Elasticity I. What is Elasticity? - Missouri State University
Elasticity
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Transcript of Elasticity
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TopicsMeasurementKindsTypeImportance
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The responsiveness of one variable to changes in another
When price rises, what happens to demand?
Demand falls BUT! How much does demand fall?
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If price rises by 10% - what happens to demand?
We know demand will fall By more than 10%? By less than 10%? Elasticity measures the extent to
which demand will change
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A. Absolute elasticity
Qd = a – b P
B. Current elasticity
E = △Q/P△
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ElasticE > 1
InelasticE < 1Unit ElasticE = 1
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4 basic types used: Price elasticity of demand Price elasticity of supply Income elasticity of demand Cross elasticity
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Price Elasticity of Demand The responsiveness of demand
to changes in price Where % change in demand
is greater than % change in price – elastic Where % change in demand is less than %
change in price - inelastic
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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)
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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.
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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
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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
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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!
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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!
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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)
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Income Elasticity of Demand: 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
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Income Elasticity of Demand:
A positive sign denotes a normal good A negative sign denotes an inferior good
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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%
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%
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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
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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)
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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
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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
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Relationship between changes in price and total revenue
Importance in determining what goods to tax (tax revenue)
Importance in analysing time lags in production
Influences the behaviour of a firm