2. Concept of elasticity: notion, types, methods of calculation

Elasticity is a measure responsiveness of a variable to a change in one of the determinants. The elasticity of A in respect to B is the percentage change in A divided by the percentage change in B.

Elasticity =

Price elasticity of demand shows the response of quantity demanded in respect to change in price.

, this indicator shows by how many percent Qd changes when price changes by 1%.

Price elasticity of demand is negative because as price grows, Qd decreases.

If Elasticity >|-1| demand is elastic

E < |-1| demand is inelastic

E = |-1| demand is (unit) unitarily elastic

Methods of elasticity calculation:

1) Elasticity in a point

2) If changes in Qand P are infiniticevely small, the deltaQ/deltaP will be the first derivative of demand function

E= =Q’ *

3) Measurement of elasticity in an interval:

E =

Price elasticity of demand and total revenue

In any market the total revenue received by producers is P*Q, or TR=P*Q. When P goes up Q goes down and vice versa.

If demand is inelastic (E<1), the % change in Q is less than the % change in P. So, total revenue (TR) changes in the same direction as P.

If demand is elastic (E>1), the % change in Q is greater than the % change in P. Thus, TR changes in the same direction as Q demanded.

When demand is unitary price elastic, the relative changes in P and Q are the same, so that TR remains constant.

Determinants of price elasticity of demand

1) The number and closeness of substitute goods (the more substitutes the greater the price elasticity)

2) The proportion of income spent on the good (the higher the proportion, the bigger will be the income effect and the more elastic will be the demand)

3) The time period (The longer the time period after a change in price, the more elastic is the demand)

Cross-price elasticity of demand

Elasticity =

It measures the relative responsiveness of Qd of good Y in respect to a change in price of good X.

For substitute goods E is positive (increase in P of B=>increase in D for B)

Complementary goods – negative

Absolutely not interconnected goods – E is 0

Income elasticity of Demand

Elasticity = measures the response of Qd to a change in income

For normal goods E is positive: D rises as income rises

Inferior - negative: Increase in Income=>decrease in D

For luxury goods – positive and greater that unity (demand grows faster then income)

Determinants of income el-ty of D:

1) The degree of necessity of the good (the more necessary is the good, the less income el-ty of D)

2) The rate at which the desire for good is satisfied as consumption increases (If a consumer gets satisfied quickly, he stops increasing his D in response to an increase in income)

3) The level of income of consumers

Price elasticity of supply

Elasticity = measures the response of Qs to a change in price of that good

This elasticity is positive.

Determinants of Price elasticity of supply

1) The amount that costs rise as output rises (Supply is likely to be more elastic if firms have spare capacity and if small additional costs can result in significant increase in output)

2) Time period (As time passes, producers can make all the necessary adjustments, so the relative response (and elasticity of Supply) will be greater in the long run rather in the short run)