Elasticity

• Introduction
• Types of elasticities
• Applications
 Introduction to Elasticity
• Elasticity is measure by taking the ratio of
percentage change in the dependent variable for
a percentage change in the independent variable
• Elasticity is a measure of the responsiveness of
quantity demanded or quantity supplied to one
of its determinants
• e= percentage change in the dependent variable
percentage change in the independent variable
• It is a unit free number
• Elastic versus inelastic conditions
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 Values and interpretations of elasticity
• Elastic if the percentage change in the
dependent variable exceeds the percentage
change in the independent variable .(e>1)
• Unitary elastic if the percentage change in the
dependent variable equals the percentage
change in the independent variable (e=1)
• Inelastic if the percentage change in the
dependent variable is less than the percentage
change in the independent variable.(0<e<1)

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• Perfectly Inelastic: any percentage
change in the independent variable do
not cause a change in the dependent
variable (e=0)
• Perfectly elastic: a very small percentage
change in the independent variable
leads to a very large change in the
dependent variable (e assumes infinity)
a) Price Elasticity of Demand (ep)
• Price elasticity of demand is a measure of the
extent to which the quantity demanded of a
good changes when the price of the good
changes.
• To determine the price elasticity of demand,
we compare the percentage change in the
quantity demanded with the percentage
change in price.
 Point vs arc price elasticity
• Point price elasticity is measured by taking final
and initial values of P and Q between two points
• Average price elasticity is measured by taking
the average values of P and Q between two
points
• Arc Elasticity measurement is used when
the change in price is relatively large.
• That is, it measures elasticity between
two points.
• It is an estimation of an average
elasticity of an arc
Arc price εp 
ΔQ P  P2 
X 1
elasticity ΔP Q1  Q 2 

Example
If price of good X rises from birr 3 to birr 5 and its quantity
demand falls from 240 units to 180 units. Calculate the arc
price elasticity of demand.
 Elastic and Inelastic Demand
• Demand is elastic if the percentage change in
the quantity demanded exceeds the
percentage change in price.
• Demand is unit elastic if the percentage change
in the quantity demanded equals the
percentage change in price.
• Demand is inelastic if the percentage change in
the quantity demanded is less than the
percentage change in price.
• Demand is perfectly elastic if the quantity
demanded changes by a very large
percentage in response to an almost zero
percentage change in price.
• Demand is perfectly inelastic if the quantity
demanded remains constant as the price
changes
 Example
• Suppose that a household demands 50 units
of oranges at the price 40 cents per piece.
If the price falls to the 30 cents per
piece, 100 oranges are demanded. What is
the elasticity of demand for Oranges?
 Elasticity Along a Linear Demand Curve
• Slope measures responsiveness. But slope
and elasticity are not the same thing
• Along a linear (straight-line) demand curve,
the slope is constant but the elasticity varies.
• Along a linear demand curve, demand is:
– Unit elastic at the midpoint of the curve.
– Elastic above the midpoint of the curve.
– Inelastic below the midpoint of the curve.
 c
• At any price Elasti
above the
midpoint, demand
is elastic. y elastic
U ni ta r
•At the midpoint,
demand is unit
e l a stic
In
elastic.
•At any price
below the
midpoint, demand
is inelastic.
 Determinants of Price Elasticity of Demand
• There are four factors that can influence price
elasticity of demand
– Availability of substitutes
– Nature of the good…luxury vs necessity
– Proportion of income spent
– Time period
• Availability of Substitutes
• The demand for a good is elastic if a substitute for
it is easy to find.
• The demand for a good is inelastic if a substitute
for it is hard to find.
 Luxury Versus Necessity
• A necessity has poor substitutes, so the
demand for a necessity is inelastic.
• Food is a necessity.
• A luxury has many substitutes, so the demand
for a luxury is elastic.
• Gold is an example
 Proportion of Income Spent and Time period

