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INBA6153: Microeconomics for

Management Decision Making

Lecture 5: Elasticity

Readings: Sloman et al Ch 5. Gillespie Chs 4,6,7; Tucker Ch


5, or Lipsey & Chrystal 10th Ed Chs 8 and 4.

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Price Elasticity of Demand: Definition

•  Price elasticity of demand measures the


responsiveness of quantity demanded to changes
in price.

•  The general idea:

–  If a small change in price leads to a big change in


quantity demanded, we say that demand is elastic.

–  If a small change in price leads to a small change in


quantity demanded, we say that demand is inelastic.

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Price Elasticity of Demand: Definition

•  Price elasticity of demand measures the


responsiveness of quantity demanded to changes
in price.
η = Δ% Q / Δ%P
•  Price elasticity of demand is defined as the
percentage change in quantity demanded divided
by the percentage change in price that brought it
about.
•  Sign is usually –ve since ΔQ and ΔP usually
move in opposite directions.
•  Interpretation: high absolute η  large response
of QHenry
to ΔP.
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Calculation of Two Demand Elasticities

Original New % change Elasticity


Good A

Quantity 100 95 -5% -5/10 = - 0.5


Price $1 $1.10 10%

Good B
Quantity
200 140 -30% -30/20 = - 1.5
Price
$5 $6 20%

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Demand Elasticity Examples

Good A: Price increases from $10 to $11 and quantity falls


from 100 to 90 units. What is η ?
η = Δ% Q / Δ%P -10% / 10% = -1.0

Good B: = η -3.0, price falls by 20% and the original quantity


was 100. What is the new quantity?
η = Δ% Q / Δ%P
-3.0 = Δ% Q / -20%
Δ% Q = -3.0 x -20% = 60%, New Q = 100+60= 160.

Good C: After a major police bust, the price of cocaine doubles,


and the amount sold falls by a quarter. What is η ?
η = Δ% Q / Δ%P
= -25% / 100% = -0.25

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Demand Elasticity Examples

•  Low Elasticity
–  Kitchen salt -0.1
–  Cigarettes -0.3 (see article in Tucker P132)
–  US Airfares 1st Class -0.3
–  Oil (W/W) -0.4

•  Approx. Unitary
–  Cinema show -1.0
–  All wine (USA) -1.0
–  Soft drinks -1.0

•  High Elasticity
–  Chevrolet cars -4.0
–  Tomatoes -4.5
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Elasticity varies along a Linear Demand Curve


∞>η>1
Price

1>η>0

0
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Quantity
Three Constant-elasticity Demand Curves

D1
Price

Quantity Price

p0 D2
D0

Quantity

Price
Quantity
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Elasticity and Total Spending
η = Δ% Q / Δ%P

If demand is elastic, then Δ% Q > Δ%P , so:


•  for a small decrease in P, total spending rises.
•  for a small increase in P, total spending falls.
A
Example: B

η = -4

Price
P1 = $10 and P2 = $8.
Δ%P = -20%
Q1= 50 and Q2 = 90.
Δ%Q = 80%. What is the change in TR ?
Quantity
TR1 = P1.Q1 = $10 x 50 = $500
TR2 = P2Henry
.Q2 Bailey
= $ 8 x 90 = $720 9
Elasticity and Total Spending
η = Δ% Q / Δ%P

If demand is inelastic, then Δ% Q < Δ%P , so:


•  for a small decrease in P, total spending falls.
•  for a small increase in P, total spending rises.

Example:
η = -0.4
P1 = $10 and P2 = $12.
Δ%P = 20%

Price
Q1= 50 and Q2 = 46.
Δ%Q = -8%. What is the change in TR ? B
A
TR1 = P1.Q1 = $10 x 50 = $500
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TR2 = P2.Q2 = $12 x 46 = $552. Quantity
Elasticity and Total Spending
η = Δ% Q / Δ%P

If demand elasticity is unitary, then Δ% Q = Δ%P , so:


•  for a small change in P, total spending stays the same.

D
Price

Henry Bailey 0 q 11
Quantity
Elasticity and Indirect Tax
Incidence
Price
S2

S1

P2
Consumer
P1
Producer

O Q2 Q1 Quantity Per Period


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Elasticity and Indirect Tax
Incidence
Price
S2

S1

P2
Consumer
P1
Producer
D

O Q2 Q1 Quantity Per Period


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Elasticity and Indirect Tax
Incidence
Price
S2

S1
P2

Consumer
P1 Producer

O Q2 Q1 Quantity Per Period


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Elasticity and Indirect Tax Incidence

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Factors Affecting Price Elasticity of Demand

•  Availability of Substitutes
•  Definition of commodity:
–  Mars Bar candy bars  confectionaries  food
•  Habit forming commodities
•  Durability
•  Number of uses of commodity
–  Generally more uses  higher elasticity
•  Proportion of income spent on commodity
–  Raises the need to respond to price changes
•  Time

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Discussion
•  How would knowledge of η help with
business decisions?

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Income Elasticity of Demand

ηY = Δ% Q / Δ%Y
Quantity

0 Henry Bailey 18
Income
Income Elasticity of Demand

•  If ηY >1 the good is said to be income elastic and a given %


change in Y leads to a greater % change in quantity
demanded. I.e. Δ%Q > Δ%Y.

•  If ηY <1 the good is said to be income inelastic and a given %


change in Y leads to a smaller % change in quantity
demanded. I.e. Δ%Q < Δ%Y.

•  ηY is +ve for normal goods and –ve for Inferior goods.

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Income Elasticity of Demand

qm

Positive income elasticity


Quantity

Zero income
elasticity Negative income elasticity
[inferior good]

0 y1 y2
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Income Elasticity of Demand

•  Normal goods have positive income elasticities.


•  Inferior goods have negative elasticities.
•  Nothing is demanded at income less than y1, so for
incomes below y1 income elasticity is zero.
•  Between incomes of y1 and y2 quantity demanded
rises as income rises, making income elasticity
positive.
•  As income rises above y2, quantity demanded falls
from its peak at qm, making income elasticity negative.

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Price Elasticity of Supply

εs = Δ%Qs / Δ%P

•  If εs >1 supply is said to be elastic and a given % change in


P leads to a greater % change in quantity supplied. I.e.
Δ%Q > Δ%P.

•  If εs <1 supply is said to be inelastic and a given % change


in P leads to a smaller % change in quantity supplied. I.e.
Δ%Q < Δ%P.

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Three Constant-elasticity Supply Curves
S1

Price
Price

p1 S2

Quantity
q1 Quantity [ii]. Infinite Elasticity

[i]. Zero Elasticity


S4
S3
Price

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[iii]. Unitary Elasticity
Factors Affecting εs
•  Diversion
•  Ability of firms to divert Q to high P markets.
•  Asset specificity
•  Ability of firms to switch production towards good
for which price has increased.
•  Gross margin
•  If ΔC is expected to exceed ΔTR, then S will be
expected to be less elastic. S 1

•  Time S2

Price
S3

D2

D1
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q1
Quantity
CROSS ELASTICITY OF DEMAND
•  Cross-elasticity is the percentage change in quantity
demanded divided by the percentage change in the price
of some other product that brought it about.
•  ηAB = Δ%QA / Δ%PB

•  Goods that are substitutes for one another have positive


cross-elasticities: If PA rises then quantity of B demanded
rises.

•  Goods that are complements for one another have


negative cross-elasticities: If PA rises then quantity of B
demanded falls.
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