ECON1101 - Price Elasticity

Price Elasticity is a measure of how a quantity demanded of a good responds to a change in price of said good.

Calculating Elasticity

It's just the percentage change in quantity/percentage change in price.

(1)
\begin{align} \frac {\frac {∆Q}{Q}} {\frac {∆P}{P}} \end{align}

Midpoint Method:

(2)
\begin{align} \frac {\frac {∆Q}{Q_{mid}}} {\frac {∆P}{P_{mid}}} \end{align}

(where the midpoint is the middle of the original P/Q and the new P/Q)

Elasticity vs Inelasticity

A smoother (less steeper) slope is more price elastic, as with the same ∆P, it creates a bigger ∆Q

If price elasticity > 1, we call it elastic demand
If price elasticity == 1, we call it unit elastic demand
If price elasticity < 1, we call it inelastic demand

Determiners of Price Elasticity

• Substitution possibilities
• i.e. if there is no substitute, demand will stay pretty much the same regardless of price change
• Budget share
• i.e. if a holiday is just the leftover budget money, the likelihood of it being spent depends drastically on the price
• Time
• i.e. if a purchase will save you time, it is more likely to be made

Determiners of Supply Elasticity:

• Flexibility of inputs (how much choice do they have over what they use)
• Mobility of inputs
• Ability to produce substitute inputs
• Time (needed to manufacture things)

Perfect Elasticity/Inelasticity

Perfectly Elastic Demand

• Horizontal graph
• You can sell as many of your product as you like at that price

Perfectly Inelastic Supply:

• Vertical Graph
• You can sell your product for as much as you like, the quantity demand will not change.
• examples are vaccinations and medicines, essential items

Importance of Curve Position

Elasticity is not a constant thing over a graph, it changes depending on the point
(e.g. a change in price for a very small quantity demand may be a 50% quantity demand increase over a 10% price reduction, whereas a change in price for a very large quantity may be the opposite).
Demand is more elastic in the top half.

Marginal Revenue

If you decrease the price to attract new customers, you decrease the profit from all customers.

Hence there is a point where you’re losing money by decreasing the price.

Elastic Demand

Increasing the price (P↑) leads to a decrease in revenue (R↓)
Decreasing the price (P↓) leads to an increase in revenue (R↑)

Inelastic Demand

Increasing the price (P↑) leads to an increase in revenue (R↑)
Decreasing the price (P↓) leads to a decrease in revenue (R↓)

Cross Price Elasticity

The percentage by which quantity demand of a good changes in response to a 1 percent change in the price of the second good.
When cross price elasticity is positive, the 2 goods are substitutes (i.e. essentially equivalent).
When cross price elasticity is negative, the 2 goods are compliments (i.e. they are related but not equivalent).

Income Elasticity of Demand

Percentage change in quantity demand in response to a 1% change in income.
Normal goods have a positive income elasticity of demand, whereas inferior goods have a negative one.

page revision: 6, last edited: 22 Aug 2011 03:37