Ch. 17 Elasticity

Economics 9th Ed, R.A. Arnold

Economics: Principles & Applications 6th ed, Hall & Lieberman

Elasticity

Price Elasticity of Demand

Continued from last slide

We found, |Ed| = 0.6

Now, we can obtain (extract) information from this number : (i.e. interpret the number)

If, P increases by 1 % then Qd decreases by 0.6% *

Or, if P decreases by 1% then Qd increases by 0.6% * (*approximately)

We can use this interpretation to analyze changes in Total Revenue (TR). We know, TR = P x Q

Therefore, if P ↑ 1 % and Q ↓ 0.6 % , then TR ↑

So, if Kashundi increases price of coffee, the total revenue is likely to increase.

Continued from last slide

We can also say, the quantity demanded of coffee does not respond much to changes in price. That is, the demand for coffee is inelastic.

Generally, if |Ed|< 1 , then we say the demand of the product is inelastic.

If, |Ed|> 1 , we say the demand is elastic

If, |Ed|= 1 , the demand is unit elastic

There are two other situations/possibilities. They are discussed in the next slide.

Continued from last slide

Price changes by a very small amount and the quantity demanded changes by a very large amount

Therefore, Ed = ∞ (or a very large number)

Here the demand is perfectly elastic

The demand is perfectly inelastic when a change in price does not affect the quantity demanded. Hence, % ∆ Qd = 0. Therefore, Ed = 0

The next slide summarizes the above discussions

In the next slide we look at the graphical representation of the different types of price elasticities of demand (above)

Determinants of Price Elasticity of Demand (Ed)(Here, we look at the factors that affect the value of Ed)

1. Number of substitutes: If a good has many substitutes then Ed will be more as compared to a good which has fewer substitutes. Why? If there are many substitutes, buyers can easily shift to them when the price of a product increases. Hence, Qd decreases by a larger % and hence value of Ed will be larger (demand more elastic).

2. Necessities versus luxuries: If a good is a necessity (e.g. water), Ed will be less as compared to a good which is a luxury (e.g. grape juice). If the price of a necessity increases then Qd will fall by a smaller % . Hence, Ed is smaller and demand less elastic.

Continued from last slide…

Time: As more time passes after the price

change, the higher will be the Ed. Since consumers can find other substitutes, change their preferences, lifestyle and habit.

Other Elasticity Concepts

P.S. Here we DO NOT take the absolute value because the sign (+ or -) gives us valuable info.In the example last slide, the quantity demanded of a good and the price of a substitute are directly (positively related). So, Ec > 0 i.e. positive for substitutes The higher the Ec, the closer the substitutes (the better the substitutes). Why? Think about this.

And negative i.e. Ec < 0 for complements. The quantity demanded of a good and the price of complements are negatively related. If one increases the other decreases.

The Relationship Between Taxes and Elasticity

In figure, Gov is taxing $1 per DVD sold.

Remember: If the demand is less elastic (more inelastic) the D curve will become steeper (more vertical). You should do the graphical analysis as an exercise. You will see that the consumer ends up paying more of the tax.

When demand is perfectly

inelastic the consumer/

buyer pays all of the tax.