Elasticity

It represents the ratio of the % change in one variable to the % change in another variable Price Elasticity of Demand - measures the responsiveness of quantity demanded for good x to a change in price of good x % change in Qx % change in Px Price Elasticity of Supply - measures the responsiveness of quantity supplied for good x to a change in price of good x % change in Qx % change in Px Elastic The % change in quantity demanded is larger than the % change in price - If elasticity is between -1 and infinity Inelastic: -the % change in quantity demanded is less than the % change in price -If elasticity is between 0 and -1 Elasticity If demand is elastic, (% change in quantity demanded is larger than the % change in price) Decrease in price will increase TR Increase in price will decrease TR Elasticity and TE / TR If demand is inelastic, (% change in quantity demanded is less than the % change in price) Decrease in price will decrease TR Increase in price will increase TR Elasticity and TE / TR If Demand is Elastic, (% change in quantity demanded is larger than the % change in price), Q and PQ move in the same direction, similarly to increase in price If Demand in Inelastic, (% change in quantity demanded is less than the % change in price), P and PQ move in the same direction, similarly to increase in price Elasticity and TE / TR Unit Elastic Elasticity = -1 - the % change in quantity demanded equals to the % change in price Elasticity Perfectly Elastic Demand/Supply Ex. Pepsi, coke Elasticity
Management Economics Guide/RK2013 Page 1

Cross-Price Elasticity of Demand Measure the responsiveness of quantity demanded for good y to a change in price of good x % change in Qy % change in Px Substitute goods: Elasticity is positive (Increase in price of good x will result in an increase in demand of good y) Complement goods: Elasticity is negative (Increase in price of good x will result in a decrease in demand of good y) Income Elasticity of Demand Measure the responsiveness of quantity demanded for good x to a change in income % change in Qx % change in I Normal goods: Elasticity is positive (Increase in income will result in an increase in demand of good x) i.e., Mercedes Benz Inferior goods: Elasticity is negative (Increase in income will result in a decrease in demand of good x) i.e., 2nd hand clothing Question 01 When the price of hot dog is $1.50 each, 500 hot dogs are sold every day. After lowering the price to $1.35 each, 510 hot dogs are sold every day. At the original price, what is the price elasticity of demand for hot dogs? 66.67 5 1 0.2 0.015. Calculating Price Elasticity of Demand

Answer 01
Price Elasticity of Demand for Hot Dogs = - 0.2 (D)

Management Economics Guide/RK2013

Page 2

Question 02 For which of the following products is demand likely to be least price elastic? Frozen Food (A) (B) (C) (D) Soft Drinks Groceries Diet Coke Not enough information provided to answer this question

Answer 02 What affects Price Elasticity of Demand? One major factor is the availability of substitutes. If there are many substitutes for Good X available in the market, people tend to be very responsive to changes in PX, and hence, higher elasticity. In this question, we check out which option is the most difficult to be substituted, i.e., necessity good. A; Frozen food can easily be replaced by fresh food. B; Soft drinks and (D) Diet coke can easily find substitutes, e.g. orange juice, coffee, tea, Zero coke, Diet Pepsi C; Groceries are the hardest to be replaced as they are necessities. Answer (C) Question 03 If the price is $2 in both locations, the Price Elasticity of Demand for a candy bar at an airport is likely to be the price elasticity for a candy bar in a grocery store. (A) (B) (C) (D) (E) Less than Equal to Greater than The reciprocal of Not enough information to determine

Answer 02 What affects Price Elasticity of Demand? Number of sellers within reach Suppose there exists only one kind of candy bar.
Management Economics Guide/RK2013 Page 3

In busy areas where you can find grocery stores, it is more likely that you can find more than one shop selling candy bars. However, in isolated areas such as airports, there may only be one seller. In other words, one will find it difficult to locate an alternative seller of a certain goods (e.g. candy bars) at the airport. A person will still have to buy candy bars from that seller at the airport even if prices are raised. Hence, quantity demanded is less responsive to price changes compared to shops at other locations. Answer (A) Question 04 The Price Elasticity of Demand for apartments is 1.3, while the Price Elasticity of Demand for toothpicks is 0.4. The likely reason for the difference is because There are few substitutes for toothpicks Apartments are chosen over a long period of time The fraction of income spent on toothpicks is minuscule Toothpicks are a necessity Apartments are a luxury (A) (B) (C) (D) (E) There are few substitute for tooth picks Apartments are chosen over a long period of time The fraction of income spent on tooth picks is miniscule Tooth picks are necessity Apartments are luxury

Answer 04 Demand for apartments is more price elastic than that for toothpicks. Why? (A & D) are not true because there exist good substitutes for toothpicks, e.g. dental floss and fingernails. (B) is true for many consumers, but is irrelevant, as we are comparing the Price Elasticity at the same point of time. (E) is relevant only if we are talking about Income Elasticity.

