Lecture #5

Elasticity and its applications

Elasticity

Basic idea:

Elasticity measures how much one variable.

Definition:

Elasticity is a numerical measure of the responsiveness of Qd or Qs to one of its determinants.

Price of elasticity of demand

Price of elasticity of demand measures how much Qd responds to change in P

Price of elasticity of demand = % change in Qd / % Change in P

Calculating Percentage Changes

Standard method of computing the % change

End value – Start value

P rises 25% Q falls 33%, elasticity = 33/25= 1.33

P falls 20%, rises 50%, 50/20 = 2.50

So, we instead use the midpoint method, End value – Start value/midpoint * 100%

Determinants of Price of Elasticity (PE): Summary

The PE of demand depends on:

The extent to which close substitutes are available

Whether the good is a necessity or a luxury

How broadly or narrowly the good is defined

The time horizon – elasticity is higher in the long run than the short run

Variety of Demand Curves

PE of demand is closely related to the slope of the demand curve

Rule of thumb:

The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity

1. “Inelastic Demand”

2. “Unit Elastic Demand”

3. “Elastic Demand”

4. “Perfectly elastic demand”

5. Elasticity of a Linear Demand Curve, The slope of a linear demand curve is constant, but the elasticity is not.

Price of Elasticity and Total Revenue

Continuing our scenario, if you raise your price from $200 to $250, would your revenue rise or fall?

Revenue = P*Q

A price increase has two effects on revenue

Higher P means more revenue on each unit you sell

But you sell fewer units (Lower Q)

If demand is elastic, then PE of demand > 1

% Change in q > % change in P

When D is elastic a price increase causes revenue to fall

PE of Supply

PE of supply measures how much Qs responds to change in P

PE of supply = % change in Qs / % change in P

Variety of Supply Curves

The slope of the supply curve is closely related to PE of supply

Rule of Thumb:

The flatter