ELASTICITY

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ELASTICITY

• PRINCIPLES OF MICROECONOMICS

Dr. Fidel Gonzalez Department of Economics and In
tl. Business
Sam Houston State University
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OPPORTUNITY COST
MARGINAL ANALYSIS
Elasticity
Elasticity
SUPPLY
DEMAND
MARKET EQUILIBRIUM
CONSUMER SURPLUS, PRODUCER SURPLUS AND TOTAL
SURPLUS
MARKET EFFICIENCY
MARKET FAILURE
Pigouvian Taxes Quotas Coase Theorem Command an
d control
TAXES
EXTERNALITIES
QUOTAS
PUBLIC GOODS
COMMON GOODS
ARTIFICIALLY SCARCE GOODS
GAME THEORY
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But before we go on to study Elasticity the
following example will show why it matters.
In 1997, the Texas Department of Transportation
(TDOT) increased the price of vanity plates with
the intention of increasing the amount of money
they received from the vanity plates.
According to the Law of Demand when the price
goes up the quantity demanded goes down. Hence,
the TDOT was expecting the quantity demanded to
go down but less than the increase in the price
so that at the end the total money they receive
increases.
So what happened? When the price of vanity plates
increased the money received by the TDOT
decreased. In other words, the percentage change
in the price of vanity plates was less that the
percentage decrease in the quantity of vanity
plates. They could have benefited from a better u
nderstanding of the elasticity concept.
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Elasticity measures how much buyers and sellers
respond to changes in market conditions. In the
case of Demand the most common market conditions
that we are going to study are price, income and
price of related goods. In the case of supply we
are going to concentrate in the change of the
quantity supplied when the price changes.
For example In the case of the demand, when the
price changes we want to know how much the
quantity demanded changes. Also, we want to know
how much the quantity demanded changes when the
income of consumers changes or the price of
related goods. You can think of Elasticity as s
omething equal to sensitivity, that is, the
elasticity is going to tells us how sensitive the
quantity demanded or supplied is to changes in
the market conditions. The Law of Supply or Deman
d tell us direction of the change when price and
quantity supplied or demanded change, Elasticity
is going to tell us the magnitude of the change.
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We have covered demand and supply. We studied the
law of demand and the law of supply.
The Law of Supply tells us that quantity supplied
and price move in the same direction.
However, neither the Law of Demand nor the Law of
Supply tell us the size of the change. For
example, the Law of Demand says that if the price
increases the quantity demanded goes down but it
does not say by how much. This is exactly what t
he concept of elasticity is all about. Elasticity
is going to measure how much the quantity
demanded (or quantity supplied) changes when the
price changes. In other words, the Law of Demand
and Supply tell us the direction of the change in
the Quantity Demanded or Quantity Supplied when
the price changes and the elasticity tell us the
magnitude of the change.
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Demand and Elasticity

• In the case of demand the three types of
  elasticity we will cover are
  
• Price Elasticity of Demand
• Income Elasticity of Demand
• Cross-Price Elasticity of Demand

We will cover all of them but spend more time in
the Price Elasticity of Demand.

