Tutorial 4: Elasticity
In Tutorials 2
and 3 we saw that
a decrease in the price of a good or service leads to an
increase in the quantity of it demanded. But this "law
of demand" reveals nothing of the size of the buyer's
response to a price change. Similarly, although we also
saw that price and the quantity supplied are directly related,
we do not know the size of the seller's response
to a price change. Finally, although we saw that an increase
in income will increase the demand for normal goods, we
have not discussed how to measure the size of the
increase in demand.
In economics, the term elasticity is
used to describe a measure of how responsive one variable
is to a change in another. Specifically, elasticity measures
the percentage change in the dependent variable in response
to a one percent change in the independent variable. In
the syntax of mathematics:
In this tutorial we discover how to measure
the size of the impact on quantity of a change in price
and income, and explore the implications of price controls
given differences in responsiveness.
Price elasticity of demand (Epd)
measures how responsive the quantity demanded is to a change
in product price. Similarly, wage elasticity of demand
measures how responsive the the quantity of labor demanded
is to a change in the wage rate. Mathematically:
The term (),
measures the slope of the demand curve, and the term
(P/Q) measures the price (P) and quantity
(Q) values for a point on that demand curve.
If we write the equation for demand as Q(P) = a
+ b*P, then
Epd = b*(P/Q) where b
Similarly, if we write the equation for demand
in inverse form, P(Q) = (a/b) + (1/b)*Q,
Epd = (1/b)*(P/Q) where
b < 0.
These latter forms of the equation for price
elasticity of demand are refered to as the point-slope
formula. Because b < 0 (do you know why?), Epd
< 0 as well. Many times, however, the minus sign is dropped
of price elasticity of demand
So far we have learned two ways to calculate
price elasticity of demand:
- using numerical data, as the ratio of the percentage
changes in Q and P;
- using the known equation for demand (or inverse demand),
as the product of the slope coefficient and the ratio
of the price and quantity values for a point on
that demand curve.
But what if we have neither the numerical data
nor an equation describing demand? One can still get a feeling
for how responsive buyers will be to a price change by remembering
the four determinants of buyer responsiveness:
- Proportion of income spent;
- Availability of good substitutes;
- Necessity (or luxury);
The greater the proportion of household
income spent on an item, the more responsive buyers
will be to a change in its price. Most durable goods, such
as houses, cars, appliances, etc., are quite expensive (as
a portion of household income). A 10% increase in the payments
on a house is likely to leave buyers with a good deal less
cash each month and, hence, demand will be rather price
elastic. A 10% increase in the price of pop is likely to
be nearly ignored by buyers, hence demand will be rather
The greater the avilability of substitutes
for the good or service whose price has just increased,
the greater the response of buyers. This is because if buyers
can easily purchase a similar item (whose price has not
risen) then they will. Soft drinks, cereals, clothing, etc.,
have many close substitutes. Thus demand tends to be rather
price elastic for these goods. For services such as medical
care, fewer substitutes are available, hence demand tends
to be rather price inelastic.
Consumtion of goods and services that are considered
a luxury can be easily reduced if the price rises.
Hence demand tends to be more elastic for fur coats, luxury
cars, extensive vacations, etc. Goods considered a necessity
are so important that buyers tend to respond little to a
price change. They do respond however, although demand tends
to be price inelastic for such goods.
The amount of time one has
to respond to a price change affects the size of that response.
For most goods, in the short run, buyers tend to purchase
nearly the same quantity as before a price change. So in
the short run, demand tends to be price inelastic. But given
time, buyers can alter their consumption behavior and look
for hard to find substitutes. So in the long run, demand
tends to be price elastic. Take an increase in the price
of gasoline for example. If you do not learn about the price
increase until you pull up to the pump (and you believe
gas prices have increased at all gas stations) you will
likely top off your tank as usual. But given time, you can
find ways to drive your car shorter distances, buy a car
that gets better gas mileage, or even move so that you live
closer to where you work. So in the long run, you will be
much more responsive to a price increase than you can be
in the short run.
But this time response is not true for a class
of goods known as durable goods (houses, automobiles,
household appliances, TV's, computers, or capital equipment
purchased by firms). Take cars for example. In the short
run, buyers tend to be very responsive to an increase in
the price of a new car. When the family car is only a few
years old it is easy to postpone the purchase of a new one.
But in the long run, as cars wear out, buyers become less
responsive to the price increase. In fact, short run price
elasticity of demand for new cars has been estimated to
be -1.2 one year after a price change, but -0.42 ten years
after that price change1.
Now it's time to
"do the thing".
Click on the following link
to download the Price
Elasticity Workbook. Work through General
Questions 1 - 6 and Excel Question 10 to improve
your understanding of price elasticity of
Return here when you have finished.
downloading the Excel file?
Now we take a close look at price elasticity of supply...