Demand and Elasticity

Modules 46-48

What’s behind the Demand Curve?

• Substitution effect– As price decreases, consumers are more likely to

use the good as a substitute for other relatively more expensive ones

• Income effect– As price decreases, consumers feel like they have

more money, since their purchasing power has increased

How sensitive one variable is to changes in another variable

Elastic – very sensitive

Inelastic – somewhat insensitive

Elasticity

Price Elasticity of DemandHow much the quantity demanded changes with change in price:

Coefficient of Elasticity = %ΔQD

%ΔP

Calculate the elasticity: Price increases from $10 to $12. Quantity falls from 100 to 90.%ΔQ =(90-100)/100 = -10% %ΔP =(12-10)/10 = 20%Coefficient of Elasticity = 0.5

Price Elasticity of Demand

If the coefficient of elasticity > 1, it is considered elastic

If the coefficient of elasticity < 1, it is considered inelastic

If the coefficient of elasticity = 1, it is considered unit elastic

When we discuss price elasticity, we typically mean price elasticity at a particular price. This is because price elasticity usually varies along a demand curve.

However, the simple method of calculating elasticity can yield a different result from the opposite direction

The Mid-Point Formula

Use the average of the two end points:

Coefficient of Elasticity =Q2-Q1

(Q1+Q2)/2

P2-P1

(P1+P2)/2

Elasticity and Total Revenue

• Depending on elasticity, an increase in price can generate more or less total revenue

• If demand is inelastic, an increase in price yields and increase in total revenue

• If demand is elastic, an increase in price yields and decrease in total revenue

How Elastic are these Goods?

Inelastic Elastic

Cross Price Elasticity of Demand

How much quantity demanded of Good A will change with respect to change in the price of Good B.

%ΔQDA

%ΔPB

If the value is negative, A and B are complementsIf the value is positive, A and B are substitutes

Income Elasticity of Demand

How much the demand for a good will change with respect to change in income.

%ΔQD

%Δ Income

If the value is negative, the good is inferiorIf the value is positive, the good is normal

Price Elasticity of SupplyHow much the quantity supplied changes with change in price:

Coefficient of Elasticity = %ΔQS

%ΔP

If elasticity is: >1, supply is elastic< 1, supply is inelastic= 1, supply is unit elastic

Factors that DetermineSupply Elasticity

• Availability of resources– If a firm can get labor, capital and materials into or

out of production quickly, supply will be more elastic

• Time– Production takes lead time – the more time to

make a change, the more elastic– Agriculture