• Price Elasticity of Demand

The Law of Demand tells us that quantity demanded
and price move in opposite directions. However,
the Law of Demand nor the Law of Supply tell us
the size of the change. For example, the Law of
Demand says that if the price increases the
quantity demanded goes down but it does not say
by how much. This is exactly what the concept of
Price Elasticity of Demand is all about.
Elasticity is going to measure how much the
quantity demanded (or quantity supplied) changes
when the price changes.
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Price Elasticity of Demand
The price elasticity of demand tells us how much
the quantity demand changes when the price
changes. We are going to use percentage changes
to measure the change in all prices and
quantities.
The Price Elasticity of Demand is given by the
following formula
Where Ed elasticity of demand.
Remember that the Law of Demand says that price
and quantity demanded move in opposite
directions. This means that if the percentage
change in the price is positive (price goes up)
then the percentage change in the quantity
demanded is negative (the quantity demanded goes
down). That is, the numerator will be negative
and the denominator will be positive, therefore
the Ed will be negative. Notice that when the
percentage change in the price is negative the
percentage change in the quantity will be
positive and the Ed will also be negative.
In other words, the Ed will always be negative
because of the Law of Demand (or if you remember
our previous classes because of the decreasing
MWTP).
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Price Elasticity of Demand
Since Ed is always negative we are going to get
rid of the negative sign and report Ed as a
positive number. This is achieved by using the
absolute number concept. Remember from you High
School classes that any number can be converted
into a positive one if we place the absolute
number operator around it .
For example, -5 5 and 55 . Therefore, our
new definition of Ed is the following
Since, I do not want to write percentage change
every time I write the formula for Ed I will use
the following expression for Ed
where ? means percentage change, QD is
quantity demanded, and P is price.
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Price Elasticity of Demand
For example if the Price of Pepsi goes up by 5
and as a response the Quantity Demanded goes down
by 10 then the Price Elasticity of Demand for
Pepsi is
This has an interesting interpretation. Ed2
indicates that the percentage change in the
quantity demanded is twice a big as the
percentage change in the price. In other words,
the quantity demanded is very sensitive to
changes in the price because in this case the
quantity demanded changed more (in percentage
terms) than the change in the price.
In general the elasticity can be interpreted as
follows the percentage change in the Quantity
Demanded is Ed times the percentage change in the
Price. In the example above Ed2 so we concluded
that QD is sensitive to changes in P. In general,
whenever the percentage change in the QD demand
is greater than the percentage change in P we are
going to say the demand is sensitive to changes
in the price. A sensitive demand is called Elast
ic, and insensitive demand is called Inelastic.
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Price Elasticity of Demand
Hence, If Ed 1 then Elastic since ? QD
?P (sensitive demand, the Quantity Demand
responds more than proportional to changes in the
Price) If Ed ?P (insensitive demand, the Quantity Demand
responds less than proportional to changes in the
Price) If Ed 1 then Unit-elastic since ? QD
?P (the Quantity Demand responds in the
same proportion to changes in the Price)
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Price Elasticity of Demand Determinants

• The Price Elasticity of Demand will vary across
  goods. The following are the main determinants of
  Ed
  
• Goods with many close substitutes will have
  higher elasticities if a good can be easily
  substituted for another then consumer will be
  very sensitive to prices. For example if two gas
  stations are located in the same corner (and the
  gasoline is roughly the same between the two)
  then consumers will pay close attention to the
  price between the two gas stations.
• Luxuries and Necessities Luxuries will tend to
  have higher elasticities. Necessities will tend
  to have lower elasticities. In the latter, since
  the good is a necessity consumer will not be very
  responsive to price changes, they still have to
  purchase the good. In the case of luxuries since
  consumers do not really need to buy the good then
  they will pay attention to the price and
  therefore will be sensitive to price changes. For
  example, vacations are luxury goods, if the price
  of a vacations increases most consumer will
  reduce the number of vacations more than
  proportionally to the change in price. However,
  if the price of food goes up people will only
  reduce the amount of food purchased a little bit
  because without food they will die or get sick.
  

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Price Elasticity of Demand Determinants
3) Definition of Markets narrowly defined
markets have higher elasticities. This is true
because narrowly defined market have more
substitutes that broadly defined markets. For
example, the QD of chicken will be more sensitive
to changes in its own the price than the QD of
food. Chicken has more substitutes because is a
narrowly defined market compared to Food.
4) Time horizon long-run demand is more elastic
than short-run demand. Long-run demand means
demand for the good in the distant future.
Shot-run demand means demand for the good today.
Long-run demand is more elastic because in the
distant future people can adjust better to
changes in the price and therefore reduce the QD
for the good. In the short-run people can not
adjust very well. For example, imagine that the
price of gasoline will be 20 per gallon in three
years. In that case buyers have time to adjust
and people will organize and carpool or buy more
fuel efficient cars, etc. This will reduce the
amount of QD than otherwise would have taken
place if people did not have time to react. If
the price of gasoline today is 20 per gallon
there is not much buyers can do about it they
have to go to work or to school and they can not
adjust very well to the price change so the
change in QD will be smaller than in the
Long-run.