Elasticity!Boingy, boingy, boingy!

Price, Income and Cross Elasticity

Elasticity – the concept The responsiveness of one variable to

changes in another

When price rises what happens to quantity demanded?• Demand falls

• BUT!

• How much does demand fall?

Elasticity – the concept If price rises by 10% - what happens to

Qd?

• We know Qd will fall

• By more than 10%?

• By less than 10%?

Elasticity measures the extent to which quantity demanded will change

Elasticity 4 basic types used:

• Price elasticity of demand – PED

• Price elasticity of supply – PES

• Income elasticity of demand – YED

• Cross elasticity – Cross ED or XED

Elasticity Price Elasticity of Demand

• The responsivenessresponsiveness of quantity demanded to changes in price

• Where % change in Qd is greater than % change in price – elastic

• Where % change in Qd is less than % change in price - inelastic

Elasticity

The Formula:

Ped =% Change in Quantity Demanded___________________________

% Change in Price

If answer is between 0 and -1: the relationship is inelastic

If the answer is between -1 and infinity: the relationship is elastic

Note: PED has – sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

Elasticity

Price (£)

Quantity Demanded

The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded.

Elasticity

Price

Quantity Demanded (000s)

D

The importance of elasticity is the information it provides on the effect on total revenue of changes in price.

£5

100

Total revenue is price x quantity sold. In this example, TR = £5 x 100,000 = £500,000.

This value is represented by the grey shaded rectangle.

Total Revenue

ElasticityPrice

Quantity Demanded (000s)

D

If the firm decides to decrease price to (say) £3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue.£5

100

£3

140

Total Revenue

Elasticity

Price (£)

Quantity Demanded

10

D

5

5

6

% Δ Price = -50%

% Δ Quantity Demanded = +20%

Ped = -0.4 (Inelastic)

Total Revenue would fall

Producer decides to lower price to attract sales

Not a good move!

Elasticity

Price (£)

Quantity Demanded

D

10

5 20

Producer decides to reduce price to increase sales

7

% Δ in Price = - 30%

% Δ in Demand = + 300%

Ped = - 10 (Elastic)Total Revenue rises

Good Move!

Elasticity If demand is price

elastic: Increasing price

would reduce TR (%Δ Qd > % Δ P)

Reducing price would increase TR (%Δ Qd > % Δ P)

If demand is price inelastic:

Increasing price would increase TR

(%Δ Qd < % Δ P) Reducing price

would reduce TR (%Δ Qd < % Δ P)

Elasticity Versus Slope

Elasticity of demand describes the shape of a demand curve, but it is not the same as slope.

Slope measures the rise or fall in a curve divided by its horizontal run.

Elasticity measures the horizontal run by the rise or fall.

Task #1 – Calculating PEDCalculate the price elasticity of demand in each of the following

examples: The change in demand is 5%, the change in price is 7%

The change in demand is 12%, the change in price is 3%

The change in demand is 9%, the change in price is 4%

The change in demand is 13%, the change in price is 25%

The change in demand is 6%, the change in price is 8%

In each case say whether the price elasticity is inelastic or elastic.

Spending and Elasticity

If demand is inelastic, buyers spend more on the good when its price is higher.

If demand is elastic, buyers spend less on the good when its price is higher.

If demand is unit-elastic, buyers spend the same amount on the good when its price is higher.

Determinants of Elasticity Time period – the longer the time under consideration

the more elastic a good is likely to be

Number and closeness of substitutes – the greater the number of substitutes the more elastic

The proportion of income taken up by the product – the smaller the proportion the more inelastic

Luxury or Necessity - for example, addictive drugs

Factors Affecting Elasticity of Demand

Availability of Substitutes Demand for a good is more elastic when

close substitutes for it are available to buyers.

Factors Affecting Elasticity of Demand

Fraction of Income Spent on the GoodAs people spend higher fractions of their

incomes on a good, their demand for the good becomes more elastic.

As they spend smaller fractions of their income on a good, their demand for it

becomes less elastic.

Factors Affecting Elasticity of Demand

Adjustment TimeDemand is more elastic when people have

more time available to adjust to a change in price.

Other Types of Elasticity

Explain how to calculate Income Elasticity of Demand

(YED), Cross-Price Elasticity of Demand (XED) and Price Elasticity of Supply (PES)

Elasticity – YED Income Elasticity of Demand (YED):

• The responsiveness of demand to changes in incomes

Normal Good – demand rises as income rises and vice versa

Inferior Good – demand falls as income rises and vice versa

Elasticity – YED

Income Elasticity of Demand: A positive sign denotes a normal good A negative sign denotes an inferior good

Elasticity – YED For example:

Yed = - 0.6: Good is an inferior good but inelastic – a rise in income of 3% would lead to demand falling by 1.8%• WHY? Use your YED formula and plug it in:• (x/0.03)=-0.6• (-0.6)(0.03)=x• -0.018=x, or -1.8%

Yed = + 0.4: Good is a normal good but inelastic – a rise in incomes of 3% would lead to demand rising by 1.2%

Yed = + 1.6: Good is a normal good and elastic – a rise in incomes of 3% would lead to demand rising by 4.8%

Yed = - 2.1: Good is an inferior good and elastic – a rise in incomes of 3% would lead to a fall in demand of 6.3%

YED Video

Elasticity – XED Cross Elasticity: The responsiveness of demand of one

good to changes in the price of a related good – either a substitute or a complement

XED = % Δ Qd of good t__________________% Δ Price of good y

Elasticity – XED Goods which are complements:

• Cross Elasticity will have negative sign (inverse relationship between the two)

Goods which are substitutes:• Cross Elasticity will have a positive sign

(positive relationship between the two)

Practice! Is the following graph

showing a situation where the goods are complements or substitutes? How can you tell?

Substitutes. As the P for good B

increases, the Qd for good A increases (XED>0).

XED video

Elasticity Price Elasticity of Supply:

• The responsiveness of supply to changes in price

• If PES is inelastic - it will be difficult for suppliers to react swiftly to changes in price

• If PES is elastic – supply can react quickly to changes in price

PES = % Δ Quantity Supplied____________________

% Δ Price

PES: determinants—length of time

PES Video

Importance of Elasticity Relationship between changes in price

and total revenue Importance in determining what goods to

tax (tax revenue) Importance in analyzing time lags in

production Influences the behavior of a firm

As you go back to read/review Think about how to solve for each: equations,

plugging in, what changes might occur given certain values

Think about what the graphs would look like for each

Think about determinants of each, and how that might affect how the graph looks

Think about substitutes, complements, inferior, superior, normal and luxury goods and how they apply to each