Elasticity

1
Elasticity

• Claudia Garcia-Szekely

2
Definition

• Elasticity measures the sensitivity of either
  demand or supply to a change in any of their
  determinants.
• Elasticity measures how responsive or
  unresponsive the quantity demanded (or supplied)
  is to changes in a given factor.
• Elasticity allows you to predict how a price
  change will affect the behavior of buyers or
  sellers.

3
Types of Elasticity

• Price elasticity of demand.
• Price elasticity of supply.
• Income elasticity of demand.
• Cross Price elasticity.

4
The Price Elasticity of Demand

• Measures the response of the quantity demanded to
  a change in price.
• How responsive do you think is the quantity
  demanded of prescription drugs to a change in
  price?
• How responsive do you think is the quantity
  demanded of bananas to a change in price?

5
Calculating the Elasticity

• Midpoint Formula.
• The elasticity is measured between two points
  along a given demand curve.

The elasticity between B and C measures the
response to a 0.50 change in the price.
Note that a point is a pair (p, q)
6
Using the Midpoint Formula

• Compute the difference between the two
  quantities 22-19 3

• Compute the average of the two quantities (22
  19)/2 41/2 20.5

• Divide the answer you got in (1) by the answer in
  (2). This is the Percentage change in the
  quantity demanded 3/20.5 0.146

7
The Midpoint Formula Continued

• Compute the difference between the two prices
  (1-0.5) 0.5

• Compute the average of the two prices (10.5)/2
  0.75

• Divide the answer in (4) by the answer in (5).
  This is the percentage change in the price
  0.5/0.75 0.667.

8
The Midpoint Formula Cont..

• Divide the percentage change in the quantity
  demanded the answer you got in (3), by the
  percentage change in the price the answer you
  got in (6).
• The answer is the Price Elasticity of Demand
  between B and C.
• 0.146 / 0.667 0.21

9
The Midpoint Formula
Change in Quantity / Average Quantity
epd
Change in Price / Average Price
10
The Price Elasticity of Demand

• Measures the responsiveness of the quantity
  demanded to a change in price.
• There is a negative relationship between the
  price and the quantity demanded.
• The price elasticity of demand is ALWAYS
  NEGATIVE.

11
Price elasticity of demand is ALWAYS NEGATIVE
Always write a negative sign in front!
epd
12
Three Types of Elasticities

• Consider only the absolute value of the
  elasticity E
• The absolute value of the elasticity can be
• egt1
• e1
• elt1

Elastic
Unitarily Elastic
Inelastic
13
Sensitive Demands are Elastic Demands (e gt 1)
If the numerator (DQ) is larger than the
denominator (DP) then epd is greater than one.
A relatively small change in price causes a
relatively large change in quantity demanded.
14
Example

• It has been observed that a 5 increase in the
  price, caused a 10 reduction in the quantity
  demanded.

epd 10 / 5 - 2
Elasticity of Demand is greater than one Elastic
15
Insensitive Demands are Inelastic Demands (e lt 1)
If the numerator (DQ) is smaller than the
denominator (DP), then epd is less than one.
A relatively large change in price causes a
relatively small change in quantity demanded.
16
Example

• It has been observed that a 20 decrease in the
  price of good X, caused a 5 increase in the
  quantity demanded of X.

epd 5 / 20 - 0.25
Elasticity of Demand is less than one Inelastic
17
The Elasticity Changes Along the Demand Curve

• As you move up along a demand curve calculating
  the effect of a price increase - the elasticity
  increases in absolute value.

• For low prices (at the bottom of the demand
  curve) demand is relatively inelastic

As Price Increases
Elasticity Increases

• For high prices (at the top of the demand curve)
  demand is relatively elastic

18
The Elasticity Changes Along the Demand Curve
At the midpoint, e 1
19
1. Compute price elasticity
20
The Elasticity Changes Along the Demand Curve
e 1
Midpoint
21
Perfectly Elastic Demand

• When the elasticity is a very large number (close
  to infinity) demand is said to be perfectly
  elastic.
• A perfectly elastic demand would show that at the
  slightest increase in the price, the quantity
  demanded would drop to zero.

0.61
0.6
100 Units
0 Units
22
Perfectly Inelastic Demand

• When the elasticity is a very small number (close
  to zero) demand is said to be perfectly
  inelastic.
• A perfectly inelastic demand would show that even
  after a large change in the price the quantity
  demanded would not change at all.

1.20
e 0
0.6
100 Units
23
What Determines the Elasticity?

• The number of substitutes available.
• The Definition of the market.
• The length of time consumers have to react to a
  price change.
• Necessities tend to have inelastic demands,
  whereas luxuries have elastic demands.
• Example Doctor visits, sailboats.

24
The number of Substitutes Available.
The more substitutes exist for a given good, the
easier it would be for consumers to switch.
The more sensitive (elastic) demand would be to
price changes
25
The Definition of the market.

• Narrowly defined markets have more elastic
  demands.

Ben and Jerrys Chocolate Ice Cream
epd gt 1
26
The Definition of the market.

• Broadly defined markets have less elastic
  demands.

Food
Ice Cream
HDz
BJ
Beverages
epd lt 1
Cookies
27
2. Which product will be less elastic? Why?

• Cars
• Convertibles
• Imported Convertibles
• Imported, red convertibles

28
The amount of time to react

• The longer the time allowed, the easier it is for
  consumers to find an alternative or modify their
  behavior.
• Goods have more elastic demands over longer time
  horizons.
• Example Gasoline.

29
The Price Elasticity of Demand and Revenues

• Total Revenues Price x Quantity
• An increase in price will increase TR only if the
  quantity demanded does not fall too much.
• If the increase in price is larger than the drop
  in quantities, TR will increase.
• 3. This is precisely what happens if demand is
  _____________

30
When Demand is Inelastic TR follow the change in P

• If the drop in quantities sold is smaller than
  the increase in price, total revenues will
  increase after a price increase.

• TR P x Q

This is the case when e lt 1.
31
When Demand is Elastic TR follow the change in Q

• If the drop in quantities sold is larger than
  the increase in price, total revenues will fall
  after a price increase.

• TR P x Q

This is the case when e gt 1.
32
Elasticity and Total Revenues
33
If a company increases prices and as a result

• Total Revenues Decrease.
• We can conclude that the rise in revenues due to
  higher prices, was completely offset by the drop
  in quantities sold.

• Total Revenues Increase.
• We can conclude that the quantities sold did not
  drop enough to offset the rise in revenues due to
  higher prices

Demand is Elastic
Demand is Inelastic
34
3. Is this demand elastic or inelastic?
35
Total Revenues, Changes in prices and Elasticity
Elastic
Decrease Price to Increase TR
Inelastic
36
Total Revenues, Changes in prices and Elasticity
e 1
If demand is UNIT elastic an increase/decrease in
price would leave TR unchanged
Midpoint