Cross-price elasticities tend to be negative when two goods are complements. e.g Printers and Computers. ↑ P computers makes people demand less printers. The "law of demand," namely that the higher the price of a good, the less consumers will purchase, has been termed the "most famous law in economics, and the. Define elasticity of demand and differentiate between elastic and inelastic elasticity price elasticity of demand price-inelastic demand price-elastic demand.
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What is elasticity? What kinds of issues can elasticity help us understand? • What is the price elasticity of demand? How is it related to the demand curve?. Demand is ELASTIC. – when the price elasticity (ignoring the negative sign) is greater than – i.e. when the % change in quantity demanded exceeds the. Price elasticity of demand. A measure of the extent to which the quantity demanded of a good changes when the price of the good changes. To determine the.
The relationship between elasticity and total outlay can also be explained in terms of Fig. Under the circumstance, the employer may be forced to employ more machines assumed to be a cheaper input than labour. In fact, most businessmen should try to form as precise an idea of elasticity as possible. For example, a cross-price elasticity of -4 suggests an individual strongly prefers to consume two goods together, compared to a cross-price elasticity of To calculate elasticity, instead of using simple percentage changes in quantity and price, economists use the average percent change.
In July , the company announced a packaging change. How did customers of the year-old firm react?
Did they abandon Netflix? The answers to those questions will be explored in this chapter with a concept economists call elasticity. Click to read the rest of the Netflix story. Anyone who has studied economics knows the law of demand: What you may not know is how much lower the quantity demanded will be.
Similarly, the law of supply shows that a higher price will lead to a higher quantity supplied. The question is: How much higher? To find answers to these questions, we need to understand the concept of elasticity.
Suppose you drop two items from a second-floor balcony. The first item is a tennis ball, and the second item is a brick. Which will bounce higher? Obviously, the tennis ball. We would say that the tennis ball has greater elasticity. Both the demand and supply curve show the relationship between price and quantity, and elasticity can improve our understanding of this relationship.
This shows the responsiveness of the quantity demanded to a change in price. Suppose there is an increase in quantity demanded from 4 coffees to 6 coffees.
These two calculations give us different numbers. This type of analysis would make elasticity subject to direction which adds unnecessary complication.
To avoid this, we will instead rely on averages. To calculate elasticity, instead of using simple percentage changes in quantity and price, economists use the average percent change. This is called the mid-point method for elasticity, and is represented in the following equations:. The advantage of the m id-point method is that one obtains the same elasticity between two price points whether there is a price increase or decrease. This is because the denominator is an average rather than the old value.
Using the mid-point method to calculate the elasticity between Point A and Point B:. This method gives us a sort of average elasticity of demand over two points on our curve. In Figure 4. As we will see in Topic 4. To calculate this, we have to derive a new equation.
This gives us our point-slope formula. This analysis gives us elasticity as a single point. This is not a coincidence. When we are calculating from Point A to Point B, we are actually just calculating the elasticity at Point A, since we are using the values on Point A as the denominator for our percentage change. When we use the mid-point method, we are just taking an average of the two points.
This solidifies the fact that there is a different elasticity at every point on our line, a concept that will be important when we discuss revenue. Even though mid-point and Point-Slope appear to be fairly different formulas, mid-point can be rewritten to show how similar the two really are.
Notice that compared to point-slope: This reinforces the conclusion that mid-point represents an average.
This means it can be applied to more that just the price-quantity relationship of our market model. We will examine this even further when we introduce consumer theory, but for now we can develop our understanding by applying what we know about elasticities.
The demand curve, thus, becomes parallel to the vertical axis Fig. Marshall offered the method of total revenue or total outlay for estimating elasticity of demand.
What the sellers receive from the sale of commodities is called total expenditure or outlay of buyers. There is no difference between total revenue and total outlay since what is spent by the buyers is received as income by the sellers.
Here we want to measure how much total outlay changes following a change in price. It depends upon the elasticity of demand. Suppose price declines rises. As a result, total expenditure rises falls. Under the circumstance, the value of elasticity of demand becomes greater than one. At a price OP, OA is demanded. As price drops to OP 1 , the quantity demanded rises to OA 1. When price and total outlay move in opposite direction, demand for the product becomes elastic.
If the total outlay falls when price falls, or if total outlay rises when price rises, then demand is said to be inelastic i. Hence, demand is inelastic. Irrespective of variations in demand and price, if the total outlay does not change, then demand is unit elastic i.
The demand curve then looks like a rectangular hyperbola since the area of all the rectangles formed by the demand curve is always the same. In this case, at a particular price, any amount is demanded. More revenue is earned at OA 1 than at OA, although price is kept fixed. The vertical straight line demand curve says that, whatever the price, quantity demanded remains the same. The relationship between elasticity and total outlay can also be explained in terms of Fig.