• The longer the time elapsed since the price change,

the more elastic is the demand for the good.
• A price rise, like a decrease in income, means
that people cannot afford to buy the same
quantities.
• The greater the proportion of income spent on a
good, the more elastic is the demand for the good.
Total Revenue and the Price Elasticity of Demand
• Total revenue is the amount spent on a good and
received by its sellers and equals the price of the
good multiplied by the quantity of the good sold.
• If demand is elastic:
– A given percentage rise in price brings a larger
percentage decrease in the quantity demanded
– Total revenue decreases.
• If demand is inelastic:
A given percentage rise in price brings a smaller
percentage decrease in the quantity demanded.
•Total revenue increases..
 Total revenue test
• Total revenue test is a method of estimating the
price elasticity of demand by observing the
change in total revenue that results from a
price change.
• If price and total revenue change in the
opposite directions, demand is elastic.
• If a price change leaves total revenue
unchanged, demand is unit elastic.
• If price and total revenue change in the same
direction, demand is inelastic.
 Addiction and Elasticity
• High taxes on cigarettes and alcohol limit the
number of young people who become
habitual users of these products.
• High taxes have only a modest effect on the
quantities consumed by established users.
 Price elasticity of supply
• Price elasticity of supply is a measure of the
extent to which the quantity supplied of a good
changes when the price of the good changes.
• To determine the price elasticity of supply, we
compare the percentage change in the quantity
supplied with the percentage change in price.
• It equals to the ratio of percentage change in
quantity supplied to percentage change in
quantity price
 Values

• If the price elasticity of supply is greater than

1, supply is elastic.
• If the price elasticity of supply equals 1,
supply is unit elastic.
• If the price elasticity of supply is less than 1,
supply is inelastic
• If the price elasticity of supply is zero, supply
is perfectly inelastic
• If the price elasticity of supply is infinite,
supply is perfectly elastic
 Elastic and Inelastic Supply
• Supply is elastic if the percentage change in
the quantity supplied exceeds the percentage
change in price.
• Supply is inelastic if the percentage change in
the quantity supplied is less than the
percentage change in price.
• Supply is unit elastic if the percentage change
in the quantity supplied equals the percentage
change in price.
• Supply is perfectly inelastic if the percentage
change in the quantity supplied is zero when
the price changes.
• Supply is perfectly elastic if an almost zero
percentage change in price brings a very large
percentage change in the quantity supplied.
Determinants of Price Elasticity of Supply
• The two main influences are:
– Production possibilities
– Storage possibilities
• Production Possibilities
– Goods that can be produced at a constant (or very
gently rising) opportunity cost have an elastic
supply.
– Goods that can be produced in only a fixed
quantity have a perfectly inelastic supply.
 Time period and storage facility
• As time passes after a price change, producers
find it easier to change their production plans,
so supply becomes more elastic.
• Storage Possibilities
– The supply of a storable good is highly elastic.
– The cost of storage is the main influence on the
elasticity of supply of a storable good.
 C) CROSS PRICE ELASTICITY
• Cross elasticity of demand is a measure of the
extent to which the demand for a good
changes when the price of a substitute or
complement changes, other things remaining
the same
• Cross elasticity of demand equals to the ratio
of percentage change in quantity demanded
of a good to percentage change in the price of
one of its substitutes or complements.
• Exy=ΔQx/Δpy*py/Qx
Exy > 0 Exy <0 Exy =0

Substitutes Complements Independent

• The cross elasticity of demand for a
substitute is positive.
• A fall in the price of a substitute of the good
brings a decrease in the quantity demanded of
the good.
• The quantity demanded of the good and the
price of its substitute change in the same
direction.
• The cross elasticity of demand for a
complement is negative.
• A fall in the price of a complement of the good
brings an increase in the quantity demanded
of the good.
• The quantity demanded of the good and the
price of one of its complements change in
opposite directions.
 Example
• Due to unknown reason the price of beef
meat increased from 260 birr per kilo to 380
birr per kilo.
• As a result of this change the quantity
demanded of chicken increase from 30
thousand per month to 50 thousand.
• Determine the cross price elasticity of
demand between beef and chicken and
interpret the result
• Determine the nature of their relationship?
 3. Income Elasticity of Demand
• Income elasticity of demand is a measure of
the extent to which the demand for a good
changes when income changes, other things
remaining the same.
• Income elasticity of demand equals to the
ratio of percentage change in quantity
demanded to percentage change in income
• It can be either positive or negative
• Income elasticity of demand is negative for
inferior goods
• Income elasticity of demand is positive for
normal goods