ECON 101 Introduction to Economics1 Session 6 The Concept of Elasticity I Lecturer: Mrs. Helen A. Seshie-Nasser, Department of Economics Contact Information: @ug.edu.gh College of Education School of Continuing and Distance Education 2014/2015 2016/2017
Session Overview When price and variables change, some goods experience a bigger change in quantity demanded than others. This session provides explanation to the extent of change in quantity when there is a change in price of goods and services (and change in other variables). Slide 2
Session Objectives At the end of the session, the student should be able to: Understand Own Price Elasticity of Demand and its measurements. Know how to measure own price elasticity using Point and Arc methods and the interpretation of the results. Understand elasticity along a straight line demand curve. Appreciate the relationship between Elasticity and Total Revenue. Enumerate and explain the determinants of elasticity. Understand Cross-price Elasticity of Demand and its interpretation Understand Income Elasticity of Demand and its interpretation Slide 3
Session Outline The key topics to be covered in the session are as follows: Demand Elasticity Price Elasticity of Demand Five Cases of Elasticity Computation of Price elasticity of demand Total Revenue and Price elasticity of demand Determinants of Price elasticity of demand Applications of Elasticity of demand Slide 4
Reading List Lipsey R. G. and K. A. Chrystal. (2007). Economics. 11 th Edition. Oxford University Press. Bade R. and M. Parkin. (2009). Foundations of Microeconomics. 4 th Edition. Boston: Pearson Education Inc., Begg. D. Fischer S. and R. Dornbusch. (2003). Economics. 7 th Edition. McGraw-Hill Slide 5
Demand Elasticity Elasticity of demand is the relationship between the Quantity demanded of a good on one hand, and the price of the good, the prices of related good and the income of the consumer on the other hand. In other words, it is the measure of the responsiveness of quantity demanded to changes in the price of a good and other economic conditions. Slide 6
Price Elasticity of Demand It is the measure of responsiveness of quantity demanded to the changes in the price of the good. It is the ratio of the percentage change in the quantity of a good demanded to a given percentage change in its price. Mathematically; Slide 7
Price Elasticity of Demand Interpretation Elasticity of Demand means quantity demanded will be twice any percentage change in price. The sign of price elasticity of demand will be negative because the demand curve is negatively sloped. In the interpretation, we can ignore the sign Slide 8
Five Cases of Elasticity Fairly elastic demand: When Demand is said to price elastic if a slight change in price brings about a more than proportionate change in quantity demanded. Quantity demanded responds strongly to changes in price. Price P 1 P 2 0 Q 1 Qty Q 2 DD Slide 9
Five Cases of Elasticity Unitary elastic: When Demand is unit elastic if a change in price brings about a proportionate change in quantity demanded P 1 P 2 D 0 Q 1 Q 2 Q 4 Slide 10
Five Cases of Elasticity Perfectly elastic: When If a negligible change in price results into an infinite change in quantity demanded, demand is said to be perfectly elastic. Price P DD 0 Slide 11 Qty
Five Cases of Elasticity Fairly inelastic demand: When Demand is inelastic if a change in price leads to a less than proportionate change in quantity demanded. Quantity demanded does not respond strongly to price changes. Price P 1 P 2 Q 1 Q 2 Slide 12 DD Q ty
Five Cases of Elasticity Perfectly inelastic demand: When If quantity demanded does not respond to change in price. The demand curve is parallel to the price line. Price P 2 P 1 Q 1 Qty Slide 13
Computing the Price Elasticity of Demand The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. Price elasticity of demand = Percentage change in quantity demanded Percentage change in price Slide 14
Computing the Price Elasticity of Demand Price elasticity of demand = Percentage change in quantity demanded Percentage change in price Example: If the price of an ice cream cone increases from Gh 2.00 to Gh 2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as: ( 10 8) 100 10 20% ( 2. 20 2. 00) 100 10% 2 2. 00 Slide 15
Arc Elasticity or the Midpoint Method The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change. Price elasticity of demand = ( Q2 Q1 ) / [( Q2 Q1 ) / 2 ] ( P P ) / [( P P ) / 2] 2 1 2 1 Slide 16
Computing the Price Elasticity of Demand Example: If the price of an ice cream cone increases from Gh 2.00 to Gh 2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as: ( 10 8) ( 10 8) / 2 ( 2. 20 2. 00) ( 2. 00 2. 20) / 2 22%. 9. 5% 2 32 P 1 A P 2 Slide 17 Price Q 1 Q 2 B DD Q ty
Point Elasticity Finding elasticity at a given point on the demand curve. Price P 1 A P 2 Q 1 Q 2 DD Q ty Slide 18
