Chap 5. Elasticity

The Determinants of Demand Elasticity

1. Availability of Substitutes: The most important factor affecting demand elasticity is the availability of substitute 2. The Importance of Being Unimportant : When an item represents a relatively small part of our total budget, we tend to pay little attention to its price. For example, if you pick up a pack of mints once in a while, you might not notice the increase in price. 3. Luxuries versus necessities: luxury goods like yatchs tend to have relatively elastic demand, while necessities like food have inelastic demand 4. The time dimension: elasticity inna short run may be different from elasticity of demand in the long run (demand more elastic or responsive)

elastic demand

A demand relationship in which the percentage change in quantity demanded is larger than the percentage change in price in absolute value (a demand elasticity with an absolute value greater than 1).

unitary elasticity

A demand relationship in which the percentage change in quantity of a product demanded is the same as the percentage change in price in absolute value (a demand elasticity with an absolute value of 1).

elasticity

A general concept used to quantify the response in one variable when another variable changes.

point elasticity

A measure of elasticity that uses the slope measurement.

elasticity of labor supply

A measure of the response of labor supplied to a change in the price of labor.

elasticity of supply

A measure of the response of quantity of a good supplied to a change in price of that good. Likely to be positive in output markets.

cross-price elasticity of demand

A measure of the response of the quantity of one good demanded to a change in the price of another good.

income elasticity of demand

A measure of the responsive- ness of quantity demanded to changes in income.

midpoint formula

A more percentages using the value precise way of calculating halfway between P, and P2 for the base in calculating the percentage change in price and the value halfway between Q and O, as the base for calculating the percentage change in quantity demanded.

Excise tax

A per unit tax on a specific good.

The Midpoint Formula

Although simple, the use of the initial values of P and Q as the bases for calculating percentage changes can be misleading. (return to the example of demand for steak in Figure 5.1(a),)

effect of price increase on a product with inelastic demand:

Because total revenue is the product of P and Q, whether TR rises or falls in response to a price increase depends on which is bigger: the percentage increase in price or the percentage decrease in quantity demanded. If the percentage decrease in quantity demanded is smaller than the percentage increase in price, total revenue will rise. This occurs when demand is inelastic, In this case, the percentage price rise simply outweighs the percentage quantity decline and PX Q = (TR) rises:

A FIGURE 5.3 Demand Curve for Lunch at the Office Dining Room

Between points A and B, demand is quite elastic at -6.33. Between points C and D, demand is quite inelastic at -.294.

> FIGURE 5.1 Slope Is Not a Useful Measure of Responsiveness

Changing the unit of measure from pounds to ounces changes the numerical value of the demand slope dramatically, but the behavior of buyers in the two diagrams is identical.

perfectly inelastic demand

Demand in which quantity demanded does not respond at all to a change in price.

perfectly elastic demand

Demand in which quantity drops to zero at the slightest increase in price.

inelastic demand

Demand that responds somewhat, but not a great deal, to changes in price. Inelastic demand always has a numerical value between zero and 1.

FIGURE 5.2 Perfectly Inelastic and Perfectly Elastic Demand Curves

Figure 5.2(b) shows a perfectly elastic demand Figure 5.2(a) shows a perfectly inelastic demand curve for insulin. Price elasticity of demand is zero. Quantity elastic demand implies that individual producers can sell all they want at the going market price but cannot curve facing a wheat farmer. A tiny price increase drives the quantity demanded to zero. In essence, perfectly charge a higher price.

A FIGURE 5.4 Point Elasticity Changes along a Demand Curve

Figure 5.4 shows the way in which elasticity changes along a linear demand curve. At the midpoint of the demand curve, elasticity is unitary (equal to -1). At higher prices, demand is elastic, and at lower prices, demand is inelastic. Again, it is useful to keep in mind the underlying economics as well as the mathematics. At high prices and low quantities, it is easy to make a big impact on the level of sales. At low prices, appreciably increasing restaurant volumes is much harder. For businesses, this is an important point to keep in mind.

effect of price increase on a product with elastic demand:

If, however, the percentage decline in quantity demanded following a price increase is larger than the percentage increase in price, total revenue will fall. This occurs when demand is elastic. The percentage price increase is outweighed by the percentage quantity decline:

calculate the percentage change in price

Once again, let us use the initial value of P-that is, P1-as the base for calculating the percentage. By using P1 as the base, the formula for calculating the percentage change in P is:

Elasticity Is a Ratio of Percentages

Once the changes in quantity demanded and price have been converted to percentages, calculating elasticity is a matter of simple division. Recall the formal definition of elasticity (see formula) - If demand is elastic, the ratio of percentage change in quantity demanded to percentage change in price will have an absolute value greater than 1. - If demand is inelastic, the ratio will have an absolute value between 0 and 1. - If the two percentages are equal, so that a given percentage change in price causes an equal percentage change in quantity demanded, elasticity is equal to an absolute value of 1.0; this is unitary elasticity.

Elasticity and Total Revenue

One of the useful features of elasticity is that knowing the value of price elasticity allows us to quickly see what happens to a firm's revenue as it raises and cuts its prices. When demand is inelastic, raising prices will raise revenues; when (as in the banana case) demand is elastic, price increases reduce revenues. In any market, PX Q is total revenue (TR) received by producers:

effect of price cut on a product with elastic demand:

The opposite is true for a price cut. When demand is elastic, a cut in price increases total revenue:

price elasticity of demand

The ratio of the percentage change in quantity demanded to the percentage change in price; measures the responsiveness of quantity demanded to changes in price.

Calculating Percentage Changes

To calculate percentage change in quantity demanded using the initial value as the base, the following formula is used:

effect of price cut on a product with inelastic demand:

When demand is inelastic, a cut in price reduces total revenue: Review the logic of these equations to make sure you thoroughly understand the reasoning.

effects of price changes on quantity demanded:

When price increases in a market, quantity demanded declines. As we have seen, when price (P) declines, quantity demanded (Qp) increases. This is true in all markets. The two factors, P and Qp, move in opposite directions: