ELASTICITY

ELASTICITY:

Elasticity (E) measures the degree of responsiveness of changes in quantity demanded or supplied to changes in several different independent (or causal) variables. In this course we will use four different measures of elasticity. In all cases we will use the "mid-point" method of calculating each elasticity. The specific elasticities are as follows:

Price Elasticity of Demand (PED)- The responsiveness of quantity demanded of a product to a change in the price of the product. Sign is ignored as only the absolute value matters. PED measures what happens along a demand curve as changes in quantity demanded are affected by change in price.

Formula: PED =	%Change QD	=(Q1-Q2/Q1+Q2/2)X100
Formula: PED =	%Change P	(P1-P2/P1+P2/2)X100

Example:

At $4/lb. The local Big Y sells 2,000 lbs./wk. of carrots.

The price is lowered to $3/lb and 2,200 lbs. are sold.

(2,000-2200)/(2,000+2200/2)X100
(4-3)/(4+3/2)X100

=(200/2100)x100
(1/3.5)X 100

=.095X100 .286X100	= 9.5% 28.6%	= .33 (Inelastic)

PED > 1 Elastic PED= 1 Unitary Elasticity PED < 1 Inelastic

Price Elasticity of Supply (PES)

PES measures what happens along a supply curve as changes in quantity supplied are affected by a change in price. Use absolute value. Mid-Point Method.

Formula: PES =	%Change QS %Change P	=(Q1-Q2/Q1+Q2/2)X100 (P1-P2/P1+P2/2)X100

Example: The price per bushel of wheat increases from $7 to $10 because of a drought in the mid-west. Farmers grow more wheat in the next season and Q increases from 10 million bushels to 20 million.

PES =

(10-20)/(10+20)/2)X100
(7-10)/(7+10/2)X100

= (10/15)X100
(3/8.5)X100

=.667X100
.353X100

= 66.7%
35.3%

= 1.89 (elastic)

INCOME ELASTICITY OF DEMAND (YED)

Y represents income because economists use I to represent Investment. The responsiveness of quantity demanded of a product to a change in personal or household income. The sign is critical in this calculation to distinguish between a normal and inferior good. (Implicit here is a shift in the demand curve-i.e. a change in demand)

Formula: YED =

%Change QD
%Change Y

= Sign(Q1-Q2/Q1+Q2/2)X100
Sign(Y1-Y2/Y1+Y2/2)X100

Example: MA personal income falls from $20 billion to 18 billion because of the current recession. The number of cases of beer demanded falls from 2 billion to1.8 bilion.

-(2-1.8)/ (2+1.8/2)X100
-(20-18)/(20+18/2)X100

= -(.2/1.9)x100
-(2/19)X 100

=.-11X100
.-11X100

= - 11%
-11%

= +1.00 (Unitary)

Cross Elasticity of Demand (CED)

CED measures what happens to the demand for one good when the price of another good changes. (Implicit here is a shift in the demand curve-i.e. a change in demand). The sign is critical in this calculation to distinguish between complement and substitute goods.

Formula:CED =

Sign%Change QSG1
Sign %Change PG2

=S(Q1Q2/Q1+Q2/2)X100
S (P1-P2/P1+P2/2)X100

Example: The price of beer at Fenway Park falls from $10 to $8 per cup and the number of bags of pretzels purchased goes up from 20 thousand to 25 thousand per game.

CED =

+(20-25)/(20+25)/2)X100
-(10-8)/(10+8/2)X100

= (5/22.5X100
(2/9)X100

= +.222X100
-.222X100

= +22.2%
-22.2%

= -1

- Complement; + Substitute

EFFICIENCY AND FAIRNESS OF MARKETS

Allocative Efficiency

Marginal Benefit and Marginal Cost
Consumer Surplus
Producer Surplus

Obstacles to Efficiency

Externalities (cost or benefit not reflected in market prices)

Public Good- consumed even if people don’t pay for it

Monopoly Power

Political Power

Are Markets Fair

Results vs. rules.