Transcript Elasticity: A Measure of Responsiveness

CHAPTER
5
1
Elasticity:
A Measure of
Responsiveness
A Closer Look at Demand and Supply
1
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
1
The Concept of Elasticity


Elasticity is a measure of the
responsiveness of people to changes
in economic variables.
How large is the response of producers
and consumers to changes in price?
Before business firms and the
government decide to change prices and
taxes, they must anticipate the
magnitude of response by those affected.
2
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Popular Elasticity Measures
Popular measures of elasticity include:




Price elasticity of demand
Price elasticity of supply
Income elasticity—and the character of
consumer goods
Cross elasticity of demand for related
goods
3
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Price Elasticity of Demand

Price elasticity of demand measures
the response of consumers to
changes in price.
percentage change in quantity demanded
Ed 
percentage change in price
4
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Computing Price Elasticity of Demand
percentage change in quantity demanded
Ed 
percentage change in price
85  100
15
% Q 

 015
. or 15%
100
100
$2.20  $2.00 $0.20
% P 

 10%
$2.00
$2.00
%  Q 15%

 150
.
%  P 10%
5
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Using the Midpoint Formula to
Compute Price Elasticity

The midpoint formula is a more accurate measure
of percentage changes.
absolute value
percentage change =
average value
85  100
15
% Q 

 16.22%
(100  85) / 2 92.5
$2.20  $2.00
$0.20
% P 

 9.52%
($2.00  $2.20) / 2 $2.10
%  Q 16.22%

 170
.
%  P 9.52%
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
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Interpreting the Value of Elasticity
Value of
Elasticity
Demand
Elasticity
Ed > 1
Elastic
%QD > %P
Responsive
Ed < 1
Inelastic
%QD < %P
Unresponsive
Unitary elastic %QD = %P
Proportional
Ed = 1
The main determinant of
demand elasticity is the
availability of substitutes
for the good in question.
Magnitudes of Response to
Change
Price Changes
Type of
Elasticity
Substitutes
Available
Elastic
Many
Inelastic
Few
7
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Interpreting the Value of Elasticity
Estimated price elasticities of demand 
for selected products
Product
Salt
Water
Coffee
Cigarettes
Shoes and footwear
Housing
Automobiles
Foreign travel
Restaurant meals
Air travel
Motion pictures
Specific brands of coffee
© 2001 Prentice Hall Business Publishing
The price elasticity for
water (0.20) suggests that
Price elasticity
a 10% increase in the
of demand
0.1
price of water would
0.2
decrease the quantity
0.3
demanded by only 2%.
0.3
 The elasticity for specific
0.7
1.0
brands of coffee (5.6)
1.2
suggests that a 10%
1.8
increase in the price of a
2.3
specific brand would
2.4
3.7
decrease its quantity
8
5.6
demanded
by
56%.
Economics: Principles and Tools, 2/e
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Elasticity Along a Linear Demand
Curve


Point r to point s
Point t to point u
Point v to point w
© 2001 Prentice Hall Business Publishing
Percentage
decrease in price
4/80 = 5%
4/50 = 8%
4/20 = 20%
Price elasticity of demand
decreases as we move
downward along a linear
demand curve
Demand is elastic on the
upper part of the demand
curve and inelastic on the
lower part.
Percentage increase
in quantity
2/10 = 20%
2/25 = 8%
2/40 = 5%
Economics: Principles and Tools, 2/e
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Elasticity
20%/5% = 4.0
8%/8% = 1
9
5%/20% = 0.25
Elasticity and Total Revenue

Elasticity of demand determines if an
increase in price will cause the firm’s
revenue to increase or decrease.
Total Revenue = Price x Quantity sold
10
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Elasticity and Total Revenue
Total Revenue = Price x Quantity sold

The good news about an increase in price is that a
higher price will increase the revenue obtained from
each unit sold.

The bad news is that at a higher price, fewer units are
sold. Elasticity of demand tells us whether the good
news dominates over the bad news.
11
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Predicting Changes in Total Revenue
This graph shows the relationship
between elasticity along a linear
demand curve and total revenue.
Note the following:
 Revenue is maximum when Ed=1.
 Along the elastic range of the
demand curve, an increase in
price leads to a decrease in total
revenue.
 Along the inelastic range, an
increase in price leads to an
increase in total revenue.
12
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Predicting Changes in Total Revenue
Elasticity and Total Revenue
Type of
demand
Effect of an
increase in
price on total
revenue
Effect of a
decrease in price
on total revenue
Value of Ed
Change in quantity
versus change in price
Elastic
Greater than
1.0
Larger percentage change Total revenue
in quantity
decreases
Total revenue
increases
Inelastic
Less than 1.0
Smaller percentage
change in quantity
Total revenue
increases
Total revenue
decreases
Unitary
elastic
Equal to 1.0
Same percentage change
in quantity and price
Total revenue
does not change
Total revenue does
not change
13
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Price Elasticity of Supply

Price elasticity of supply is a measure of
the responsiveness in quantity supplied to
changes in price.
percentage change in quantity supplied
Es 
percentage change in price
14
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Computing Price Elasticity of Supply
percentage change in quantity supplied
Es 
percentage change in price
120  100
20
% Qs 

 20%
100
100
$2.20  $2.00 $0.20
% P 

 10%
$2.00
$2.00
%  Qs 20%
Es 

 2.0
%  P 10%
15
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Supply Elasticity and Time

Supply becomes more
elastic over time.
The increase in quantity
supplied as a response
to an increase in price
is greater when supply
is more elastic.
Higher market prices give business firms an incentive to expand
production and output. As time goes by, the ability of firms to expand
productive capacity is greater, and supply becomes more elastic.
16
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Predicting Price Changes Using
Elasticities

The price-change formula can be used to
predict the change in price resulting from a
change in demand.
percentage change in demand
percentage change in price =
E s  Ed

For changes in price resulting from a change
in supply:
percentage change in supply
percentage change in price =
Es  Ed
17
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Predicting Price Changes Using
Elasticities: an Example

Assume that Ed=1.5
and Es=2.0, a
rightward shift in
demand by 35%, will
increase price by the
following percentage:
% demand
% P =
E s  Ed
35%
% P =
 10%
2.0  15
.
18
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Income Elasticity

Income elasticity is a measure of the
responsiveness of the quantity
demanded to changes in consumer
income.
percentage change in quantity demanded
Ei =
percentage change in income
19
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Income Elasticity
percentage change in quantity demanded
Ei =
percentage change in income
Classification of Goods According to Income Elasticity
Income Elasticity
Type of Good
Responsiveness
E i> 0
Normal
Income  QD
Ei<0
Inferior
Income  QD
Ei>1
Luxury
% QD > % I
Ei<1
Necessity
% QD < % I
20
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Cross Elasticity of Demand

Cross elasticity of demand is a
measure of the responsiveness of the
quantity demanded to changes in price
of a related good.
E xy
percentage change in quantity of X demanded
=
percentage change in price of Y
21
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Cross Elasticity of Demand
E xy
percentage change in quantity of X demanded
=
percentage change in price of Y
Classification of Goods According to Cross Elasticity
Cross Elasticity
Type of Good
Responsiveness
Exy > 0
Substitutes
Py   Qx
Exy < 0
Complements
Py   Qx
22
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin