Elasticity and its Application

Elasticity•A measure of how much buyers and sellers respond to changes in market conditions

•A measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants

Price Elasticity of Demand•Measures how much the quantity demanded responds to a change in price.

Factors Influencing PED

•Availability of Close Substitute

• Necessities vs. Luxuries

• Definition of Market

• Time Horizon

Computing the PED

Price Elasticity of Demand = % ∆ Qd

% ∆P

PED = 20% / 10% = 2

Midpoint Method• Price elasticity between two points on a demand curve

Ex. Point A: P=$4 Q=120

Point B: P=$6 Q=80

$6

$5

$4

80 100 120

B

A

A (6-4)/ 5 X 100 = /40%/

B (4-6)/ 5 X 100 = /40%/

Variety of Demand Curves

• Elastic- when elasticity is greater than 1.

• Inelastic-when elasticity is less than 1.

•Unit Elastic- when elasticity is equal to 1.

• Perfectly elastic- when elasticity is infinite.

• Perfectly inelastic- when elasticity is 0.

PERFECTLY INELASTIC DEMAND: ELASTICITY EQUALS 0

demand

Inelastic Demand: Elasticity Is Less Than 1

demand

Unit Elastic Demand: Elasticity Equals 1

demand

Elastic Demand: Elasticity Is Greater Than 1

demand

Perfectly elastic demand: Elasticity equals infinity

demand

Total Revenue and the PED

• amount paid by the buyers and received by the sellers. (PxQ)

a. The Case of Inelastic Demand

Ex. Consider rice as an inelastic demand. An increase in price leads to a decrease in quantity demanded that is proportionately smaller

$5

$4

90 100

$5

$4

70 100

b. The Case of Elastic Demand

The increase in price leads to a decrease in quantity demanded that is proportionately larger.

Elasticity and TR along a linear demand curve

•The slope of a linear demand curve is constant but its elasticity is not.

Price Quantity TR(PxQ)

%Change in Price

% Change in Quantity

ElasticityDescription

7 0 0 15 200 13.0 Elastic

6 2 12 18 67 3.7 Elastic

5 4 20 22 40 1.8 Elastic

4 6 24 29 29 1.0 Unit elastic

3 8 24 40 22 0.6 Inelastic

2 10 20 67 18 0.3 Inelastic

1 12 12 200 15 0.1 Inelastic

0 14 0 Inelastic

Price

Quantity

Elasticity is larger than 1

Elasticity is smaller than 1

Income Elasticity of demand• Measures how the quantity demanded changes as

consumer income changes.

• = %∆Qd/%∆Y

Cross Price Elasticity of Demand

-- measures how the quantity demanded of one good respond to a change in the price of another good.

= %∆Qd of good 1

%∆P of good 2

The Elasticity of Supply

DETERMINANTS

Flexibility of Sellers

Time Period

Price Elasticity of Supply

•Measures how much the quantity supplied responds to changes in the price

•= %∆ Quantity Supplied

%∆ in Price

(a) Perfectly Inelastic Supply: Elasticity Equals 0

supply

Supply

(b) Inelastic Supply: Elasticity Is Less Than 1

supply

c) Unit Elastic Supply: Elasticity Equals 1

(d) Elastic Supply: Elasticity Is Greater Than 1

supply

Supply

Perfectly Elastic Supply

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