Elasticity and Its Determinants Highlighted Sections An Important Note Before You Begin with Elasticity Price Elasticity of Demand and Its Determinants Total Revenue and Price Elasticity of Demand Income Elasticity of Demand Price Elasticity of Supply and Its Determinants An Important Note Before You Begin with Elasticity - (Back to Top) Please Read this Carefully   Open your textbook to chapter 5. First find the section called "Computing the Price Elasticity of Demand". Second find the section (on the next page) "FYI: Calculating Elasticity Using the Midpoint Method". Read both of these sections NOW.   What you'll quickly notice is that there are two ways to calculate price elasticity of demand. In creating the java applets for this chapter, your CD author was confronted with EXACTLY the problem described in "FYI: Calculating Elasticity Using the Midpoint Method" - the problem is that only the midpoint method will give you the same percentage change moving from $6 to $4 as from $4 to $6 (the book gives you the exact calculations).   This "NOTE" is included to point out to you that ALL examples, problems and java applets in this CD use the midpoint method to calculate elasticity. Figure 5-1 in your textbook ALSO uses the midpoint method as well.   PLEASE ask YOUR Professor which formula YOU should use in YOUR course (the one in the section "Computing the Price Elasticity of Demand" or the one in "FYI: Calculating Elasticity Using the Midpoint Method").   These two methods will give SLIGHTLY different answers, so please be careful. Price Elasticity of Demand and Its Determinants - (Back to Top) Price Elasticity of Demand is defined as: Whenever the absolute value of price elasticity of demand is: greater than 1, economists say that demand is elastic. This means that a change in the price of the product causes a large change in the quantity demanded for the product. equal to 1, economists say that demand is unit elastic. This means that a change in the price of the product causes an equally large (in percentage terms) change in the quantity demanded for the product. less than 1, economists say that demand is inelastic. This means that a change in the price of the product causes a small change in the quantity demanded for the product. *****It is important for students to understand why elasticity is such an important concept to economists. We know from the law of demand that quantity demanded and price are inversely related. Because of this, economists know that quantity demanded will rise when the price of a product falls. The reason that price elasticity of demand is so important is that it gives us information on the size of the change in quantity demanded when price changes. Determinants of Price Elasticity of Demand   Necessities vs. Luxuries - Because necessities are goods that people need to consume, they tend to have an inelastic demand. This means that when the price of a necessity rises, quantity demanded for the necessity does NOT change much. Luxuries, on the other hand, are not goods that people need to consume (people just consume them if they are able). Because of this, an increase in the price of a luxury tends to be associated with a large decrease in the quantity demanded for the luxury. Economists usually find that luxuries have elastic demand. Availability of Close Substitutes - Products that have readily available substitutes tend to have elastic demand. This is because consumers will switch to the available substitute when the price of the product rises, causing a large decrease in quantity demanded. When products do NOT have readily available substitutes, consumers are not able to switch when the price of the product rises - therefore the decrease in quantity demanded will be smaller. Products without readily available substitutes tend to have more inelastic demand. Definition of the Market - The more restrictive is your definition of a market, the more inelastic will be the product demand. As an example, think of the price elasticity of demand for clothing versus the price elasticity of demand for blue jeans. There are many more substitutes for blue jeans than for clothing in general, and the price elasticity of demand for blue jeans is likely to be more elastic. Time Horizon - Most products have more elastic demand over a longer period of time. The reason is that more substitutes will become available in the future than are currently available. Additionally, people may simply modify their consumption behavior in the future. Calculating Elasticity   Before you experiment with the Java Applet (below), let's review how to numerically calculate price elasticity of demand, using the "midpoint method". We will calculate the elasticity of demand for the movement from $5.00 to $4.00 (and quantity 80 to 100) originally depicted in the applet. If you have already moved the slider in the applet, simply return it to its center position at this time.   