Chapter 6: Elasticity

1. Chapter 6: Elasticity

2. Elasticity • A measure of the responsiveness of one variable (usually quantity demanded or supplied) to a change in another variable • Most commonly used elasticity: price elasticity of demand, defined as: Price elasticity of demand =

3. Price elasticity of demand • Demand is said to be: • elastic when Ed > 1, • unit elastic when Ed = 1, and • inelastic when Ed < 1.

4. Perfectly elastic demand

5. Perfectly inelastic demand

6. Elasticity & slope • a price increase from $1 to $2 represents a 100% increase in price, • a price increase from $2 to $3 represents a 50% increase in price, • a price increase from $3 to $4 represents a 33% increase in price, and • a price increase from $10 to $11 represents a 10% increase in price. • Notice that, even though the price increases by $1 in each case, the percentage change in price becomes smaller when the starting value is larger.

7. Elasticity along a linear demand curve

8. Elasticity along a linear demand curve

9. Arc elasticity measure where:

10. Example • Suppose that quantity demanded falls from 60 to 40 when the price rises from $3 to $5. The arc elasticity measure is given by: In this interval, demand is inelastic (since elasticity < 1).

11. Elasticity and total revenue • Total revenue = price x quantity • What happens to total revenue if the price rises? Price elasticity of demand =

12. Elasticity and TR (cont.) • A reduction in price will lead to: • an increase in TR when demand is elastic. • a decrease in TR when demand is inelastic. • an unchanged level of total revenue when demand is unit elastic. Price elasticity of demand =

13. Elasticity and TR (cont.) • In a similar manner, an increase in price will lead to: • a decrease in TR when demand is elastic. • an increase in TR when demand is inelastic. • an unchanged level of total revenue when demand is unit elastic. Price elasticity of demand =

14. Elasticity and TR (cont.)

15. Price discrimination • different customers are charged different prices for the same product, due to differences in price elasticity of demand • higher prices for those customers who have the most inelastic demand • lower prices for those customers who have a more elastic demand.

16. Price discrimination (cont.) • customers who are willing to pay the highest prices are charged a high price, and • customers who are more sensitive to price differentials are charged a low price.

17. Determinants of price elasticity Price elasticity is relatively high when: • close substitutes are available, • the good or service is a large share of the consumer's budget, and • a longer time period is considered.

18. Cross-price elasticity of demand • The cross-price elasticity of demand between two goods j and k is defined as:

19. Cross-price elasticity (cont.) • cross-price elasticity is positive if and only if the goods are substitutes • cross-price elasticity is negative if and only if the goods are complements.

20. Income elasticity of demand • A good is a normal good if income elasticity > 0. • A good is an inferior good if income elasticity < 0.

21. Income elasticity of demand • A good is a luxury good if income elasticity > 1. • A good is a necessity good if income elasticity < 1.

22. Price elasticity of supply

23. Perfectly inelastic supply

24. Perfectly elastic supply

25. Determinants of supply elasticity • short run - period of time in which capital is fixed • all inputs are variable in the long run • supply will be more elastic in the long run than in the short run since firms can expand or contract their capital in the long run.

26. Tax incidence • distribution of the burden of a tax depends on the elasticities of demand and supply. • When supply is more elastic than demand, consumers bear a larger share of the tax burden. • Producers bear a larger share of the burden of a tax when demand is more elastic than supply.