The Concept of Elasticity

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# The Concept of Elasticity - PowerPoint PPT Presentation

##### The Concept of Elasticity

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1. The Concept of Elasticity

2. Elasticity What is the concept and why do we need it? Elasticity is used to measure the effects of changes in economic variables

3. The Most Important Elasticity • Price elasticity of demand • A measure of the responsiveness of the quantity demanded of a good to a change in its price.

4. Demand: Gallons vs Litres Price(\$/g) Quant(g) Price(\$/L) Quant(L) a 100 0 a' 25 0 b 50 25 b' 12.50 100 c 0 50 e' 0 200

5. Elasticity: A Units-Free Measure Percentage change in quantity demanded Price elasticity of demand = Percentage change in price

6. Calculating Elasticity = (Q/P)(Pave/Qave) Which is negative, but price elasticity of demand is given as a positive number

7. Calculating Elasticity • Negative sign is ignored • The changes in price and quantity are expressed as percentages of the average price and average quantity.

8. Calculating the Elasticity of Demand Original point 410 Price (dollars per chip) 400 New point 390 Da 36 40 44 Quantity (millions of chips per year)

9. = \$20 = 8 Calculating the Elasticity of Demand Original point 410 Price (dollars per chip) 400 New point 390 Da 36 40 44 Quantity (millions of chips per year)

10. = \$20 = 8 Original point 410 Price (dollars per chip) 400 Pave = \$400 New point 390 Da 36 40 44 Quantity (millions of chips per year)

11. = \$20 = 8 Calculating the Elasticity of Demand Original point 410 Price (dollars per chip) 400 Pave = \$400 New point Qave = 40 390 Da 36 40 44 Quantity (millions of chips per year)

12. Calculating Elasticity Price elasticity = 4 meaning, on average, each 1% price decrease Causes a 4% increase in quantity demanded

13. Some Interesting Characteristics of Linear Demand Curves (It is a straight Line) Can be Deduced

14. Compute Elasticity for Gasoline (in Gallons) from Earlier Example When: Price falls from \$100/gal to \$0/gal Price (\$/unit) 100 |P/Q| = 100/50 = 2 Pavg = 100/2 (=50) Qavg = 50/2 (=25) Pavg/ Qavg = (100/2)/(50/2) = 2 Gallons: slope = -2 50 25 0 25 50 100 200 Quant. (G)

15. |P/Q| = 100/50 = 2 Pavg/ Qavg = (100/2)/(50/2)= 2 The ratio of midpoint Price and Quantity = The slope But for elasticity we want |Q/P|, the reciprocal of demand curve slope |Q/P| = 1/2 Elasticity = |Q/P| (Pavg/ Qavg) = (1/2)*2 =1

16. A Lesson: Elasticity on linear demand curves Price (\$/unit) 100 For any Price-Quantity combination Elasticity > 1 Elasticity = 1 50 Elasticity < 1 25 0 25 50 100 200 Quant. (G or L)

17. Three types of price elasticity of demand • inelastic • Unit elastic • elastic

18. Inelastic Demand • Inelastic demand • The percentage change in quantity is less than the percentage change in price. • Price elasticity of demand < 1

19. Extreme Case: Perfectly Inelastic Demand D1 Elasticity = 0 WHY? Price 12 (Q/P)(Pave/Qave) = 6 (0/P)(Pave/Qave) = 0 Because Q = 0 Quantity

20. Elastic Demand • Elastic demand • The percentage change in quantity is greater than the percentage change in price. • Price elasticity of demand > 1

21. Extreme Case:Perfectly Elastic Demand Price Elasticity = 12 D3 (Q/P)(Pave/Qave) = 6 (Q/0)(Pave/Qave) = Because P = 0 Quantity

22. Unit Elastic Demand • Unit elasticity • The percentage change in quantity equals the percentage change in price. • Price elasticity of demand = 1

23. Extreme Case:Unit Elastic Demand Everywhere Price Elasticity = 1 12 Unit Elasticity 6 D2 Quantity 1 2 3

24. Factors That Influence Elasticity • The Closeness of Substitutes. • The closer the substitutes, the more elastic the demand • more elastic means a higher price elasticity (but not necessarily > 1)

25. Elasticity and Closeness of Substitutes Orange Roughy 10 Price (dollars per pound) 5 Close subs No close subs 1 2 3 4 7 Quantity (pounds per week)

26. Factors That Influence Elasticity • Proportion of Income Spent on the Good • The greater the proportion of income spent on food, the more elastic the demand • Because of Income Effect of a price change

27. Factors That Influence Elasticity • Time Elapsed Since Price Change • The longer the time, the more elastic the demand • Short-run demand • Long-run demand

28. Factors Affecting Price Elasticity of Demand • Availability of substitutes • The better & more numerous the substitutes for a good, the more elastic is demand • Percentage of consumer’s budget • The greater the percentage of the consumer’s budget spent on the good, the more elastic is demand • Time period of adjustment • The longer the time period consumers have to adjust to price changes, the more elastic is demand

29. Income Elasticity • Income elasticity (EM) measures the responsiveness of quantity demanded to changes in income, holding the price of the good & all other demand determinants constant • Positive for a normal good • Negative for an inferior good

30. Cross-Price Elasticity • Cross-price elasticity (EXY) measures the responsiveness of quantity demanded of good X to changes in the price of related good Y, holding the price of good X & all other demand determinants for good X constant • Positive when the two goods are substitutes • Negative when the two goods are complements