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Understanding Elasticity: A Comprehensive Guide to Price Sensitivity and Demand

Dive into the concept of elasticity with this detailed overview that explains how responsiveness to price changes affects demand and supply. Learn about price elasticity of demand, income elasticity, and cross-price elasticity, along with their determinants. Discover how elasticity impacts total revenue and pricing strategies in various markets, from necessities to luxuries. This guide also covers the implications of taxation and case studies that illustrate the principles of elasticity in real-world scenarios.

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Understanding Elasticity: A Comprehensive Guide to Price Sensitivity and Demand

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Presentation Transcript

  1. Our Friend Elasticity Or, how I learned to love percentages

  2. Measuring Responsiveness or Sensitivity • Slope • Unit dependent • Currency • Quantities • No Starting Point • Percentages • Unit free • Relational

  3. Computing Elasticity • Price elasticity of demand = %change in quantity demanded/% change in price • Income elasticity of demand = %change in demand/% change in income • Cross-price elasticity of demand = %change in demand/% change in the price of a related good

  4. An Intuitive Approach to Elasticity • Since price elasticity is always zero (law of demand) we ignore the negative sign and take the absolute value of price elasticity. • Ep > 1 Responsive or elastic • %ΔQd > %ΔP a small %ΔP creates a large %ΔQd • Ep < 1 Not responsive or inelastic • %ΔQd < %ΔP a large %ΔP creates a small %ΔQd • Ep = 1 unit elastic • %ΔQd = %ΔP a given %ΔP creates an equal %ΔQd

  5. So????Price and Total RevenueTR= P X Q • Ep > 1 Responsive or elastic • %ΔQd > %ΔP if P goes down (up) total revenue goes up (down) • Ep < 1 Not responsive or inelastic • %ΔQd < %ΔP if P goes down (up) total revenue goes down (up) • Ep = 1 unit elastic • %ΔQd = %ΔP if P goes down (up) total revenue stays the same

  6. Determinantsof Price Elasticity • Availability of close substitutes • Necessity versus luxury • Definition of the market • Time horizon • Percentage of consumer budget

  7. Price Elasticity – Using Numbers Ep = %ΔQd/ %ΔP = (Q2- Q1)/[(Q2+ Q1)/2] (P2- P1)/[(P2+ P1)/2]

  8. Calculating Price Elasticitymputing the Price Elasticity of Demand Price $5 4 Demand Quantity 0 50 100 Demand is price elastic

  9. Linear Demand Curve:Elasticity

  10. Elasticity of Other Demand Curves • Perfectly Elastic • Perfectly Inelastic • Unit Elastic

  11. Elasticity of Supply • Price elasticity of supply = %change in quantity supplied/% change in price Es = %ΔQs/ %ΔP = (Q2- Q1)/[(Q2+ Q1)/2] (P2- P1)/[(P2+ P1)/2] • Perfectly elastic and inelastic supply and unit elastic (crossing the P or Q axis) • Supply curves where elasticity varies

  12. Determinants of elasticity of supply • Ability to increase or decrease production (e.g Ellensburg agates, farm crops, automobiles) • Time period

  13. Applications of Elasticity • Farmers : fallacy of composition and good crop/bad revenue years • The economics of addictive drugs • Pricing decisions and your future business

  14. Government and Markets • Price Controls • Price Ceilings (e.g. rent control) • Price Floors (e.g. water) • Taxes • Who appears to pay the tax? • Buyers “pay” tax • Sellers “pay” tax • Who really pays the tax? Tax incidence and burden

  15. Case study – The payroll tax: Federal Insurance Contribution Act (FICA) for Social Security and Medicare

  16. Elasticity and Tax Incidence • Intuitive approach: • If the buyers can respond relatively more to price changes more than suppliers, suppliers pay more of the tax. • If the suppliers can respond relatively more than the buyers, then the buyers pay more of the tax.

  17. Extreme examples: • Perfectly elastic demand • Perfectly elastic supply • Perfectly inelastic demand • Perfectly inelastic supply • Less extreme examples (e.g. the luxury tax)

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