Lesson 5: Elasticity in Economics

Lesson 5: Elasticity in Economics Introduction to Elasticity ● Elasticity measures the responsiveness of quantity demanded/supplied to changes in price, income, or other factors. - Thus iIt helps economists and businesses understand how consumers and producers react to changes in the market. Price Elasticity of Demand (PED): measures the responsiveness of quantity demanded to changes in price. ● Formula: PED = (% Change in Quantity Demanded) / (% Change in Price) Interpretation: - - - If PED > 1, demand is elastic. This means that a change in price leads to a proportionately larger change in quantity demanded. If PED = 1, demand is unit elastic. This means that a change in price leads to a proportionate change in quantity demanded. If PED < 1, demand is inelastic. This means that a change in price leads to a proportionately smaller change in quantity demanded. Factors Affecting Price Elasticity of Demand ● Availability of Substitutes: The more substitutes available for a product, the more elastic the demand tends to be. e.g, if the price of one brand of cereal increases, consumers may switch to another brand with a lower price. ● ● Necessity vs. Luxury: Necessities tend to have inelastic demand because consumers need them regardless of price changes. Luxury goods, on the other hand, often have elastic demand because consumers can easily forego them if prices rise. Proportion of Income Spent: Goods that represent a large proportion of consumers' income tend to have more elastic demand. e.g, if the price of gasoline increases, consumers may reduce their quantity demanded because it represents a significant portion of their budget. Income Elasticity of Demand (YED): Income elasticity of demand (YED) measures the responsiveness of quantity demanded to changes in income. ● Formula: YED = (% Change in Quantity Demanded) / (% Change in Income) Interpretation: - If YED > 1, the good is considered a luxury. An increase in income leads to a proportionately larger increase in quantity demanded. If YED < 1, the good is considered a necessity. An increase in income leads to a proportionately smaller increase in quantity demanded. If YED = 1, the good is income-neutral. An increase in income leads to a proportionate change in quantity demanded. Cross-Price Elasticity of Demand (XED) ● ● Cross-price elasticity of demand (XED) measures the responsiveness of quantity demanded of one good to changes in the price of another good. Formula: XED = (% Change in Quantity Demanded of Good A) / (% Change in Price of Good B) Interpretation: - - - If XED > 0, the goods are substitutes. An increase in the price of one good leads to a proportionately larger increase in quantity demanded of the other. If XED < 0, goods are complements. An increase in the price of one good leads to a proportionately smaller increase in quantity demanded of the other. If XED = 0, goods are unrelated. A change in the price of one good has no effect on the quantity demanded of the other. Price Elasticity of Supply (PES): measures the responsiveness of quantity supplied to changes in price. ● Formula: PES = (% Change in Quantity Supplied) / (% Change in Price) Interpretation: - If PES > 1, supply is elastic. This means that a change in price leads to a proportionately larger change in quantity supplied. If PES = 1, supply is unit elastic. This means that a change in price leads to a proportionate change in quantity supplied. If PES < 1, supply is inelastic. This means that a change in price leads to a proportionately smaller change in quantity supplied. Applications of Elasticity ● Business Decision Making: Understanding elasticity helps businesses make pricing decisions. Hence if demand for a product is elastic, a decrease in price can lead to a significant increase in revenue. Government Policies: Policymakers use elasticity to design effective policies. - Iff the goal is to reduce smoking, increasing taxes on cigarettes can be more effective if demand for cigarettes is inelastic.