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Elasticity Elasticity is a general concept that can be used to quantify the response in one variable when another variable changes. % A elasticity of A with respect to B % B Price Elasticity of Demand A popular measure of elasticity is price elasticity of demand measures how responsive consumers are to changes in the price of a product. % change in quantity demanded price elasticity of demand % change in price • The value of demand elasticity is always negative, but it is stated in absolute terms. Types of Elasticity Hypothetical Demand Elasticities for Four Products % % CHANGE IN CHANGE QUANTITY ELASTICITY IN PRICE PRODUCT DEMANDED (%QD) (%QD d %P) (%P) Insulin +10% 0% 0.0 Perfectly inelastic Basic telephone +10% -1% -0.1 Inelastic service Beef +10% -10% -1.0 Unitarily elastic Bananas +10% -30% -3.0 Elastic • When the percentage change in quantity demanded is smaller than the percentage change in price, demand for that product is inelastic. • When the percentage change in quantity demanded is larger than the percentage change in price, demand for that product is elastic. Perfectly Elastic and Perfectly Inelastic Demand Curves When demand does not Demand is perfectly elastic when respond at all to a change in quantity demanded drops to zero price, demand is perfectly at the slightest increase in price. inelastic. Calculating Elasticities Calculating percentage changes: P2 P % change in price 1 x 100% P1 Q2 Q1 % change in quantity demanded x 100% Q1 Calculating Elasticities Elasticityis a ratio of percentages. • Using the values on the graph to compute elasticity, using percentage changes yields the following result: 100% price elasticity of demand 3.0 33.3% Calculating Elasticities A more accurate way of computing elasticity than percentage changes is the midpoint formula: Q2 Q1 x 100% % Qd (Q1 Q2 ) / 2 % P P2 P1 x 100% ( P P2 ) / 2 1 10 5 5 x 100% x 100% % Qd (5 10) / 2 7.5 66.7% = 167 . % P 2 3 -1 -40.0% x 100% x 100% ( 3 2) / 2 2.5 Calculating Elasticities Here is how to interpret two different values of elasticity: When e = 0.2, a 10% increase in price leads to a 2% decrease in quantity demanded. When e = 2.0, a 10% increase in price leads to a 20% decrease in quantity demanded. Elasticity and Total Revenue TR P Q Effect of an increase in Effect of a Type of Change in quantity price on decrease in deman Value of versus change in total price on total d Ed price revenue revenue Elastic Greater than Larger percentage Total revenue Total revenue 1.0 change in quantity decreases increases Inelastic Less than Smaller percentage Total revenue Total revenue 1.0 change in quantity increases decreases Unitary Equal to 1.0 Same percentage Total revenue Total revenue does total revenues are elastic When demand is inelastic, price anddoes not change in quantity and not change directly related.price change Price increases generate higher revenues. When demand is elastic, price and total revenues are indirectly related. Price increases generate lower revenues. Other Important Elasticities Income elasticity of demand – measures the responsiveness of demand to changes in income. % change in quantity demanded income elasticity of demand % change in income • Income elasticity of demand is positive for normal goods and negative for inferior goods. Other Important Elasticities Cross-price elasticity of demand: A measure of the response of the quantity of one good demanded to a change in the price of another good. % change in quantity of Y demanded cross - price elasticity of demand % change in price of X • Cross-price elasticity of demand is positive for substitutes and negative for complements. Other Important Elasticities Elasticity of supply: A measure of the response of quantity of a good supplied to a change in price of that good. Likely to be positive in output markets. % change in quantity supplied elasticity of supply % change in price