Topic 4 - Elasticity

Elasticity

Price Elasticity of Demand

Price Elasticity of Demand is a measure of the responsiveness of the quantity demanded of a good to changes in its price. It is the % change in quantity that results from a 1% change in price

Determinants of Price Elasticity of Demand

• Substitution Possibilities: Elasticity will be higher for products with close substitutes– Branded Salt
• Budget Share: Elasticity will be higher for items that take up a larger proportion of the budget
• Time: Elasticity will be higher over the long run, more time to adjust to price changes

Price Elasticity of Demand Along the Demand Curve

The elasticity of demand declines steadily as we move down the demand curve.

Exceptions to the Rule: 2 Special Cases

• Perfect Elastic Demand (E=∞) - slight increases in price lead to zero sales - Horizontal

• Perfect Inelastic Demand (E = 0) - Non Responsive to changes in price - Vertical

Elasticity And Total Expenditure

Will I get more sales (P×Q) with high quantity low price or high price low quantity?

• Depends on price elasticity of demand, Highest at the curve’s midpoint

E > 1, Price has an inverse relationship with revenue [responsive] E < 1, Price has a positive relationship with revenue [less responsive]

Income And Cross Price Elasticity

1. Income [E] - The % by which the quantity demanded of a good changes in response to a 1% change in income
   • Є > 0 - Normal Good
   • Є < 0 - Inferior Good
2. Cross Price [E] - the % by which the quantity demanded of a good changes in response to a 1% change in the price of a second good. E.g. if a 2% increase in Cashew prices = 5% increase in quantity demanded [Peanuts} cross price elasticity = 2.5
   • Є > 0 - Substitutes
   • Є < 0 - Complements

Price Elasticity of Supply

The % change in quantity supplied that occurs in response to a 1 % change in price. The elasticity of supply declines as quantity increases. If it passes through the origin price elasticity of supply = 1

• Perfect Elasticity - marginal costs are fixed, same inputs and price

• Perfectly Inelastic - supply is fixed and cannot be duplicated

Determinants of Price Elasticity of Supply

• Flexibility of Inputs: If additional inputs are relatively easy to attract, the price elasticity of supply is high.
• Mobility of Inputs: If inputs can be transported more easily, elasticity will be higher
• Ability to Produce Substitute Inputs: If a fixed quantity of inputs can be overcome (technology), elasticity higher
• Time: Elasticity will be higher in the long run – more time to build machinery etc.
• Spare Capacity