Chapter 6 Elasticity.pdf

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Chapter 6:
Elasticity
ECO1001 Chapter 6
Elasticity

Learning Outcomes
Once you have studied this chapter you should be able to
• define elasticity
• explain the meaning and significance of price elasticity of demand
• distinguish between five categories of price elasticity of demand
• explain the determinants of price elasticity of demand
• define income elasticity and cross elasticity of demand
• explain the meaning and significance of price elasticity of supply

Introduction
Demand and supply allows:
• Explanations of economic phenomena
• Price is determined
• Predictions according to changes in economic variables
• Changes in determinants of SS and DD
• Analyse the effects of policy decisions
• Tax VS welfare costs
The public interested in magnitude of changes
• How does changes in price affect quantities

Introduction
The public is interested in magnitude of changes
• How does changes in price affect quantities
• Will changes in price yield higher/lower revenue
• Increase/decrease consumer spending
How responsive is quantity demanded and supplied to price
changes
• Elasticity of demand and supply.

A general definition of elasticity
Elasticity is a measure of responsiveness or sensitivity.
• How responsive/sensitive the dependent variable is to changes
in the independent variable
• Cause-effect relationship of changes between related variables
• Eg. Changes in interest rates VS demand for housing
• Eg. Changes in wage rate VS supply of labour
Elasticity indicates the percentage change in the dependent
variable (affected variable) due to the independent variable
(causing the change) changing by one per cent, ceteris paribus
Elasticity = % Δ dependent variable
% Δ independent variable

A general definition of elasticity
Four types of elasticity:
1. the price elasticity of demand
2. the income elasticity of demand
3. the cross elasticity of demand
4. the price elasticity of supply

The price elasticity of demand
QD = f (Px , Pg , Y , T , N, …)
• Price elasticity of demand is concerned with the how the change
in price affects quantities demanded
• QD = f (Px)
ep = % Δ Quantity demanded
% Δ Price of the product
• Eg. If the price of petrol changes by 5% resulting in a 10% change in the
quantity demanded
ep = 10 % / 5 % = 2
• Therefore a 1% change in price of the product changes quantity
demanded by 2%
• ep indicates the sensitivity of quantity demanded to price
changes

Important aspects and implications:
• Units do not affect the result- elasticity is calculated
using percentage changes. RELATIVE VALUES.
• Elasticity coefficients enables us to compare
different goods and services- indicates their respective
demand sensitivities across various products and services.
• Consider the absolute value- Elasticity of demand has a
negative sign (changes occur in opposite directions)

Figure: The impact of different demand elasticities on the
equilibrium price and quantity (Textbook page 105)
Demand curve flat
• Small Δ P large Δ Qd
• Demand relatively
elastic

Figure: The impact of different demand elasticities on the equilibrium
price and quantity continued
•Demand curve steep
• Large Δ P small Δ Qd
• Demand relatively
inelastic

Two formula:
Point elasticity (used for small price changes)
➢ ep = = = X
Arc elasticity (used for larger price fluctuations)
• ep(a) =
•Box: calculating arc elasticity (Textbook page 107)
100
*
)
/
(
100
*
)
/
(
P
P
Q
Q


P
P
Q
Q
/
/


P
Q


Q
P
)
/(
)
( /2
/(
)
(
2
1
1
2
2
1
1
2
P
P
P
P
Q
Q
Q
Q
+
-
+
- )/2

The price elasticity of demand can be used to determine by
how much the total expenditure by consumers on a product
changes when the price of the product changes
• TR = PQ
• Changes in price has an inverse relationship to quantity demanded
➢ Price elasticity of demand > 1
TR increases as Q increases
➢ Price elasticity of demand = 1
TR reaches a maximum
➢ Price elasticity of demand < 1
TR falls as Q increases

Table: The demand for cappuccinos and total revenue from
cappuccino sales

• As long as:
➢ Price elasticity of demand > 1
TR increases as Q sold increases
➢ Price elasticity of demand = 1
TR reaches a maximum
➢ Price elasticity of demand < 1
TR falls as Q sold increases

Different categories of price elasticity
of demand

Figure: The different categories of price elasticity of demand
Different categories of price elasticity of demand

Figure: The different categories of price elasticity of demand continued
Different categories of price elasticity of demand

• Determinants of the price elasticity of demand
• Substitution possibilities- more substitutes more
elasticity
• The degree of complementarity of the product-
highly complementary, less elastic
• The type of want satisfied by the product-
necessities VS luxury goods
• The time period under consideration- LR more
elastic
• The proportion of income spent on the product-
higher income spent, more elastic

• Determinants of the price elasticity of demand
• The definition of the product- food (broad, less
elastic) VS chicken
• Advertising- brand’s(OMO) elasticity higher than
product(washing powder)
• Durability- more durable more elastic (power-tools)
• The number of uses for the product- more uses the
more elastic demand(availability of substitutes)
• Addiction- low elasticity of demand
The combined effect of the determinants- determine
elasticity in a holistic manner. Cannot be determined in
isolation.

Other demand elasticities
• The income elasticity of demand – measures the
responsiveness of the quantity demanded to changes in
income
➢ ey =
• As income changes quantities demanded of various good change.
• an increase in income usually results in an increase in quantity
demanded
• ep may be positive or negative:
➢ POSITIVE; as income increases so does quantity demanded of product – NORMAL goods
➢ normal goods are EITHER luxury or essential goods.
➢ 0 < ey < 1 normal good, essential good (certain basic foodstuffs)
➢ 1 < ey normal good, luxury good (electronics, furniture)
➢ NEGATIVE, as income increases quantity demanded of product decreases – INFERIOR goods
➢ ey < 0 inferior good
Y
Qd


%
%

• Cross elasticity of demand – measures the responsiveness of the quantity demanded for
a particular good when the price of another good changes
- Related to the sensitivity of changes in price and quantities demanded between related
goods.
• ec =
•
➢ 0 < ec , substitutes (positive ec) change in price causes same
direction change in Qd of substitute (butter vs margarine).
➢ ec < 0, complements (negative ec) change in price causes
opposite direction change in Qd of complement (motor cars vs tyres)
➢ ec = 0, unrelated goods.
b
a
P
Qd


%
%

• The price elasticity of supply – measures the responsiveness of
the quantity supplied to changes in price
➢ es =
•
•
• The determinants of the price elasticity of supply:
• Time period- Short run VS long run
• Expectations- higher expected prices, elastic response
• Stockpiling/ Excess capacity- responds quicker to price changes
• Availability of inputs- scarce FOP causes inelastic responses
P
Qs


%
%

Figure: Different categories of price elasticity of supply
The price elasticity of supply
The determinants of the price elasticity of supply

The price elasticity of supply
The determinants of the price elasticity of supply
Figure: Different categories of price elasticity of supply continued

Important concepts
• Elasticity
• Price elasticity of demand
• Elasticity coefficient
• Arc elasticity
•
•
•
•
•
•
Total revenue (or expenditure) •
Perfectly inelastic demand
Inelastic demand
Unitarily elastic demand
Elastic demand
Perfectly elastic demand
• Slope and inverse of slope
• Determinants of price
elasticity
• Income elasticity of demand
Normal and inferior goods
• Essential and luxury goods
• Cross elasticity of demand
• Price elasticity of supply
• Elastic and inelastic supply

Chapter 6 Elasticity.pdf

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Chapter 6 Elasticity.pdf