Elasticity - A Measure of Response

Elasticity: A Measure of Response

Can anything be so elegant as to have few wants, and to serve them one's self?

-Ralph Waldo Emerson

Slide 1 of 50

Eab

Ey

Ed

Es

Elasticity can measure numerous things

Each of these concepts refers to how sensitive changes in one

variable are to changes in another variable.

Elasticity of Demand

Elasticity of Supply

Cross Elasticity

Income Elasticity

We’ll use these symbols as shorthand

In this presentation, we’ll look at four concepts related to elasticity.

They include:

Slide 2 of 50

So far, we have always looked at 45 degree demand curves


In reality, demand curves can change in slope

depending on how sensitive quantity demand is to price. That sensitivity is referred to

as elasticity of demand!

Slide 3 of 50

A demand curve that is more horizontal is referred to as ‘elastic’

P1

Qd1

P2

Qd2

That is typical of goods that have very elastic demand.

Consumers are sensitive to price changes. Even small

increases will scare away a lot of customers.


Have you ever changed travel dates or

destinations to save money on vacation air

fare? Probably so because

as a vacation air traveler, you were sensitive to price.

Consider this very elastic demand

curve for example.

At a price of P1, quantity demand is

Qd1.

Now imagine the price of this good goes up a little.

Look what happens to the quantity

demand!

Small changes in price result in big

changes in quantity demanded

Examples of goods that have elastic demand include:

Restaurant foodVacation air travel

Luxury goods

Slide 4 of 50

Now consider this very

inelastic demand curve.

A demand curve that is more vertical is referred to as ‘inelastic’

P1

Qd1

P2

Qd2

Examples:Milk & Salt

Business air travelHabit forming goods

Doctor/Medical Visits


Even big changes in price

result in only small changes in

quantity demanded.

Consultants are business air travelers. When they book plane tickets, they usually don’t care about

price. They want to be on time for the meeting!

Slide 5 of 50

Real world example of an inelastic price elasticity of demand

Every year, we seem to see this outside of big box

stores.

People wait in line for days for a particular product.

Clearly, these folks are not sensitive to price.

If upon entering the store, they found the price to be higher, would they have

cared?


Based on this behavior, we’d probably classify their demand as: ______________.Inelastic!

Slide 6 of 50

Price Elasticity of Demand- the technical definition


Price elasticity of demand (also simply called elasticity of demand) – The rate of response of quantity demanded

due to a change in price.

It is commonly referred to as Ed (as it is in this presentation) or eD (as it is in your

course reading material.Ed

Slide 7 of 50

Price Elasticity of Demand- the technical definition seen graphically


When we talk about price elasticity of demand, we are asking how sensitive changes in quantity demand are…

…to changes in price.

Slide 8 of 50

Individual exercises

1) Identify one item that you routinely buy that you would be

willing to pay a lot more for if you had to.

2) Now identify one item that you would not buy if the price were to

go up even only a little.


Here are mine:

I am insensitive to the price of ESPN. If it doubled, I’d still pay. My demand for ESPN is inelastic! Don’t tell

them that!

I like pineapples but they are $5 and they are a lot of work. I only buy them on sale. I am very sensitive to price- my

demand for pineapples is very elastic!

Slide 9 of 50

Different elasticity of demand scenarios

Unit ElasticElastic Inelastic


Note how the horizontal demand curve looks like the middle flat part of the “E” for elastic!

Note how the vertical demand

curve looks like an “I” for inelastic!

This means a one unit change in price (i.e. 1%) results in a one unit change in Quantity demand

(i.e. 1%)Slide 10 of 50

We’ve reached a key learning outcome here. We are applying the concept of

elasticity of demand to consumer decisions.

When demand is very elastic, consumers are quite sensitive to price. When it is

very inelastic, they care much less about price…they are willing to pay more.

Why is this important?

Understanding elasticity is important for economists because it lets us measure

what the impact that a price change had, is having, or will have on the amount of

product that is demanded.


Let’s look at a case study on the next few slides to see how this can be applied.

Slide 11 of 50

Case study: the Dulles GreenwayElasticity of Demand

The Dulles Greenway is a 14 mile road that

opened in 1995.

It allowed people to avoid all the stoplights

on Route 7 as they made their way into Tyson’s Corner, the

nation’s tenth largest employment center.

