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Microeconomics

PGP-I

Session 5

Price Elasticity

Elasticity
Elasticity
--Measure
Measureof
ofthe
theresponsiveness
responsivenessof
ofquantity
quantity
demanded
demandedor
orquantity
quantity supplied
supplied
--To
Toaachange
changein
inone
oneof
ofits
itsdeterminants
determinants
Price
Priceelasticity
elasticityof
ofdemand
demand
How
Howmuch
muchthe
thequantity
quantitydemanded
demanded of
ofaagood
good
responds
respondsto
toaachange
changein
inthe
theprice
priceof
ofthat
thatgood
good

Price Elasticity
Price
Priceelasticity
elasticityof
ofdemand
demand
Percentage
Percentagechange
changein
inquantity
quantity demanded
demandeddivided
dividedby
by
the
thepercentage
percentagechange
changein
inprice
price
Elastic
Elasticdemand
demand
Quantity
Quantity demanded
demandedresponds
respondssubstantially
substantiallyto
to
changes
changesin
inprice
price
Inelastic
Inelasticdemand
demand
Quantity
Quantity demanded
demandedresponds
respondsonly
onlyslightly
slightlyto
to
changes
changesin
inprice
price
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Price Elasticity
Defined:

The Price Elasticity of Demand is the percentage


change in quantity demanded brought about by a
one-percent change in the price of the good.

Q,P
=( ) = ( )()
Q,P= ( ) = ( ) ( )

Price Elasticity

Elasticity is not slope !!


Slope
Slopeisisthe
theratio
ratioof
ofabsolute
absolutechanges
changesin
inquantity
quantity
and
andprice.
price. (=
(=Q/P).
Q/P).
Elasticity
Elasticityisisthe
theratio
ratioof
ofrelative
relative (or
(or percentage)
percentage)
changes
changesin
inquantity
quantityand
andprice.
price.

Price Elasticity

Key Characteristics:
When a one percent change in price leads to a greater than
one-percent change in quantity demanded, the demand curve
is elastic.
When a one-percent change in price leads to a less than
one-percent change in quantity demanded, the demand curve
is inelastic.
When a one-percent change in price leads to an exactly onepercent change in quantity demanded, the demand curve is
unit elastic.
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Elasticity Linear Demand Curve


Qd = a bP
Re-writing, we have:
P = a/b (1/b)Q

Where:
a and b are positive constants
P is price
b is the slope
a/b is the choke price(price at which
quantity demanded falls to zero)

Elasticity is:
Q,P = ( )( ) = b( )

Elasticity falls from 0 to - along the linear demand curve, but


slope is constant.
Example: Calculate elasticity when P = 30 and Qd = 400 10P
Answer: Q,P = -3 elastic
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Elasticity Linear Demand Curve


P

a/b

Q,P = -
Elastic region

a/2b

Q,P

= -1
Inelastic region
Q,P = 0

a/2

a
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Price Elasticity of Demand


Computing
the price elasticity of demand

Percentage change in quantity demanded divided by


percentage change in price
Use absolute value (drop the minus sign)
Midpoint method
Two points: (Q1, P1) and (Q2, P2)

Price Elasticity of Demand =

(b) Inelastic Demand: Elasticity Is


Less Than 1

(a) Perfectly Inelastic Demand:


Elasticity Equals 0

Price

Price
1. An
increase in
price

Demand

$5

$5

2. leaves
the quantity
demanded
unchanged
100

Quantity

2. leads
to an 11%
decrease in
quantity
demanded

1. A 22%
increase
in price

Demand

90 100

Quantity

The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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(c) Unit Elastic Demand: Elasticity Equals 1


Price
Demand

1. A 22%
increase
in price

$5
4
2. leads to a 22%
decrease in quantity
demanded
0

80

100

Quantity

The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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(e) Elastic demand:

(f) Perfectly Elastic Demand

Elasticity > 1

Elasticity = Infinity

Price

Price 1. At any price


above $4, quantity
demanded is zero

1. A 22%
increase
in price
$5
Demand

$4

2. leads to a
67% decrease in
quantity
demanded
0

50

100

Quantity

2. At exactly $4,
consumers will
buy any quantity
Demand

3. At a price
below $4, quantity
demanded is infinite
0

Quantity

The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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Price Elasticity
Value of
0

Demand Curve
Classification

Meaning

Perfectly Inelastic Quantity Demanded is


Demand
completely insensitive to Price

Between 0
and -1

Inelastic Demand

-1

Unitary Elastic
Demand

% change in Quantity
Demanded is equal to %
change in Price

Elastic Demand

Quantity Demanded is
relatively sensitive to Price

Relatively
Flatter

Perfectly Elastic
Demand

Any increase(decrease) in
Price results in Quantity
Demanded decreasing
(increasing)to zero(infinity)13

Horizontal

Between -1
and -
-

Quantity Demanded is
relatively insensitive to Price

Vertical

Relatively
Steeper
Mid-Point of
Linear Demand

Price Elasticity and Total Revenue

Total Revenue (TR) = PQ


P
Q
Demand is elastic
Fall in Q > Rise in P

TR falls

Demand is inelastic
Fall in Q < Rise in P

TR rises
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Determinants of price elasticity of demand


Availability of close substitutes
Goods with close substitutes more elastic demand
Necessities vs. luxuries
Necessities inelastic demand
Luxuries elastic demand
Time horizon
Demand is more elastic over longer time horizons

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Durable Goods
Defined:

The Durable Good is a good that


provides valuable services over a
long time (usually many years).
Demand for non-durables is less elastic in the
short run when consumers can only partially
adapt their behavior.
Demand for durables is more elastic in the
short run because consumers can delay
purchase.
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Income Elasticity
How much the quantity demanded of a good responds to a
change in consumers income
Percentage change in quantity demanded brought about by a
one-percent change in income.
Normal goods : Positive income elasticity
1. Necessities : Smaller income elasticity
2. Luxuries : Large income elasticity

Inferior goods: Negative income elasticities

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Cross-Price Elasticity
How much the quantity demanded of one good responds to a
change in the price of another good
Percentage change in quantity demanded of one good brought
about by a one-percent change in the price of the other good.
Substitutes
- Goods typically used in place of one another
- Positive cross-price elasticity
Complements
- Goods that are typically used together
- Negative cross-price elasticity
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Elasticity of Supply
How much the quantity supplied of one good responds to a
change in the price
Percentage change in quantity supplied brought about by a
one-percent change in the price.
Supply is perfectly inelastic
Price elasticity of supply = 0
Supply curve vertical
Supply is perfectly elastic
Price elasticity of supply = infinity
Supply curve horizontal
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Paradox of Public Policy

New hybrid of wheat increase production per acre


20%
Supply curve shifts to the right
Higher quantity; lower price
Demand inelastic
Total revenue falls
Paradox of public policy
Induce farmers not to plant crops
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Why Did OPEC Fail to Keep the Price of Oil High?

Increase in prices 1973-1974, 1971-1981


Short-run: supply and demand are inelastic
Decrease in supply: large increase in price
Long-run: supply and demand are elastic
Decrease in supply: small increase in price

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