Management Economics Guide/RK2013

Page 4

Cross-Price Elasticity
The Cross-Price Elasticity of Demand measures the rate of response of quantity demanded of one good, due to a price change of another good. If two goods are substitutes, we should expect to see consumers purchase more of one good when the price of its substitute increases. Similarly if the two goods are complements, we should see a price rise in one good cause the demand for both goods to fall. Your course may use the more complicated Arc Cross-Price Elasticity of Demand formula. If so you'll need to see the article on Arc Elasticity. The common formula for the Cross-Price Elasticity of Demand (CPEoD) is given by: CPEoD = (% Change in Quantity Demand for Good X)/(% Change in Price for Good Y)

Calculating the Cross-Price Elasticity of Demand

Question 04 With the following data, calculate the cross-price elasticity of demand for good X when the price of good Y changes from $9.00 to $10.00." Using the chart on the bottom of the page, we'll answer this question. We know that the original price of Y is $9 and the new price of Y is $10, so we have Price (OLD) =$9 and Price (NEW) =$10. From the chart we see that the quantity demanded of X when the price of Y is $9 is 150 and when the price is $10 is 190. Since we're going from $9 to $10, we have Q Demand (OLD) =150 and Q Demand (NEW) = 190. You should have these four figures written down:

Price (OLD) = 9 Price (NEW) = 10 Q Demand (OLD )= 150 Q Demand (NEW) = 190

Answer 04
To calculate the cross-price elasticity, we need to calculate the percentage change in quantity demanded and the percentage change in price. We'll calculate these one at a time. Calculating the Percentage Change in Quantity Demanded of Good X. The formula used to calculate the percentage change in quantity demanded is: [Q Demand (NEW) Q Demand (OLD)] / Q Demand (OLD) By filling in the values we wrote down, we get: [190 - 150] / 150 = (40/150) = 0.2667 So we note that % Change in Quantity demanded = 0.2667 (This in decimal terms. In percentage terms this would be 26.67%).
Management Economics Guide/RK2013 Page 5

Calculating the Percentage Change in Price of Good Y, The formula used to calculate the percentage change in price is: Price (NEW) Price (OLD)] / Price (OLD) We fill in the values and get: [10 - 9] / 9 = (1/9) = 0.1111

We have our percentage changes, so we can complete the final step of calculating the crossprice elasticity of demand. Final Step of Calculating the Cross-Price Elasticity of Demand We go back to our formula of:
CPEoD = (% Change in Quantity Demanded of Good X) / (% Change in Price of Good Y)

We can now get this value by using the figures we calculated earlier. CPEoD = (0.2667) / (0.1111) = 2.4005 We conclude that the cross-price elasticity of demand for X when the price of Y increases from $9 to $10 is 2.4005. Interpret the Cross-Price Elasticity of Demand The cross-price elasticity of demand is used to see how sensitive the demand for a good is to a price change of another good. High positive cross-price elasticity tells us that if the price of one good goes up, the demand for the other good goes up as well. A negative tells us just the opposite, that an increase in the price of one good causes a drop in the demand for the other good. A small value (either negative or positive) tells us that there is little relation between the two goods. Often an assignment or a test will ask you a follow up question such as "Are the two goods complements or substitutes? To answer that question, you use the following rule of thumb:

If CPEoD > 0 then the two goods are substitutes If CPEoD = 0 then the two goods are independent (no relationship) If CPEoD < 0 then the two goods are complements

In the case of our good, we calculated the cross-price elasticity of demand to be 2.4005, so our two goods are substitutes when the price of good Y is between $9 and $10.

Management Economics Guide/RK2013

Page 6