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Notes - Elasticity and It's Application

This document defines and explains different types of elasticity, including price elasticity of demand, income elasticity of demand, and cross elasticity of demand. It provides formulas for computing each type and discusses factors that determine price elasticity, such as whether a good is a necessity or luxury and the availability of substitutes. The document also explores how elasticity relates to a firm's total revenue.

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93 views10 pages

Notes - Elasticity and It's Application

This document defines and explains different types of elasticity, including price elasticity of demand, income elasticity of demand, and cross elasticity of demand. It provides formulas for computing each type and discusses factors that determine price elasticity, such as whether a good is a necessity or luxury and the availability of substitutes. The document also explores how elasticity relates to a firm's total revenue.

Uploaded by

shihabsince99
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Elasticity and It’s Application

Elasticity
Elasticity is a measure of how much buyers and sellers respond to
changes in market conditions.
It allows us to analyze supply and demand with greater precision.

Elasticity of Demand
Elasticity of demand refers to the change in demand for something in
relation to one of the variables.
There are 3 types of elaticity of demand:
● Price Elasticity of Demand
● Income Elasticity of Demand
● Cross Elasticity of Demand

Price Elasticity of Demand


Price elasticity of demand is the percentage change in quantity demanded
in relation to percent change in price.
It is a measure of how much the quantity demanded of a good responds to
a change in the price of that good.

×
Δ�d P
ΔP Qd
Formula: PED =
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.
Percentage Change in�d
Percentage Change in Price
Price Elasticity Of Demand =

Ranges of Elasticity
Perfectly Inelastic Demand: Quantity demanded does not respond to
changes in price.
If we change price, the quantity demanded does not change.

Here, �� = 0

E.g. Life-saving medication. People will buy the same amount even if the
price increases significantly because they need it for survival.
Inelastic Demand: Quantity demanded changes relatively less than the
change in price.
If we change the price, quantity demanded changes a bit but less than the
change in price.

Here, �� < 1

E.g. Gasoline. If the price of gas increases, people may still buy a similar
amount because there are few alternatives, and it's a necessity for many.
Unit Elastic: Percentage change in quantity demanded is exactly equal to
the percentage change in price.

Here, �� = 1

E.g. If the price of a certain type of bread rises by 10%, and the quantity
demanded decreases by exactly 10%, then it's unit elastic.
Elastic Demand: Quantity demanded changes relatively more than the
change in price.
If we change the price, the quantity demanded changes more than
quantity demanded.

Here, �� > 1

E.g. Luxury goods, like expensive watches. If the price increases, people
might significantly cut back on buying them because they can switch to
less expensive alternatives.
Perfectly Elastic: Change in price is not possible, because if we change
the price, no one will buy.

Here, �� = ∞

E.g. Agricultural commodities in a perfectly competitive market. If a


farmer tries to sell their goods at a price higher than the market price,
they won't sell anything because consumers can easily switch to another
seller offering the same product at the market price.
Determinants of Price Elasticity of Demand

1. Necessities versus Luxuries: This refers to whether a good a necessity


or a something people desire but can live without.
If it is a necessity, for change in price, the demand will be less elastic.
And, if it is a luxury, for change in price, the demand will be more elastic.
E.g. Bread is a necessity, and people are less sensitive to its price changes.
On the other hand, a luxury item like designer handbags may see a larger
impact on demand if the price increases.

2. Availability of Close Substitutes: If there are many similar alternatives


for a product, consumers can easily switch to another if the price changes.
If there are many substitutes available, the demand will be more elastic.
Similarly, if there are fewer substitutes available, the demand will be less
elastic.
E.g. If the price of one brand of cola increases, consumers may switch to
another brand that is similar in taste and cheaper.

3. Definition of the Market: This involves how narrowly or broadly we


define the market. A more specific market definition can result in higher
price elasticity.
If the market is narrower, the demand will be more elastic when the price
changes. And, if the market is broader, the demand will be less elastic
when the price changes.
E.g. if the price of the price of apple increases, you may switch to orange.
But if the price of food goes up, there are no alternatives.
4. Time Horizon: It's about how much time consumers have to adjust to
price changes. Demand tends to be more elastic over a longer time period.
Over short time frame, demand tends to be less elastic. But over long
time frame, demand tends to be more elastic.
E.g. if the price of gasoline increases, people may still need to drive and
won't immediately change their habits. Over a longer period, they might
switch to more fuel-efficient vehicles or alternative transportation.

Elasticity and Total Revenue

Total revenue is the amount paid by buyers and received by sellers of a


good.
Computed as the price of the good times the quantity sold.

Income Elasticity of Demand

Income elasticity of demand measures how much the quantity demanded


of a good responds to a change in consumers’ income.
It is computed as the percentage change in the quantity demanded
divided by the percentage change in income.

×
Δ�d I
ΔI Qd
IED =
Income Elasticity - Types of Goods

Normal Goods: Normal goods are goods for which demand increases as
consumer income rises.
In other words, as people earn more money, they tend to buy more of
these goods.
If income elasticity of demand is positive, the good is a normal good.
Example: If someone's income increases, they may choose to buy a better
quality or more expensive car, upgrading from a basic model to a luxury
one.

Inferior Goods: Inferior goods are goods for which demand decreases as
consumer income rises.
In this case, as people earn more money, they tend to buy fewer of these
goods.
If income elasticity of demand is negative, the good is an inferior good.
Example: Consider generic or store-brand products. When someone's
income increases, they might switch from buying the cheaper store-brand
products to more expensive, higher-quality brands.
Cross Price Elasticity of Demand

Cross Price Elasticity of Demand measures how the quantity demanded


of one good changes in response to a change in the price of another
related good.
It is an elasticity measure that looks at the impact a change in the price of
one good has on the demand of another good.
For substitutes, cross elasticity of demand is positive.
For complimentary goods, CED is negative.
For unrelated goods, CED is 0.
E.g. Think of Pepsi and Coca-cola. If you assume the two brands of soda
are substitutes, if the price of Coke falls, consumer demand for Pepsi will
fall because more consumers will choose to buy Coke over Pepsi.

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