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Chapter 4: Concept of Elasticity

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Mags Apatan

on 21 January 2013

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Transcript of Chapter 4: Concept of Elasticity

Chapter 4:
Concept of Elasticity What is Elasticity? DEMAND ELASTICITY SUPPLY ELASTICITY IMPORTANCE AND APPLICATION OF ELASTICITY Elasticity can be applied to demand in order to measure its responsiveness to the changes on its selected determinants. The concept of Elasticity has several applications both in business and economic decision making. Elasticity measures the percentage change in one variable in relation to the percentage change in another variable. Basic formula to determine Elasticity Elasticity = percentage change in variable x percentage change in variable y Using Mathematical Symbols ε Where: = Greek letter Epsilon, used as a symbol for elasticity. = Greek letter Delta, which means 'change'. % = percentage x = independent variable y = dependent variable PRICE ELASTICITY OF DEMAND The price elasticity of demand measures the responsiveness of the quantity demanded with respect to its price. Basic formula to calculate the coefficient of Price Elasticity Demand Price Elasticity of Demand = Percentage Change in Quantity Demanded Percentage Change in Price Mathematically It is the percentage change in quantity demanded that occurs with respect to a percentage change in price. OR E D = % Q % P Q P Q P OR Q 1 - Q 2 Q 1 P 1 P 2 P 1 - OR Q 1 Q 2 P 1 P 2 - - x P 1 Q 1 It is expected that the price elasticity of demand is negative because the relationship between the price and quantity is inversely related. However, it is the absolute value and the negative sign is omitted. EXAMPLE OF PRICE ELASTICITY
OF DEMAND POINT ELASTICITY Used when measuring a very small change in both the price and quantity on a demand curve on a particular point. Q Q P P 1 1 2 2 P Q A B Q d Graphical Interpretation ARC ELASTICITY It measures the elasticity at the midpoint between two points on a curve. Formula: E D = Q 1 Q 2 Q 1 P 1 P 2 P 1 - Formula: E ARC = - Q 1 Q 2 - P 1 P 2 - x 1 P 2 P + ( ) 2 1 Q 2 Q + 2 Q Q P P 1 1 2 2 Q Graphical Interpretation DEGREE OF PRICE ELASTICITY DEMAND Values of price elasticity of demand ranges from zero to infinity. 1. Elastic Demand Demand is price elastic when the elasticity coefficient is GREATER THAN ONE. E D > 1 2. Inelastic Demand Demand is price inelastic when the elasticity coefficient is LESS THAN ONE. E D < 1 Demand is unitary elastic when the elasticity coefficient is EQUAL TO ONE. E D = 1 1. Perfectly Elastic Demand Demand is perfectly elastic when demand is totally responsive to changes in price. E D = EXTREME CASES OF PRICE ELASTICITY 3. Unitary Elastic Demand 2.Perfectly Inelastic Demand Demand is perfectly inelastic when quantity demanded totally does not respond to any changes in price. E D = 0 DETERMINANTS OF PRICE ELASTICITY DEMAND The importance or degree of necessity of the goods. The more essential or necessary the goods are services, the more inelastic the demand. On the other hand, goods and services that are not very important tend to have an elastic demand. Number of available substitutes. Demands for goods with greater number of substitutes are elastic, while goods with less or no substitute have inelastic demand. The proportion of income in price changes. Demand is inelastic for a product whose changes in price seemingly have no effect on the consumer income or budget. The time period. The longer the time period is, the less elastic or more inelastic the demand will be. EFFECT ON TOTAL REVENUE Price Effect This refers to an increase in price that will result to positive effect revenue, and vice versa. Quantity Effect This pertains to an increase in price that will lead to less quantity sold, and vice versa. ELASTICITY OF LINEAR DEMAND CURVE Relationship between the price elasticity of demand and the total revenue. If the price elasticity of demand for a commodity is ELASTIC (e > 1), a price increase will make the total revenue fall, and vice versa. If the price elasticity of demand