They thought people would be willing to pay a big toll to avoid stoplights on alternate routes.

Slide 12 of 50

Elasticity of demand, misread

$1.75


The Bryant’s hired a consultant to determine how much people would be willing to pay to use the road. In other words, they wanted to know the price elasticity of demand for

this road!

The consultants estimated that the demand curve would take the

following shape.

That meant that if the toll was set at $1.75, about 30,000 cars would

use the toll road every day.

The owners determined that would generate enough money to meet

their obligations…

In reality, the demand curve was much more elastic.

At $1.75 per trip, full time use would cost $910 per year.

People were sensitive to this price!

Instead of attracting 30,000 cars per day, they attracted about

10,000.

At least at first, the roadway lost money in what must have been a painful learning experience about

elasticity of demand!

Slide 13 of 50

Factors that determine elasticity of demand

• Availability of close substitutes– Example: margarine and butter are close substitutes

so they are more elastic

• Necessity versus Luxury– Doctor’s costs are not likely to respond as much to

price increases as the cost of 60” plasma TV

• Definition of Market– Elasticity of demand for any market will depend on

how the market is defined. Broad definitions, such as food will have fewer substitutes and will be more inelastic. Conversely, snow peas, will have many substitutes and will be more elastic.

• Time Horizon– Goods tend to be more elastic over time as markets

adjust to changes in price


Slide 14 of 50

How can time impact elasticity?

Typical car in 1960 Typical car just 12 years later

Weighed up to 5,000 pounds

35 MPG


10 MPG

Weighed only 2,600 pounds

We are seeing another broad and dramatic change in our fleet now. A movement to electric and hybrid cars!

In the 1970s, the supply of oil was reduced for a

number of reasons and on a number of occasions.

At that time, what could we do? Not much. We still had to drive to work. So we still bought gas. Our

demand for gas was inelastic in the short run.

Over time, what could we do? Change our behavior so we demanded less gas.

Slide 15 of 50

Calculating elasticity of demandElasticity of Demand

If a small change in price results in a big change in

quantity demand, then price elasticity of demand for that good is high - it is elastic!

-50%

+1%

= 50

If a BIG change in price results in a SMALL change in quantity demand, then price elasticity of demand for that

good is low- it is INELASTIC!

-1%

+50%

= .02

Note: this ratio will always be negative.

For this first example, -50%/1% is actually -50.

For this second example, -1%/50% is actually -.02.

Since we know the sign will always be negative, we ignore it.

Slide 16 of 50

Here are some possible price elasticity of demand scenarios


Slide 17 of 50

Examples of some elasticity's for selected goods

Source: Mackinac Center for Public Policy


Slide 18 of 50

A closer look at the demand curve

Elasticity's differ at different points along the demand curve


Slide 19 of 50

The demand schedule and curveElasticity of Demand

Let’s start with the demand schedule and curve shown

here:

Slide 20 of 50

Calculating Elasticity

Assume price falls from $9 to $8, what is the elasticity of demand?

• Step 1: Calculate the percent change in Quantity Demanded (Qd)– Quantity demanded increases from 1 to 2.– The percent change in Qd = change/first or

1/1=100%• Step 2: Calculate the percent change in

Price – The price decreased by 1– The percent change in price = change/first or

(-1)/9 or -11.1%• Step 3: Calculate Elasticity

– Divide the percent change in Qd by the percent change in price

– Ed = 100%/11% = 9• Step 4: Interpret the results

– This is elastic! (it is greater than one) Note: we dropped the negative sign. Since the demand curve

represents a negative relationship, this figure is always negative. The negative sign is

understood and is therefore ignored!


Slide 21 of 50


Assume price falls from $8 to $7, what is the elasticity?



Price – The percent change in price = change/first or



– Ed = 50%/12.5% = 4• Step 4: Interpret the results

– This is elastic! (it is greater than one)


Slide 22 of 50




1/8=12.5%• Step 2: Calculate the percent change in

Price – The percent change in price = change/first or

(-1)/2 or -50%• Step 3: Calculate Elasticity


– Ed = 12.5%/50% = .25• Step 4: Interpret the results

– This is inelastic! (it is less than one)


Slide 23 of 50

Lets look more closely at the demand curve

This portion of the demand curve is elastic.


Slide 24 of 50


This portion of the demand curve is inelastic.


