Our Friend Elasticity

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## Our Friend Elasticity

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**Our Friend Elasticity**Or, how I learned to love percentages**Measuring Responsiveness or Sensitivity**• Slope • Unit dependent • Currency • Quantities • No Starting Point • Percentages • Unit free • Relational**Computing Elasticity**• Price elasticity of demand = %change in quantity demanded/% change in price • Income elasticity of demand = %change in demand/% change in income • Cross-price elasticity of demand = %change in demand/% change in the price of a related good**An Intuitive Approach to Elasticity**• Since price elasticity is always zero (law of demand) we ignore the negative sign and take the absolute value of price elasticity. • Ep > 1 Responsive or elastic • %ΔQd > %ΔP a small %ΔP creates a large %ΔQd • Ep < 1 Not responsive or inelastic • %ΔQd < %ΔP a large %ΔP creates a small %ΔQd • Ep = 1 unit elastic • %ΔQd = %ΔP a given %ΔP creates an equal %ΔQd**So????Price and Total RevenueTR= P X Q**• Ep > 1 Responsive or elastic • %ΔQd > %ΔP if P goes down (up) total revenue goes up (down) • Ep < 1 Not responsive or inelastic • %ΔQd < %ΔP if P goes down (up) total revenue goes down (up) • Ep = 1 unit elastic • %ΔQd = %ΔP if P goes down (up) total revenue stays the same**Determinantsof Price Elasticity**• Availability of close substitutes • Necessity versus luxury • Definition of the market • Time horizon • Percentage of consumer budget**Price Elasticity – Using Numbers**Ep = %ΔQd/ %ΔP = (Q2- Q1)/[(Q2+ Q1)/2] (P2- P1)/[(P2+ P1)/2]**Calculating Price Elasticitymputing the Price Elasticity of**Demand Price $5 4 Demand Quantity 0 50 100 Demand is price elastic**Elasticity of Other Demand Curves**• Perfectly Elastic • Perfectly Inelastic • Unit Elastic**Elasticity of Supply**• Price elasticity of supply = %change in quantity supplied/% change in price Es = %ΔQs/ %ΔP = (Q2- Q1)/[(Q2+ Q1)/2] (P2- P1)/[(P2+ P1)/2] • Perfectly elastic and inelastic supply and unit elastic (crossing the P or Q axis) • Supply curves where elasticity varies**Determinants of elasticity of supply**• Ability to increase or decrease production (e.g Ellensburg agates, farm crops, automobiles) • Time period**Applications of Elasticity**• Farmers : fallacy of composition and good crop/bad revenue years • The economics of addictive drugs • Pricing decisions and your future business**Government and Markets**• Price Controls • Price Ceilings (e.g. rent control) • Price Floors (e.g. water) • Taxes • Who appears to pay the tax? • Buyers “pay” tax • Sellers “pay” tax • Who really pays the tax? Tax incidence and burden**Case study – The payroll tax: Federal Insurance**Contribution Act (FICA) for Social Security and Medicare**Elasticity and Tax Incidence**• Intuitive approach: • If the buyers can respond relatively more to price changes more than suppliers, suppliers pay more of the tax. • If the suppliers can respond relatively more than the buyers, then the buyers pay more of the tax.**Extreme examples:**• Perfectly elastic demand • Perfectly elastic supply • Perfectly inelastic demand • Perfectly inelastic supply • Less extreme examples (e.g. the luxury tax)