ELASTICITY

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ELASTICITY. A concept used by economists to measure the responsiveness of people to changes in economic variables. ELASTICITY. If people are very responsive to changes in economic variables, the measure is said to be elastic or highly elastic.

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ELASTICITY

A concept used by economists to measure the responsiveness of people to changes in economic variables.

ELASTICITY

If people are very responsiveto changes in economic variables, the measure is said to be elastic or highly elastic.

If people are not very responsive to changes in economic variables, the measure is said to be inelastic.

PRICE ELASTICITY OF DEMAND
• How much more of a product will a consumer buy when the product price decreases.
• How much less of a product will a consumer buy when the product price increases.
• What is the responsiveness of consumers to changes in price.
PRICE ELASTICITY OF DEMAND

percentage change in quantity demanded Ed= --------------------------------------------

percentage change in price

• Percentage change in price equals the absolute change in price divided by the initial price;
• Percentage change in quantity equals the absolute change in quantity divided by the initial quantity.
PRICE ELASTICITY OF DEMAND
• If the price of milk increases from \$2.00/quart to \$2.20/quart, and
• the resulting quantity demanded changes from 100 million gallons of milk to 85 gallons of milk,
• what is the elasticity of demand for milk ?
PRICE ELASTICITY OF DEMAND

% change Quantity Ed = -------------------------------------- % change Price

(New Quantity - Original Quantity) / (Original Quantity) Ed = ---------------------------------------------------------------- (New Price - Original Price) / (Original Price)

PRICE ELASTICITY OF DEMAND

Market Demand

Curve

PRICE

OF MILK

\$\$

\$2.20

\$2.00

85

100

Millions of Gallons of Milk per Year

• (85 -100) / 100 -15 / 100 Ed = ------------------------------ = ------------------------------ \$2.20 -\$2.00) / \$2.00 \$0.20 / \$2.00
• Ed = 15% / 10% = 1.50 Demand is elastic.
PRICE ELASTICITY OF DEMANDMidpoint (More Precise) Approach

% change Quantity Ed = ----------------------------- % change Price

(New Quantity - Original Quantity) / (AverageQuantity) Ed = ---------------------------------------------------------------- (New Price - Original Price) / (Average Price)

PRICE ELASTICITY OF DEMANDMidpoint (More Precise) Approach

PRICE

OF MILK

\$\$

Market Demand

Curve

\$2.20

\$2.00

85

100

Millions of Gallons of Milk per Year

• [ (85 - 100) ÷ (85 +100) ] / 2 Ed = ------------------------------------- [ (\$2.20 - \$2.00) ÷ (\$2.20 + \$2.00) ] / 2
• -15 / 92.5 16.22% Ed = ---------------------------- = -------------------------- = 1.70 Demand is elastic. \$0.20 / \$2. 9.52%

THREE ELASTICITY GROUPS OF CONSUMER DEMAND

GROUP QUANTITY TO PRICE RELATIONSHIP VALUE

ELASTIC Percentage change in quantity > 1 greater than percentage change in price.

INELASTIC Petrcentage change in quantity < 1

less than percentage change in price.

UNIT Percentage change in quantity =1

ELASTIC equal to percentage change in price.

PRICE ELASTICITY AND SUBSTITUTES
• NO GOOD SUBSTITUTES --

Consumers are not very responsive to changes in price;

Example: insulin for diabetics;

Price elasticity of demand is inelastic.

• MANY SUBSTITUTES --

Consumers will readily switch to alternative product for small price changes;

Example: cornflakes;

Price elasticity of demand is elastic.

Estimated Price Elasticities of Demand for Selected Products

PRODUCT ELASTICITY

salt 0.1

water 0.2

coffee 0.3

cigarettes 0.3

shoes and footware 0.7

housing 1.0

automobiles 1.2

foreign travel 1.8

restaurant meals 2.3

air travel 2.4

motion pictures 3.7

specific brands of coffee 5.6

Other Determinants of Demand Elasticity
• TIME -

Greater time permits finding more substitutes; consequently, elasticity of demand increases with time: Greater time -- greater elasticity.

• PERCENTAGE OF BUDGET -

The smaller the price of a product with respect to the size of the household budget, the moreinelastic will be the product demand.

• NECESSITIES VERSUS LUXURIES -

The greater the need for a product, the moreinelastic will be the product demand.