Slide 25 of 50


This portion of the demand curve is referred to as “Unit Elastic”. A

change in price results in an equal percentage change in quantity

demanded.

Percent change in quantity demand = (6-5)/5 = 20%

Percent change in price = (4-5)/5 = 20%

20% / 20% = 1.0. This is unit elastic!


Slide 26 of 50

Note an annoying problem when calculating Ed

• Elasticities will change in the same portion of the demand curve depending on whether prices are increasing or decreasing

?


Slide 27 of 50

Calculating elasticity, again


• Step 1: Calculate the percent change in Quantity Demanded (Qd)– Quantity demanded increases by 1.– The percent change in Qd = change/first or


Price – The price decreased by 1– The percent change in price = change/first or



– Ed = 100%/11% = 9• Step 4: Interpret the results

– This is elastic! (it is greater than one) Note: We previously determined that Ed is 9


Slide 28 of 50

Calculating Elasticity, the other direction

Assume price rises from $8 to $9, what is the elasticity?

• Step 1: Calculate the percent change in Quantity Demanded (Qd)– Quantity demanded decreases by 1.– The percent change in Qd = change/first or

(-1)/2=-50%• Step 2: Calculate the percent change in

Price – The price increased by 1– The percent change in price = change/first or

(1)/8 or 12.5%• Step 3: Calculate Elasticity


– Ed = -50%/12.5% = 4• Step 4: Interpret the results

– This is elastic! (it is greater than one) Note: We now determine that Ed is 4…along the

same part of the demand curve!


Slide 29 of 50

Calculations of elasticity will change depending on direction

We should be careful…

As we just saw a price decrease from $9 to $8 gave us an Ed of 9…

very elastic.

But an increase in price from $8 to $9 gave us an Ed of 4…still elastic

but not as much as before.

Using the midpoint formula can help solve this problem.

Slide 30 of 50

The midpoint formula

As you’ll probably note, the midpoint formula gets around this problem by taking an average of these

starting points using the formula below.

Let’s try an example.

Slide 31 of 50

The midpoint formula

Regardless of direction, if price moved from 8 to 9 we could use the midpoint formula to get Ed

• Step 1: Calculate the change in quantity demanded divided by the average of the two quantities Demanded (Qd)– Change in Qd is 1.– The average of the Qd’s is 1.5– This ratio is 1/1.5 or 66.6%

• Step 2: Calculate the change in price divided by the average of the two prices The price increased by 1– Change in P is 1.– The average of the P’s is 8.5– This ratio is 1/8.5 or 11.7%

• Step 3: Calculate Elasticity– Divide the results from step one by the results

from step two– Ed = 66.6%/11.7% = 5.7

• Step 4: Interpret the results– This is elastic! (it is greater than one)


Slide 32 of 50

WHEW!

• I know that the material related to calculating elasticity of demand was heavy. In addition, having two methodologies to calculate it that are closely related makes it confusing.

• On a test, be prepared to calculate elasticity of demand using either formula (you don’t need to know both).

Slide 33 of 50

Part II - Income Elasticity of Demand

Income Elasticity - A measure of how sensitive quantity demand is to changes in income

It is commonly referred to as Ey

Normal Goods (Like this steak)

Inferior Goods (like this Spam?)

Income Elasticity

When we discuss income elasticity, we are talking about normal versus inferior goods

Slide 34 of 50

Calculating Income ElasticityIncome Elasticity

Notice: as your income goes up,

you may demand more normal goods

Let’s assume your income increases by 10%

Let’s assume that in response, your demand for steaks increases by 10%

10%

10%

Ey would equal one (10%/10% = 1)

Slide 35 of 50

Calculating Income ElasticityIncome Elasticity

Notice: as your income goes up,

you may demand less inferior goods

Let’s assume your income increases by 10%

Let’s assume that in response, your demand for SPAM falls by 10%

10%

-10%

Ey would equal one (-10%/10% = -1)

Slide 36 of 50

Interpreting Income Elasticity

• If income elasticity of demand is greater than zero, than goods are normal– i.e., as you make more money, you demand

more of these goods– Example: your income goes up so you buy

more clothes• If income elasticity of demand is less

than zero, than goods are inferior– i.e. as your income goes down, you buy more of

these goods– Example: your income goes down so you buy

Raman noodles

Income Elasticity

Slide 37 of 50

Inferior goods…a subjective classification

Keep in mind that your perceptions of normal and inferior goods may differ. You may love Spam!

