ATW 107 Microeconomics
Chapter 4: Elasticity and Its Application DR. TANG CHOR FOON Centre for Policy Research & International Studies Universiti Sains Malaysia, Room: 116, Tel: 04 – 653 2044 E-mail:
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LESSON OUTLINE • Definition of Elasticity? • Price Elasticity of Demand • Price Elasticity of Supply • Cross Elasticity of Demand • Income Elasticity of Demand • Applications of Variety of Elasticities
WHAT IS ELASTICITY? • … allows us to analyse supply and demand with greater precision. • Elasticity is a measure of how much buyers (consumers) and sellers (producers) response to changes in market conditions. • Elasticity is also known as “sensitivity”
THE PRICE ELASTICITY OF DEMAND • The price elasticity of demand is a measure of how much of the quantity demanded of a good responds to a change in the price of that good. • When we talk about elasticity, that responsiveness is always measured in percentage terms. • Specifically, the price elasticity of demand is the percentage change in quantity demanded owing to a percentage change in the price. • How sensitive is consumer response to price change?
Computing the Price Elasticity of Demand • The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.
Price elasticity of demand=
Percentage change in quantity demanded Percentage change in price
Q2 Q1 100 Price elasticity of demand=
Q1 %Q P2 P1 100 %P P1
Computing the Price Elasticity of Demand • Example: If the price of an ice-cream cone increases from RM2.00 to RM2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as: %Qd Price elasticity of demand= %P 10 8 100 20% 10 Price elasticity of demand= 2 2.2 2 100 10% 2
The Mid-Point Method: A Better Way to Calculate Percentage Changes and Elasticities • The mid-point formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the price change.
Price elasticity of demand ED =
Q2 Q1 Q2 Q1 2 P2 P1 P2 P1 2
The Mid-Point Method: A Better Way to Calculate Percentage Changes and Elasticities • Example: If the price of an ice-cream cone increases from RM2.00 to RM2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the mid-point formula, would be calculated as:
ED =
Q2 Q1 Q2 Q1 2 10 8 10 8 2 P2 P1 P2 P1 2 2.2 2 2.2 2 2
22% ED = 2.32 9.5%
The Variety of Demand Curves 1. Elastic Demand • Quantity demanded responds strongly to changes in price • %∆Q > %∆P • Price elasticity of demand is greater than ONE (ED > 1)
2. Inelastic Demand • Quantity demanded does not respond strongly to price changes • %∆Q < %∆P • Price elasticity of demand is less than ONE (ED < 1)
3. Unit Elastic Demand • Quantity demanded changes by the same percentage as the price • Price elasticity of demand is equal to ONE (ED = 1)
The Variety of Demand Curves 4. Perfectly Elastic Demand • A price increase will cause the quantity demanded to decline from an infinite amount to zero. • When a small percentage change in price causes an extremely large percentage change in the quantity demanded (from buying all to buying nothing) • Price elasticity of demand is infinity(ED = ∞)
5. Perfect Inelastic Demand • Quantity demanded does not respond price changes • Price elasticity of demand is equal to ZERO (ED = 0)
The Variety of Demand Curves
The Variety of Demand Curves Perfectly Elastic Demand: Elasticity Equals Infinity Price 1. At any price above RM8, quantity demanded is zero. 8
Demand 2. At exactly RM8, consumers will buy any quantity.
0 3. At a price below RM8, quantity demanded is infinite (unlimited).
Quantity
The Variety of Demand Curves • As the price elasticity of demand measures how much of quantity demanded responds to the price, it is also closely related to the slope of the demand curve. • However, it is not the same thing as the slope!!
Elasticity is Not Slope
Elasticity is Not Slope Between point A and B
QB QA 100 100 50 100 QA QB 50 100
50 2 2 ED 75 3.67 PB PA 100 10 12 100 2 11 PA PB 12 10 2 2
of axis vertical P 10 12 Slope 0.040 of axis horizonal Q 100 50
Elasticity is Not Slope Between point B and C
QB QA 100 150 100 100 QA QB 100 150 ED
2 PB PA 100 PA PB 2
2 8 10 100 8 10 2
50 125 1.80 2 9
8 10 of axis vertical P Slope 0.040 of axis horizonal Q 150 100
Total Revenue & the Price Elasticity of Demand • Total Revenue (TR) is the amount paid by consumers and received by the producers of a good. • TR can be calculated as the product price (P) multiply the quantity sold (Q):
TR P Q
Total Revenue & the Price Elasticity of Demand • When the P = 2, Q = 10 and TR = $20 • When price reduces, e.g. P = 1, Q = 40 and TR = $40 • Summary: If the ED > 1, P should ↓ to gain extra revenue (R) (yellow area < blue area.)
