Chapter 4: Elasticity

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Chapter 4Elasticity

• Price elasticity of demand
• Cross elasticity of demand
• Income elasticity of demand
• Elasticity of supply

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Price elasticity of demand

• The price elasticity of demand is a units-free
  measure of the responsiveness of the quantity
  demanded of a good to a change in its price when
  all other influences on buyers plans remain the
  same.
• Calculating Elasticity
• The price elasticity of demand is calculated by
  using the formula
• Percentage change in quantity demanded
• --------------------------------------------------
  ------------
• Percentage change in price

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Price elasticity of demand

• To calculate the price elasticity of demand
• We express the change in price as a percentage of
  the average pricethe average of the initial and
  new price,
• and we express the change in the quantity
  demanded as a percentage of the average quantity
  demandedthe average of the initial and new
  quantity.

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Inelastic Demand

• If the quantity demanded doesnt change when the
  price changes, the price elasticity of demand is
  zero and the good as a perfectly inelastic
  demand.

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Unit elastic demand

• If the percentage change in the quantity demanded
  equals the percentage change in price, the price
  elasticity of demand equals 1 and the good has
  unit elastic demand.

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• Between the two previous cases, the percentage
  change in the quantity demanded is smaller than
  the percentage change in price so that the price
  elasticity of demand is less than 1 and the good
  has inelastic demand.
• If the percentage change in the quantity demanded
  is infinitely large when the price barely
  changes, the price elasticity of demand is
  infinite and the good has perfectly elastic
  demand.

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Figure 4.4 Elasticity Along Straight-Line
Demand Curve
P
h gt 1
25
20
h 1
12.50
h lt 1
5
Q
10
40
0
50
25
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Total revenue and elasticity

• The total revenue from the sale of good or
  service equals the price of the good multiplied
  by the quantity sold.
• When the price changes, total revenue also
  changes.
• But a rise in price doesnt always increase total
  revenue.

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• The change in total revenue due to a change in
  price depends on the elasticity of demand
• If demand is elastic, a 1 percent price cut
  increases the quantity sold by more than 1
  percent, and total revenue increases.
• If demand is inelastic, a 1 percent price cut
  decreases the quantity sold by more than 1
  percent, and total revenues decreases.
• If demand is unitary elastic, a 1 percent price
  cut increases the quantity sold by 1 percent, and
  total revenue remains unchanged.

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• The total revenue test is a method of estimating
  the price elasticity of demand by observing the
  change in total revenue that results from a price
  change (when all other influences on the quantity
  sold remain the same).
• If a price cut increases total revenue, demand is
  elastic.
• If a price cut decreases total revenue, demand is
  inelastic.
• If a price cut leaves total revenue unchanged,
  demand is unit elastic.

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Figure 4.5 Elasticity and Total Revenue
P
25
Q
0
50
TR
Q
50
0
.
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• Elasticity of demand depends on
• closeness of substitutes closer substitutes
  elasticity
• necessities poor substitutes, inelastic
  demands
• luxuries many substitutes, elastic demands
• proportion income spent on good greater
  proportion elasticity
• time elapsed longer time elasticity

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Cross elasticity of demand

• The cross elasticity of demand is a measure of
  the responsiveness of demand for a good to a
  change in the price of a substitute or a
  compliment, other things remaining the same.
• The formula for calculating the cross elasticity
  is
• Percentage change in quantity demanded
• --------------------------------------------------
  --------------
• Percentage change in price of substitute or
  complement
• The cross elasticity of demand for a substitute
  is positive.
• The cross elasticity of demand for a complement
  is negative.

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Income elasticity of demand

• The income elasticity of demand measures how the
  quantity demanded of a good responds to a change
  in income, other things equal.
• The formula for calculating the income elasticity
  of demand is
• Percentage change in quantity demanded
• --------------------------------------------------
  ---------------
• Percentage change in income

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• When Demand is
• hy gt 1 income elastic (normal good, luxury)
• 0 lt hy lt 1 income inelastic (normal good,
  necessity)
• hy lt 0 negative income elasticity
  (inferior good)

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Elasticity of supply

• The elasticity of supply measures the
  responsiveness of the quantity supplied to a
  change in the price of a good when all other
  influences on selling plans remain the same.
• The elasticity of supply is calculated by using
  the formula
• Percentage change in quantity supplied
• --------------------------------------------------
  ------------
• Percentage change in price

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Elasticity of supply

• Supply is perfectly inelastic if the supply curve
  is vertical and the elasticity of supply is 0.
• Supply is unit elastic if the supply curve is
  linear and passes through the origin. (Note that
  slope is irrelevant.)
• Supply is perfectly elastic if the supply curve
  is horizontal and the elasticity of supply is
  infinite.

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• Elasticity of supply depends on
• resource substitution possibilities more
  common the resources hs
• time frame for supply decision hs with
  time
• (Short-run supply is somewhat elastic)
• (Long-run supply is the most elastic)