Topic 3: Elasticity PDF

EC4101 Topic 3: Elasticity Learning objectives What is the definition of elasticity? What is the meaning and importance of: price elasticity of demand? income elasticity of demand? price elasticity of supply? What factors influence the size of these various elasticities? Elast...

EC4101 Topic 3: Elasticity Learning objectives What is the definition of elasticity? What is the meaning and importance of: price elasticity of demand? income elasticity of demand? price elasticity of supply? What factors influence the size of these various elasticities? Elasticity… … allows us to analyse supply and demand with greater precision … is a measure of how much buyers and sellers respond to changes in market conditions Price elasticity of demand A demand curve is elastic when an increase in price reduces the quantity demanded a lot (and vice versa) When the same increase in price reduces quantity demanded just a little, then the demand curve is inelastic Elasticity rule Elasticity slope BUT: If two linear demand (or supply) curves run through a common point, then at any given quantity, the curve that is FLATTER is MORE ELASTIC 5 Price elasticity of demand The more responsive quantity demanded is to a change in price, the more elastic is the demand curve... Price The same €50 price increase… €40 Elastic demand Inelastic demand 20 75 80 Quantity … causes a small decrease in quantity … causes a big decrease in quantity demanded if demand is inelastic. demanded if demand is elastic. Price elasticity of demand Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good Price elasticity of demand is the percentage change in quantity demanded given a percentage change in the price Price elasticity of demand  Demand for vaccinations Price of vaccination When price rises to €21 per vaccination, global quantity demanded falls B €21 to 9.9m vaccinations per day (point B) A 20 D 0 9.9 10.0 Quantity of vaccinations (millions)  Calculating price elasticity of demand − 0.1 million vaccinations % change in quantity demanded = x 100 = −1% 10 million vaccinations €1 % change in price = x 100 = 5% €20 % change in quantity demanded Price elasticity of demand = % change in price - 1% Price elasticity of demand = = −0.2 5%  Using the midpoint formula for elasticity There is a problem: Our percentage change calculation depends on our choice of starting point To solve this problem, we calculate the price elasticity of demand using the midpoint formula for percentage changes 11  Calculating price elasticity of demand 0.1 million vaccinations % change in quantity demanded = x 100 = 1.01% 9.9 million vaccinations - €1 % change in price = x 100 = −4.76% €21 % change in quantity demanded Price elasticity of demand = % change in price 1.01% Price elasticity of demand = = −0.212 - 4.76% Using the midpoint method Instead of dividing by the initial quantity or price the midpoint method calculates changes in a variable compared with the average, or midpoint, of the starting and final values The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change  Using the midpoint method Change in X % change in X = x 100 Average value of X Starting value of X + final value of X Average value of X = 2 Q2 - Q1 (Q1+ Q2) / 2 Price elasticity of demand = P2 - P1 (P1+ P2) / 2  Mathematics of demand elasticity Example: At the initial price of €10, the quantity demanded is 100. When the price rises to €20, the quantity demanded is 90 90 − 100 % change in quantity demanded = 𝑥100 = −10.5% 100 + 90 2 20 − 10 % change in price = 𝑥100 = 66.6% 10 + 20 2 −10.5% Price elasticity of demand = = −0.15 66.6% 15 The variety of demand curves Price Inelastic Demand Quantity demanded does not respond strongly to price changes Price elasticity of demand is less than one Price Elastic Demand Quantity demanded responds strongly to changes in price Price elasticity of demand is greater than one Interpreting the price elasticity of demand Two Extreme Cases of Price Elasticity of Demand: Demand is perfectly inelastic when the quantity demanded does not respond at all to changes in the price. When demand is perfectly inelastic, the demand curve is a vertical line Demand is perfectly elastic when any price increase will cause the quantity demanded to drop to zero. When demand is perfectly elastic, the demand curve is a horizontal line Interpreting the price elasticity of demand Demand is elastic if the price elasticity of demand is greater than 1 Demand is inelastic if the price elasticity of demand is less than 1 Demand is unit-elastic if the price elasticity of demand is exactly 1  Estimating elasticities Economists (and many others) are interested in price elasticity of demand. Estimating elasticity is crucial to understanding and predicting market outcomes Why does it matter whether demand is unit-elastic, inelastic, or elastic? Because this classification predicts how changes in the price of a good will affect the total revenue earned by producers from the sale of that good The total revenue is defined as the total value of sales of a good or service, i.e. Total Revenue = Price × Quantity Sold  Total revenue by area Price of crossing €0.90 Total revenue = price x quantity = €990 D 0 1,100 Quantity of crossings (per day) Elasticity and total revenue When a seller raises the price of a good, there are two countervailing effects in action (except in the rare case of a good with perfectly elastic or perfectly inelastic demand): A price effect: After a price increase, each unit sold sells at a higher price, which tends to raise revenue A quantity effect: After a price increase, fewer units are sold, which tends to lower revenue Effect of a price increase on total revenue Price of crossing Price effect of price increase: higher price for each unit sold Quantity effect of €1.10 price increase: C fewer units sold 0.90 B A D 0 900 1,100 Quantity of crossings (per day) Effect of a price increase on total revenue (a) Unit-Elastic Demand: Price Elasticity of Demand = 1 At a price of €0.90: TR = €0.90 x 1,100 = €990 Price of crossing At a price of €1.10: TR = €1.10 x 900 = €990 €1.10 0.90 D 0 900 1,100 Quantity of crossings (per day) Effect of a price increase on total revenue (b) Inelastic Demand: Price Elasticity of Demand = 0.5 Price of crossing At a price of €0.90: TR = €0.90 x 1,050 = €945 At a price of €1.10: TR = €1.10 x 950 = €1,045 €1.10 0.90 D 2 0 950 1,050 Quantity of crossings (per day) Effect of a price increase on total revenue (c) Elastic Demand: Price Elasticity of Demand = 2 Price of crossing At a price of €0.90: TR = €0.90 x 1,200 = €1,080 At a price of €1.10: TR = €1.10 x 800 = €880 €1.10 0.90 D 3 0 800 1,200 Quantity of crossings (per day) Elasticity and total revenue If demand for a good is elastic (the price elasticity of demand is >1), an increase in price reduces total revenue In this case, the quantity effect is stronger than the price effect If demand for a good is inelastic (the price elasticity of demand is 1, demand is elastic If it is 1, a good is income elastic if it is positive and