Elasticity and its implications
Lecture 2 – academic year 2015/16
Introduction to Economics
Dimitri Paolini
Where we are…
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Lect. 1: Demand and supply
Lect. 1: Market equilibrium
Lect. 1: Market adjustment processes
Lect. 2: Elasticity
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What do we do today?
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The concept of elasticity
The elasticity of demand with respect to prices
Elasticity and total revenue
Elasticity of demand with respect to income
Elasticity of supply with respect to prices
Examples
3
Elasticity
It measures the sensibility of buyers and
sellers to variations in the market conditions.
It allows one to study demand and supply with
greater precision.
4
Three types of elasticity
• Elasticity of demand with respect to prices
• Elasticity of demand with respect to income
• Elasticity of supply with respect to prices
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Elasticity of demand with
respect to prices
The elasticity of demand with respect to
prices ED(p) measures how the quantity
demanded respond to variations in market
prices.
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Elastic and inelastic demand
Inelastic demand
• The quantity demanded does not significantly react
to variations in market prices
Elastic demand
• The quantity demanded significantly react to
variations in market prices
Limit cases: perfectly inelastic, elastic and unitary.
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Perfectly inelastic demand
Price
Demand
5
4
1. An increase
in price...
0
100
Quantity
2. …leaves the quantity demanded unaltered .
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Perfectly elastic demand
Price
1. For any price greater than 4 euro
the quantity demanded in null
4
Demand
2. When the price is equal to 4
euro consumers are available
to buy any quantity
0
Quantity
3. For any price smaller than 4 euro
the quantity demanded in infinite
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Demand with unitary elasticity
Price
5
4
1. A 25%
increase in
price...
Demand
0
75 100
2. …causes a 25% reduction in
the quantity demanded
Quantity
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Elastic demand
Price
5
4
Demand
1. A 25%
increase in
price...
0
50
100
2. …causes a 50% decrease in the
quantity demanded
Quantity
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Inelastic demand
Price
5
4
Demand
1. A 25%
increase in
price...
0
90
2. …causes a 10% decrease
in the quantity demanded
100
Quantity
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When is ED(p) high?
Demand tends to be elastic..
.. for luxury goods
.. in the long period
.. in general, for goods that have close
substitutes.
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When is ED(p) low?
• Demand tends to be inelastic...
… for primary goods
… in the short period
… in general, for goods that have no
substitutes
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Low elasticity: Oil
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How to compute ED(p)
ED(p) is computed as the ratio between the
percentage variation in the quantity demanded
and the percentage variation in price.
ED(p) = – [Δ q / q0] / [Δ p / p0] =
= – [(q1 – q0) / q0] / [(p1 – p0) / p0]
Notice: ED(p) is a positive number.
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How to compute ED(p)
Price
5
4
Demand
0
50
100
Quantity
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How to compute ED(p)
(50-100)
ED = -
Price
100
(5,0-4,0)
4,0
5
4
Demand
0
50
100
Quantity
(- 0,5)
==2
0, 25
Demand is elastic with
respect to price
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Elasticity and total revenue
Total revenue is the total expenses of consumers and
the total proceeds for producers
It is computed as the product of price and quantity
sold
TR = p X q
Total revenue varies along the demand curve depending on the
degree of elasticity.
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Elasticity and total revenue
Price
4
P · Q = 400
(Total revenue)
P
0
Demand
100
Q
Quantity
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Elasticity and total revenue
If the demand is elastic, an in price
(more
than proportional decrease) in the quantity
demanded:
total revenue
If the demand is inelastic, an in price
(less
than proportional decrease) in the quantity
demanded:
total revenue
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Elasticity and total revenue
Example: Inelastic demand
Price
Price
3
1
0
Revenue = 100
Demand
100
Quantity
1
0
Revenue = 240
Demand
80 100
Quantity
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Elasticity of demand
with respect to income
• The elasticity of demand with respect to
income ED(Y) measures how the quantity
demanded respond to changes in income
• It is computed as the ratio between the
percentage variation in the quantity
demanded and the percentage variation in
income
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How to compute ED(Y)
Elasticity of demand with respect to income
æ percentage variation in ö
ç quantity demanded ÷
÷
=ç
ç percentage variation ÷
÷
çè
in income
ø
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When is ED(Y) low?
