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Ch. 17 Elasticity Economics 9th Ed, R.A. Arnold

The Study of Microeconomics Previously we defined economics as a social science. We have seen that an economy is made up of these economic actors/players: households/consumers, business/firms and government. Microeconomics – a branch of economics - studies the behavior and decision making of these economic actors. Each and every one of these economic actors face the problem of scarcity.

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In ECO 101 we focus on the households and firms. Government is studied in ECO 104. Household/Consumers: Objective: Maximize utility (satisfaction) => Unlimited want Remember: We obtain utility from goods. Our want for goods is unlimited.

Constraint: Limited income => Limited resources Hence, households face the problem of scarcity and need to make choices between different goods The spending of the household/consumer is consumption – the amount spent on goods

Business/Firms: Produces goods using resources/inputs (land, labor, entrepreneurship)* Objective: Maximize profit Constraint: Limited resources, competitors, consumers want lower price & higher quality Firms need to choose what quantity of goods to produce and what price to charge *(Land, labor, entrepreneurship) are provided by the households. From land households earn rent and from labor they earn wage/salary – a source of income of households.

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Remember: The actors (households and firms) meet in a market (ch. 3). So the choices made by them are made in a market setting. E.g. in a labor market (e.g. Bdjobs): the households supply/sell labor. The firms are the buyer. The price in this market is wage/salary. Firms choose the labor they want to hire in this market. Household choose the goods in a goods market (e.g. Agora). Firms are the supplier/seller here.

Elasticity Inside the market the law of demand is at work. If, price decreases then quantity demanded increases. Hence, Firms or business compete with each other by reducing price (price-cutting). A lower price increases the quantity demanded of their goods (attracts more customers) So a firm may want to know, by what % the quantity demanded will increase if they reduce the price of their good by 1 %? This answer is given by the price elasticity of demand

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Price Elasticity of Demand Price Elasticity of demand, Ed =

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

=

%∆𝑄𝑑 %∆𝑃

(1)

We only take the magnitude (absolute value) and ignore the sign %∆𝑄𝑑 = %∆𝑃 =

𝑄𝑑(𝑛𝑒𝑤) −𝑄𝑑(𝑜𝑙𝑑) 𝑄𝑜𝑙𝑑

𝑃𝑛𝑒𝑤 −𝑃𝑜𝑙𝑑 𝑃𝑜𝑙𝑑

× 100

× 100

(2) (3)

Price elasticity of demand is a measure of the responsiveness (change) in quantity demanded of a good due to changes in the price of that good. E.g. a juice-shop reduces its price from 100 taka to 90 taka and sees that quantity demanded of juice increases from 100 cups to 120 cups. Pold = 100, Pnew = 90. Using equation (2) in last slide %∆P =10%. Qold = 100 and Qnew = 120. Using eq (3) %∆Q = 20%. Using (1) Ed = 2. Interpretation: if the tea-shop reduces price by 1% the quantity demanded of tea will increase by 2% This is an example where the demand is elastic; occurs when %∆Qd > %∆P , Ed > 1

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Another example: A rice-seller increases it’s price by 10% and finds that the quantity demanded decreases by 5%. Using equation (1), Ed = 0.5. I.e. if the price increases by 1% then the quantity demanded decreases by 0.5% If Ed < 1 (occurs when %∆Qd < %∆P) then we say the demand is inelastic i.e. the quantity demanded does not respond much to changes in price. If Ed = 1, (occurs when %∆Qd = %∆P). Then we say the demand is unit elastic.

There are two other situations/possibilities: Seller reduces price and the quantity demanded increases by an extremely (infinitely large amount), i.e. % ∆ Qd = ∞ (infinity) Using equation (1), Ed = ∞ Here the demand is perfectly elastic The demand is perfectly inelastic when a change in price does not affect the quantity demanded. Hence, % ∆ Qd = 0. Using equation (1) Ed = 0 The next slide summarizes the above discussions

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In the next slide we look at the graphical representation of the different types of price elasticities of demand (above)

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Determinants of Price Elasticity of Demand (Ed) 1. Number of substitutes: If a good has many substitutes then Ed will be more as compared to a good which has fewer substitutes. Why? You should be able to explain in your own words. 2. Necessities versus luxuries: If a good is a necessity (e.g. water), Ed will be less as compared to a good which is a luxury (e.g. grape juice) 3. Percentage of one’s budget spent on the good: If a greater percentage of one’s budget is spent on a good (e.g. meals) then the Ed will be more as compared to a good on which a lesser percentage of our budget is used (e.g. pen). 4. Time: As more time passes after the price change, the higher will be the Ed since it is easier to move to substitutes

Other Elasticity Concepts Cross Elasticity of Demand (Ec): A measure of the responsiveness in quantity demanded of one good to changes in price of another (related) good (substitute or complement) Ec =

%∆𝑄𝑑 𝑜𝑓 𝑜𝑛𝑒 𝑔𝑜𝑜𝑑 %∆𝑃 𝑜𝑓 𝑎𝑛𝑜𝑡ℎ𝑒𝑟 𝑔𝑜𝑜𝑑

For example, Coke may want to know by what % will the Qd of coke increase, if price of Pepsi increases by 1 %. To find the answer the above formula is used.

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In the example last slide, the quantity demanded of a good and the price of a substitute are directly/positively related. So, Ec > 0 i.e. positive for substitutes The higher the Ec, the greater the degree of substitution. Why? Think about this. And negative i.e. Ec < 0 for complements. The quantity demanded of a good and the price of complements are negatively related. If one increases the other decreases.

Income Elasticity of Demand (EY): A measure of the responsiveness of quantity demanded to %∆𝑄𝑑 changes in income. EY = %∆𝑖𝑛𝑐𝑜𝑚𝑒 Remember: For normal goods, if income (Y) increases then demand increases. Positive/direct relation. Hence, EY > 0. For inferior goods Y increases, demand decreases (negative/inverse relation). EY < 0. For neutral good, change in Y does not change demand of the good. EY = 0.

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Price Elasticity of Supply (ES): A measure of the responsiveness of the quantity supplied (QS) to %∆𝑄𝑠 changes in price. ES = %∆𝑃

ES > 1 : Elastic supply, ES < 1 : Inelastic supply As more time passes after a price change, the price elasticity of supply will increase (since it takes time for additional production – to hire workers, increase capital).

The Relationship Between Taxes and Elasticity

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In figure, Gov is taxing $1 per DVD sold. Remember: If the demand is less elastic (more inelastic) the D curve will become steeper (more vertical). You should do the graphical analysis as an exercise. You will see that the consumer ends up paying more of the tax. When demand is perfectly inelastic the consumer/ buyer pays all of the tax.

Application of Price Elasticity of Demand Total Revenue (TR) = Price (P) x Quantity (Q) If, Ed = 5 (elastic demand; Ed > 1), it means if P increases by 1% then Qd will decrease by 5%. Using above equation, TR will decrease. If, P decreases by 1% then Qd will increase by 5%. Using above equation, TR will increase. If, Ed < 1 then inelastic demand. If P increases by 1% then Qd decreases by less than 1%. TR increases. If, P decreases, TR decreases.

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