Economic variables
Elasticities of demand and supply.
Total, average, and marginal
values of economic variables.
Elasticities of demand and supply



We are interested not only in the direction
but also in the intensity of change in price
and quantity
Elasticity gives a way to measure by how
much a variable will change with the change
in another variable.
Specifically, it gives the percentage change in
one variable resulting from a one percent
change in another.
Price Elasticity of Demand

Measures the sensitivity of quantity
demanded to price changes.

It measures the percentage change in the
quantity demanded of a good that results
from a one percent change in price.
D
EP
%Q D

%P
Price Elasticity of Demand


The percentage change in a variable is
the absolute change in the variable
divided by the original level of the
variable.
Therefore, elasticity can also be written
as:
Q Q P Q
D
EP 

P P Q P
Price Elasticity of Demand

Usually a negative number

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When EP > 1, the good is price elastic


As price increases, quantity decreases
As price decreases, quantity increases
%Q > % P
When EP < 1, the good is price inelastic

%Q < % P
Price Elasticity of Demand

The primary determinant of price
elasticity of demand is the availability of
substitutes.

Many substitutes - demand is price elastic


Can easily move to another good with price
increases
Few substitutes - demand is price inelastic
Price Elasticity of Demand



Looking at a linear demand curve, as
we move along the curve Q/P will
change
Price elasticity of demand must
therefore be measured at a particular
point on the demand curve
Elasticity will change along the demand
curve in a particular way
Price Elasticity of Demand

Given a linear demand curve


Elasticity depends on slope and on the
values of P and Q
The top portion of demand curve is elastic


Price is high and quantity small
The bottom portion of demand curve is
inelastic

Price is low and quantity high
Price Elasticity of Demand
Price
4
EP = -
Demand Curve
Q = 8 – 2P
Elastic
Ep = -1
2
Inelastic
4
8
Q
Ep = 0
Price Elasticity of Demand



The steeper the demand curve, the
more inelastic the demand.
The flatter the demand curve, the more
elastic the demand
Two extreme cases of demand curves


Completely inelastic demand – vertical
Infinitely elastic demand - horizontal
Infinitely Elastic Demand
Price
EP = 
D
P*
Quantity
Completely Inelastic Demand
Price
D
EP = 0
Q*
Quantity
Other Demand Elasticities

Income Elasticity of Demand

Measures how much quantity demanded
changes with a change in income.
Q/Q
I Q
EI 

I/I
Q I
Other Demand Elasticities

Cross-Price Elasticity of Demand

Measures the percentage change in the
quantity demanded of one good that
results from a one percent change in the
price of another good.
EQb Pm
Qb Qb Pm Qb


Pm Pm Qb Pm
Other Demand Elasticities

Complements: Cars and Tires

Cross-price elasticity of demand is negative


Price of cars increases, quantity demanded of
tired decreases
Substitutes: Butter and Margarine

Cross-price elasticity of demand is positive

Price of butter increases, quantity of margarine
demanded increases
Price Elasticity of Supply

Measures the sensitivity of quantity
supplied given a change in price

Measures the percentage change in
quantity supplied resulting from a 1
percent change in price.
S
EP
% ΔQ S

% ΔP
Point v. Arc Elasticities

Point elasticity of demand


Price elasticity of demand at a particular
point on the demand curve
Arc elasticity of demand

Price elasticity of demand calculated over a
range of prices
E PD

 ΔQ

P 
ΔP  Q 
Short-Run Versus Long-Run
Elasticity


Price elasticity varies with the amount
of time consumers have to respond to a
price.
Short run demand and supply curves
often look very different from their
long-run counterparts.
Short-Run Versus Long-Run
Elasticity

Demand

In general, demand is much more price
elastic in the long run

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Consumers take time to adjust consumption
habits
Demand might be linked to another good that
changes slowly
More substitutes are usually available in the
long run
Gasoline: Short-Run and LongRun Demand Curves
Price
DSR
•People cannot easily
adjust consumption in
short run.
•In the long run, people
tend to drive smaller and
more fuel efficient cars.
DLR
Quantity of Gas
Cars: Short-Run and Long-Run
Demand Curves
Price
DLR
•Initially, people may put
off immediate car
purchase
•In long run, older cars
must be replaced.
DSR
Quantity of Cars
Short-Run Versus Long-Run
Elasticity

Income elasticity also varies with the
amount of time consumers have to
respond to an income change.

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For most goods and services, income
elasticity is larger in the long run
When income changes, it takes time to
adjust spending
Short-Run Versus Long-Run
Elasticity

Most goods and services:

Long-run price elasticity of supply is
greater than short-run price elasticity of
supply.
Short-Run v. Long-Run
Elasticity – An Application
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Why are coffee prices very volatile?
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Most of the world’s coffee produced in
Brazil.
Many changing weather conditions affect
the crop of coffee, thereby affecting price
Price following bad weather conditions is
usually short-lived
In long run, prices come back to original
levels, all else equal
Price of Brazilian Coffee
Short-Run v. Long-Run
Elasticity – An Application
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
Demand and supply are more elastic in
the long run
In short-run, supply is completely
inelastic
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Weather may destroy part of the fixed
supply, decreasing supply
Demand relatively inelastic as well
Price increases significantly
An Application
Coffee
S’ S
Price
A freeze or drought
decreases the supply
of coffee
Price increases
significantly due to
inelastic supply and
demand
P1
P0
D
Q1
Q0
Quantity
An Application - Coffee
Price
S’
S
Intermediate-Run
1) Supply and demand are
more elastic
2) Price falls back to P2.
P2
P0
D
Q2 Q0
Quantity
An Application - Coffee
Price
Long-Run
1) Supply is extremely elastic.
2) Price falls back to P0.
3) Quantity back to Q0.
S
P0
D
Q0
Quantity
Economic variables
The relationships between total,
average, and marginal values
Economic variables
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Total utility
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Average utility

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TU = f(x)
AU = TU/x = f(x)/x
Marginal utility

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MU = dTU/dx = df(x)/dx
The change in value of the dependent variable
divided by the unit change of the independent
variable
Economic variables
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Main relationships:
(1) Total value is the sum of all
marginal values.
(2) If a constant is added to all total
values, marginal values will not change.
Economic variables
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(3) Average value increases when
marginal value is higher, M > A
(4) Average value decreases when
marginal value is lower, M < A
(5) Average value is constant when it is
equal to the marginal value, M = A
Economic variables

To understand marginal values, it is
necessary to understand the concept of
the derivative
First derivative

Shows the SLOPE of the graph of a
function at a specific point
dy/dx = lim Δy/Δx
Δx-0

We estimate the slope Δy/Δx “in the
limit” when Δx approaches zero