Elasticity and its Elasticity and its Application Application Suppose, you design websites for local businesses. You charge Rs.200,000 per website, and currently sell 12 websites per month. Your costs are rising (including the opportunity cost of your time), so you’re thinking of raising the price to Rs.250,000. The law of demand says that you won’t sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase?
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Elasticity and its ApplicationElasticity and its Application
Suppose, you design websites for local businesses.
You charge Rs.200,000 per website, and currently sell 12
websites per month.
Your costs are rising (including the opportunity cost of your
time), so you’re thinking of raising the price to
Rs.250,000.
The law of demand says that you won’t sell as many
websites if you raise your price. How many fewer
websites? How much will your revenue fall, or might it
increase?
Elasticity allows us to analyze supply and demand with greater precision.
It is a measure of how much buyers and sellers respond to changes in market conditions
Price Elasticity of Demand
Price elasticity of demand measures how much Qd responds to a change in P
Price elasticity of demand
=Percentage change in Qd
Percentage change in P
=
Price Elasticity of Demand
Elasticity and Slope
We can see that the elasticity is related to the slope (and the derivative) but is not quite the same as the slope of the demand curve.
While elasticity and slope are not the same thing, we can roughly correlate elastic demand with a shallow slope of the demand curve, and conversely.
Elasticity and Slope
The figure above shows an example of high elasticity: a small decline in price (about 20%) leads to a large increase in quantity (about 120%), so that elasticity would be about 6.
This figure shows an example of inelasticity: a large decrease in price (about 75%) leads to a small increase in quantity (about 25%), so that elasticity would be about 0.33.
The Price Elasticity of Demand and Its Determinants
Availability of Close Substitutes
Necessities versus Luxuries
Definition of the Market
Time Horizon
The Price Elasticity of Demand and Its Determinants
Demand tends to be more elastic :
the larger the number of close
substitutes.
if the good is a luxury.
the more narrowly defined the market.
the longer the time period.
Computing the Price Elasticity of Demand
The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.
P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed
P ercen tag e ch an g e in p rice
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as:
Computing the Price Elasticity of Demand
P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed
P ercen tag e ch an g e in p rice
The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities
The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.
P rice e las tic ity o f d em an d =( ) / [( ) / ]
( ) / [( ) / ]
Q Q Q QP P P P2 1 2 1
2 1 2 1
2
2
The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:
Computation of Price Elasticity
For a demand FunctionAt a point on a Demand CurveElasticity and Total Expenditure
The Variety of Demand Curves
Inelastic Demand Quantity demanded does not respond strongly
to price changes. Price elasticity of demand is less than one.
Elastic Demand Quantity demanded responds strongly to
changes in price. Price elasticity of demand is greater than one.
Computing the Price Elasticity of Demand
Demand is price elastic
$5
4Demand
Quantity1000 50
-3percent 22-percent 67
5.00)/2(4.005.00)-(4.00
50)/2(10050)-(100
ED
Price
The Variety of Demand Curves
Perfectly Inelastic Quantity demanded does not respond to price
changes. Perfectly Elastic
Quantity demanded changes infinitely with any change in price.
Unit Elastic Quantity demanded changes by the same
percentage as the price.
The Variety of Demand Curves
Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.
… leads to an Increase in total revenue from $100 to $240
Elasticity and Total Revenue along a Linear Demand Curve
With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.
Figure 4 How Total Revenue Changes When Price Changes: Elastic Demand
2. At exactly $4,producers willsupply any quantity.
1. At any priceabove $4, quantitysupplied is infinite.
Determinants of Elasticity of Supply
Ability of sellers to change the amount of the good they produce.
Beach-front land is inelastic. Books, cars, or manufactured goods are
elastic.
Time period. Supply is more elastic in the long run.
APPLICATION of ELASTICITY
Can good news for farming be bad news for farmers?
What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties?
THE APPLICATION OF SUPPLY, DEMAND, AND ELASTICITY Examine whether the supply or demand
curve shifts.
Determine the direction of the shift of the curve.
Use the supply-and-demand diagram to see how the market equilibrium changes.
Figure 8 An Increase in Supply in the Market for Wheat