Elasticity of

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Elasticity of Demand
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The idea of elasticity Based on the same idea
as the elastic in boxer shorts and rubber
bands, as well as the elasticity in concrete
and glass. Notice in these examples that the
degree of elasticity varies quite a bit between
the items.
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We might say that the elastic in our clothing
as well as a rubber band is very elastic. While
the elasticity of concrete or glass is elastic
but not very. Economists say that consumer
demand also varies in its elasticity. It is
elastic in some cases but inelastic in others.
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Quantity demanded of a good may be very
responsive to price (we say "elastic") or not
very responsive to price (we say
"inelastic"). Which case, elastic or inelastic
demand? Heroin. Diamond ring.
Yoghurt. Medicine. Broccoli.
"Lord of the Rings"
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Definition of Elasticity 1. Demand elasticity
is the percentage change in quantity
demanded divided\ by the percentage change
in the price. 2. So, elasticity measures the
responsiveness of quantity demanded to
changes in price.
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Some determinants of elasticity A. Nature of
the good. B. Availability of close
substitutes. C. Fraction of income. D. Passage of
time.
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A. The nature of the good. Some goods are
vitally important to us. Medicine, Emergency
Medical Services, cigarettes to some, or maybe
a poster of Legolos to others--necessities. Some
goods offer pleasure but we can do without them
and might not buy them at all unless price etc
were just right-- luxuries.
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B. Availability of close substitutes. When it is
simple and easy to switch to another similar
brand or when a good that looks different
actually satisfies the same need then its
demand is likely to be relatively more
elastic. Whereas when it is difficult or
expensive to search for and find a good that
meets the same need, then demand for the good is
more likely to be inelastic.
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C. Fraction of income. Elasticity of demand is
greater when consumers are shopping for
something that is expensive--that represents a
large fraction of their income. They will shop
around more vigorously thus making their
responsiveness to price greater. For things,
like pencils, that cost very little shopping
around hardly seems worthwhile. Thus demand for
cheap things is often actually quite
inelastic.
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D. The passage of time. The amount of time
available for you to shop around and to make
adjustments to your home or to your life
influences the elasticity of your demand. In
the very short term, you may have very little
chance to adjust when businesses raise their
prices for something you usually buy--thus your
short term demand may be relatively more
inelastic. But, over the long term, you can
shop around more and make more
adjustments--thus your long term demand may be
relatively more elastic.
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Try your hand at this guessing game. For each
good, offer the most plausible reason you can
think of for the good to be relatively elastic
or inelastic. Bananas Wedding rings Budweiser
beer A new house A Caribbean cruise Insulin
Straight pins Gasoline tax hike
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How to measure elasticity? How would you measure
the responsiveness of your customers demand for
your product to changes in the price?
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No, it's best not to use the slope to measure
elasticity.
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So we convert both changes to percentage
changes ? (Qa-Qb)/(QbQa)/2/ (Pa-Pb)/(Pa
Pb)/2
This formula is called arc elasticity
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When elasticity is calculated right at a point
on a demand curve (instead of between two points
A and B) then it is called a Point Elasticity
and calculus is used to calculate it.
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Using laymens terms, either definition of
demand elasticty is equivalent to the
following ? ?Q ? ?P. where Q is quantity
demanded and P is price.
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Think of the rubber band I increase my force
on it by one percent and I get a big percent
move in the end of the band-- very elastic and a
very large number for (??Position of end point
of band) ? ??Pulling force on the end of the
band) Now think a consumer who is very
responsive to price changes will respond to a
one percent increase in price by reducing his
quantity demanded by a large percentage change
thus giving a very large (absolute) value to the
ratio (??Quantity demanded ? ??Price)
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Calculating these elasticities in econ
principles class isn't really the main point.
But, once or twice through it helps to learn
more clearly the meaning of elasticity
numbers. Try some
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An example calculation
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Now you try it
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This demand curve is "perfectly inelastic."
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This demand curve is "perfectly elastic."
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Shorthand phrases to describe the degree of
elasticity Unitary elasticity ?
1 Elastic demand ? gt 1 Inelastic demand
? lt 1
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Elasticity and total revenue Let price rise
Then, what happens to the firm's revenue (PxQ)
depends on elasticity. If ? lt 1 then PQ will
rise. If ? ? 1 then PQ will fall. If ?
1 then PQ will be unaffected.
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Illustrates that having inelastic demand means
that raising your price will increase your
firm's revenues.
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Cross-elasticity Change in quantity demanded
of X divided by the Change in price of
Y
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Some examples of cross-elasticity ?CP
(?CokeDemand)/(?PepsiPrice). This will be
positive. Why?
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?BE (?BaconDemand)/(?EggPrice). This will be
negative. Why? Now try this
Cross-elasticity has which sign for
complements? which for substitutes? HINT
Which of these are complementary? Pepsi
Coke or Bacon Eggs?
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How cross-elasticity is used, e.g. Suppose a
firm is on trial in the courtroom accused of
being a monopolist, virtually the only firm in
the market. Then the big question is What
exactly is the firms market area?
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Let the white square represent a trade area
expert's idea of your firm's actual trade area.
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Cross-elasticity estimates add very important
information, and they aren't so arbitrary as
geographic drawings can become Discussion
questions 1. Which case supports a Firm As
claim that he has competition from a Firm B?
When cross-elasticity is positive (or neg.)?
2. Is there a standard cross-elasticity used by
the courts do you think? Why or why not?
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Cigarettes and Price Elasticity
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When the government places an excise tax (that
is a per unit tax) on a product, this
effectively shifts the supply curve vertically
by exactly the amount of the tax. Remember
the supply curve shifts directly upwards.
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Tax shifts supply upwards by Ttax.
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Recap When smokers are the most flexible and
can stretch their minds to think of alternatives
to cigarettes when prices get too high, then
they are price elastic.
Result It is easier for the government to coax
smokers to cut down when using the power to tax.
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Recap When smokers are dead set on smoking,
when they have to have that cigarette and just
can't cut back very easily at all, they are
inelastic Result The tax hike has relatively
little effect on their smoking, it raises tax
revenues to be sure, but it fails at its major
goal.
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What is the real world of smoking like? Which
case--elastic or inelastic--more accurately
describes actual smokers? Studies so far have
shown that the price elasticity for cigarettes
in the US is somewhere between 0.20 and 0.70.
It therefore is clearly inelastic. Will a tax
be useless then?
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Calculations applying these numbers Suppose a
pack of cigarettes cost 4.00 and a tax increase
raises that price to 5.00. The percent
increase is 25. An elasticity at the low end,
0.20, therefore implies a reduction in smoking
due to the tax of 0.20x0.255 Alternatively
the elasticity at the high end of 0.70 would
imply a reduction due to the tax of 17.5.
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The special case of young smokers Health
economists now believe that the youngest age
groups tend to have a higher elasticity of
demand for cigarettes, and they therefore would
be more easily influenced by the tax. This could
prove to be the least intrusive way to encourage
our fellows to quit smoking.
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Why do people interfere with others like this?
The reason so many people are ready to tax
smokers, and thus intrude on their freedoms, is
mainly that smoking kills so many people each
year, over twice as many as all those others
listed here.
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Regardless of which side of the issue you choose
for yourself-- a. raise cigarette prices to save
lives, or b. hands off to preserve smoker's
freedoms-- please always notice and remember
that the smoker's response to price changes,
that is, the price elasticity of demand for
cigarettes, is the key to the whole issue.