LECTURE 06: ELASTICITIES (CONTINUED)
INELASTIC DEMAND 0< Є< 1
• Price rises:
As P increases, Q decreases
Percentage change in P > percentage change in Q
Now TR = P x Q
TR will also increase
• Price falls:
As P decreases, Q increases
Percentage change in P > percentage change in Q
Now TR = P x Q
TR will also decrease
ELASTIC DEMAND Є> 1
• Price rises:
As P increases, Q decreases
Percentage change in P < percentage change in Q
Now TR = P x Q
TR will also decrease
• Price falls:
As P decreases, Q increases
Percentage change in P < percentage change in Q
Now TR = P x Q
TR will also increase
UNIT ELASTIC DEMAND Є= 1
• Price rises:
As P increases, Q decreases
Percentage change in P = percentage change
in Q. Now TR = P x Q TR will remain
unchanged.
• Price falls:
As P decreases, Q increases
Percentage change in P = percentage change
in Q. Now TR = P x Q TR will remain
unchanged.
6.1 TABLE OF UNITARY ELASTICITY
The curve of unitary elastic demand will be a hyperbola.
6.2 DETERMINANTS OF PRICE ELASTICITY OF DEMAND
1. Number of close substitutes within the market - The more (and closer) substitutes
available in the market the more elastic demand will be in response to a change in price. In
this case, the substitution effect will be quite strong.
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2. Percentage of income spent on a good - It may be the case that the smaller the proportion
of income spent taken up with purchasing the good or service the more inelastic demand will
be.
3. Time period under consideration - Demand tends to be more elastic in the long run
rather than in the short run. For example, after the two world oil price shocks of the 1970s the "response" to higher oil prices was modest in the immediate period after price increases,
but as time passed, people found ways to consume less petroleum and other oil products.
This included measures to get better mileage from their cars; higher spending on insulation
in homes and car pooling for commuters. The demand for oil became more elastic in the
long-run.
6.3 EFFECTS OF ADVERTISING ON DEMAND CURVE
Advertising aims to:
• Change the slope of the demand curve – make it more inelastic. This is done by
generating brand loyalty;
• Shift the demand curve to the right by tempting the people’s want for that specific
product.
6.4 PRICE ELASTICITY OF SUPPLY
The relative response of a change in quantity supplied to a relative change in price. More
specifically the price elasticity of supply can be defined as the percentage change in quantity
supplied due to a percentage change in supply price.
•
•
Calculating elasticities between two points at the same curve involves arc elasticity
method.
While calculating elasticity at a certain point involves point elasticity method.
6.5 DETERMINANTS OF PRICE ELASTICITY OF SUPPLY
•
•
If costs increases, lower will be the supply. Lower the costs the more will be the
supply.
Amount of time given to quantity respond to a price increase or decrease. There
may be immediate time period, short term and long term time period.
6.6•INCOME ELASTICITY OF DEMAND
The relative response of a change in demand to a relative change in income. More
specifically the income elasticity of demand can be defined as the percentage change in
demand due to a percentage change in buyers' income.
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The income elasticity of demand quantitatively identifies the theoretical relationship between
income and demand.
If the sign of income elasticity of demand is positive, the good is normal and if sign is
negative, the good is inferior.
The Good is normal (the sign is positive). But its demand is income inelastic o< | Є| < 1.
6.7 DETERMINANTS OF INCOME ELASTICITY OF DEMAND
The determinants of income elasticity of demand are:
• Degree of necessity of good.
• The rate at which the desire for good is satisfied as consumption increases
• The level of income of consumer.
Short Run and Long Run
Short run is a period in which not all factors can adjust fully and therefore adjustment to
shocks can only be partial.
Long run is a period over which all factors can be changed and full adjustment to shocks can
take place.
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6.8 CROSS-PRICE ELASTICITY OF DEMAND
Cross price elasticity of demand is the percentage change in quantity demanded of a specific
good, with respect to the percentage change in the price of another related good.
PbЄda = ∆Qa ÷ ∆Pb
Q a
Pb
Goods are substitutes (sign is positive). Demand is cross price elastic | є| > 1.
6.9 DETERMINANTS OF CROSS PRICE ELASTICITY OF DEMAND
•
•
Time period
The longer the time period, the more will be the elasticity,
Tastes and preferences
Taste and preferences can change.
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6.10 INCIDENCE OF TAXATION
A tax results in a vertical shift of the supply curve as it increases the cost of producing the
taxed product.
6.11 THREE CORE RULES OF ELASTICTY
RULE # 01
RULE # 02
RULE # 03
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