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ELASTICITY Chapter 9 – Mohr and Fourie Week 4 Today’s session Definition of Elasticity Different types of elasticity 1. Price elasticity of demand Calculating the price elasticity of demand (at a point => point elasticity) Elasticity Elasticity is a measure of responsiveness or sensitivity. How sensitive or responsive the dependent variable is to changes in the independent variable. Example – maize crop dependent of rainfall and ….. MAIZE CROP = DEPENDENT VARIABLE (BEING EXPLAINED) RAINFALL = INDEPENDENT (EXPLANATORY) VARIABLE How sensitive to is maize crop to changes in rainfall Elasticity Other examples – How responsive is investment spending to changes in the interest rate How responsive is governments tax revenue to changes in taxpayers’ income How responsive is the quantity of labour supplied to changes in the wage rate Elasticity The measure of such responsiveness is called elasticity. ELASTICITY is THE PERCENTAGE CHANGE IN THE DEPENDENT VARIABLE IF THE RELEVANT INDEPENDENT VARIABLE CHANGES BY ONE PER CENT. Elasticity Elasticity = % change in dep. var. % change in indep. var. E.g.’s DV= Maize crop, IV= Rainfall DV=Investment, IV= Interest Rate DV=Qd of Rice, IV= Price of Rice Elasticity We will look at different types of elasticity: - 1. Price elasticity of demand 2. Income elasticity of demand 3. Cross elasticity of demand 4. Price elasticity of supply 1. Price elasticity of demand % change in quantity demanded if the price of the product changes by one per cent, ceteris paribus. If quantity demanded = dependant variable & price = independent variable, -- how responsive is quantity demanded to changes in price. continued… 1. Price elasticity of demand Price elasticity of demand = % change in quantity demanded of a product % change in the price of the product continued… 1. Price elasticity of demand Example:- If the price of the product changes by 5%, and it results in a 10% change in the quantity demanded, ceteris paribus, the price elasticity of demand is 2. Product >> calculators Initial price = R100 Price increases by 5% => to R105 Quantity of calculators demanded per month was 1000 (at initial price of R100) After price increase => quantity of calculators demanded is 900 >>> a reduction of 10%. So price elasticity of demand for calculators is 2 % change in quantity demanded/ % change in price = -10/5 = -2 Elasticity Important – it uses percentage changes and not units, i.e. relative changes, not absolute. Absolute => price expressed in monetary terms (rands, pounds, euros), quantity expressed in term of physical units (kilos, boxes, bags). Price elasticity of demand is the ratio and this ratio is called the ELASTICITY COEFFICIENT Elasticity ELASTICITY COEFFICIENT shows how people react to changes in prices of different goods and services. Because it is in %, we can compare them to each other. Elasticity E.g. because we use % changes, we can compare how people react to price changes of meat, bread, petrol, cars, pens….etc. Would not be possible if used ‘absolute numbers’ e.g. a R1 change in price of these products would have very different effects on the quantity demanded. Can compare a 1% change in the price of the product. Elasticity E.g. look at two products Cars and bread If the price of cars and bread ↑ by R1, the effect on quantity demanded would be very different. Because the price of a car of approximately R100,000 is far greater compared to the price of a bread that is under R10. % change in car price would be <1%, % change in price of bread (R10 each) would be 10%. Today’s session Definition of Elasticity Different types of elasticity 1. Price elasticity of demand Calculating the price elasticity of demand (at a point => point elasticity) Calculating the price elasticity of demand Price elasticity of demand (ep) = % change in quantity demanded of a product % change in the price of the product ∆Q/Q x100 (can cancel out the 100s) ∆P/P x 100 = ∆Q/Q ∆P/P = ∆Q/ Q x P/∆P ep = ∆Q/∆P x P/Q (elasticity at a POINT) Calculating the price elasticity of demand Price elasticity of demand (ep) = % change in quantity demanded of a product % change in the price of the product ∆Q/Q x100 (can cancel out the 100s) ∆P/P x 100 Calculator example Initial price R100, after increase of 5% increase, R105 Initial Qd 1000 per week, after P increase, 900 per week Working out % change in Qd = ∆Q/Q = 100/1000 = 0.1 (0.1x100 = 10%) Calculating the price elasticity of demand Price elasticity of demand (ep) = % change in quantity demanded of a product % change in the price of the product ∆Q/Q x100 (can cancel out the 100s) ∆P/P x 100 Working out change in price Initial price R100, after increase of 5% increase, R105 ∆P/P =5/100 = 0.05 (0.05x100 = 5%) Calculating the price elasticity of demand Price elasticity of demand (ep) = % change in quantity demanded of a product % change in the price of the product ∆Q/Q x100 (can cancel out the 100s) ∆P/P x 100 = ∆Q/Q ∆P/P = ∆Q/ Q x P/∆P ep = ∆Q/∆P x P/Q (Derive this for yourself to check if you fully understand how we got to this final equation!) Continued… Calculating the price elasticity of demand The slope of the linear demand curve = ∆P/ ∆Q So the one part of the equation is ∆Q/ ∆P which is the inverse of the slope of the linear demand curve. Second part of the equation is P/Q which is the ratio of price to quantity at any point on the line (therefore the know as POINT ELASTICITY… ELASTICITY AT A POINT. Continued… Calculating the price elasticity of demand Since the ratio is different at any point on the demand curve, the price elasticity of demand will be different at any point on the curve, since the slope (or inverse of the slope) is constant. Today’s session Definition of Elasticity Different types of elasticity 1. Price elasticity of demand Calculating the price elasticity of demand (at a point => point elasticity)