Lecture 6: Elasticity

Outline:

1. The notion of elasticity in simple terms.

2. Price elasticity of demand.

3. Why price elasticity of demand is an important concept for economic policy makers:

a. Cigarettes and teenage smoking

b. Illegal drugs

4. Price elasticity of demand and total revenue.

5. How price elasticity of demand is determined

6. Price elasticity of demand in the short run and the long run.

7. Other demand elasticities:

a. income elasticity of demand

b. cross price elasticity of demand

8. Price elasticity of supply

9. How price elasticity of supply is determined

10. Price elasticity of supply in the short run and the long run.

1. The notion of elasticity in simple terms:

* Elasticity tells us something about the responsiveness of one variable to changes in another variable

* For example, we know that if price increases, quantity demanded decreases - but the question is BY HOW MUCH does it decrease?

* If something is very elastic we think of it being very responsive - like an elastic band.

* If something is very inelastic we think of it being very unresponsive - like ?

* In terms of changes in supply and demand in markets we are often interested in knowing not only the direction of the change in quantity but also the magnitude of the change - that's why we make use of the concept of elasticity.

2. Price Elasticity of Demand (D):

Definition:

The price elasticity of demand measures the responsiveness of Qd to a change in P.

Measuring price elasticity of demand:

ND = % change in Qd / % change in P

Intuitively:

* If Qd is very responsive to a change in P we say that demand is price elastic.

* If Qd is NOT very responsive to a change in P we say that demand is price inelastic.

More precisely:

* To be very responsive means that a 1% change in P results in a more than 1% change in Qd.

If % change in Qd > % change in P then ND > 1

And Demand is said to be PRICE ELASTIC

* To be very unresponsive means that a 1% change in P results in a less than 1% change in Qd.

If % change in Qd < % change in P then ND < 1

And Demand is said to be PRICE INELASTIC

* There is an intermediate case where a 1% change in P results in a 1% change in Qd.

If % change in Qd = % change in P then ND = 1

And Demand is said to be UNITARY ELASTIC.

Note:

Although there is a negative relationship between P and Qd which makes the price elasticity of demand a negative number, it is the convention of economists to take the absolute value of ND and express it as a positive number.

Graphically:

A steep demand curve will be relatively INELASTIC

A flat demand curve will be relatively ELASTIC

Questions:

What is the price elasticity of demand for a vertical demand curve?

What is the price elasticity of demand for a horizontal demand curve?

What is the price elasticity of demand along a straight line?

3. Price elasticity of demand and economic policy:

* Policy makers often attempt to influence the quantity of some commodity that households consume.

* They institute policies to change supply or demand or both.

* One policy may be more effective than another policy at changing the quantity of the commodity exchanged depending on the price elasticity of demand.

Example 1: Teenage smoking

Example 2: Illegal drugs

4. Price Elasticity of Demand and Total Revenue:

Total revenue (TR) = the total amount firms receive from the sale of a commodity

= P*Qexchanged

* TR depends on the price elasticity of demand.

* Because P and Qd move in opposite directions the effect of change in P on TR is unknown unless we know

HOW MUCH Qd has changed in relation to the change in P.

If ND > 1 then % change in Qd > % change in P

An increase in P decreases TR

A decrease in P increases TR

If ND < 1 then % change in Qd < % change in P

An increase in P increases TR

A decrease in P decreases TR

If ND = 1 then % change in Qd = % change in P

An increase in P leaves TR unchanged

A decrease in P leaves TR unchanged

5. How the price elasticity of demand is determined:

AVAILABILITY OF SUBSTITUTES:

* a product with close substitutes will tend to have an elastic demand

* a product without close substitutes will have an inelastic demand.

6. Price elasticity of demand in the short-run and in the long-run:

Because it often takes time to find substitutes for a good the long run demand curve for a good will tend to be more elastic than the short run demand curve.

Example: The short-run response to an increase in the price of gasoline versus the long-run.

7. Other elasticities of demand:

Definition:

Income elasticity of demand measures the responsiveness of Qd to changes in average income

Measuring income elasticity of demand:

NI = % change in Qd / % change in I

If NI >0 The good is a NORMAL GOOD

If NI >1 The good is a Luxury

If NI <1 The good is a Necessity

If NI < 0 The good is an INFERIOR GOOD

Note: The sign of income elasticity of demand matters - it can be positive or negative and that tells us something about the good.

Definition:

Cross price elasticity of demand measures the responsiveness of Qd for one good to changes in the price of another good.

Measuring cross price elasticity of demand:

Nxy = % change in Qdx / % change in Py

If Nxy >0 The goods are SUBSTITUTES

If Nxy <0 The goods are COMPLEMENTS

If Nxy =0 The good are UNRELATED

Note: The sign of cross price elasticity of demand is important - it can be positive or negative and that tells us something about the good.

8. Price Elasticity of Supply:

NS = % change in Qs / % change in P

NS > 1 Supply is PRICE ELASTIC

NS < 1 Supply is PRICE INELASTIC

NS = 1 Supply in UNITARY ELASTIC

Vertical supply curve - PERFECTLY INELASTIC

Examples

9. Determinants of price elasticity of supply:

1. AVAILABILITY OF SUBSTITUTES IN PRODUCTION - can the firm move out of production of one good and into production of another higher priced good easily?

2. HOW COSTS BEHAVE WITH RESPECT TO OUTPUT - do costs rise rapidly when the firm increases its output or do they rise slowly?

10. Price elasticity of supply in the short run and in the long run:

The long run supply curve for a product will be more elastic than the short run supply curve, since the firm has more opportunities for substitution in production given more time.

Note: The sign of price elasticity of demand doesn't matter since the relationship between Qs and P is always positive.