Understanding Elasticity in Microeconomics

1. College of Business – Rabigh Chapter-4 FINA251Fundamentals of MicroeconomicsWeek 82016

2. 4 Elasticity

3. Lesson Objectives • Explain the factors that influence the elasticity of demand. • Explain the factors that influence the elasticity of supply. • Explain the relationship between revenue and elasticity

4. The Factors that Influence the Elasticity of Demand • The availability and closeness of substitutes goods. • The proportion of income spent on the good. • The time elapsed since a price change.

5. The Factors that Influence the Elasticity of Demand • The availability and closeness of substitutes. The greater and closer the substitutes for a good or service, the more elastic is the demand for the good or service. Because consumers could choose its substitutes easily. • The demand for a good is elastic if a substitute for it is easy to find. • The demand for a good is inelastic if a substitute for it is hard to find.

6. The Factors that Influence the Elasticity of Demand • The availability and closeness of substitutes. • Necessities, such as food or housing, generally have inelastic demand. • Luxuries, such as exotic vacations, generally have elastic demand.

7. The Factors that Influence the Elasticity of Demand • The proportion of income spent on the good The greater the proportion of income consumers spend on a good, the larger is the elasticity of demand for that good. Because a change in the price of such a good has an affect consumers' budget with a bigger magnitude. Consumers will respond by cutting back more on these product when price increases.

8. The Factors that Influence the Elasticity of Demand • Time Elapsed Since Price Change The longer the time after the price change, the more elastic will be the demand. It is because consumers are given more time to carry out their actions. The longer the adjustment period, increase the consumers’ ability to substitute away from relatively higher-priced products toward lower-priced substitutes.

9. Initial price = $1.00 Dw = the demand curve one week after the price change Dm = one month after Dy, = one year after. $1.25 Suppose the price now increases to $1.25. The more time for consumers to respond to price increase, the greater the reduction in quantity demanded. $1.00 Dy Price per unit Dw shows that one week after the price increase, the quantity demanded has not changed much – in this case from 100 to 95. Conversely, after one month, the quantity demanded has declined to 75, and after one year to 50 per day. Dm Dw 0 Quantity per period 50 75 95 100 Note that among these demand curves, the flatter the demand curve, the more price elastic the demand.

10. More Elasticities of Demand • Cross elasticity of demand The responsiveness of the demand for one good to changes in the price of another good is called the cross-price elasticity of demand In simplest terms the percent change in the demand of one good divided by the percent change in the price of another good.

11. More Elasticities of Demand • Cross elasticity of demand The responsiveness of the demand for one good to changes in the price of another good is called the cross-price elasticity of demand. In simplest terms the percent change in the demand of one good divided by the percent change in the price of another good. The formula for calculating the cross elasticity Percentage change in quantity demanded = ------------------------------------------------------------------------ Percentage change in price of substitute or complement or unrelated

12. More Elasticities of Demand • Cross elasticity of demand Its numerical value can be positive, negative, or zero depending on the nature of goods. • If goods are substitutes, the cross elasticity of demand is positive • If goods are complements, the cross elasticity of demand is negative • If goods are unrelated, the cross elasticity of demand is zero.

13. More Elasticities of Demand • Income elasticity of demand The income elasticity of demand measures how responsive demand is to a change in income. In simplest terms the percent change in the demand of one good divided by the percent change in income. The formula for calculating the income elasticity of demand Percentage change in quantity demanded = --------------------------------------------------------------------------- Percentage change in income

14. More Elasticities of Demand • Income elasticity of demand • If the income elasticity of demand is greater than 1, demand is income elastic and the good is a normal good(luxury goods) • If the income elasticity of demand is greater than zero but less than 1, demand is income inelastic and the good is a normal good(necessity goods) • If the income elasticity of demand is less than zero (negative) the good is an inferior good.

