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Elasticity

Elasticity. Elasticity of Demand. Elasticity : measures the responsiveness of demand or supply to one of its determinants Own price Income Price of related goods. Price Elasticity. Own Price Elasticity of Demand : measures how responsive the quantity demanded is to its price

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Elasticity

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  1. Elasticity

  2. Elasticity of Demand • Elasticity: measures the responsiveness of demand or supply to one of its determinants • Own price • Income • Price of related goods

  3. Price Elasticity • Own Price Elasticity of Demand : measures how responsive the quantity demanded is to its price • Defined as the percentage change in quantity demanded divided by the percentage change in price • Tells us how willing consumers are to buy more if the price goes down, or buy less if the price goes up

  4. Elastic Demand • Quantity demanded relatively responsive to price changes • Inelastic Demand • Quantity demanded relatively unresponsive to price changes

  5. Determinants of Elasticity • Availability of Close Substitutes • If there are many close substitutes then will tend to be very elastic • Necessity vs Luxury • If it is a necessary good it will be inelastic • If it is a luxury good it will be elastic • Definition of Market • Narrow definition of good would be more elastic • Time Horizon • Longer time horizon makes it more elastic

  6. Calculating Elasticity • Elasticity is not constant over the demand curve – changes at every point • %change in Q/%change in P (absolute value) • = 1/slope x (P/Q) (slope = ) Or: Midpoint method (why) • Two points (Q1,P1) and (Q2,P2) • Own price elasticity =

  7. Elasticity > 1 : elastic • Elasticity < 1 : inelastic • Elasticity = 1 : unit elasticity • Elasticity = 0 : perfectly inelastic (vertical DC) • Elasticity = ∞ : perfectly elastic (horizontal DC) • Linear Demand curves (except perfectly elastic or inelastic) will be half elastic, half inelastic and midpoint where it is unit elastic • At any given point (Q,P) the flatter the curve the more elastic

  8. Perfectly Inelastic Demand Perfectly Elastic Demand P P Demand Curve Demand is zero above 7 8 Demand Curve 7 Will buy any quantity at 7 6 Demand is infinite below 7 Change in price has no effect on quantity demanded 50 Q Q

  9. Slope of Demand is 1 (remember all in absolute values) Elastic Unit Elastic : 1/Slope*(p/q) = 1*(p/q =1) =1 Inelastic : 1/Slope*(p/q) = 1*(p/q <1) <1

  10. |Slope of Demand Curve| = 3 Elastic : 1/Slope*(p/q) = 1/3*(p/q >3) >1 Unit Elastic : 1/Slope*(p/q) = 1/3*(p/q =3) =1 Inelastic : 1/Slope*(p/q) = 1/3*(p/q <3) <1

  11. Midpoint Method P To get elasticity at this (any) point would have to take derivative (calculus required) (Q1,P1) = (3,11) ; (Q2,P2) = (9,5) 11 Remember absolute value 5 3 9 Q

  12. Revenue of Seller and Elasticity • Total Revenue • Total Amount Given by buyers • Total Amount received by sellers • TR = P x Q (market price, and market quantity) P Demand TR = P x Q = 10 x 8 = $80 10 TR 8 Q

  13. If at market price/quantity demand is elastic • Raising price reduces revenue • Lowering price raises revenue • Why • If at market price/quantity demand is inelastic • Raising price raises revenue • Lowering price lowers revenue • Why

  14. Inelastic Demand Slope = 1/10 ; At original pt Elasticity = 10 * 4/100 = 2/5 < 1 P P Raising Price Raises Revenue Lowering Price Lowers Revenue TR = 480 6 TR = 330 4 3 TR = 400 100 Q 80 110 Q

  15. Elastic Demand Slope = 1/50 ; At original pt Elasticity = 50 * 4/100 = 2> 1 P P Raising Price Lowers Revenue Lowering Price Raises Revenue TR = 250 5 TR = 450 4 3 TR = 400 100 Q 50 150 Q

  16. Income Elasticity of Demand • Measures how responsive quantity demanded is to changes in ones income • % change in Q/% change in Income • No absolute value here, because two types of goods distinguished by sign of elasticity (+/-) • Normal Good : positive elasticity • Necessary Good : small elasticity • Luxury Good : large elasticity • Inferior Good : negative elasticity

  17. Cross Price Elasticity of Demand • Measures how responsive quantity demanded is to changes in the price of a related good • % change in Q(of good one)/% change in P (of good two) • Again here no absolute value because we distinguish two types of related goods • Substitute: positive cross price elasticity • Price of sub goes up, then demand goes up • Compliment: negative cross price elasticity • Price of comp goes up, then demand goes down

  18. For both income elasticity of demand, and cross price elasticity of demand • Use midpoint method • Cross Price: • Income:

  19. Elasticity of Supply • Measures how responsive the quantity supplied is to changes in that goods price • % change in Q/% change in price • Again if linear we can use 1/slope * P/Q • If not use midpoint method • Main determinant is technology/time • How quick can they respond and does the technology they use allow more/less production

  20. All the Same as Elasticity of Demand • Elastic: very responsive to price >1 • Inelastic: not responsive <1 • Unit elastic = 1 • Perfectly elastic : infinite elasticity • Horizontal supply curve • Perfectly inelastic: zero elasticity • Vertical supply curve

  21. Application • Say new crop technology comes out which increases corn yields per acre (GM foods) • This shifts the supply curve out (to the right) • But demand is fairly inelastic • So we get a lower price, and slightly higher quantity • But farm revenues fall

  22. P 3 Technology Shifts supply curve 2 Original Revenue = 3*200 = 600 New Revenue = 2*220 = 440 200 220 Q Public Policy Implications

  23. Application to Illegal Drugs • Focus on reducing supply (raids etc) or focus on reducing demand (education, rehab etc)? • Note: demand for drug inelastic • Assumption: addiction • Reducing supply increases price/reduce quantity, but • Increases revenue, more incentive to sellers • Reducing demand decreases price/reduces quantity, and • Decreases revenue

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