1 C H A P T E R 1 5 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin 1 Elasticity: A Measure of Responsiveness

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© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin

Elasticity:A Measure of

ResponsivenessA Closer Look at Demand and Supply

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The Concept of Elasticity

How large is the response of producers and consumers to changes in price? Before business firms and the government decide to change prices and taxes, they must anticipate the magnitude of response by those affected.

Elasticity is a measure of the responsiveness of people to changes in economic variables.

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Popular Elasticity Measures

Price elasticity of demand Price elasticity of supply Income elasticity—and the character of

consumer goods Cross elasticity of demand for related

goods

Popular measures of elasticity include:

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Price Elasticity of Demand

Price elasticity of demand measures the response of consumers to changes in price.

E d p ercentage change in q uantity d em and ed

p ercentage change in p r ice

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Computing Price Elasticity of Demand

E d p ercentage change in q uantity d em and ed


% .Q

8 5 1 0 0

1 0 0

1 5

1 0 00 1 5 o r 1 5 %

%$ 2. $ 2 .

$ 2 .

$ 0.

$ 2 .P

2 0 0 0

0 0

2 0

0 010%

%

%.

Q

P

1 5 %

1 0 %1 5 0

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Using the Midpoint Formula to Compute Price Elasticity

The midpoint formula is a more accurate measure of percentage changes.

p ercentage change = ab so lute va lue

average va lue

%( ) / .

Q

8 5 1 0 0

1 0 0 8 5 2

1 5

9 2 516.22%

%$ 2. $ 2 .

($ 2 . $ 2 . ) /

$ 0.

$ 2 .P

2 0 0 0

0 0 2 0 2

2 0

1 09.52%

%

%

.

..

Q

P

1 6 2 2 %

9 5 2 %1 7 0

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Interpreting the Value of Elasticity

Response to Price Changes

Responsive

Unresponsive

Proportional

Value of

Elasticity

Ed > 1

Ed < 1

Ed = 1

Demand Elasticity

Elastic

Inelastic

Unitary elastic

Magnitudes of Change

%QD > %P

%QD < %P

%QD = %PType of

Elasticity

Elastic

Inelastic

Substitutes Available

Many

Few

The main determinant of demand elasticity is the availability of substitutes for the good in question.

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Interpreting the Value of Elasticity

The price elasticity for water (0.20) suggests that a 10% increase in the price of water would decrease the quantity demanded by only 2%.

The elasticity for specific brands of coffee (5.6) suggests that a 10% increase in the price of a specific brand would decrease its quantity demanded by 56%.

Estimated price elasticities of demand for selected products

ProductPrice elasticity

of demandSalt 0.1

Water 0.2

Coffee 0.3

Cigarettes 0.3

Shoes and footwear 0.7

Housing 1.0

Automobiles 1.2

Foreign travel 1.8

Restaurant meals 2.3

Air travel 2.4

Motion pictures 3.7

Specific brands of coffee 5.6

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Elasticity Along a Linear Demand Curve

Price elasticity of demand decreases as we move downward along a linear demand curve

Demand is elastic on the upper part of the demand curve and inelastic on the lower part.

Percentage decrease in price

Percentage increase in quantity

Elasticity

Point r to point s 4/80 = 5% 2/10 = 20% 20%/5% = 4.0

Point t to point u 4/50 = 8% 2/25 = 8% 8%/8% = 1

Point v to point w 4/20 = 20% 2/40 = 5% 5%/20% = 0.25

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Elasticity and Total Revenue

Elasticity of demand determines if an increase in price will cause the firm’s revenue to increase or decrease.

Total Revenue = Price x Quantity sold

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The good news about an increase in price is that a higher price will increase the revenue obtained from each unit sold.

The bad news is that at a higher price, fewer units are sold. Elasticity of demand tells us whether the good news dominates over the bad news.

Total Revenue = Price x Quantity sold

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Predicting Changes in Total Revenue

Along the elastic range of the demand curve, an increase in price leads to a decrease in total revenue.

This graph shows the relationship between elasticity along a linear demand curve and total revenue. Note the following:

Along the inelastic range, an increase in price leads to an increase in total revenue.

Revenue is maximum when Ed=1.

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Predicting Changes in Total Revenue


Type of demand Value of Ed

Change in quantity versus change in price

Effect of an increase in price on total revenue

Effect of a decrease in price on total revenue

Elastic Greater than 1.0

Larger percentage change in quantity

Total revenue decreases

Total revenue increases

Inelastic Less than 1.0 Smaller percentage change in quantity

Total revenue increases

Total revenue decreases

Unitary elastic

Equal to 1.0 Same percentage change in quantity and price

Total revenue does not change

Total revenue does not change

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Price Elasticity of Supply

Price elasticity of supply is a measure of the responsiveness in quantity supplied to changes in price.

E s p ercentage change in q uantity sup p lied


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Computing Price Elasticity of Supply

E s p ercentage change in q uantity sup p lied


% Q s

1 2 0 1 0 0

1 0 0

2 0

1 0 02 0 %

%$ 2. $ 2 .

$ 2 .

$ 0.

$ 2 .P

2 0 0 0

0 0

2 0

0 01 0 %

EQ

Pss

%

%.

2 0 %

1 0 %2 0

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Supply Elasticity and Time

Supply becomes more elastic over time.

The increase in quantity supplied as a response to an increase in price is greater when supply is more elastic.

Higher market prices give business firms an incentive to expand production and output. As time goes by, the ability of firms to expand productive capacity is greater, and supply becomes more elastic.

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Predicting Price Changes Using Elasticities

The price-change formula can be used to predict the change in price resulting from a change in demand.

p ercentage change in p r ice = p ercentage change in d em and

E Es d

For changes in price resulting from a change in supply:

p ercentage change in p r ice = p ercentage change in sup p ly

E Es d

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Predicting Price Changes Using Elasticities: an Example

Assume that Ed=1.5 and Es=2.0, a rightward shift in demand by 35%, will increase price by the following percentage:

% P = % dem and

E Es d

% P = 3 5 %

2 0 1 5

1 0 %. .

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Income Elasticity

Income elasticity is a measure of the responsiveness of the quantity demanded to changes in consumer income.

E = p ercentage change in q uantity d emand ed

p ercentage change in inco mei

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Income Elasticity

E i > 0 Normal Income QD E i < 0 Inferior Income QD E i > 1 Luxury % QD > % I

E i < 1 Necessity % QD < % I

Income Elasticity Type of Good Responsiveness

Classification of Goods According to Income Elasticity

E = p ercentage change in q uantity d emand ed

p ercentage change in inco mei

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Cross Elasticity of Demand

Cross elasticity of demand is a measure of the responsiveness of the quantity demanded to changes in price of a related good.

E = p ercentage change in q uantity o f X d em and ed

p ercentage change in p r ice o f Yxy

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Exy > 0 Substitutes Py Qx

Cross Elasticity of Demand

Exy < 0 Complements Py Qx

Classification of Goods According to Cross Elasticity

Cross Elasticity Responsiveness

Type of Good

E = p ercentage change in q uantity o f X d emand ed

p ercentage change in p r ice o f Yxy

Documents

1 C H A P T E R 1 5 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin 1 Elasticity: A Measure of Responsiveness