When the good is necessary, such as
clothes, food, fuel, drugs, but also
cigarettes for a heavy smoker
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When is ED(R) high?
When the good is luxury, such as sport
cars, caviar, fur coat, etc.
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Cross elasticity of demand
The cross elasticity of demand with respect to
price E(p) measures the responsiveness of the
demand for a good to a change in the price of
another good.
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Cross elasticity of demand
We can consider two goods, such as sugar (S)
and coffee (C) :
The elasticity of demand of good S
with respect to the price of good C=
æ % change in the
ö
ç quantity demanded of S ÷
÷
=ç
ç % chnage in the
÷
çè
÷
price of C
ø
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Cross elasticity of demand
• Complementary goods (coffee and sugar):
cross elasticity with negative sign: as the price
of coffee rises, the demand for sugar falls.
• Substitute goods (tea and coffee): cross
elasticity with positive sign: as the price of tea
rises, the demand for coffee rises.
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Elasticity of supply with
respect to price
Elasticity of supply with respect to price ES(p) is
measured as the ratio between the percentage
change in the quantity supplied and the
percentage change in price.
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Values of ES(p)
• Perfectly elastic
ES(p) =∞
• Elastic
ES(p) >1
• Unitary elasticity
ES(p) =1
• Inelastic
ES(p) <1
• Perfectly inelastic
ES(p) =0
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Perfectly inelastic supply
Price
Supply
5
4
1. An increase
in price…
0
100
Quantity
2. …leaves the quantity supplied unaltered.
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Perfectly elastic supply
Price
1.For any price greater than
4 euro the quantity supplied
is infinite
4
Offerta
2. At the price of 4 euro sellers
are willing to sell any quantity.
0
3. For any price greater than
4 euro the quantity supplied
is null
Quantity
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When is ES(p) high?
• When producers enjoy some flexibility in the
use of resources:
– Residential zonings close to the sea have low
elasticity of supply;
– Books, cars, TVs, have high elasticity of supply.
• In the long-run.
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Elasticity of demand:
An application
• Ascertain whether the demand curve or the
supply curve shifts.
• In which direction?
• Draw the S-D graph to see how the market
equilibrium and total revenue change.
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Elasticity of demand:
An application
• Can good news for agriculture be bad news for
farmers?
• What does it happen to a wheat farmer and to
the wheat market if some university
researchers discover a new variety of wheat
that is more productive than the varieties
presently available?
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An increase of supply in the
market for wheat
• Check whether the event affects both supply
and demand.
• Ascertain the directions of the shifts
• Draw the supply-demand graph to identify the
new market equilibrium
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An increase of supply in the
market for wheat
Price of
wheat
S1
3
Demand
0
100
Quantity of wheat
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An increase of supply in the
market for wheat
Price of
wheat
S1
S2
1. If the demand is
inelastic an increase of
supply…
3
2
Demand
0
100 110
Quantity of wheat
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An increase of supply in the
market for wheat
Price of
wheat
S1
1. If the demand is inelastic
an increase of supply…
3
2
2. …causes
a significant
drop in
price...
0
S2
Demand
100 110
Quantity of wheat
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An increase of supply in the
market for wheat
Price of
wheat
S1
3
2
2. …causes
a significant
drop in
price...
0
S2
1. If the demand is inelastic
an increase of supply…
Demand
100 110
Quantity of wheat
3. … and a less than proportional increase in the
quantity sold. As a consequence the total revenue
falls (from 300 to 220 €).
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An increase of supply in the
market for wheat
Price of
wheat
S1
S2
3
2
TR1= 3·100= 300
Demand
0
100 110
Quantity of wheat
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An increase of supply in the
market for wheat
Price of
wheat
S1
S2
3
2
Demand
TR2= 2·110= 220
0
100 110
Quantity of wheat
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Conclusion
• The elasticity of demand with respect to
price measures the responsiveness of
demand to price changes
• If the demand is elastic, an increase in price
causes a reduction in total revenue
• If the demand is inelastic, the total revenue
increases as the price rises
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Conclusion
• The elasticity of supply with respect to price
measures the responsiveness of supply to
price changes
• Usually, both demand and supply are more
elastic in the long-run than in the short-run
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Next week
Demand, supply and elasticity: applications
and exercises
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