Here ABCD is the total outlay curve. As total outlay remains invariant when price changes in the region BC, demand is unitary elastic.
When the change in price is infinitesimally small, Marshallian method may not provide accurate estimate of elasticity of demand. In that case, a geometrical method may be employed. This method aims at measuring elasticity of demand at a particular point on a demand curve. So long, we tried to calculate the elasticity over certain area or segment of a demand curve and the terms elastic, inelastic and unit elastic had been applied to the whole demand curve.
However, such is not true. It may happen that the demand for a product can be elastic in one price range and inelastic in another. In fact, the degree of elasticity varies from one price range to another. So, it is better to calculate elasticity at a particular point on a demand curve to have an accurate estimate. This is explained in terms of Fig. Demand curve is DD 1.
Points E and H are very close to each other. On the basis of this method of measurement, one can estimate elasticity of demand on a linear demand curve, shown in Fig. Here, DD 1 is a linear demand curve. Elasticity of demand varies from point to point on a demand curve. As the distance between PD 1 and PD is the same, it is unit elastic i.
As we move downwards along the curve DD 1 from the mid-point, say point P 2 , elasticity declines. At P 2 it is, inelastic i. Further, as we move upwards from the mid-point, elasticity increases. At P 1 , it is elastic i. Thus, at lower prices it is inelastic, and at higher prices it is elastic.
For very small movements in price and quantity, point elasticity method is an appropriate one. In other words, point elasticity method measures price elasticity of demand at a particular point on the demand curve. However, if price change is somewhat of a larger magnitude then geometrical method may give misleading estimate.
To avoid this problem, elasticity is measured over an arc of the demand curve. In other words, when we intend to estimate price elasticity of demand over some portion i. Sometimes we know two prices and two quantities. Under the circumstance, the point elasticity method may not provide good estimate.
What is required in this case is the average elasticity of two prices and two quantities. Here changes in both price and quantity are much larger.
Using old price P 1 and old quantity Q 1 , one finds the value of elasticity of demand as: When new price P 2 and new quantity Q 2 are taken into account, the coefficient becomes. Thus, estimation of elasticity in accordance with the formula for point elasticity method gives vastly different results. In other words, since elasticity of demand varies depending on the base, one should consider average price and average quantity demanded to calculate elasticity of demand. That is to say, we want to measure average elasticity over an arc of the demand curve i.
In terms of Fig. In other words, we want to measure elasticity between points A and B. The above formula measures arc elasticity over the straight line AB. Greater the convexity of the demand curve between A and B, one obtains almost perfect estimate of elasticity.
Or greater the concavity of the demand curve between points A and B, the poorer the approximation of measurement of arc elasticity. As we go on making the price change smaller and smaller, the arc of the demand curve may vanish or converge to a point. So, as a special case of arc elasticity, the concept of point elasticity becomes relevant. In the first place, it depends on the nature of the commodity.
Commodities which are supposed to be essential or critical to our daily lives must have an inelastic demand, since price change of these items does not bring about a greater change in quantity demanded. But, luxury goods have an elastic demand. Demand for these good can be quickly reduced when their prices rise. When their prices fall, consumers demand these goods in larger quantities. However, whether a particular commodity is a necessary or a luxury depends on income, tastes and preferences of the consumer.
A particular good may be necessary to someone having an inelastic demand. Same commodity may be elastic to another consumer. For instance, owning a TV may be a luxury item to a low income person. But the same may be bought as an essential item by a rich person.
Secondly, commodities having large number of substitutes must have an elastic demand. A change in the price of, say, Horlicks—the prices of other substitutes remaining constant—will lead a consumer to substitute one beverage for another.
If the price of Horlicks goes down, buyers will demand more of it and less of its substitutes. Conversely, demand is fairly inelastic in the case of those commodities which do not have a large number of substitutes. Thirdly, there are some commodities which can be used for a variety of purposes. For example, electricity. If price per unit of electricity consumed falls, people will reduce their consumption of its substitutes e.
Coefficient of price elasticity of demand in this case must be greater than one. On the other hand, when a commodity is used only for one or two purposes, a price change will have less effect on its quantity demanded and, therefore, demand will be inelastic.
Fourthly, there are some commodities consumed out of habits and conventions— they have an elastic demand. Even in the face of rising prices of those commodities or falling income, people will consume those such as, cigarette. For this reason, price elasticity as well as income elasticity of demand for this type of commodity is inelastic.
When gold is used in this way, its demand becomes inelastic. Fifthly, shorter the time, lower will be the elasticity of demand.
This is because in the short run satisfactory substitutes of a product may not be available. Thus, demand for a product in the short run usually becomes inelastic. Such a commodity will be elastic in the long run when close substitutes may be produced. Thus, the response of quantity demanded to a change in price will tend to be greater smaller , the longer shorter the time-span considered.