for a good is INELASTIC (e < 1), a price increase will give rise to total revenue, and vice versa. If the price elasticity of demand for a good is UNITARY ELASTIC (e = 1), a change in price will not affect total revenue. If the price elasticity of demand for a good is PERFECTLY ELASTIC (e > ), a raise in price creates a zero total revenue. If the price elasticity of demand for a good is PERFECTLY INELASTIC (e = 0), raising prices will cause total revenue to increase. Q 1 Q 2 Q - 1 + Q 2 E D = 2 P 1 P 2 P 1 - + P 2 2 The slope of the curve and elasticity of the curve are different. The SLOPE OF THE CURVE depends upon the absolute change in price and quantity while the ELASTICITY OF THE CURVE depends upon the percentage change in quantity. Mathematically: Slope = Q d P WHILE Elasticity of demand = % % Q P INCOME ELASTICITY OF DEMAND The responsiveness of quantity demanded in response to a change in income. Income elasticity of demand measures the percentage change in demand over the percentage change in income. FORMULA FOR INCOME ELASTICITY DEMAND Income Elasticity of Demand = Percentage Change in Quantity Demanded Percentage Change in Income E Y = % Q d % Y OR E Y = Y Q d x Y Q d Where: Y = income E = elasticity % = percentage = Greek letter Delta, which means 'change'. Q = quantity demanded It can be considered that as income rises, more goods and services will be demanded. But this is not always true. GOODS Normal Good Inferior Good When income elasticity is POSITIVE. When income elasticity is negative. Indicates positive (+) sign or E > 0. As income increases, more goods and services will be demanded. Indicates negative (-) sign or E < 0. As income rises, quantity demanded for such goods, decline. Luxury Goods Necessity Goods Normal goods with an income elasticity coefficient greater than 1 (E > 1). Normal goods with an income elasticity of less than one (E < 1), yet still manifest a positive result. CROSS PRICE ELASTICITY OF DEMAND Measures the responsiveness of quantity demanded of a good to a change in the price of another good. It simply measures whether the good is a SUBSTITUTE or COMPLEMENTARY. Substitute Goods Complementary Goods Goods that can be used in place of another, such that, an increase of price of one good tends to increase the quantity demanded of its substitute. Goods that are used in conjunction with other goods. FORMULA Cross Price Elasticity of Demand = Percentage Change in Quantity Demanded of Good X Percentage Change in Price of Good Y E XY = % % Q P d Y X PRICE ELASTICITY OF SUPPLY It measures the responsiveness of quantity supplied in response to a percentage change in the price of the goods. FORMULA Price Elasticity of Supply = Percentage Change in Quantity Supply Percentage Change in Price E S = % % Q P S Q S1 Q S2 Q S1 + Q S2 2 P 1 P 2 P 1 - + P 2 2 - DEGREE OF PRICE ELASTICITY OF SUPPLY 1. Elastic Supply A change in price leads to a greater change in quantity supplied. 2. Inelastic Supply A change in price leads to a lesser change in quantity supplied. 3. Unitary Elastic Supply A change in price leads to an equal change in quantity supplied. EXTREME CASES OF PRICE ELASTICITY OF SUPPLY 1. Perfectly Elastic Supply This occurs when there is no change in price, and there is an infinite change in quantity supplied. It can determine the effect of price changes on the revenue. With the knowledge about Elasticity, producers can assess consumers' responsiveness with respect to any change in the price of commodity. 2. Perfectly Inelastic Supply This happens when a change in price has no effect on quantity supplied. DETERMINANTS OF PRICE ELASTICITY OF SUPPLY *The primary determinant of price elasticity of supply is, the TIME PERIOD involved. The time period of supply according to Alfred Marshall: Monetary or Intermediate In this period, supply will be perfectly inelastic and the supply is fixed. Short-run Long-run In this state, supply is inelastic. The output of production can increase even if equipment is fixed. In this period, supply is elastic. New firms are expected to enter or the old one may leave the industry.
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