not change with price
Price Elasticity of Demand and Changes in Total Revenue
Responsiveness and Demand
A
B
Movement from Point A to B Price falls by $.10 Quantity rises by 20,000 rides
Movement from Point A to B Price falls by $.10 Quantity rises by 20,000 rides
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TR before (.8 * 40,000) 16,000TR after (.7 * 60,000) 42,000TR is rising with Price
TR before (.8 * 40,000) 16,000TR after (.7 * 60,000) 42,000TR is rising with Price
Is the Demand elastic or inelastic in this region?
Is the Demand elastic or inelastic in this region?
ElasticElastic
Responsiveness and Demand
A
B
Movement from Point A to B Price falls by $.10 Quantity rises by 20,000 rides
Movement from Point A to B Price falls by $.10 Quantity rises by 20,000 rides
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TR before (.4 * 120,000) 48,000TR after (.3 * 140,000) 42,000TR is falling with Price
TR before (.4 * 120,000) 48,000TR after (.3 * 140,000) 42,000TR is falling with Price
Is the Demand elastic or inelastic in this region?
Is the Demand elastic or inelastic in this region?
InelasticInelastic
Price Elasticity Along a Linear Demand Curve
eD = -.33
eD = -1.00
eD = -3.00
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Elasticity and the TR Curve
0 1 2 3 4 5 6 7 8
0 1 2 3 4 5 6 7 8
Quantity Demanded
Quantity Demanded
Price
Total Revenue(Thousands of Dollars)
$2018161412108642
$87654321
a
bc
de
fg
h
ElasticEd > 1
Unit ElasticEd = 1
InelasticEd < 1
D
TR
Constant Price Elasticity of Demand Curves
Perfectly Inelastic (Insensitive to price changes) Refers to a situation in which the price elasticity of demand is zero
|Ed| = 0 Perfectly Elastic (Sensitive to price changes) Refers to a situation in which the price elasticity of demand is infinite
|Ed| = ∞
22
Demand Curves with Constant Price Elasticity
Ed=0Ed=∞
Ed=-1
Ed=-.5
Determinants of the Price Elasticity of Demand
Availability of substitutes If there are lots of close substitute goods to choose from consumers can switch easily
Importance in household budgets Price of good relative to income
Luxuries versus Necessity Luxuries are more elastic
Time In the short run it is often difficult to find substitutes.
Income Elasticity of Demand
Income elasticity of demand is the percentage change in quantity demanded at a specific price divided by the percentage change in income that produced the demand change, all other things unchanged.
Incomein %
DemandedQuantity in %
IE
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Normal Good (DVD’s)
An increase in income… Increases demand.
A decrease in income… Decreases demand.
Inferior Good (Used clothing)
An increase in income… Decreases demand.
A decrease in income… Increases demand.
Income Elasticity of Demand
Price Elasticity of Supply
Price elasticity of Supply is the ratio of the percentage change in quantity supplied of a good or service to the percentage change in its price, all other things unchanged.
pricein change %
suppliedquantity in change %se
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Cross Price Elasticity of Demand
Cross price elasticity of demand is the percentage change in the quantity demanded of one good or service at a specific price divided by the percentage change in the price of a related good or service.
B good of Pricein %
A good of demandedQuantity in %,
BAE
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Time: An Important Determinant of the
Elasticity of Supply
In the short run supply is likely to be inelastic
In the long run supply is likely to be more elastic
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Price Elasticity of Supply
In Short Run, supply tends to be Inelastic
P
QD1 D2
Ss
Q0
P1
P0
Q1
%△Q < %△P → Inelastic %△Q < %△P → Inelastic
P
Q
D1 D2
Sl
Q0
PlP0
Ql
In Long Run, supply tends to be more Elastic
In Long Run, supply tends to be more Elastic
%△Q > %△P → Elastic %△Q > %△P → Elastic
Selected Elasticity Estimates
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Selected Elasticity Estimates
32