Some stores however specialize in the sale of what most of us consider inferior goods. Can you name one?

Slide 38 of 50

Part III - Cross Elasticity of Demand

Cross Elasticity - A measure of how sensitive quantity demand is to price changes for related goods

Commonly referred to as Ea,b

Cross Elasticity

For example, if the price of this goes up, do you buy more of this?

Slide 39 of 50

Calculating Cross Elasticity

Notice: as price of B (Pepsi) goes up,

you may demand more of A (Coke)

Cross Elasticity

Let’s assume Pepsi prices go up by 10%

Let’s assume that in response, demand for Coke increased by 10%

10%

10%

Ea,b would equal one (10%/10% = 1)Slide 40 of 50

Interpreting Cross Elasticity (part 1)

• If cross elasticity of demand is greater than zero, than goods are substitutes– Example: Price of DVDs goes up so you

demand more Blu-ray Discs

Cross Elasticity of Blu-ray and DVDs

Price of DVDs increases 100%

Change in quantity of Blu-ray discs demanded increases 20%

Cross elasticity of demand = 20%/100% = +0.2

These goods are substitutes!

Cross Elasticity

Slide 41 of 50

Interpreting Cross Elasticity (part 2)

• If cross elasticity of demand is less than zero, than goods are compliments– Price of ketchup goes up so you demand

fewer french fries

Cross Elasticity of french fries and ketchup

Price of ketchup increases 300%

Change in quantity of french fries demanded decreases 10%

Cross elasticity of demand = -10%/300% = -0.03

These goods are compliments!

Cross Elasticity

Slide 42 of 50

Part IV – Elasticity of Supply

For this one, Imagine that you

are a tomato farmer….

Lastly, let’s turn to the fourth and final elasticity


Slide 43 of 50

First a definition: what is price elasticity of supply

Price Elasticity of Supply (Es)- A measure of how sensitive quantity supplied is to price

In other words, how do changes in price effect the amount of a product (for you, that means tomatoes)

that suppliers will provide?

That depends a lot on the time.


Slide 44 of 50

What does “That depends a lot on the time” mean?

We’ll analyze three time periods:

Market Period: a time where producers are unable to change supply given a change in price. In other words, right now.

Short run: a time horizon where plant capacity cannot be changed but the intensity to which that capacity is used can be. In other words, this season.

Long run: a time horizon where plant size can be adjusted, firms can enter and exit market.In other words, next season or beyond.

A plant is a physical establishment that

performs one or more functions in the

production of goods or services. For you, the

tomato farmer, it is your farm.

Slide 45 of 50

In the “market period”, there is no time to change output

• In the market period: You’re truck is loaded with tomatoes and you are on the way to sell them. You can either sell the tomatoes or let them spoil.

• Supply is perfectly inelastic

Note how Qs does not change regardless of price! The production

decision has been made and is irreversible.

Qs


Slide 46 of 50

In the “short run”, output can be changed a little

• Short run: you’ve planted the crops. All you can do now is perhaps adjust the fertilizers or hire more crop pickers to maximize your harvest.

• Supply is more elastic but is still pretty inelastic

Note how Qs changes only slightly with a change in price. The “plant” (or

farm) decision has been made and only the intensity with which it is

worked can be altered.

QsQs2


Slide 47 of 50

In the “long run”, output can be changed a lot

• Long run: You could buy more land. You could alter crops to more productive produce.

• Supply is more much elastic

Note how Qs changes significantly with a change in price. The “plant” (or farm) decision has not been made and

can be significantly altered.

Qs Qs2


That is what I mean by “the price elasticity of supply has a lot to do with

time.”

Slide 48 of 50

Interpreting Elasticity of Supply

Market Period

Short run

Long run


Slide 49 of 50

In Summary

We’ve learned that an elasticity refers to a sensitivity

We’ve studied four of those here – elasticity to price, elasticity to income, elasticity to prices of other goods, and

elasticity of supply.

These are important concepts, particularly for a business owner considering a change in price.

Depending on how sensitive consumers are, price changes could drastically change quantity demand!

Slide 50 of 50

Elasticity - A Measure of Response

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