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Unit 3: ELASTICITY, Elasticity tells us the degree to which changes in…
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Elasticity tells us the degree to which changes in prices and incomes affect supply and demand. Sometimes the responses are substantial, other times minimal or nonexistent
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As per LAW OF DEMAND: other things equal consumers will buy more of a product when the price declines and less when its price increases. But how much more or less will they buy? It varies from product to product and over different price ranges for the same product. It also may vary over time.
PRICE ELASTICITY OF DEMAND = consumers' responsiveness (or sensitivity) to a price change is measured by a product's 'price elasticity of demand'
Relatively elastic/elastic = modest price changes cause very large changes in the quantity purchased i.o.w the demand for such products is elastic
Relatively inelastic/inelastic = even substantial price changes cause only small changes in the quantity purchased i.o.w the demand for such products is inelastic
Price elasticity coefficient and formula
Ed = the coefficient that economists use to measure the degree to which demand is elastic (price sensitive) or inelastic (price insensitive)
Ed = (percentage change in quantity demanded of product X) / (percentage change in price of product X
Ed = ([change in quantity demanded of product X] / [original quantity demanded of product X]) / ([change in price of product X] / [original price of product X])
Using Averages: when change in quantity or price differs along the curve, use the average i.o.w. the midpoint formula
Ed = (change in quantity / [sum of quantities/2]) / (change in price / [sum of prices/2])
Using percentages:
1) when using absolute amounts (dollars or cents), the answer will be so different that we will get the wrong impression of the actual effect
2) by using percentages we can correctly compare consumer responsiveness to change in the prices of different products
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Ed > 1 elastic demand
Ed = 1 unit elasticity
Ed < 1 inelastic demand
Ed = 0 extreme cases, perfectly inelastic (insulin), no response to a price change
Ed = infinite i.o.w. perfectly elastic, small price reduction causes purchasers to increase their purchases from zero to all they can obtain (infinite)
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Firms want to know the effect of price changes on total revenue and ultimately on profit (total revenue minus total cost)
Total revenue = the total amount the seller receives from the sale of a product in a particular time period
TR = P x Q
P = product price
Q = quantity sold
Total revenue is the PxQ rectangle lying below a point on a demand curve
Total revenue and price elasticity of demand are related
TR changes in opposite direction of price - demand is elastic
TR changes in same direction of price - demand is inelastic
TR does not change when price changes - demand is unit-elastic
- Elastic demand: decrease in price increases total revenue and price increase results in decrease in total revenue i.o.w. even though a lower price is received per unit, enough additional units are sold to more than make up for the lower price
- Inelastic demand: decrease in price decrease total revenue, increase in price will increase total revenue
- Unit elasticity: increase or decrease in price leaves total revenue unchanged
Price elasticity along a linear demand curve
Slope of a demand curve (flatness or steepness) is not a basis for judging elasticity. Slope is computed from absolute changes in price and quantity, while elasticity involves relative or percentage changes in price and quantity.
DO NOT confuse slope and elasticity. Slope can be constant even while elasticity varies significantly along the length of a curve
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Factors that affect price elasticity of demand
- Substitutability: the more substitute goods available the greater the price elasticity of demand; elasticity of demand for a product depends on how narrowly the product is defined
- Proportion of income: other things equal, the higher the price of a good relative to consumers' incomes, the greater the price elasticity of demand; price elasticities for goods that make up a greater proportion of consumers' income is higher
- Luxuries versus necessities: price elasticity of demand is greater for luxuries than for necessities (electricity)
- Time: generally, product demand is more elastic over longer time periods; consumers often need time to adjust to price changes
Applications of Price Elasticity of Demand
- Large Crop Yields
- Excise tax
- Decriminalization of illegal drugs
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If the quantity supplied by producers is relatively responsive to price changes, supply is elastic; if it is relatively insensitive to price changes, supply is inelastic
Price elasticity coefficient and formula
Es = the coefficient that economists use to measure the degree to which supply is elastic (price sensitive) or inelastic (price insensitive)
Es = (percentage change in quantity supplied of product X) / (percentage change in price of product X
Es = ([change in quantity supplied of product X] / [original quantity supplied of product X]) / ([change in price of product X] / [original price of product X])
Es > 1 elastic supply
Es = 1 unit elasticity
Es < 1 inelastic supply
Never negative as the case for demand
Degree of price elasticity of supply: depends on how quickly and easily producers can shift resources between alternative uses; the more easily and rapidly producers can shift resources, the greater the price elasticity of supply
Analysing the impact of time on elasticity
1) Immediate market period - length of time over which producers are unable to respond to a change in price to a change in quantity supplied (farmer brings tomatoes to market)
2) Short run - period of time too short to change plant capacity but long enough to use the fixed-sizes plant more intensively or less intensively
3) Long run - time period long enough for producers to adjust their plant sizes and for new firms to enter (or existing firms to leave) the industry
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Applications of Price Elasticity of Supply
- Antiques and Reproductions
- Volatile Gold Prices
Cross Elasticity and Income Elasticity of Demand
- Price elasticities measure the responsiveness of the quantity demanded and supplied of a good to a change in price; the consumption of a good is also affected by price changes and, additionally by income changes.
- CROSS ELASTICITY OF DEMAND
Exy = (percentage change in quantity demanded of product X) / (percentage change in price of product Y
- SUBSTITUTE GOODS: if cross elasticity of demand is positive, meaning that sales of X move in the same direction as a change in the price of Y; the larger the positive cross-elasticity coefficient, the greater is the substitutability between the two products
- COMPLEMENTARY GOODS: when cross elasticity is negative we know that X and Y go together, an increase in the price of one decreases the demand for another; the larger the negative cross-elasticity coefficient, the greater is the complementarity between the two products
- INDEPENDENT GOODS: a zero or near-zero cross elasticity suggests that the two products are unrelated or independent goods
Applications of Cross-Elasticity of Demand
- Antiques and Reproductions
- Volatile Gold Prices
- INCOME ELASTICITY OF DEMAND
Measures the degree to which consumers respond to a change in their incomes by buying more of less of a particular good
Ei = (percentage change in quantity demanded) / (percentage change in income)
- NORMAL GOODS/SUPERIOR GOODS: income elasticity coefficient is POSITIVE; more of these goods are demanded as income rises
- INFERIOR GOODS: income elasticity coefficient is NEGATIVE; consumers decrease their purchases of inferior goods as their income rises.
- INSIGHTS: coefficients of income elasticity of demand provide insights into the economy; during recessions when incomes fall, demand for certain products fall (housing, restaurant meals, cars) = relatively high income elasticity coefficient. Low or negative income elasticity coefficient = much less affected by changes in income (meals prepared at home)