Economics: Elasticity and Applications

Elasticity and Its Applications

• Elasticity allows for more precise analysis of supply and demand.
• It measures how buyers and sellers react to market changes.

Demand Elasticity

• Measures the sensitivity of quantity demanded to factors like price, income, and related goods.
• Types of demand elasticity include:
  • Price elasticity of demand
  • Income elasticity of demand
  • Cross-price elasticity of demand

Price Elasticity of Demand

• Measures how much quantity demanded of a good changes in response to a change in its price.
• Calculated as the percentage change in quantity demanded divided by the percentage change in price.
• Formula: Ep = (%∆Q)/ (%∆P)
• Determinants of price elasticity of demand include:
  • Availability of close substitutes
  • Whether the good is a necessity or a luxury
  • Definition of the market
  • Proportion of income devoted to the product
  • Time horizon

Computing Price Elasticity of Demand

• Calculated as the percentage change in quantity demanded divided by the percentage change in price.
• Example: If the price of an ice cream cone rises from €2.00 to €2.20, and the quantity demanded falls from 10 cones to 8 cones, the elasticity of demand is 2.

Using the Point Elasticity of Demand Method

• Formula: Price elasticity of demand = (P/Qd) x (1/ΔP/ΔQd)

The Variety of Demand Curves

• Price Inelastic Demand: Quantity demanded is not greatly affected by price changes, elasticity is less than 1.
• Price Elastic Demand: Quantity demanded changes considerably with price changes, elasticity is greater than 1.
• Perfectly Price Inelastic: Quantity demanded stays constant regardless of price changes.
• Perfectly Price Elastic: Quantity demanded changes infinitely with any change in price.
• Unit Price Elastic: Quantity demanded changes by the same percentage as the price.

Computing the Price Elasticity of Demand

• Example showing a graph, and explanation showing how the price elasticity of demand is price elastic.

Figure 1a: Perfectly Price Inelastic Demand

• A price increase does not change the quantity demanded.

Figure 1b: Price Inelastic Demand

• A price increase causes a smaller decrease in quantity demanded.

Figure 1c: Unit Elastic Demand

• A price increase causes an equal percentage decrease in quantity demanded.

Figure 1d: Price Elastic Demand

• A price increase causes a larger percentage decrease in quantity demanded.

Figure 1e: Perfectly Price Elastic Demand

• Any price above a certain level leads to zero demand; at that exact level, any quantity is demanded.

Total Expenditure, Total Revenue, and Price Elasticity of Demand

• Total expenditure: Amount paid by buyers (price x quantity).
• Total revenue: Amount paid by buyers and received by sellers (price x quantity).

Figure 2: Total Revenue

• Graph demonstrating total revenue as a function of quantity demanded.

Figure 3: Price Inelastic Demand

• An increase in price leads to a smaller decrease in quantity demanded, thus increasing total revenue.

Figure 4: Price Elastic Demand

• An increase in price leads to a larger decrease in quantity demanded, thus decreasing total revenue.

Price Elasticity of a Linear Demand Curve

• Slope of a linear demand curve is constant, but elasticity varies along the curve.
• Elasticity is inelastic at low prices and high quantities, and elastic at high prices and low quantities.
• Total revenue varies at different points along the demand curve.

Price Elasticity of a Linear Demand Curve.

• Demand curve is a straight line.
• Elasticity depends on the slope of the demand curve and on price & quantity.
• Elasticity varies along the curve as price & quantity change.
• Elasticity is large at the top of the curve (high prices, low quantities) and becomes smaller at the bottom

Other Demand Elasticities

• Income elasticity of demand: Percentage change in quantity demanded resulting from a 1% increase in income.
• Cross-price elasticity of demand: Percentage change in quantity demanded for one good resulting from a 1% increase in the price of another good.

Income Elasticity of Demand

• Percentage change in quantity demanded related to a 1% increase in income.
• Higher necessity (food, medicine) goods show lower income elasticity.
• Luxury goods have higher income elasticity.

Cross-price Elasticity of Demand

• Percentage change in quantity demanded for a good related to a 1% increase in price of another good.
• Positive cross-price elasticity indicates substitutes (e.g., tea and coffee).
• Negative cross-price elasticity indicates complements (e.g., coffee and milk).

The Price Elasticity of Supply

• Measures how much the quantity supplied of a good responds to a change in its price.
• Calculated as the percentage change in quantity supplied divided by the percentage change in price.
• Types: Perfectly price inelastic, price inelastic, unit elastic, price elastic, and perfectly price elastic supply.

Summary

• Price elasticity of demand measures the responsiveness of quantity demanded to price changes.
• Elastic demand means total revenue falls with price increases, whereas inelastic demand means total revenue rises with price increases.
• Income elasticity measures the effect of income changes on demand, with higher income elasticity for luxury goods.
• Cross-price elasticity measures the effect of one price change on the demand for another good.
• Price elasticity of supply measures the responsiveness of quantity supplied to price changes, with supply often more elastic in the long-run.