Total Revenue & the Price Elasticity of Demand • When P = 4, Q = 10 and TR = $40 • When price reduces: P = 1, Q = 20 and TR = $20 • Summary: If the ED < 1, P should ↑ to gain extra revenue (R) (yellow area > blue area.)
Total Revenue & the Price Elasticity of Demand • When P = 3, Q = 10 and TR = $30 • When price reduces: P = 1, Q = 30 and TR = $30 • Summary: If the ED = 1, P should ↑ / ↓ earn no extra revenue (R). (yellow area = blue area.)
Total Revenue & the Price Elasticity of Demand
Total Revenue & the Price Elasticity of Demand
The Factors that Influence the Elasticity of Demand 1. The Number of Close Substitutes for the Good 2. Proportion of Income Spent on the Good 3. Necessities VS Luxuries 4. Time Horizon (The Duration of the Price Change) 5. Definition of the Market 6. Addiction / Habit 7. Low VS High Income Consumers
(1) The Number of Close Substitutes • Goods with close substitutes are likely to have more elastic demand because it easier for consumers to switch from that good to others. • E.g. Coca-Cola & Pepsi / butter & margarine are easily substitutable. A small increase in the price of butter (Coca-Cola), the quantity demanded for butter (Coca-Cola) drop tremendously.
(2) Proportion of Income Spent on the Good • The greater the proportion of income spent on a good, the more elastic is the demand for it. • Likewise, the smaller the percentage of income goes to buy a good, the lower the price elasticity of demand will be. • E.g. The share of income spent on salt is very low. Even if the price of salt doubles, you consume almost the same amount or only a small decline in the quantity demand. How about “houses”, “cars”, & “furniture”?
(3) Necessities VS Luxuries • Goods that are luxuries usually have more elastic demand curve that goods that are necessities. • E.g. 1: “Bread & Tickets to concert” - the demand for Bread is inelastic as bread is a necessity good, and the quantity that people buy is not very sensitive to its price. Tickets to concert are a luxury, so the demand are more elastic. • E.g. 2: “Jewellery & Medicine” – If jewellery price ↑, demand ↓ is easy as one can survey without jewellery. If the price of medicine ↑, demand ↓ is NOT easy. “ED for Jewellery > ED for Medicine”
(4) Time Horizon • If the price of a good rises, consumers need some time to adjust their buying habits or to find and experiment with other goods to see they are acceptable. Thus, the longer the time period, the more elastic is demand curve. • So, long-run demand for gasoline is more elastic (ED = 0.8) than the short-run demand (ED = 0.2). • E.g. If price of gasoline ↑ by RM0.20 per litre in a week (short-run), it is unlikely that you will buy a hybrid-car. But, if the price ↑ RM1.00 per litre in a year (long-run), it is likely that you will buy a hybridcar or car-pool to reduce the consumption of gasoline.
(5) Definition of the Market • The more narrowly defined the market, the demand tend to be more elastic because it is easier to find close substitutes for narrowly defined goods. • E.g. “Food” is a broadly defined item, has a fairly inelastic demand as there are no good substitutes for food. But, if the definition is more narrowed e.g. ice-cream, has a more elastic demand since it is easy to substitute other desserts for ice-cream.
(6) Addiction / Habit • When consumers are addicted to certain good, the demand for it tends to be inelastic. • E.g. 1: An addicted smoker will continue to buy the same quantity of cigarette even when the price of cigarette increase.
(7) Low VS High Income Consumers • The higher the income of a consumer, the more inelastic demand for a good. • E.g. The demand for a millionaire will not change much with respect to the change in price. However, the respond of low income consumer to such increase is very significant.
Summary Demand tends to be more elastic: (a)The larger the number of close substitutes (b)The larger the portion of income spent of a good (c) If the good is a luxury (d)The more narrowly defined the market (e) The longer the time period (f) If not addicted to a specific good (g)If the consumers’ income is low
THE PRICE ELASTICITY OF SUPPLY • The price elasticity of supply is a measure of how much of the quantity supplied of a good responds to a change in the price of that good. • Price elasticity of supply is the percentage change in quantity supplied resulting from a percentage change in price.
