Elasticity

Elasticity is a tool that is used to describe the relationship between two variables. Decision makers would like to describe how a change in price might alter the quantity demanded.

A measure of this relationship is called the “ own” price elasticity of demand.

It is also useful to describe how a change in buyers’ income shifts the demand function for a good; this measure is called income elasticity.

When the price of a related good (substitute or compliment) changes, the demand for a good will shift. Cross elasticity is a measure of the responsiveness of buyers of a good to changes in the prices of related goods.

Elasticity is defined as

E = percentage change of the dependent variable \ percentage change of the independent variable

This is the percentage change in the dependent variable caused by a percentage change in the independent variable.

The “own” price elasticity of demand is sometimes called price elasticity or price elasticity of demand. The price elasticity of demand measuresnthe responsiveness of buyers to changes in the goods “own” price. It reflects a movement along a given demand function or a change in quantity demanded.

Point elasticity of demand:

Arc elasticity of demand:

P_x P_x P_x P_x P_x

D D D

D

D D D D

0 Q_x 0 Q_x 0 Q 0 Q 0 Q_x

E_D = - ¥ - ¥ < E_D < - 1 E_D = - 1 - 1 < E_D < 0 E_D = 0

pure elastic unitary inelastic pure

elastic elasticity inelastic

When |Εp |> 1, we call demand elastic, the percentage change in quantity is greater than the percentage change in price. When demand is elastic price and total revenue (TR) move in opposite directions. When ΔP > 1, TR will decrease; when ΔP < 1, TR will increase.

When |Εp |< 1, we call demand inelastic, the percentage change in quantity is less than the percentage change in price. When demand is inelastic, price and TR move in the same direction. When ΔP > 1, TR will increase; when ΔP < 1, TR will decrease.

When |Εp|= 1, TR will be a maximum. This is called unitary elasticity.

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Price Elasticity of demand is influenced by:

1. Availability of substitutes. Generally, the more substitutes that are available, the moreelastic the demand for a good. The demand for a class ofgoods (soft drinks) is usually more inelastic than the demandfor a specific brand of the good (Pepsi or Coca-Cola). A Firmmay try to differentiate their product to make the demandrelatively more inelastic.

b. Proportion of item in budget. When the expenditures on a product are a relatively smallportion of a budget, the demand is relatively more elastic.

c. Time available to adapt. The longer that consumers or buyers have to make adjustmentsin their behavior, the more elastic the demand is likely to be.The absolute value of the short run price elasticity of demandfor gasoline would be smaller than the absolute value of thelong run price elasticity of demand. The longer time allows consumers more opportunity to adjust to price changes.