Chapter 4

Elasticity

Elasticity

• Movement along demand and supply curves when the price of the good changes.

• QUESTION: HOW CAN WE PREDICT THE MAGNITUDE OF THESE REACTIONS?

• ANSWER: ELASTICITIES!!

Elasticity

• Elasticity: a general concept used to quantify the response in one variable when another variable changes.

• Elasticity of A with respect to B

B

A

%

%

Price Elasticity of Demand

• Measures how responsive consumers are to changes in the price of a product.

PRICE ELASTICITY OF DEMAND

• Price elasticity of demand is always negative.

• Elasticity is not the same as the slope of the demand curve.

• Ed = (% change Qd)/ (% change P)

p1

p2

q1q2

D

Price increase

Quantity demanddecrease

Q

P

The shape of a demand curve gives you some idea of the good’s general elasticity. (1)

pD

Q

P

D

Q

P

Perfectly elastic Relatively elastic

D

Q

P

D

Q

P

Perfectly inelastic Relatively inelastic

The shape of a demand curve gives you some idea of the good’s general elasticity.(2)

To calculate price elasticity of demand, use the midpoint formula.

Paverage

PP

Qaverage

QQ

Pchange%

Qdchange%Ed

21

21

Example-To find the price elasticity of demand between points a and b :

P1=$2

P2=$3

Q1=10Q2=5

D

Price increase

Quantity demanddecrease

Q

P

Paverage

PP

Qaverage

QQ

Pchange%

Qdchange%Ed

21

21

67.1

5.2

15.7

5

2/)23(

32

2/)105(

510

Ed

a

b

Example-To find the price elasticity of demand between points a and b :

P1=$2

P2=$3

Q1=10Q2=5

D

Price increase

Quantity demanddecrease

Q

P

a

b

67.1%40

%7.66

5.2

15.7

5

2/)23(

32

2/)105(

510

Ed

The price elasticity of demand at the midpoint between points a and b is -1.67.

Interpret the result

• What exactly does this tell you about the demand for this product in this price range?

Let’s try another, inelastic demand

P1=$2

P2=$3

Q1=10Q2=9

D

Price increase

Quantity demanddecrease

Q

P

a

bPaverage

PP

Qaverage

QQ

Pchange%

Qdchange%Ed

21

21

26.0

5.2

15.9

5

2/)32(

32

2/)910(

910

Ed

Let’s try another, inelastic demand

P1=$2

P2=$3

Q1=10Q2=9

D

Price increase

Quantity demanddecrease

Q

P

a

b

26.0%40

%5.10

5.2

15.9

5

2/)32(

32

2/)910(

910

Ed

The following categories help to describe consumer responsiveness:

• If the elasticity coefficient is less than -1 demand is elastic. Consumers are relatively responsive to price changes.

• If the elasticity coefficient is between -1 and 0 demand is inelastic. Consumers are not very responsive to price changes.

• If the elasticity coefficient is equal to -1, demand is unitary elastic.

Why we need elasticity?

• Why would a business firm need to calculate them, and how would the firm use the information?

• Now that you can calculate price elasticities of demand, what would you use them for?

There is an important relationship between price elasticity of demand and

total revenues:• When demand is inelastic, price and total

revenues are directly related. Price increases generate higher revenues.

• When demand is elastic, price and total revenues are indirectly related. Price increases generate lower revenues.

Now...what factors help to determine price elasticity of demand?

• Notice that this gives the firm information that it can use to establish pricing policy.

DETERMINANTS OF PRICE ELASTICITY OF DEMAND

• Availability of substitutes -- demand is more elastic when there are more substitutes for the product.

• Importance of the item in the budget -- demand is more elastic when the item is a more significant portion of the consumer’s budget.

• Time frame -- demand becomes more elastic over time.

Other types of elasticities

• INCOME ELASTICITY

• CROSS-PRICE ELASTICITY

incomeconsumerinchangeQdchangeelasticityincome

%%

goodanotherofpricetheinchange

Qdchangeelasticitypricecross

%

%

Other types of elasticities

• PRICE ELASTICITY OF SUPPLY

pricetheinchange

QschangeSupplyofelasticityprice

%

%

CHAPTER SUMMARY

• The price system rations goods and services to the consumers who are willing and able to pay market prices.

• Governments and firms sometimes try to bypass the price mechanism, generating excess demand and excess supply.

• Elasticity is a general concept that can be used to measure several types of market responsiveness.

Review questions

• Understand the meaning of elasticity.

• Apply the method to calculate elasticity.