For notation, let's assume that the original point on the demand curve (price = $5.00 and quantity = 80) can be called point "A", and the new point on the demand curve (price = $4.00 and quantity = 100) is called point "B". The formulas for the percentage change in price and quantity are given below: First notice that, in its original position, this figure depicts a demand curve that is unit elastic. This is because, as we move along the demand curve, the percent change in price is equal to the percent change in quantity - therefore, the elasticity is equal to 1. Now move the slider to the left until the percent change in quantity is 11%. The demand curve has become steeper, which means that the change in quantity (along the horizontal axis of the graph) is smaller. In fact, if you calculate the elasticity you will find that it is now equal to 0.5 (demand is inelastic because the elasticity is less than 1). Continue to move the slider all the way to its left end. At the extreme, we have a demand curve that is vertical. Here the change in quantity demanded (and the percent change in quantity demanded as well) is ALWAYS 0!! For a vertical demand curve, the price elasticity of demand is also equal to zero. This special case is called "perfectly inelastic demand". Now move the slider slightly right of center (until the percent change in quantity is 44%). At this point, the price elasticity of demand is 2.0. Remember that demand is elastic whenever the elasticity is greater than 1. The result of making demand elastic is that the demand curve has become flatter. Finally, move the slider all the way to the right. At this extreme, the demand curve becomes horizontal. In this situation, the change in price (and the percent change in price as well) is ALWAYS 0. For a horizontal demand curve, the price elasticity of demand is infinitely large (because to calculate elasticity you have to divide by zero). This special case is called "perfectly elastic demand". Total Revenue and Price Elasticity of Demand - (Back to Top) There is an important relationship between Price Elasticity of Demand Total Revenue.   def: Total Revenue = Price times Quantity   This section focuses on total revenue and elasticity. In general, you will learn that, if demand is elastic, revenue increases as price falls, and that, if demand is inelastic, revenue increases as price rises. Table #1 Sample Demand Schedule pt. P QD TR A 6 1 $6 B 5 2 $10 C 4 3 $12 D 3 4 $12 E 2 5 $10 F 6 1 $6 The table above provides a sample demand schedule. This demand schedule is graphed in the figures at right. First, notice that this is a linear demand curve (every time price drops by $1, quantity increases by 1-unit). For practice, use the midpoint elasticity formula (given above) to calculate the price elasticity of demand from point A to point B, from point B to point C, and so on thru point F. You should get the following answers:     A-B = -11/3 B-C = -9/5 C-D = -1 D-E = -5/9 E-F = -3/11   Be sure you can use the midpoint formula and get these answers.   OK...now notice the relationship between price elasticity of demand and total revenue. In the upper figure, the total revenue at point B is represented by the blue shaded area (that rectangle has price as it height and quantity as its width...therefore, the area of the rectangle is price times quantity...total revenue.). In the lower figure, the total revenue at point C is represented by the red shaded area. From B-C, the price elasticity of demand was -9/5 (therefore, demand is elastic since the absolute value of -9/5 is greater than 1). Also, from B-C, total revenue increased as price fell.   Now refer back to the table above and see the following relationships: When demand is elastic, total revenue rises as price falls (see A-B or B-C) When demand is unit elastic, total revenue is at its maximum, and does not change when price changes (see C-D) When demand is inelastic, total revenue rises as price rises (see E-D or F-E) You are now ready for this chapter's java exercise. Income Elasticity of Demand - (Back to Top) Income Elasticity of Demand is defined as: Normal Goods - A good is a normal good if its income elasticity is positive. This means that when income rises, quantity demanded rises - most goods are normal goods. Also, as shown below, there are different types of normal goods: Necessity Goods - A good is a necessity if its income elasticity is positive, but less than 1. This means that if income rises by 10%, quantity demanded rises by less than 10% - therefore, as people's income rises, they spend a smaller percentage of their income on necessities. Luxury Goods - A good is a luxury good if its income elasticity is positive, and greater than 1. This means that if income rises by 10%, quantity demanded rises by more than 10% - therefore, people spend more of their income on luxuries when they have larger incomes. Inferior Goods - A good is an inferior good if its income elasticity is negative. This means that when income rises, quantity demanded falls. Price Elasticity of Supply and Its Determinants - (Back to Top) Price Elasticity of Supply is defined as: Determinants of Price Elasticity of Supply   The ability of producers to change output - the easier it is for producers to alter their output, the more elastic will be the supply of a product. For example, the supply of fine art is fixed, because artists cannot create more after they die. Therefore, as prices change, the only way for the number of paintings offered for sale to change is for people to decide to sell the art they already own. Because of this, the supply for fine art is quite inelastic. Time Horizon - The price elasticity of supply for most products is more elastic in the long-run than in the short-run. This is because a longer time horizon gives producers more opportunity to alter their output of a good.