Elasticity Along a Linear Demand Curve

Elasticity = 4 = (20% / 5%)

PRICE

\$\$

80

Elasticity = 1.0 = (8% / 8%)

76

Elasticity = 0.25 =

(5% / 20%)

50

46

20

16

10

12

25

42

27

40

QUANTITY CONSUMED PER DAY

Elasticity Along a Linear Demand Curve

Elasticity = 4 : ELASTIC

PRICE

\$\$

80

Elasticity = 1.0 : UNIT ELASTIC

76

Elasticity = 0.25 :

INELASTIC

50

46

20

16

10

12

25

42

27

40

QUANTITY CONSUMED PER DAY

GIVEN:

• Elasticity of Demand;
• Percentage change in Price;
• Ed = % change Quantity ÷ % change Price;

Percentage change in quantity may be calculated from the two known values:

• % change Quantity = Ed x % change Price

DEMAND PRICE TOTAL REVENUE

Elastic Increase Declines

Elastic Decrease Increases

(A negative relationship exists between price and total revenue for an elastic demand.)

Inelastic Increase Increases

Inelastic Decrease Declines

(A positive relationship exists between price and total revenue for an inelastic demand.)

PRICE ELASTICITY OF SUPPLY
• How much more of a product will a producer make when the product price increases.
• How much less of a product will a producer make when the product price drops.
• What is the responsiveness of producers to changes in price.
PRICE ELASTICITY OF SUPPLY

percentage change in quantity supplied Ed= ---------------------------------------- percentage change in price

• Percentage change in price equals the absolute change in price divided by the initial price;
• Percentage change in quantity equals the absolute change in quantity divided by the initial quantity.
PRICE ELASTICITY OF SUPPLY
• If the price of milk increases from \$2.00/quart to \$2.20/quart, and
• the resulting quantity supplied changes from 100 million gallons of milk to 120 gallons of milk,
• what is the elasticity of supply for milk ?
Elasticity of Supply

% change Quantity Es = ------------------------------- % change Price ;

(New Quantity - Original Quantity) / (Average Quantity) Es = --------------------------------------------- (New Price - Original Price) / (Average Price)

Elasticity of Supply

PRICE

OF MILK

\$\$

Market Supply Curve

\$2.20

\$2.00

100

120

Millions of Gallons of Milk per Year

(20 /110) Es = ------------------------- = 20% /10% = 2.0 ( \$0.20 / \$2.10)

Supply is elastic;

PRICE ELASTICITY OF SUPPLY
• Increases with time;
• Limitations of production facilities in the short run prevent firms from responding with as much output increase as price increases;
• As firms can increase production facilities, in the longer run, the larger will be the increase in quantity supplied.
Predicting Price Changes Using Elasticities

An increase in demand (i.e., rightward shift):

• results in shortage at original price (demand exceeds supply);
• establishes market equilibrium at higher price, and quantity between original equilibrium quantity and quantity consumers now willing to buy at original price;
• encourages producers to supply more and consumers to buy less.

shortage

PRICE

OF MILK

\$\$

Supply S1

Demand D2

\$2.00

Demand D1

100

150

Millions of Gallons of Milk per Year

Predicting Price Changes Using Elasticities

With an increase in demand, the resulting equilibrium price increase will be:

• small if consumers and producers are very responsive to price changes (elastic demand and elastic supply) ;
• larger if either is not very responsive (i.e., inelastic);

original

equilibrium

new

equilibrium

PRICE

OF MILK

\$\$

Supply S1

\$2.05

Demand D2

\$2.00

Demand D1

100

130

Millions of Gallons of Milk per Year

Predicting Price Changes Using Elasticities

With an increase in demand, the resulting percentage change in price can be found by:

• Percentage change in price = Percentage change in demand ------------------------------------------- (Es + Ed)
Predicting Price Changes Using Elasticities

With an increase in supply, the resulting percentage change in price can be found by:

• Percentage change in price = Percentage change in supply ------------------------------------------- (Es + Ed)
Predicting Price Changes Using Elasticities

An increase in supply (i.e., rightward shift):

• results in excess at original price (supply exceeds demand);
• establishes market equilibrium at lower price, and quantity between original equilibrium quantity and quantity producers now willing to supply at original price;
• encourages producers to supply less and consumers to buy more.

PRICE

OF MILK

\$\$

Supply S1

\$2.00

Supply S2

Demand D1

100

Millions of Gallons of Milk per Year

Predicting Price Changes Using Elasticities

With an increase in supply, the resulting equilibrium price decrease will be:

• small if consumers and producers are responsive to price changes (elastic demand and elastic supply) ;
• larger if either is not very responsive (i.e., inelastic);

new

equilibrium

original

equilibrium

PRICE

OF MILK

\$\$

Supply S1

\$2.00

Supply S2

\$1.80

Demand D1

100

110

Millions of Gallons of Milk per Year