Chapter 4: Elasticity
Chapter 4: Elasticity Key terms and Ideas
Price elasticity of demand
A units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buying plans remain the same. Formula: percentage change in quantity demanded/percentage change in price Percentage change is also the average
Essentially, %DQ / %DP = DQ / DP
In the example: The percentage change in quantity demanded, %DQ, is calculated as DQ/Qave x 100, which is (2/10) x 100 = 20%. The percentage change in price, %DP, is calculated as DP/Pave x 100, which is ($1/$20) x 100 = 5%.
By using average price and average quantity, we get the same elasticity value regardless of whether the price rises or falls Since elasticity is a units-free measure or a ratio of percentages, a change in the units of measurement of price/quantity leaves the elasticity value the same
Inelastic and Elastic Demand
Demand can be inelastic, unit elastic, or elastic – can range from zero to infinity Perfectly inelastic demand o Quantity demanded doesn’t change when the price changes, the price elasticity of demand is zero o If the percentage change in quantity demanded is smaller than the percentage change in price - the price elasticity of demand is less than 1 o Vertical demand curve
o
i.e. insulin, gasoline, illicit drug
Unit Elastic demand o Percentage change in the quantity demanded = percentage change in price, the price elasticity of demand is 1 Perfectly Elastic demand o Percentage change in the quantity demanded is infinitely large when the price barely changes – the price elasticity of demand is infinite o Horizontal demand curve
Total revenue o The price of the good multiplied by the quantity sold o Changes when the price changes, but a rise in the price doesn’t necessarily increase total revenue o If demand is elastic, a 1% price cut increases the quantity sold by more than 1%, total revenue increases o If demand is inelastic, a 1% price cut increases the quantity sold by less than 1%, total revenues decreases o If demand is unit elastic, a 1% price cut increases the quantity sold by 1%, total revenue remains unchanged
Ed = %aveQ %aveP
Total revenue test o Method of estimating the price elasticity of demand through observation of the change in total revenue resulted from a price change (when all other influences on the quantity sold stays constant) o Elastic if a price cut increases total revenue o Inelastic if a price cut decreases total revenue o Unit elastic if a price cut leaves total revenue unchanged Your Expenditure and Your Elasticity o If demand is elastic, a 1% price cut increases the quantity you buy by more than 1% and your expenditure on the item increases o If demand is inelastic, a 1% price cut increases the quantity you buy by less than 1% and your expenditure on the item decreases o If demand is unit elastic, a 1% price cut increases the quantity you buy by 1% and your expenditure on the item does not change
Factors Influencing the Elasticity of Demand o The closeness of substitutes The closer the sub for a good/service, the more elastic are the demand for the good/service Necessities generally are inelastic Luxuries generally are elastic Cross Elasticity of Demand - A measure of the responsiveness of a demand for a good to a change in the price of a substitute or complement, other things remaining the same Formula: % change in Qd/ % change in P (of substitute/complement) For substitute is positive (shift right) For complement is negative (shift left) o The proportion of income spend on the good The greater the proportion of income consumers spend in a good, the larger is the elasticity of the demand Income elasticity of demand A measure of the quantity demanded of a good responding to a change in income, things remaining the same Formula: % change in quantity demanded/& change in income Income elasticity of demand > 1, demand is income elastic and the good is a normal good Income elasticity of demand >0 but
Price elasticity of demand
A units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buying plans remain the same. Formula: percentage change in quantity demanded/percentage change in price Percentage change is also the average
Essentially, %DQ / %DP = DQ / DP
In the example: The percentage change in quantity demanded, %DQ, is calculated as DQ/Qave x 100, which is (2/10) x 100 = 20%. The percentage change in price, %DP, is calculated as DP/Pave x 100, which is ($1/$20) x 100 = 5%.
By using average price and average quantity, we get the same elasticity value regardless of whether the price rises or falls Since elasticity is a units-free measure or a ratio of percentages, a change in the units of measurement of price/quantity leaves the elasticity value the same
Inelastic and Elastic Demand
Demand can be inelastic, unit elastic, or elastic – can range from zero to infinity Perfectly inelastic demand o Quantity demanded doesn’t change when the price changes, the price elasticity of demand is zero o If the percentage change in quantity demanded is smaller than the percentage change in price - the price elasticity of demand is less than 1 o Vertical demand curve
o
i.e. insulin, gasoline, illicit drug
Unit Elastic demand o Percentage change in the quantity demanded = percentage change in price, the price elasticity of demand is 1 Perfectly Elastic demand o Percentage change in the quantity demanded is infinitely large when the price barely changes – the price elasticity of demand is infinite o Horizontal demand curve
Total revenue o The price of the good multiplied by the quantity sold o Changes when the price changes, but a rise in the price doesn’t necessarily increase total revenue o If demand is elastic, a 1% price cut increases the quantity sold by more than 1%, total revenue increases o If demand is inelastic, a 1% price cut increases the quantity sold by less than 1%, total revenues decreases o If demand is unit elastic, a 1% price cut increases the quantity sold by 1%, total revenue remains unchanged
Ed = %aveQ %aveP
Total revenue test o Method of estimating the price elasticity of demand through observation of the change in total revenue resulted from a price change (when all other influences on the quantity sold stays constant) o Elastic if a price cut increases total revenue o Inelastic if a price cut decreases total revenue o Unit elastic if a price cut leaves total revenue unchanged Your Expenditure and Your Elasticity o If demand is elastic, a 1% price cut increases the quantity you buy by more than 1% and your expenditure on the item increases o If demand is inelastic, a 1% price cut increases the quantity you buy by less than 1% and your expenditure on the item decreases o If demand is unit elastic, a 1% price cut increases the quantity you buy by 1% and your expenditure on the item does not change
Factors Influencing the Elasticity of Demand o The closeness of substitutes The closer the sub for a good/service, the more elastic are the demand for the good/service Necessities generally are inelastic Luxuries generally are elastic Cross Elasticity of Demand - A measure of the responsiveness of a demand for a good to a change in the price of a substitute or complement, other things remaining the same Formula: % change in Qd/ % change in P (of substitute/complement) For substitute is positive (shift right) For complement is negative (shift left) o The proportion of income spend on the good The greater the proportion of income consumers spend in a good, the larger is the elasticity of the demand Income elasticity of demand A measure of the quantity demanded of a good responding to a change in income, things remaining the same Formula: % change in quantity demanded/& change in income Income elasticity of demand > 1, demand is income elastic and the good is a normal good Income elasticity of demand >0 but
