Elasticity

Elasticity

 … allows us to analyze supply and demand

with greater precision.

 … is a measure of how much buyers and

sellers respond to changes in market
conditions
 The Economic Concept of
Elasticity
 Elasticity: the percentage change in one
variable relative to a percentage change in
another.

percent change in A
Coefficien t of Elasticity 
percent change in B
 The Price Elasticity of Demand

 Price elasticity of demand: The

percentage change in quantity demanded
caused by a 1 percent change in price.

% Quantity
Ep 
% Price
 Elasticity

 Point Elasticity
 Arc Elasticity
 The Price Elasticity of Demand
1.Arc elasticity: Elasticity which is measured
over a discrete interval of a demand (or a
supply) curve.
Q2  Q1 P2  P1
Ep  
(Q1  Q2 ) / 2 ( P1  P2 ) / 2
 Ep = Coefficient of arc price elasticity
 Q1 = Original quantity demanded
 Q2 = New quantity demanded
 P1 = Original price
 P2 = New price
If a price of a product rises from $11 to
$12, causing a fall in the quantity
demanded from 7 to 6, the arc price
elasticity coefficient:

67 12  11
Ep  
(7  6) / 2 (11  12) / 2

 1.77
Computing the Price Elasticity of
Demand
Percentage change in quantity demanded
Price elasticity of demand =
Percentage change in price
 Example: If the price of Dunkin Doughnuts increases from RM2.00
to $RM2.20 and the amount you buy falls from 10 to 8 pieces, then
your elasticity of demand would be calculated as:

(10  8)
 100 20%
10  2
(2.20  2.00)
 100 10%
2.00
 The Price Elasticity of Demand

 Point elasticity: Elasticity measured at a

given point of a demand (or a supply)
curve.

dQ P1
εP = x
dP Q1
The Price Elasticity of Demand

The point elasticity of a linear demand

function can be expressed as:

Q P1
p  
P Q1
The point elasticity of a linear demand

Q = 18 - P : If P = 12 and Q = 6

dQ P1
εP = x
dP Q1

12
 p  1 *
6
 2
The point elasticity of a non-linear
demand
Q = 100 - P2 : If P = 5 and Q = 75

dQ P1
εP = x
dP Q1

5
 p  2 P *
75
 0.67
The Price Elasticity of Demand
 Some demand curves have constant
elasticity over the relevant range
 Such a curve would look like:
Q = aP-b
where –b is the elasticity coefficient
 This equation can be converted to linear
by expressing it in logarithms:
log Q = log a – b(log P)
 The Price Elasticity of Demand

 Categories of Elasticity
 Relative elasticity of demand: EP > 1
 Relative inelasticity of demand: 0 < EP < 1
 Unitary elasticity of demand: EP = 1
 Perfect elasticity: EP = ∞
 Perfect inelasticity: EP = 0
 Elasticities

 Inelastic Demand
 Quantity demanded does not respond strongly
to price changes.
 Price elasticity of demand is less than one.
 Elastic Demand
 Quantity demanded responds strongly to
changes in price.
 Price elasticity of demand is greater than one.
The Price Elasticity of Demand
 Factors affecting demand elasticity
 Ease of substitution
 Proportion of total expenditures
 Durability of product
 Possibility of postponing purchase
 Possibility of repair

 Used product market

 Length of time period

 The Price Elasticity of Demand

 Derived demand: The demand for

products or factors that are not directly
consumed, but go into the production of a
final product.
 The demand for such a product or factor
exists because there is demand for the
final product.
The Price Elasticity of Demand
 The derived demand curve will be more
inelastic:
 the more essential is the component in question.
 the more inelastic is the demand curve for the final
product.
 the smaller is the fraction of total cost going to this
component.
 the more inelastic is the supply curve of cooperating
factors.
 The Price Elasticity of Demand
 A long-run demand curve
will generally be more
elastic than a short-run
curve.
 As the time period
lengthens consumers find
way to adjust to the price
change, via substitution
or shifting consumption
 The Price Elasticity of Demand
 There is a relationship between the price
elasticity of demand and revenue received.
 Because a demand curve is downward sloping, a
decrease in price will increase the quantity demanded
 If elasticity is greater than 1, the quantity effect is
stronger than the price effect, and total revenue will
increase
Demand Elastcity and Revenue
Price Qtt TR MR Arc (Ep)

