ELASTICITY AND ITS

APPLICATION
Elasticity

 Elasticity is a tool that is used to describe the relationship between

two variables.
 Elasticity measure the responsiveness of quantity demanded or
quantity supplied to a change in one of its determinants.
 Elasticity varies among products because some products may be
more essential to the consumer.
Elasticity of Demand

 Demand is the willingness and ability of consumers to purchase a

given quantity of a good or service at various prices.
 When we calculate the elasticity of demand, we are measuring the
relative change in the total amount of goods or services that are
demanded by the market or by an individual. The quantity
demanded depends on several factors.
Elasticity of Demand

 The demand depends on several factors. We can calculate the

elasticity of demand according to each one of these inputs.
 If we calculate the elasticity of demand according to the price
of the good, we are calculating the price elasticity of demand.
 If we calculate the elasticity according to the price of other
goods, we are calculating the cross price elasticity of demand.
 If we calculate the elasticity of the demand according to the
income, we are calculating the income elasticity of demand.
 Price elasticity of demand
Percentage change in quatity demanded
=
Percentage change in price
Price Elasticity of Demand

A measure of how much Example: If the price of an ice cream

the quantity demanded cone increases from P2.00 to P2.20 and
of a good respond to a the amount you buy falls from 10 to 8
change in the price of cones then your elasticity of demand
that good, computed as
the percentage change would be calculated as:
in quantity demanded
divided by the (10 − 8)
percentage change in × 100 20 𝑝𝑒𝑟𝑐𝑒𝑛𝑡
10 = =2
price. Use absolute (2.20 − 2.00)
value (drop the minus
10 𝑝𝑒𝑟𝑐𝑒𝑛𝑡
× 100
sign) 2.00
 Price Elasticity of
(Q 2 − Q1 )/[(Q 2 + Q1 )/2]
Demand=
Price Elasticity of (P2 − P1 )/[(P2 + P1 )/2]
Demand
Example: If the price of an ice cream
cone increases from P2.00 to P2.20 and
The midpoint formula the amount you buy falls from 10 to 8
is preferable when cones the your elasticity of demand,
calculating the price using the midpoint formula, would be
elasticity of demand calculated as:
because it gives the
same answer (10 − 8)
(10 + 8)/2 22 𝑝𝑒𝑟𝑐𝑒𝑛𝑡
regardless of the = = 2.32
(2.20 − 2.00) 9.5 𝑝𝑒𝑟𝑐𝑒𝑛𝑡
direction of the (2.00 + 2.20)/2
change.
Classification of the Price Elasticity of Demand

 Inelastic Demand
Percentage change in price is greater than percentage change in
quantity demand.
Price elasticity of demand is less than one.

 Elastic Demand
Percentage change in quantity demand is greater than percentage
change in price.
Price elasticity of demand is greater than one.
  In the case of demand curve Da,
when the price changes from $5 to
Perfectly Inelastic $10, the quantity demanded does not
Demand respond at all and remains at 50.
 All such demand curves where
quantity demanded is totally
unresponsive to changes in price are
called perfectly inelastic demand
curves. Further, such demand curves
imply that when price increases, the
total revenue increases and vice-
versa.
 Elasticity is equals to 0
Relatively Inelastic  In the case of demand curve Da,
Demand when the price changes from $5 to
$10 (50%), the quantity demanded
decrease (28%).
 Demand curves which have an
elasticity coefficient between 0 and 1
are called relatively inelastic or simply
inelastic. When the price falls, the
quantity demanded expands but total
revenue still decreases.
 Elasticity is less than 1
  It occurs when consumer’s demand for a
Unitary Elastic product is proportionally related to the
Demand product’s price.

 Examples of unitary elastic demand

curves occur when a person budgets a
certain amount of money for, say, meat
or magazines and will not deviate from
that figure regardless of price.