Computing the Price Elasticity of Supply • The price elasticity of supply is computed as the percentage change in the quantity supplied (%∆Qs) divided by the percentage change in price (%∆P). Percentage change in quantity supplied Price elasticity of supply (Es) = Percentage change in price
Q2 Q1 100 Price elasticity of supply (Es) =
Q1 %Q P2 P1 100 %P P1
The Variety of Supply Curves 1. Elastic Supply • Quantity supplied responds strongly to changes in price • %∆Q > %∆P • Price elasticity of supply is greater than ONE (ED > 1)
2. Inelastic Supply • Quantity supplied does not respond strongly to price changes • %∆Q < %∆P • Price elasticity of supply is less than ONE (ED < 1)
3. Unit Elastic Supply • Quantity supplied changes by the same percentage as the price • Price elasticity of supply is equal to ONE (ED = 1)
The Variety of Supply Curves 4. Perfectly Elastic Supply • A price increase will cause the quantity supplied to decline from an infinite amount to zero. • When a small percentage change in price causes an extremely large percentage change in the quantity supplied (from buying all to buying nothing) • Price elasticity of supply is infinity(ED = ∞)
5. Perfect Inelastic Supply • Quantity supplied does not respond price changes • Price elasticity of supply is equal to ZERO (ED = 0)
The Variety of Supply Curves
The Unity Elastic Supply Curves
The Perfectly Elastic Supply Curve Perfectly Elastic Supply: Elasticity Equals Infinity Price 1. At any price above RM4, quantity supplied is infinite (Unlimited). 4
Supply 2. At exactly RM4, producers will supply any quantity.
0 3. At a price below RM4, quantity supplied is zero.
Quantity
The Factors that Influence the Elasticity of Supply 1. Mobility of Resources / Factors of Production 2. Time Frame for the Supply Decision 3. Number of firm in a industry 4. Durability
(1) Mobility of Resources • If the factors of production / resources can be easily move from one to other production used, then the supply of the good tend to be more elastic. • E.g. Labour is more elastic than capital.
(2) Time Frame for the Supply Decision • Time is the most important determinants that affect the price elasticity of supply. • If the price of good changed, producers need some time to make adjustment in the level of output. 3 types of time frame, i.e. immediate, shortrun and long-run supply. • If the time frame is short, the supply cannot be expanded even the price of good increase. Thus, time frame ↑, supply is more elastic. • ES of agricultural good < ES of manufacturing good.
Immediate Supply
Short-Run Supply
Long-Run Supply
P
T1
T2 T3 T4 T5
Q • When the Time Period increase the Supply Curve will rotate close wise from T1 to T5 • Moving from Perfectly inelastic to Perfectly Elastic of supply
(3) Number of Firm in a Industry • The larger the number of firm in a industry, the more good can be produce, thus the higher the price elasticity of supply. • E.g. Price of good increase, many firm wish to produce the same item, thus the supply increase tremendously.
(4) Durability • If the goods are durable and can be easily store, the supply tends to be elastic than the goods which are perishable and do not have storage facilities. • E.g. vegetable, fruits, & seafood.
THE CROSS-PRICE ELASTICITY OF DEMAND • Cross-price elasticity of demand measures how much of the quantity demanded of one good responds to a change in the price of another good. • It can be computed as the percentage change in quantity demand of the first good divided by the percentage change in the price of the second good. Cross-price elasticity of demand E XY
Percentage change in quantity demanded of good 1 Percentage change in price of good 2
THE CROSS-PRICE ELASTICITY OF DEMAND • Cross-price elasticity of demand allow one to identify whether the goods are classified as substitute, complementary or independent (unrelated) goods. • Substitution Goods → EXY > 0 (Positive) • Complementary Goods → EXY < 0 (Negative) • Independent (Unrelated) Goods → EXY = 0
THE INCOME ELASTICITY OF DEMAND • Income elasticity of demand measures how much of quantity supplied of a good responds to a change in consumers’ income. • It computed as the percentage change in the quantity demanded divided by the percentage change in income.
Computing the Income Elasticity of Demand • The income elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. Income elasticity of demand EY =
Income elasticity of demand EY =
Percentage change in quantity demanded Percentage change in income
Q2 Q1 100
Q1 %Q Y2 Y1 100 %Y Y1
Income Elasticity: Type of Goods • One can uses income elasticity to identify or provide some insights about the type of goods. • Type of Goods • Normal Goods → (EY) > 0 (Positive) • Inferior Goods → (EY) < 0 (Negative)
• Among the normal goods, one also differentiate them into necessity and luxury. • Necessity Goods → 0 ≤ (EY) ≤ 1 (or close to zero) • Luxury Goods → 1 < (EY) < ∞
can
Summary of Elasticities
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