Post on 07-Apr-2015
Chapter 4
Demand Elasticity
Demand Elasticity
The Economic Concept of Elasticity The Price Elasticity of Demand The Cross-Elasticity of Demand Income Elasticity Other Elasticity Measures Elasticity of Supply
Learning Objectives
Define and measure elasticity Apply concepts of price elasticity,
cross-elasticity, and income elasticity Understand determinants of elasticity Show how elasticity affects revenue
The Economic Concept of Elasticity
The demand curve sloped downward to the right (the lowered the price, the greater the quantity demanded)
Elasticity: the percentage change in one variable relative to a percentage change in another.
Bin changepercent
Ain changepercent Elasticity oft Coefficien
The Price Elasticity of Demand
A firm contemplating lowering its price to counteract new competition
Price elasticity of demand: The percentage change in quantity demanded caused by a 1 percent change in price.
Price %
Quantity %E
p
Measurement of Price Elasticity Arc elasticity: Elasticity which is
measured over a discrete interval of a demand (or a supply) curve.
Ep = Coefficient of arc price elasticity Q1 = Original quantity demanded Q2 = New quantity demanded P1 = Original price P2 = New price
2/)(2/)( 21
12
21
12
PP
PP
QQEp
Example
P1=11 P2=12 Q1=7 Q2=6
Then what is EP ?
The Price Elasticity of Demand
Point elasticity: Elasticity measured at a given point of a demand (or a supply) curve.
1
1
εP
PdQx
dP Q=
The Price Elasticity of Demand
The point elasticity of a linear demand function can be expressed as:
1
1
Q
P
P
Q
p
Example
Q=18-P at when P=$12 and Q=6then what is EP ?
Q=100-P2 when P1=5, then Q=75 then what is EP ?
The Price Elasticity of Demand
Some demand curves have constant elasticity over the relevant range
Such a curve would look like:Q = aP-b
where –b is the elasticity coefficient This equation can be converted to
linear by expressing it in logarithms:log Q = log a – b(log P)
The Price Elasticity of Demand Elasticity differs
along a linear demand curve
The Price Elasticity of Demand
Categories of Elasticity Relative elasticity of demand: EP > 1
Relative inelasticity of demand: 0 < EP < 1
Unitary elasticity of demand: EP = 1
Perfect elasticity: EP = ∞
Perfect inelasticity: EP = 0
Special Cases
P
D
D
Q0 0 Q
Infinitely (price) elastic Infinitely price inelastic
The Price Elasticity of Demand
Factors affecting demand elasticity Ease of substitution Proportion of total expenditures Durability of product
Possibility of postponing purchase Possibility of repair Used product market
Length of time period
The Price Elasticity of Demand
Derived demand: The demand for products or factors that are not directly consumed, but go into the production of a final product.
The demand for such a product or factor exists because there is demand for the final product.
The Price Elasticity of Demand The derived demand curve will be
more inelastic: the more essential is the component in
question. the more inelastic is the demand curve
for the final product. the smaller is the fraction of total cost
going to this component. the more inelastic is the supply curve of
cooperating factors.
Example
Consider demand for residential housing (the final product) and the derived demand for one class of labor employed in construction , electricians ( the demand for electricians does not exist for its own sake) Assumptions: 1. can not build a house
without electricians 2. the cost of electricians is a relatively small percentage of the entire cost of the house
The Price Elasticity of Demand A long-run demand
curve will generally be more elastic than a short-run curve.
As the time period lengthens consumers find way to adjust to the price change, via substitution or shifting consumption
The Price Elasticity of Demand
There is a relationship between the price elasticity of demand and revenue received. Because a demand curve is downward
sloping, a decrease in price will increase the quantity demanded
If elasticity is greater than 1, the quantity effect is stronger than the price effect, and total revenue will increase
The Price Elasticity of Demand As price decreases
Revenue rises when demand is elastic.
Revenue falls when it is inelastic.
Revenue reaches it peak when elasticity of demand equals 1.
The Price Elasticity of Demand
Marginal Revenue: The change in total revenue resulting from changing quantity by one unit.
QuantityMR
Revenue Total
The Price Elasticity of Demand For a straight-line
demand curve the marginal revenue curve is twice as steep as the demand
The Price Elasticity of Demand At the point where
marginal revenue crosses the X-axis, the demand curve is unitary elastic and total revenue reaches a maximum.
The Price Elasticity of Demand
Some sample elasticities Coffee: short run -0.2, long run -0.33 Kitchen and household appliances: -0.63 Meals at restaurants: -2.27 Airline travel in U.S.: -1.98 Beer: -0.84, Wine: -0.55
The Cross-Elasticity of Demand
Cross-elasticity of demand: The percentage change in quantity consumed of one product as a result of a 1 percent change in the price of a related product.
B
AX P
QE
%
%
The Cross-Elasticity of Demand
Arc Elasticity
2/)(2/)( 21
12
21
12
BB
BB
AA
AAx PP
PP
QQE
The Cross-Elasticity of Demand
Point Elasticity
B
B
A
AX P
P
Q
QE
The Cross-Elasticity of Demand
The sign of cross-elasticity for substitutes is positive.
The sign of cross-elasticity for complements is negative.
Two products are considered good substitutes or complements when the coefficient is larger than 0.5.
Income Elasticity
Income Elasticity of Demand: The percentage change in quantity demanded caused by a 1 percent change in income.
Y is shorthand for Income
Y
QEY
%
%
Income Elasticity
Arc Elasticity
2/)(2/)( 21
12
21
12
YY
YY
QQEY
Other Elasticity Measures Categories of
income elasticity Superior goods: EY
> 1 Normal goods: 0
>EY >1 Inferior goods –
demand decreases as income increases: EY < 0
Elasticity of Supply
Elasticity is encountered every time a change in some variable affects quantities. Advertising expenditure Interest rates Population size
Elasticity of Supply Price Elasticity of Supply: The
percentage change in quantity supplied as a result of a 1 percent change in price.
If the supply curve slopes upward and to the right, the coefficient of supply elasticity is a positive number.
Price %
SuppliedQuantity %E
S
Elasticity of Supply
Arc elasticity
2/)(2/)( 21
12
21
12
PP
PP
QQEs
Demand Elasticity
When the supply curve is more elastic, the effect of a change in demand will be greater on quantity than on the price of the product.
With a supply curve of low elasticity, a change in demand will have a greater effect on price than on quantity.
Global application
Example: price elasticities in Asia
imports almost always price inelastic if exports price inelastic, export
earnings will rise as prices rise if exports price elastic, export
earnings will rise with world incomes