 Elasticity is equals 1
Relatively Elastic  In the case of Db when price
Demand increases from $5 to $10 (50%), the
quantity demand decreases (67%).
 Such demand curves have an
elasticity coefficient above 1 and
have the property that when price
decreases total revenue increases
and vice-versa.
 Elasticity is greater than one
  When the price is $10, 50 units are being
sold and the total revenue is $500. When
the price falls to $5, the quantity
Perfectly Elastic
demanded increases infinitely and so
Demand does the total revenue. On the other
hand, when price rises above $10 the
quantity demanded falls to Zero and total
revenue also falls to zero.
 Such horizontal demand curves, where
quantity demanded is infinitely responsive
to price changes, are called perfectly
elastic demand curves. These perfectly
elastic demand curves have a property
that when price decreases total revenue
increases, and vice-versa.
 Elasticity equals infinity
Perfectly Elastic
Demand  Perfectly elastic demand is an extreme
example.
 So here are the examples of highly elastic
demand:
 luxury goods
 goods that take a large share of
individual’s income
 Good’s with many substitutes
Important factors that determines the
Elasticity of Demand
Income Elasticity

 Measure of how much the quantity demanded of a good responds

to a change in consumers’ income.

 A normal good is one where a percentage increase in income

ceteris paribus causes a percentage increase in quantity
demanded and vice-versa. It has positive income elasticity.
 An inferior good is one where a percentage increase in income
ceteris paribus, causes a percentage decrease in quantity
demanded and vice-versa. (e.g. cheap whisky, artificial jewelry,
imitation shoes) It has negative income elasticity.
Cross Price Elasticity

 Measure of how much the quantity demanded of one good responds to

a change in the price of another good.

 Complements: If the price of bread (Y) rose ceteris paribus, there would
be a decrease in the quantity demanded of bread (Y) and a decrease in
the quantity demanded of butter (X). Negative cross-price elasticity
 Substitutes: If the price of coffee rose ceteris paribus, there would be a
decrease in the quantity demanded of coffee and an increase in the
quantity demanded of tea as consumers would readily "substitute" tea for
coffee. Positive cross-price elasticity
Elasticity of Supply

 Supply is the specific quantity of output that the producers are

willing and able to make available to consumers at a particular
price over a given period of time.
 When we calculate the elasticity of supply, we are measuring the
relative change in the total amount of goods or services that one or
several firms supply. The quantity supplied depends on several
factors (price of the good or service, the cost of the input and the
technology of production).
 Price elasticity of supply
Percentage change in quantity supplied
=
Percentage change in price
Price Elasticity of Supply = ΔQs/Qs / ΔP/P

Measure of how much

the quantity supplied
of a good responds to
a change in the price
of that good
Factors determining elasticity of supply

 Spare production Capacity- high Pes when business or the economy has
plenty of spare capacity.
 Stocked of finished product and components: high level of stocks means
that supply can quickly be adjusted to meet changes in demand
 The ease and cost of factor substitution- if both capital and labor
resources are occupationally mobile the elasticity of supply for a product
tends to be high because capital and labor can be swapped with little
loss of efficiency and productivity.
 Time period involved in the production process-Pes is higher the longer the
time period that a firm is allowed to adjust its production levels.
Price Elasticity of Supply

 Curve: Vertical  Curve: Relatively Steep

 Seller’s Price: Sensitivity None  Seller’s Price Sensitivity: Relatively Low
 Elasticity is 0  Elasticity is < 1
Unit Elastic Supply

Supply of a commodity is
said to be unit elastic, if the
percentage change in
quantity supplied is equal
to the percentage change
in price.
Price Elasticity of Supply

 Curve: Relatively Flat  Curve: Horizontal

 Seller’s Price: Relatively High  Seller’s Price Sensitivity: Extreme
 Elasticity is > 1  Elasticity is ∞

Cross Price Elasticity of
Supply
The cross elasticity of supply
measures a proportional change
in the quantity supplied in relation
to the proportional change in the
price.
e12 = ΔQs1/Qs1 / ΔP2/P2
Where:
e12 : cross elasticity between
goods 1 and 2
ΔQs1 : change in quantity
supplied of good 1
ΔP2 : change in quantity supplied
of good 2
 Complements in Production: 2 goods are
complements in production when they are
simultaneously produced using the same resources.
For example: low fat milk and cream.
 The cross elasticity of complements in
production goods is positive: if the price of a
complement in production increases, the
supply of the other good increases. The
producer will assign more resources for the
production of both goods.
 Substitutes in Production: 2 goods are substitutes in
production when they use the same inputs, but the
inputs can be assigned to the production of a
good or another, not both simultaneously. For
example: corn and soybeans.
 The cross elasticity of substitutes in production
goods is negative: if the price of a substitute in
production increases, the supply of the other
good decreases. The supplier will move
resources from the production of a good to the
other one.