Lecture Element of economics - Chapter 3: Elasticity/sensitivity analysis

At the end of this lecture, students should be able to define elasticity, define price elasticity of demand/supply and its determinants, compute the price elasticity of demand/ supply, know the variety of demand/supply curves, to know the relationship between total revenue and the price elasticity of demand, define and compute income elasticity of demand, define and compute cross-price elasticity of demand.

• Compute the Price Elasticity of Demand/ Supply

• Know the Variety of Demand/supply Curves

• To know the relationship between Total Revenue and the Price Elasticity of Demand

• Define and compute Income Elasticity of Demand

• Define and compute Cross-Price Elasticity of Demand

concept that can be used

to quantify the response in one variable when another variable changes.

e l a s t i c i t y   o f   A   w i t h   r e s p e c t   t o   B A

B

%

%

The Elasticity of Demand

• Price Elasticity of Demand

• Price-Cross Elasticity of Demand

• Income Elasticity of Demand

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Price Elasticity of Demand

• A popular measure of elasticity is

price elasticity of demand

measures how responsive consumers are to changes in the price of a product.

p r i c e   e l a s t i c i t y   o f   d e m a n d   %   c h a n g e   i n   q u a n t i t y   d e m a n d e d

  c h a n g e   i n   p r i c e

%

Sign of Price Elasticity

• According to the law of demand, whenever the price rises, the

quantity demanded falls Thus the value of demand elasticity is always negative, but it is stated in absolute terms.

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What Information Price Elasticity

Provides

• Price elasticity of demand and supply gives the exact quantity response to a change in price.

Slope and Elasticity

• Changing the units of measure yields a very different value of the slope, yet the behavior of buyers in both diagrams is identical.

(% QD) (% Q ELASTICITYD  % P)

Basic telephone service +10% -1% -0.1 Inelastic

Perfectly Elastic and Perfectly Inelastic Demand Curves

• When demand does not

respond at all to a change in

price, demand is perfectly

inelastic E= zero

• Demand is perfectly elastic

when quantity demanded drops to zero at the slightest

increase in price E= infinity

E > 1

in quantity  demanded

E < 1

D

A greater %  change in price  leads to a smaller 

% change in  quantity demanded

Unit Elastic Demand

P

P1 P2

%   c h a n g e   i n   p r i c e   P 2 P   x   1 0 0 %

P

1 1

• According to the law of demand, whenever the price rises, the

quantity demanded falls.

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• When = 2.0, a 10% increase in price leads to a 20% decrease in quantity demanded.

Elasticity Changes along a Straight-Line Demand Curve

Elasticity along any straight line varies unless it is completely rectangular

hyperbola, perfectly elastic or perfectly inelastic.

Elasticity Changes along a Straight-Line Demand Curve

• Price elasticity of demand decreases as

we move downward along a straight line demand curve.

• Demand is elastic in the upper range and inelastic in the lower range of the line.

Elasticity Changes Along Straight-Line

Curves

• Elasticity is not the same as slope.

• Elasticity changes along straight line supply and demand curves–slope

does not.

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Elasticity Along a Demand Curve

The Price Elasticity of Demand Along a

Straight-line Demand Curve

• When price elasticity is between zero and -1

we say demand is inelastic.

• When price elasticity is between -1 and

- infinity, we say demand is elastic.

• When price elasticity is -1, we say demand is

• The numerical value of elasticity on a straight line dd curve ranges from ∞ (infinity) at price axis to zero (0) at the qty axis.

• The numerical value of elasticity at mid-point of a straight line dd curve is =1

• Point to the left of the mid point of a straight line dd curve has elasticity greater than 1 and point to the right has

elasticity less than 1

The Use of Price Elasticity of

Demand

Why Elasticity matters?

Elasticity, Total Revenue, and

Demand

• The elasticity of demand tells suppliers how their total revenue will change if their price changes.

sold multiplied by price of good.

Elasticity, Total Revenue, and

Demand

• If E D is elastic (E D > 1), a rise in price

lowers total revenue.

• Price and total revenue move in opposite directions.

Elasticity, Total Revenue, and

Demand

• If E D is unit elastic (E D = 1), a rise in price leaves total revenue

unchanged.

Elasticity, Total Revenue, and

Demand

• If E D is inelastic (E D < 1), a rise in

price increases total revenue.

• Price and total revenue move in the same direction.

Elasticity and Total Revenue

Elasticity and Total Revenue

Gained  revenue

TRG = $1 x 9 = $9

TRH = $2 x 8 = $16

B

Gained  revenue

TR J  = $8 x 2 = $16

TR K  = $9 x 1 = $9

Total Revenue Along a Demand Curve

• With elastic demand – a rise in price lowers total revenue.

• With inelastic demand – a rise in price increases total revenue.

Price Elasticity and Total Revenue

directly related Price increases generate higher revenues.

indirectly related Price increases generate lower revenues.

Type of

Change in quantity versus change in price

Effect of an increase in price on total revenue

Effect of a decrease in price

Total revenue increases

Unitary

elastic

in quantity and price

Total revenue does not change

Total revenue does not change

• Availability of substitutes demand is more elastic when there are more substitutes for the product.

• Importance of the item in the budget demand is more elastic when the item is a more significant portion of the consumer’s budget.

• Time dimension demand becomes more elastic over time.

• Proportion of income spent on a product –if small portion of your income, a product is said to be

inelastic, if greater % of income, product is elastic

Cross-price elasticity of demand

• A measure of the response of the quantity of one good demanded to a change in the price of another good.

c r o s s ­ p r i c e   e l a s t i c i t y   o f   d e m a n d   %   c h a n g e   i n   q u a n t i t y   o f     d e m a n d e d

  c h a n g e   i n   p r i c e   o f  

Y X

%

Income elasticity of demand –

• measures the responsiveness of demand to changes in income.

Incidence and Taxes

• Incidence is the measure of who actually pays for a cost increase or a tax

• In general, the more elastic the demand and the less elastic the supply the more the incidence of

a tax falls on businesses and the less it falls on consumers.