Chapter%205 - Econ 160, Vardanyan Chapter 5 Elasticity: A...

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Econ 160, Vardanyan 1 Chapter 5 Elasticity: A Measure of Responsiveness In the previous chapter we discussed the law of demand and the law of supply. The first said that an increase in price causes a decrease in the quantity demanded, ceteris paribus , whereas the second said that an increase in price cases the quantity supplied to go up, ceteris paribus . In this chapter we will quantify both laws, i.e. we will show how to find by how much the demand and supply change as the price changes. The Price Elasticity of Demand The price elasticity of demand measures the responsiveness of the quantity demanded to changes in price . It is computed by dividing the percentage change in quantity demanded by the percentage change in price and taking the absolute value of the result, i.e. price in demanded quantity in E d = % % For example, if a 10% increase in price causes the quantity demanded to fall by 15% then E d equals 5 . 1 % 10 % 15 = . Note that although an increase in price (by 10%) causes the quantity demanded to go down (i.e. to change by –15%), our measure of elasticity is, nevertheless, a positive number, since we have taken the absolute value of the result. Price elasticity can be computed using two methods: initial value and midpoint. Suppose we know that when the price increases from $20 to $22 the quantity demanded falls from 100 to 80 units. The formula we specified earlier can be used to compute the elasticity using the initial values of variables, i.e. 2 100 2 20 20 20 2 100 20 20 20 22 100 100 80 = × × = = = d E When using the midpoint method for computing the elasticity, we divide the change in each variable not by its starting value but by its average, i.e. () () 33 . 2 90 2 21 20 21 2 90 20 2 22 20 20 22 2 80 100 100 80 × × = = + + = m d E Thus, the price elasticity using midpoint method is equal to approximately 2.33. Using the midpoint method we can calculate the price elasticity more precisely. There are five cases as far as the price elasticity of demand is concerned (Fig. 5.1):
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Econ 160, Vardanyan 2 Elastic demand – the price elasticity is greater than 1 . When the demand is price elastic the demand curve is relatively flat (Fig. 5.1 panel A) Inelastic demand the price elasticity is less than 1 . This is the case when the percentage change in quantity demanded is smaller than the percentage change in price. When the demand is price inelastic the demand curve is relatively steep (panel B) Unitary elastic demand – the price elasticity equals 1
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Chapter%205 - Econ 160, Vardanyan Chapter 5 Elasticity: A...

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