15. Elasticity of Supply • The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain the same. • In simplest term, The price elasticity of supply equals the percent change in quantity supplied divided by the percent change in price. The elasticity of supply = Percentage change in quantity supplied ------------------------------------------------------------ Percentage change in price

16. Elasticity of Supply Note that the categories of supply elasticity same as demand elasticity. • If supply elasticity is less than 1.0, supply is inelastic • If it equals 1.0, supply is unit elastic • If it exceeds 1.0, supply is elastic • If it is infinity, supply is perfectly elastic • If it is zero, supply is perfectly inelastic.

17. Elasticity of Supply • Calculation formula is Here, P = initial price, Qs = initial quantity, P’ = new price, Q’s = new quantity,  = change • Due to law of supply, the price elasticity of supply is usually a positive number.

18. The Factors that Influence the Elasticity of Supply The elasticity of supply depends on • Resource availability and substitution possibilities. • Time frame for supply decision. • Number of Producers • Easy of storing stock • Improvement in Technology • Stock of finished goods • Increase in cost of production as compared to output.

19. The Factors that Influence the Elasticity of Supply Resource availability and substitution possibilities • The easier it is to substitute among the resources used to produce a good or service, the greater is its elasticity of supply. Alternatively also true. • So the greater the availability of resources, the supply of goods and services will be elastic and the smaller the availability, the supply will be inelastic.

20. S S w m S y Price per unit 0 100 200 140 Quantity per period 110 Sw is the supply curve when the period of adjustment is a week. In this situation, the higher price does not elicit much of a response in quantity supplied because firms have little time to adjust  supply curve is inelastic if the price increases from $1.00 to $1.25 • Time frame for supply decision Supply becomes more elastic over time as producers adjust to price changes Sm is the supply curve when the adjustment period is one month. Here the firms have a greater ability to vary output  supply is more elastic Supply is even more elastic when the adjustment period is a year as shown by Sy

21. The Factors that Influence the Elasticity of Supply • Number of producers More producers mean that the output can be increased more easily. Thus supply is more elastic. • Easy of storing stocks If goods can be stocked with ease and have a long shelf life, the supply will be elastic, otherwise inelastic. For example perishable goods such as fresh flowers, vegetables have comparatively inelastic supply because it is difficult to store them for longer periods.

22. The Factors that Influence the Elasticity of Supply • Improvement in Technology In industries where there is a rapid improvement in technology, the price elasticity of supply of such goods will be more elastic as compared to industries where there is not much improvement in technology. • Stock of finished goods In industries where there are high inventories/stocks of finished goods, the suppliers can easily supply more as the price rises. Thus, the price elasticity of supply for these goods will be elastic.

23. The Factors that Influence the Elasticity of Supply • Increase in cost of production as compared to output In cases where there is a significant increase in cost of production when output is increased, supply is inelastic. This is because suppliers will have to have to do a significant investment in order to increase the output. It will take time and some suppliers may be hesitant in doing so.

24. Elasticity and Total Revenue • Total revenue(TR) is the total amount of money that received by selling goods or services. That means TR equals the price of the good multiplied by the quantity sold  TR = p x q What happens to total revenue when price changes?

25. Elasticity and Total Revenue If demand is elastic: A given percentage rise in price brings a larger percentage decrease in the quantity demanded. Total revenue decreases. If demand is inelastic: A given percentage rise in price brings a smaller percentage decrease in the quantity demanded. Total revenue increases. If demand is unit elastic: No change in total revenue

26. Elasticity and Total Revenue Total revenue test: • If price and total revenue change in the opposite directions, demand is elastic. • If a price change leaves total revenue unchanged, demand is unit elastic. • If price and total revenue change in the same direction, demand is inelastic.

27. (a) Demand and Price Elasticity e u n e v e r l a t o T $100 90 a 80 b 70 60 50 c Price per unit 40 30 20 d 10 e D 0 100 200 500 800 900 1,000 Quality per period (b) Total Revenue TR = p x q $25,000 Total revenue 0 1,000 500 Quantity per period

28. Now it’s over for today. Do you have any question?