Problem Sets Example I When the price of taxi transportation increases from 0.75 to 1, the number of committers willing to take taxi declines from 150 to 100, calculate the price elasticity of demand at the initial point. Example II A change in the price of photocopies from 5p to 4p causes the quantity demanded to increase from 50 to 55. Calculate the price elasticity of demand at the new point. Question Using elasticity concept, explain why government does not reduce the price of fuel when world price falls? Slide 19
Elasticity along straight line downward sloping demand curve Elasticity is not constant along a straight line downward sloping demand curve. It increases as one moves up the demand curve. Price Quantity Slide 20
Total Revenue/spending and the Price Elasticity of Demand Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold. TR = P x Q Slide 21
Total Revenue Price 4 P P Q = 400 (revenue) Demand 0 100 Quantity Q Slide 22
Elasticity and Total Revenue along a Linear Demand Curve With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases. With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases. Slide 23
Figure 3: How Total Revenue Changes When Price Changes: Inelastic Demand Price An Increase in price from Ghc1 to Ghc3 Price leads to an Increase in total revenue from $100 to $240 3 Revenue = Ghc240 1 Revenue = 100 Demand Demand 0 100 Quantity 0 80 Quantity Slide 24
Figure 4: How Total Revenue Changes When Price Changes: Elastic Demand Price Price An Increase in price from Ghc4 to Ghc5 leads to an decrease in total revenue from Ghc200 to Ghc100 5 4 Demand Demand Revenue = ȼ200 Revenue = ȼ100 0 50 Quantity 0 20 Quantity Slide 25
Elasticity of a Linear Demand Curve Slide 26
Elasticity and Total Revenue The relationship between elasticity and total revenue is illustrated in the diagram. Revenue Total Revenue curve Qty On a straight line demand curve, the elastic region presents increasing total revenue with decreases in price. At the unit elastic region total revenue is constant with decreases in price while at the inelastic region total revenue declines. Slide 27
Elasticity and Total Revenue Therefore, a firm considering a price change and its effect on total revenue would be better off with a decrease in price if the demand for its product is elastic; and an increase in price if the demand for the product is inelastic. Slide 28
Determinants of Price Elasticity of Demand Availability of substitutes. Elasticity increases with availability of substitutes to a product. Availability of close substitutes may depend on the definition of the product and the time period under consideration. The more broadly defined the good, the fewer the substitutes and the more narrowly defined the good the greater the substitutes. Example: Food has no substitutes, but a type of food ( kenkey ) has close substitutes. We have Ga kenkey and Fante kenkey Car has train, bus, bicycle and walking as close substitutes. But Toyota has Ford, Chrysler, Benz, Honda, VW, Nissan.etc as close substitutes Slide 29
Application Question The Government is considering ways of increasing its tax revenue by increasing tax on jewellery or on cigarette. You are an economist and a consultant. Advise government on what to do and give reasons for your recommendations. Slide 30
Determinants of Price Elasticity of Demand 2. Proportion of income spent on the good. As the proportion increases elasticity increases, and vice versa. 2. Luxuries and necessities: demand for luxurious goods is elastic while necessities have inelastic demand. 3. Habit formation: The more a consumption of a product is out of habit, the more inelastic is the demand for it. Slide 31
Determinants of Price Elasticity of Demand 4. Time: As time passes, buyers have greater opportunities to be responsive to a price change. As time passes, one has more chances to change consumption by finding substitutes, changing lifestyle, etc. Example, increase in electricity tariff. As time passes, a household may replace a stove with a gas cooker, change bulbs to energy-saving ones, replace an old more powerconsuming fridge with a newer fridge, generally reduce the number of electric gadgets. Thus, in the short run elasticity is lower than in the long run Slide 32
Cross-Price Elasticity of Demand It is defined as the ratio of the percent change in demand for a good to a given percentage change in the price of another good. x and y are substitutes x and y are complements Slide 33
Income Elasticity of Demand Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income. Income elasticity of demand = Percentage change in quantity demanded Percentage change in income Slide 34
Computing Income Elasticity the commodity is a normal good the commodity is an inferior good Slide 35
Income Elasticity Types of Goods Normal Goods Inferior Goods Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. Slide 36
Income Elasticity Goods consumers regard as necessities tend to be income inelastic Examples include food, fuel, clothing, utilities, and medical services. Goods consumers regard as luxuries tend to be income elastic. Examples include sports cars, and expensive foods. Slide 37