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Elasticity and its Application

Elasticity and its Application. Elasticity measures the responsiveness of one variable to changes in another variable How much does Y (dependent variable) change if X changes by 1% (independent variable). Definition of Elasticity. Price elasticity of demand Price elasticity of supply

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Elasticity and its Application

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  1. Elasticity and its Application

  2. Elasticity measures the responsiveness of one variable to changes in another variable How much does Y (dependent variable) change if X changes by 1% (independent variable) Definition of Elasticity

  3. Price elasticity of demand Price elasticity of supply Income elasticity of demand Cross price elasticity of demand Examples

  4. Responsiveness of quantity demanded to a change in price The percentage change in quantity demanded, resulting from a 1% change in price PeD= %QD / %P Price Elasticity of Demand(PeD)

  5. Market supply and demand S2 S1 b The effect on price of a shift in supply depends on the responsiveness of demand to a change in price. P2 Price c P3 a D' P1 D Q1 Q2 Q3 O Quantity

  6. Availability of close substitutes Necessities versus luxuries Definition of the market Time horizon Determinants of PeD

  7. Measuring elasticity using the arc method m n P (£) Demand Q (000s)

  8. Measuring elasticity using the arc method m P = –2 7 n Q = 10 Mid P 15 Mid Q DQ DP Ped = ¸ mid Q mid P P (£) Demand Q (000s)

  9. Measuring elasticity using the arc method m P = –2 7 n Q = 10 Mid P 15 Mid Q DQ DP Ped = ¸ mid Q mid P 10-2 15 7 ¸ = P (£) Demand Q (000s)

  10. Measuring elasticity using the arc method m P = –2 7 n Q = 10 Mid P 15 Mid Q DQ DP Ped = ¸ mid Q mid P 10-2 15 7 ¸ = = - 2.33 P (£) Demand Q (000s)

  11. Total Consumer Expenditure / Firm’s total revenue TE (TR) = P x Q Applications to pricing decisions PeD &Consumer Expenditure

  12. Elasticity greater than 1 (PeD > 1) Effect of price change P rises: TE falls P falls: TE rises Elastic Demand

  13. Elastic demand between two points Expenditure rises as price falls Expenditure falls as price rises b 5 4 20 10 P(£) a D 0 Q (millions of units per period of time)

  14. Elasticity less than 1 (PeD < 1) Effects of a price change P rises: TE rises P falls: TE falls Inelastic Demand

  15. Inelastic demand between two points Expenditure rises as price rises Expenditure falls as price falls c 8 a 4 15 20 P(£) D 0 Q (millions of units per period of time)

  16. PeD = 0 (Perfectly Inelastic Demand) PeD =  (Perfectly Elastic Demand) PeD = 1 (Unit Elastic Demand) Special cases

  17. Perfectly inelastic demand (PÎD= 0) b P2 P D a P1 Q1 O Q

  18. Perfectly elastic demand (PÎD= ¥) b Q2 P a D P1 Q1 O Q

  19. Unit elastic demand (PÎD = 1) b 8 100 P Expenditure stays the same as price changes a 20 D 40 O Q

  20. Responsiveness of quantity supplied to a change in price The percentage change in quantity supplied, resulting from a 1% change in price PeS = %QS / %P Price Elasticity of Supply(PÎS)

  21. Price elasticity of supply P S1 P0 O Q Q0

  22. Price elasticity of supply P S1 S2 P1 P0 O Q1 Q2 Q Q0

  23. Responsiveness of demand to a change in consumer incomes The percentage change in quantity demanded, resulting from a 1% change in consumers income YeD= %QD / %Y Income elasticity ofdemand (YeD)

  24. Normal goods: Positive income elasticity If the income increases (decreases) the quantity demanded increases (decreases) Example: Clothing, wine Inferior goods: Negative income elasticity If the income increases (decreases) the quantity demanded decreases (increases) Example: public transport Income elasticity ofdemand (YeD)

  25. The responsiveness of demand for one good to a change in the price of another. The percentage change in quantity demanded of one good, resulting from a 1% change in price of another good. CeDab = %QDa / %Pb Cross-Price Elasticity ofDemand (CeDab)

  26. Substitutes: Positive cross-price elasticity If the price of good B increases the demand for good A increases Example: hamburgers & burritos Complements: Negative income elasticity If the price of good B increases the demand for good A decreases Example: crude oil & cars Cross-Price Elasticity ofDemand (CeDab)

  27. Managers Price elasticity of demand: Pricing strategy Cross-price elasticity of demand: Defining the company’s market, production plan Income elasticity: Forecast long-term demand Government policy Price elasticity of demand: Decision on tax rate Cross-price elasticity of demand: Competitive forces in a market (how a change in local prices impact the demand for export and import) Why are elasticity useful?

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