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Elasticity and its Application

Elasticity and its Application. Concept of Elasticity. Elasticity is used to describe the behavior of buyers and sellers in the market Elasticity is a measure of the quantity demanded or supplied to one of its determinants

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Elasticity and its Application

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  1. Elasticity and its Application

  2. Concept of Elasticity • Elasticity is used to describe the behavior of buyers and sellers in the market • Elasticity is a measure of the quantity demanded or supplied to one of its determinants • Elasticity of demand measures how much quantity demanded responds to change in one of its determinants • Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good

  3. Concept of Elasticity Price e of demand= % change in quantity demanded/ % change in price • Remember price elasticity of demand is always negative • Price e of demand determines whether the demand curve is steep or flat • Demand for a good is elastic if the quantity demanded responds substantially to changes in the price • Demand for a good is inelastic if the quantity demanded responds only slightly to changes in the price

  4. Determinants of Price Elasticity of Demand • Necessities (inelastic) versus luxuries (elastic) • Availability of close substitutes (highly elastic) • Definition of the market • Time horizon

  5. Computing Price Elasticity of Demand • Using the midpoint method • The midpoint method gives us the same price elasticity of demand between two points regardless of the direction of change • The midpoint method computes a % change by dividing the change by midpoint of the initial and final levels • Always use midpoint method to calculate elasticity between two points

  6. Variety of Demand Curves • Perfectly inelastic demand (e=0) • Inelastic demand (e<1) • Unit elastic demand (e=1) • Elastic demand (e>1) • Perfectly elastic demand (e=infinity) • The flatterthe curve passing through a given point, the greater the elasticity of demand • The steeper the curve passing through a given point, the smaller the elasticity of demand

  7. Total revenue and the Price Elasticity of Demand • TR= PxQ • TR changes as one moves along the demand curve due to changing price elasticity of demand • The slope of a linear demand curve is constant but its elasticity is not • The following general rules apply: • When demand is inelastic, a price increase raises TR, and a price decrease reduces TR • When demand is elastic, a price increase reduces TR, and a price decrease raises TR • In case of unit elastic demand, a change in the price does not affect TR

  8. Other Demand Elasticities • Income elasticity of demand =% change in quantity demanded/ % change in income • Normal goods (positive income elasticity) • Inferior goods (negative income elasticity) • Necessities (small income elasticity) • Luxuries (high income elasticity) • Cross price elasticity of demand= % change in quantity demanded of good X/ % change in price of good Y • Substitutes (positive cross-price elasticity) • Complements (negative cross-price elasticity)

  9. Elasticity of Supply • Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good • Price elasticity of supply= % change in quantity supplied/ % change in price • Determinants of elasticity of supply: • Flexibility of sellers to change their production levels • Time period (short versus long)

  10. Elasticity of Supply • Supply of a good is elastic if the quantity supplied responds substantially to changes in price • Supply of a good is inelastic if the quantity supplied responds slightly to changes in price • Computing price elasticity of supply using midpoint method • (Change in quantity/midpoint of initial and final quantity) / (change in price/midpoint of initial and final price)

  11. Variety of Supply Curves • Perfectly inelastic supply (e=0) • Inelastic supply (e<1) • Unit elastic supply (e=1) • Elastic supply (e>1) • Perfectly elastic supply (e=infinity) • The flatterthe curve passing through a given point, the greater the elasticity of supply • The steeper the curve passing through a given point, the smaller the elasticity of supply

  12. Variety of Supply Curves • Price elasticity of supply varies over the supply curve in some markets. Why? e<1 Price e>1 QS

  13. Applications of supply, demand, and elasticity • Impact of change in technology on market equilibrium • Can good news for farming be bad news for farmers? • Advanced technology results in a new market equilibrium with lower prices and larger quantity sold in the market. • Behavior of supply and demand in the SR and LR • Why did OPEC fail to keep the price of oil high? • In the SR supply and demand are inelastic and in the LR both of them are elastic

  14. Applications of supply, demand, and elasticity • Impact of policy on market equilibrium • Does drug interdiction policy increase or decrease drug-related crime? • Drug related crime increases in the SR and decreases in the LR • Drug education policy would reduce drug usage and drug- related crime in the SR.

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