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# Concept of elasticity in economics

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### Concept of elasticity in economics

1. 1. Concept of Elasticity in Economics1 Wali Memon Wali Memon
2. 2. Concept of Elasticity in EconomicsA unit free measure of responsiveness of changes in one variable to changes in another variable. Own price elasticity of demand: a measure of responsiveness of quantity demanded to a change in the price of the good 2 Wali Memon
3. 3. Slope is not a good measure. The demand for apples (measured in pounds) as a function of their price (in dollars) is given by Qd = 10 - 2P If the price is expressed in cents the equation becomes Qd = 10 - 200P3 Wali Memon
4. 4. Elasticity ∆ %QD ε= ∆% P4 Wali Memon
5. 5. Interpreting elasticity The price elasticity of demand for DVD players is equal to 2. A 1% increase in the price results in a 2% decrease in the quantity demanded. ∆ %QD ε =2 2= ∆% P ∆ %QD = 2∆ % P5 Wali Memon
6. 6. Limiting case 1.Perfectly elastic demand.Perfectly elastic supply.6 Wali Memon
7. 7. Limiting case 2.Perfectly inelastic demand.Perfectly inelastic supply.7 Wali Memon
8. 8. The demand is elastic if the elasticity greater than one.The demand is inelastic if the elasticity is smaller than one.The demand is unit-elastic if the elasticity is equal to one.8 Wali Memon
9. 9. Own-Price Elasticityand Total Revenue Elastic Increase (a decrease) in price leads to a decrease (an increase) in total revenue. Inelastic Increase (a decrease) in price leads to an increase (a decrease) in total revenue. Unitary Total revenue is maximized at the point where demand is unitary elastic.9 Wali Memon
10. 10. Elasticity, TR, and Linear Demand Price 10 Elastic 8 6 4 Inelastic 2 D 1 2 3 4 5 Quantity10 Wali Memon
11. 11. Example. Parking service . Imagine that the goal of the parking service is to maximize revenue Imagine that the cost of providing parking for an additional day is zero What is the price elasticity of demand for illegal parking?11 Wali Memon
12. 12. Factors AffectingOwn Price Elasticity Available Substitutes The more substitutes available for the good, the more elastic the demand. Time Demand tends to be more inelastic in the short term than in the long term. Time allows consumers to seek out available substitutes. Expenditure Share Goods that comprise a small share of consumer’s budgets tend to be more inelastic than goods for which consumers spend a large portion of their incomes.12 Wali Memon
13. 13. Who pays the tax? An application of the concept of elasticity The price of a gallon of gas is \$1.53 This price includes 23 cents of tax What would be the price is the tax were removed?13 Wali Memon
14. 14. Effect of a sales tax (tax) on the equilibrium. Price in the market goes up but not by the full amount of the tax. ∆P T14 Wali Memon
15. 15. Effect of a sales tax (tax) on the equilibrium. A tax causes a decrease in the total surplus: Tax Revenue15 Wali Memon
16. 16. Who pays the tax? The burden of a sales tax is carried by the sellers or the buyers depending who loses more surplus as a result of the tax. Consumer’s share of lost surplus Producer’s share of lost surplus16 Wali Memon
17. 17. The more inelastic the demand the greater share of the tax is paid buy the consumers. Think of cigarettes, gasoline, or alcoholic beverages.17 Wali Memon
18. 18. The more elastic the supply the greatershare of the tax is paid by consumers.18 Wali Memon
19. 19. What about a situation in which supply is inelastic? Think of real estate.19 Wali Memon
20. 20. Cross Price Elasticity of Demand d %∆QX EQX , PY = %∆PY + Substitutes - Complements20 Wali Memon
21. 21. Income Elasticity d % ∆Q X EQX , M = %∆M + Normal Good - Inferior Good21 Wali Memon
22. 22. Uses of Elasticities Pricing Managing cash flows Impact of changes in competitors’ prices Impact of economic booms and recessions Impact of advertising campaigns And lots more!22 Wali Memon
23. 23. Example 1: Pricing and Cash Flows According to an FTC Report by Michael Ward, AT&T’s own price elasticity of demand for long distance services is -8.64. AT&T needs to boost revenues in order to meet it’s marketing goals. To accomplish this goal, should AT&T raise or lower it’s price?23 Wali Memon
24. 24. Answer: Lower price! Since demand is elastic, a reduction in price will increase quantity demanded by a greater percentage than the price decline, resulting in more revenues for AT&T.24 Wali Memon
25. 25. Example 2: Quantifying the Change If AT&T lowered price by 3 percent, what would happen to the volume of long distance telephone calls routed through AT&T?25 Wali Memon
26. 26. Answer• Calls would increase by 25.92 percent! d %∆QX EQX , PX = −8.64 = %∆PX d %∆QX − 8.64 = − 3% − 3% × (− 8.64) = %∆QX d d %∆QX = 25.92%26 Wali Memon
27. 27. Example 3: Impact of a change in acompetitor’s price According to an FTC Report by Michael Ward, AT&T’s cross price elasticity of demand for long distance services is 9.06. If competitors reduced their prices by 4 percent, what would happen to the demand for AT&T services?27 Wali Memon
28. 28. Answer• AT&T’s demand would fall by 36.24 percent! d %∆QX EQX , PY = 9.06 = %∆PY d %∆QX 9.06 = − 4% d − 4% × 9.06 = %∆QX d %∆QX = −36.24%28 Wali Memon
29. 29. The following graph represents demand for illegal parking in the town of Parkdale. P 50 40 30 20 10 Q 0 M A) What price maximizes revenue from parking tickets? B) What price minimizes illegal parking? C) What is the equation of the demand curve? D) Population of the Parkdale doubled as a result of increased enrollment at a29 localMemon Wali university. What can we say about the revenue maximizing price?
30. 30. Demand FunctionsMathematical representations of demand curvesExample: d QX = 10 − 2 PX + 3PY − 2 MX and Y are substitutes (coefficient of PY is positive)X is an inferior good (coefficient of M is negative)30 Wali Memon
31. 31. Specific Demand Functions Linear Demand d QX = α 0 + α X PX + α Y PY + α M M + α H H P PY M EQX , PX = α X X EQX , PY = αY EQX , M = α M QX QX QX Own Price Cross Price Income Elasticity Elasticity Elasticity31 Wali Memon
32. 32. Example of Linear Demand Qd = 10 - 2P Own-Price Elasticity: (-2)P/Q If P=1, Q=8 (since 10 - 2 = 8) Own price elasticity at P=1, Q=8: (-2)(1)/8= - 0.2532 Wali Memon
33. 33. Log-Linear Demand ln Q X d = β 0 + β X ln PX + βY ln PY + β M ln M + β H ln H Own Price Elasticity : βX Cross Price Elasticity : β Y Income Elasticity : βM33 Wali Memon
34. 34. Example of Log-Linear Demand ln Qd = 10 - 2 ln P Own Price Elasticity: -234 Wali Memon
35. 35. P P D D Q Q Linear Log Linear35 Wali Memon