Topic 2. Elasticity - Christiane Schwieren PDF

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Introduction to microeconomics

TOPIC 2: SLOPE AND ELASTICITY OF DEMAND AND SUPPLY

Elasticity measures how much one variable responds to changes in another variable. It is the numerical measure of the responsiveness of Q d or Qs to one of its determinants. Supply and demand curves show the relationship between the quantity supplied or demanded and price. If price rises, in general: -

The quantity demanded falls (slope -) The quantity supplied rises (slope +)

Slope: -

The sensitivity of demand (or supply) to price changes depends on the slope (gradient) of the demand curve. The change in quantity demanded when price increases by one unit.

In general: -

Supply curve: (+) when the price increases by one unit the quantity supplied increases. Demand curve: (-) when the price increases by one unit the quantity demanded decreases. The more horizontal the curve  the greater the change in quantity The more vertical the curve  the lesser the change in quantity

CALCULATION OF THE SLOPE

Introduction to microeconomics

* PROBLEM! The slope of the demand curve depends on the units in which we measure prices and quantity. Economists usually measure the sensitivity of one variable to another by estimating the percentage change the first variable would experience if the amount of the second variable increased by 1 percent.

Elasticity: The price-elasticity of demand is the percentage change in quantity caused by a change in the price of 1 percent (as we move along the demand curve). The price-elasticity of supply is the percentage change in quantity caused by a change in the price of 1 percent (as we move along the supply curve).

Price Elasticity of a curve=

Percentage change=

Percentage change of Q Percentage changeof P

Final value−initial value ∆ P ∨Q ×100 %= ×100 Initial value P∨Q

∆Q ∆Q Q Q P ∆Q = Elasticity= = × ∆ P ∆P Q ∆ P 100 × P P 100 ×

* Elasticity changes along the curve

Price elasticity is higher when close substitutes are available. Example: if the prices of cereal and sunscreen rise by 20%, Qd will drop the most for cereal because it has close substitutes, so buyers can switch if the price rises. Price elasticity is higher for narrowly defined goods than broadly defined ones. Example: if the prices of blue jeans and clothing rise by 20%, Q d will drop the most for blue jeans because there are many substitutes, but there is no substitute for clothing. Price elasticity is higher for luxuries than for necessities. Example: if the prices of insulin and Caribbean cruises rise by 20%, Q d will drop the most for luxury cruises because insulin is a necessity.

Introduction to microeconomics

Price elasticity is higher in the long run than the short run. Example: if the price of gasoline rises 20%, Qd drop more in the long run because people can search for cheaper alternatives, whereas in the short run there is not much people can do.

Summary: Price elasticity depends on: -

The extent to which close substitutes are available Whether the good is a necessity or a luxury How broadly or narrowly the good is defined The time horizon – elasticity is higher in the long run than the short run

Properties of the price elasticity -

If |ED| > 1, we say that demand is elastic o When price rises, the quantity demanded falls more than proportionally o Elastic Demand:   < ED < -1

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If |ED| < 1, we say that demand is inelastic o When price rise, the quantity demanded falls less than proportionally. o Inelastic Demand: -1 < ED < 0

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If ED = -, demand is Perfectly Elastic (prices do not vary)

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If ED = 0, demand is Perfectly Inelastic (consumers have to bear all taxes)

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The terms apply similarly to the supply curve o Elastic Supply: 1 < ES < +  (prices increase, consumers pay taxes) o Inelastic Supply: 0 < ES < 1 (prices do not vary)

Elastic: the amount varies proportionately more than price. Inelastic: the amount varies proportionally less than price.

Introduction to microeconomics

Introduction to microeconomics

Elasticity and total revenue Total revenue = Price  Quantity (without reducing the costs!)

Introduction to microeconomics

•

If demand is elastic with respect to price (–∞ < Ed < –1), then if P drops, Q increases more than proportionately and therefore total revenue increases.

•

If demand is inelastic with respect to price (–1 < Ed < 0), then if P falls, Q increases less than proportionally, and hence total revenue decreases.

With a negative sloping demand curve, as we move along the demand curve: a) price and total revenue vary in the same direction if demand is inelastic regarding price. b) the price and total revenue vary in the opposite direction if demand is elastic regarding price.

The more inelastic, the greater the impact or burden of the tax. The more elastic, the less the impact or the burden of the tax.

DEAD WEIGHT LOSS (DWL) Apuntes cetec OTHER ELASTICITIES Income elasticity of demand = % change in QD / % change in income It measures the response of Qd to a change in consumer income. An increase in income causes an increase in demand for a normal good -

For a normal good, income elasticity > 0 For inferior goods, income elasticity < 0

Cross-price elasticity of demand= % change In Qd for good 1 / % change in price of good 2 It measures the response of demand for one good to changes in the price of another good. -

For substitutes, cross-price elasticity > 0 For complements, cross-price elasticity < 0...