$100 1 $100 $- Ep

90 2 180 80 -6.33

80 3 240 60 -3.40

70 4 280 40 -2.14

60 5 300 20 -1.44

50 6 300 0 -1.00

40 7 280 -20 -0.69

30 8 240 -40 -0.47

20 9 180 -60 -0.29

10 10 100 -80 -0.16

Price Qtt Arc Elasticity Revenue
18 0 0
17 1 -35.0 17
16 2 -11.0 32
15 3 -6.2 45
14 4 -4.1 56
13 5 -3.0 65
12 6 -2.3 72
11 7 -1.8 77
10 8 -1.4 80
9 9 -1.1 81
8 10 -0.9 80
7 11 -0.7 77
6 12 -0.6 72
5 13 -0.4 65
4 14 -0.3 56
3 15 -0.2 45
2 16 -0.2 32
1 17 -0.1 17
0 18 0.0 0
 The Price Elasticity of Demand
 As price decreases
 Revenue rises when
demand is elastic.
 Revenue falls when it
is inelastic.
 Revenue reaches it
peak when elasticity of
demand equals 1.
 The Price Elasticity of Demand

 Marginal Revenue: The change in total

revenue resulting from changing quantity
by one unit.

Total Revenue
MR 
Quantity
 The Price Elasticity of Demand
 For a straight-line
demand curve the
marginal revenue
curve is twice as
steep as the demand.
 The Price Elasticity of Demand
 At the point where
marginal revenue
crosses the X-axis,
the demand curve is
unitary elastic and
total revenue reaches
a maximum.
The Price Elasticity of Demand
 Some sample elasticities
 Coffee: short run -0.2, long run -0.33
 Kitchen and household appliances: -0.63
 Meals at restaurants: -2.27
 Airline travel in U.S.: -1.98
 Beer: -0.84, Wine: -0.55
The Cross-Elasticity of Demand

 Cross-elasticity of demand: The

percentage change in quantity consumed
of one product as a result of a 1 percent
change in the price of a related product.

% Q A
EX 
% PB
The Cross-Elasticity of Demand

 Arc Elasticity

Q2 A  Q1 A P2 B  P1B
Ex  
(Q1 A  Q2 A ) / 2 ( P1B  P2 B ) / 2
The Cross-Elasticity of Demand

 Point Elasticity

QA PB
EX  
QA PB
 Cross Elasticity

 Substitutes: Related products for which a

price increase for one leads to an increase
in demand for another.
 Complements: Related products for which
a price increase for one leads to a
reduction in demand for the other
The Cross-Elasticity of Demand
 The sign of cross-elasticity for substitutes
is positive.
 The sign of cross-elasticity for
complements is negative.
 Two products are considered good
substitutes or complements when the
coefficient is larger than 0.5.
 Empirical Elasticity

 Cross elasticity of demand for electric

energy with respect to price of gas energy
Is about +0.13
 Aluminum with price of steel is +2.0
 Beef with price of chicken is +0.12
 Income Elasticity

 Income Elasticity of Demand: The

percentage change in quantity demanded
caused by a 1 percent change in income.
 Y is shorthand for Income

%Q
EY 
%Y
 Income Elasticity

 Arc Elasticity

Q2  Q1 Y2  Y1
EY  
(Q1  Q2 ) / 2 (Y1  Y2 ) / 2
 Income Elasticity
 Categories of income
elasticity
 Superior goods: EY > 1
 Normal goods: 0 >EY >1
 Inferior goods – demand
decreases as income
increases: EY < 0
 Empirical Elasticity

 Jewelry and watches to be 1.0

 Food expenditure to be 0.5
 Restaurant meal to be 1.6
 Air Travel between USA and Europe to be
1.9
 Other Elasticity Measures
 Elasticity is encountered every time a
change in some variable affects
quantities.
 Advertising expenditure
 Interest rates
 Population size
 Elasticity of Supply
 Price Elasticity of Supply: The
percentage change in quantity supplied as
a result of a 1 percent change in price.

% Quantity Supplied
ES 
% Price
 If the supply curve slopes upward and to
the right, the coefficient of supply
elasticity is a positive number.
 Elasticity of Supply

 Arc elasticity

Q2  Q1 P2  P1
Es  
(Q1  Q2 ) / 2 ( P1  P2 ) / 2
 Elasticity of Supply

 When the supply curve is more elastic, the

effect of a change in demand will be
greater on quantity than on the price of
the product.
 With a supply curve of low elasticity, a
change in demand will have a greater
effect on price than on quantity.
 Try This
 Tots-R-Us operates the only day care center in
an exclusive neighborhood. Tots-R-Us is
making substantial economic profit, but the
owners know that new day-care centers will
soon learn from this highly profitable market
and attempt to enter the market. The owner
decide to begin spending immediately a rather
large sum of advertising designed to decrease
elasticity. Should they wait until new firms
actually enter?
 Answer
 Tots-R-US should begin advertising
immediately in order to enhance brand
loyalty which will decrease elasticity of
demand. Also the less elastic is demand,
the greater the fall in price that results
when new firms enter. To the extent that
potential entrants consider post-entry
price, they will be less likely to enter the
more inelastic is demand.