Lecture 5 - Elasticity

Understanding Elasticity By Dr. Idris Djouahra Anyone who has studied economics knows the law of demand: - A higher price will lead to a lower quantity demanded. - What you may not know is how much lower the quantity demanded will be? - Similarly, the law of supply states that a higher price will lead to a higher quantity supplied. - The question is: How much higher? This lesson will explain how to answer these questions and why they are critically important in the real world. - To find answers to these questions, we need to understand the concept of elasticity. - Elasticity is an economics concept that measures responsiveness of one variable to changes in another variable. Definition: Elasticity is a fundamental concept in economics. It describes how changes in price affect the quantity demanded or supplied of a good or service. This presentation will explore the key principles of elasticity and its practical applications. Price Elasticity of Demand and Price Elasticity of Supply - Both the demand and supply curve show the relationship between price and the number of units demanded or supplied. - Price elasticity is the ratio between the percentage change in the quantity demanded (Qd) or supplied (Qs) and the corresponding percent change in price. - The price elasticity of demand is the percentage change in the quantity demanded of a good or service divided by the percentage change in the price. - The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price. We can divide elasticities into three broad categories: Elastic, inelastic, and unitary elastic. Because price and quantity demanded move in opposite directions, price elasticity of demand is always a negative number. Therefore, price elasticity of demand is usually reported as its absolute value, without a negative sign. The summary table is assuming absolute values for price elasticity of demand. An elastic demand or elastic supply is one in which the elasticity is greater than 1, indicating a high responsiveness to changes in price. Elasticities that are less than 1 indicate low responsiveness to price changes and correspond to inelastic demand or inelastic supply. Unitary elasticities indicate proportional responsiveness of either demand or supply. 1. Elastic Demand: Definition: Demand is considered elastic when a small change in price leads to a relatively large change in the quantity demanded. Example: Luxury goods, such as high-end electronics or designer clothes, often have elastic demand. A small price decrease can lead to a significant increase in quantity demanded. 2. Inelastic Demand: Definition: Demand is inelastic when changes in price have a relatively small effect on the quantity demanded. Example: Necessities, such as gasoline or basic food items, typically have inelastic demand. Even significant price increases do not drastically reduce the quantity demanded because consumers need these goods. 3. Unit Elastic Demand: Definition: Demand is unit elastic when the percentage change in quantity demanded is exactly equal to the percentage change in price. Example: If the price of a good increases by 10% and the quantity demanded decreases by 10%, the demand for that good is unit elastic. An example could be certain types of consumer goods where changes in price lead to proportional changes in demand. To calculate elasticity along a demand or supply curve economists use the average percent change in both quantity and price: Calculating Price Elasticity of Demand Let’s calculate the elasticity between points A and B and between points G and H . We calculate the price elasticity of demand as the percentage change in quantity divided by the percentage change in price. First, apply the formula to calculate the elasticity as price decreases from $70 at point B to $60 at point A: - Therefore, the elasticity of demand between these two points is 0.45. - An amount smaller than 1, showing that the demand is inelastic in this interval. This means that, along the demand curve between point B and A, if the price changes by 1%, the quantity demanded will change only by 0.45%. A change in the price will result in a smaller percentage change in the quantity demanded. For example: A 10% increase in the price will result in only a 4.5% decrease in quantity demanded. Or, A 10% decrease in the price will result in only a 4.5% increase in the quantity demanded. Price elasticities of demand are negative numbers indicating that the demand curve is downward sloping, but we read them as absolute values. Calculate the price elasticity of demand for an increase in price from G to H. Has the elasticity increased or decreased? - Therefore, the elasticity of demand from G to is H 1.47. - The elasticity has increased (in absolute value) as we moved up along the demand curve from points A to B. - Recall that the elasticity between these two points was 0.45. So, Demand was inelastic between points A and B and then becomes elastic between points G and H. - This shows us that price elasticity of demand changes at different points along a straight-line demand curve. Calculating the Price Elasticity of Supply Assume that an apartment rents for $650 per month and at that price the landlord rents 10,000 units. When the price increases to $700 per month, the landlord supplies 13,000 units into the market. By what percentage does apartment supply increase? What is the price sensitivity? Price Elasticity of Supply We calculate the price elasticity of supply as the percentage change in quantity divided by the percentage change in price Is the elasticity the slope? - It is a common mistake to confuse the slope of either the supply or demand curve with its elasticity. - The slope is the rate of change in units along the curve (change in y over the change in x). - For example, in previous Figure, at each point shown on the demand curve, price drops by $10 and the number of units demanded increases by 200 compared to the point to its left. - The slope is –10/200 along the entire demand curve and does not change. - The price elasticity, however, changes along the curve. Elasticity between points A and B was 0.45 and increased to 1.47 between points G and H. - Elasticity is the percentage change, which is a different calculation from the slope and has a different meaning. Elasticity in the Short vs. Long Run Short-Run Elasticity Implications In the short term, both demand and supply tend to be more inelastic. Consumers have fewer alternatives, and producers have less time to adjust their output. 1 The difference in elasticity between the short and long run has important implications for how markets respond to changes in price, cost, and other factors. 2 3 Long-Run Elasticity Over the long run, demand and supply become more elastic. Consumers have more options, and producers can make greater changes to their production capacity. Elasticity Beyond Goods and Services Labor Supply Savings The elasticity of labor supply describes The elasticity of savings measures how how the quantity of labor changes in the quantity of savings responds to response to changes in wages or changes in the rate of return. income. Other Applications The general concept of elasticity can be applied to many other economic behaviors, such as the demand for credit or the supply of natural resources. Importance of Elasticity Revenue Maximization Cost Pass-Through Market Reactions Elasticity determines whether Elasticity insights help predict Understanding elasticity helps producers can pass on cost how markets will respond to businesses set prices to increases to consumers. shifts in supply and demand. maximize revenue. Conclusion Elasticity Concept Measures the responsiveness of quantity demanded or supplied to changes in price. Elasticity Types Inelastic, elastic, or unitary, depending on the degree of responsiveness. Short vs. Long Run Elasticity tends to be more inelastic in the short run and more elastic in the long run. Practical Applications Elasticity insights inform pricing strategies, cost pass-through, and market predictions.