Elasticity:ComprehensiveCalculations Ingeneral,elasticityisthepercentagechangeinsomethingrelativetothepercentagechangein somethingelse.Becausethechangeismeasuredintermsofpercent,unitsofmeasurearenolonger relevant. Thereareanumberofwaystocalculateelasticity.Forsimplicity,Iwillfocusontheprice elasticityofdemandonthissheet.Theonethingtorememberaboutpriceelasticityofdemandisthat becauseyouaremeasuringthesensitivityofanegativerelationship(recallthelawofdemand)the resultingnumberisgoingtobenegative.Therefore,itiscustomarytoreporttheabsolutevalueofthe priceelasticityofdemand.Iwillexplicitlyshowtheabsolutevaluefunction. |%QD/%P| StartingPointElasticity: Inmanypracticalapplicationsofelasticityitisofinteresttoknowwhatwillhappenifthereisa changefromastatusquo.Forexample,howmuchwillsalesincreaseifyoudecreasepricebyten percent?Therefore,itisappropriatetocalculateelasticityrelativetoacurrentstartingpoint.

ExamineFigure1below:
Figure1

Elasticity
30 25 20 Price 15 10 5 0 0 20 40 60 Quantity 80 100 120 Elasticity

ImaginethatcurrentsalesareatQuantity=40andPrice=15(40,15).IfIdecreasepriceto10,sales wouldincreaseto60.LetQ1=StartingQuantity=40andQ2=EndingQuantity=60.LetP1=Starting Price=15andP2=EndingPrice=10.Thepercentagechangeinquantitydemandedismeasuredrelative tothestartingquantityof40:%QD=(Q2Q1)/Q1=(6040)/40=20/40=0.5or50%.Thepercentage changeinpriceismeasuredrelativetotheStartingPriceof15:%P=(P2P1)/P1=(1015)/15=5/15= 0.33or331/3%.Thepriceelasticityofdemandstartingat(40,15)is|50%/331/3%|=1.5. 1

Startingpointelasticityismostbeneficialtothosepeoplewhoareconsideringachangeina currentsituationandwouldlikeawaytoanticipatetheresultsofaparticularchange.Theonereason whysometextbookauthorsdonotlikestartingpointelasticityisthatitisdependentonwhatyou chooseasyourstartingpoint.Noticeintheexampleaboveifwechoosethepoint(60,10)asour startingpointandmoveto(40,15)themeasureofelasticitychanges: |(4060)/60/(1510)/10)|=0.66. Therefore,oneapproachtoavoidthispotentialconfusionistointroducemidpointelasticity. MidpointElasticity: Someauthorsliketointroducethemidpointelasticityapproachtoavoidtheproblemofgetting differentmeasuresofelasticityifstudentsusethewrongdenominatorwhencalculatingpercentage changes.Furthermore,ifyouwantasimpledescriptionofconsumerbehavioroveraportionofa demandcurveratherthanatasinglepointonthedemandcurve,midpointelasticityisappropriate.The onlychangefromaboveistoredefinethepercentagechangestobeintermsoftheaveragepoint betweenthestartingpointandtheendpoint.Fromtheexampleabovewecanseethattheaverage quantityis:(Q1+Q2)/2=(40+60)/2=50.Theaveragepriceis:(P1+P2)/2=(15+10)/2=12.5.Theformula forthemidpointpriceelasticityofdemandis: |%QD/%P|=|(Q2Q1)/((Q1+Q2)/2)/(P2P1)/((P1+P2)/2)| Thetwoscanceltocleanuptheequationalittle:|(Q2Q1)/(Q1+Q2)/(P2P1)/(P1+P2)| Thenicethingabouttheformulaisthatitdoesnotmatterifyouconfusethestartingpointandtheend point.Themathematicalresultwillbethesame.Considerthepointsweusedabove,(40,15)and(60, 10): |(6040)/50/(1015)/12.5|=1 |(4060)/50/(1510)/12.5|=1 Itisworthmentioningthatthenewmeasureofelasticityisdifferentfromthetwoprevious measures.Noticethatitisnotsimplytheaverageofthetwo. ArcElasticity: Arcelasticityissimplyavariantofthemidpointelasticitybutisconvenientifyouareworking withanonlinearfunctionandyouhavenotyettakencalculus(gotakecalculusifyouhavethechance itimpressesallofthepeoplewhoareafraidofmathclasses). Initssimplestform,arcelasticityisexactlylikethemidpointmethod.Thedifferenceisthatthe demandcurveofinterestisactuallycurved.ThedemandcurveinFigure2isaconstantelasticity demandcurve.Itconvenientlygoesthroughthesametwopointswehavebeenexamining.Therefore, youcanseefairlyquicklythatifyouweretoevaluatethepercentchangequantitydemandedrelativeto 2

thepercentchangepriceoverthesametwopointsyouwillgetthesamemeasureofpriceelasticity.It isworthnoting,however,thatasyouworkyourwaytowardeitheraxisthecurveflattensout.Thisis whatallowsitselasticitytoremainconstant.

Figure2

30 25 20 P 15 10 5 0 0 20 40 60 80 100 120 Linear

ExactPointElasticity: Oneofthewayseconomistsmakealivingisbycalculatingelasticities.Becauseunderstanding elasticityissoimportant,ownersoffirmsbothlargeandsmallarewillingtopayhandsomelyfor informationaboutthesensitivityofthedemandtheyface.Wheneconomistsconductempirical researchtheyexamineaproblematthemargin.Thatis,theylookatthesensitivityofdemandto changesinpricewithinaverysmallrangerelativetotheobservedpriceandquantity.Theexactpoint elasticityformulaprovidesameasureofpriceelasticityofdemandthatrelatestoonepointona(linear) demandcurve.Formymoney,itistheeasiestofallofthemeasuresofelasticitytorememberanditis themostuseful.But,itdoesrequireaslightlydeeperunderstandingofdemand.ReferbacktoFigure1. Noticethatataparticularprice(25)thequantitydemandedgoestozero.Refertothispointasa. Someeconomistscallaachokepricethepriceatwhichalldemandischokedoff.Atanygivenprice, P,thepointelasticityofdemandissimply: 1 |P/(Pa)| Quicklycheckthreepointsofinterest: AtP=15:|15/(1525)|=11/3 AtP=10:|10/(1025)|=2/3
1

Notethatthequantitydemandedisnotneededtocalculatetheexactpointelasticity.Thisisbecauseallofthe informationthatisnecessaryiscapturedintherelativepositionofthecurrentpriceandthechokeprice.

AtP=12.5:|12.5/(12.525)|=1 Noticethatwegetthesameanswersasthestartingpointmethodinthefirsttwocasesand,byusing themidpointprice,wegetthesameanswerasthemidpointmethodinthelastcase.Therearesome additionalnicethingsaboutusingtheexactpointelasticity.Forone,itremindsusthatasprice increases,elasticityincreasesandaspricedecreases,elasticitydecreases.Anotherniceaspectabout theexactpointelasticityisthatitisanalogoustousingmoreadvancedcalculusapproaches.Toseethis, consideranonlineardemandfunctionsuchastheoneinFigure2.Now,examineanarccreatedby squeezingtwopointseverclosertogether.Oncethosetwopointsbecomeonepoint,drawatangentto thearcatthatpoint.Thetangentrepresentsthestraightlinedemandfunctionatthatpoint.Theexact pointelasticitygivesyoutheelasticityatthatpoint.