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Elasticity is one of the most important concepts in neoclassical economic theory. It is useful in understanding the incidence of indirect taxation, marginal concepts as they relate to the theory of the firm, and distribution of wealth and different types of goods as they relate to the theory of consumer choice. Elasticity is also crucially important in any discussion of welfare distribution, in particular consumer surplus, producer surplus, or government surplus. PRICE ELASTICITY OF DEMAND Law of demand tells us that consumers will respond to a price drop by buying more, but it does not tell us how much more. The degree of sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand. Price elasticity formula: Ed = If the percentage change is not given in a problem, it can be computed using the following formula: % change in Qd = where Q1 = initial Qd, and Q2 = new Qd. where P1 = initial Price, and P2 = New Price.

Percentage change in P =

Ed =

Because of the inverse relationship between Qd and Price, the Ed coefficient will always be a negative number. But, we focus on the magnitude of the the change by neglecting the minus sign and use absolute value. Examples: 1. If the price of Product A increased by 10%, the quantity demanded decreased by 20%. Then the coefficient for price elasticity of the demand of Product A is: Ed = = =2

2. If the quantity demanded of Product B has decreased from 1000 units to 900 units as price increased from $2 to $4 per unit, the coefficient for Ed is:

Ed =

= -0.11

Take the absolute value of - 0.11, Ed = 0.11 Characteristics: Ed approaches infinity, demand is perfectly elastic. Consumers are very sensitive to price change. Ed > 1, demand is elastic. Consumers are relatively responsive to price changes. Ed = 1, demand is unit elastic. Consumers response and price change are in same proportion. Ed < 1, demand is inelastic. Consumers are relatively unresponsive to price changes. Ed approaches 0, demand is perfectly inelastic. Consumers are very insensitive to price change. Ed is usually greater in the higher price range than in lower price range. Demand is more elastic in upper left portion of the demand curve than in the lower right portion of the curve. However, it is impossible to judge elasticity of a demand curve by its flatness or steepness. Along a linear demand curve, its elasticity changes.

PRICE ELASTICITY OF SUPPLY Law of supply tells us that producers will respond to a price drop by producing less, but it does not tell us how much less. The degree of sensitivity of producers to a change in price is measured by the concept of price elasticity of supply. Price elasticity formula: Es = If the percentage change is not given in a problem, it can be computed using the following formula: Percentage change in Qs = Percentage change in P = where Q1 = initial Qs, and Q2 = new Qs. where P1 = initial Price, and P2 = New Price.

Es =

Because of the direct relationship between Qs and Price, the Es coefficient will always be a positive number. Examples: 1. If the price of Product A increased by 10%, the quantity supplied increases by 5%. Then the coefficient for price elasticity of the supply of Product A is: Es = = = 0.5

2. If the quantity supplied of Product B has decreased from 1000 units to 200 units as price decreases from $4 to $2 per unit, the coefficient for Es is:

Es =

= 1.6

Characteristics: Es approaches infinity, supply is perfectly elastic. Producers are very sensitive to price change. Es > 1, supply is elastic. Producers are relatively responsive to price changes. Es = 1, supply is unit elastic. Producers response and price change are in same proportion. Es < 1, supply is inelastic. Producers are relatively unresponsive to price changes. Es approaches 0, supply is perfectly inelastic. Producers are very insensitive to price change. It is impossible to judge elasticity of a supply curve by its flatness or steepness. Along a linear supply curve, its elasticity changes. Determinant: 1. Time lag: How soon the cost of increasing production rises and the time elapsed since the price change influence the Es. The more rapidly the production cost rises and the less time elapses since a price change, the more inelastic the supply. The longer the time elapses, more adjustments can be made to the production process, the more elastic the supply. 2. Storage possibilities: Products that cannot be stored will have a less elastic supply. For example, produces usually have inelastic supply due to the limited shelf life of the vegetables and fruits.

CROSS ELASTICITY OF DEMAND Cross elasticity (Exy) tells us the relationship between two products. it measures the sensitivity of quantity demand change of product X to a change in the price of product Y. Price elasticity formula: If the percentage change is not given in a problem, it can be computed using the following formula: Percentage change in Qx = Percentage change in Py = where Q1 = initial Qd of X, and Q2 = new Qd of X. where P1 = initial Price of Y, and P2 = New Price of Y.

Exy =

Characteristics: Exy > 0, Qd of X and Price of Y are directly related. X and Y are substitutes. Exy approaches 0, Qd of X stays the same as the Price of Y changes. X and Y are not related. Exy < 0, Qd of X and Price of Y are inversely related. X and Y are complements. Example: 1. If the price of Product A increased by 10%, the quantity demanded of B increases by 15 %. Then the coefficient for the cross elasticity of the A and B is : Exy = = = 1.5 > 0, indicating A and B are substitutes.

2. If the price of Product A increased by 10%, the quantity demanded of B decreases by 15 %. Then the coefficient for the cross elasticity of the A and B is : Exy = = = -1. < 0, indicating A and B are complements.

INCOME ELASTICITY OF DEMAND Income elasticity of demand (Ey, here y stands for income) tells us the relationship a product's quantity demanded and income. It measures the sensitivity of quantity demand change of product X to a change in income. Price elasticity formula: Ey = If the percentage change is not given in a problem, it can be computed using the following formula: % change in Qx = % change in Y = where Q1 = initial Qx, and Q2 = new Qx. where P1 = initial Income, and P2 = New Income.

Ey =

Characteristics: Ey > 1, Qd and income are directly related. This is a normal good and it is income elastic. 0< Ey<1, Qd and income are directly related. This is a normal good and it is income inelastic. Ey < 0, Qd and income are inversely related. This is an inferior good. Example: If income increased by 10%, the quantity demanded of a product increases by 5 %. Then the coefficient for the income elasticity of demand for this product is: Ey = = = 0.5 > 0, indicating this is a normal good and it is income inelastic.

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