4 4 Demand and Elasticity. ●Elasticity: Measure of Responsiveness ●Price Elasticity of Demand:...

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Demand and Elasticity

● Elasticity: Measure of Responsiveness

● Price Elasticity of Demand: Its Effect on Total Revenue

● What Determines Demand Elasticity?

● Elasticity as a General Concept

● Real-World Application: Polaroid versus Kodak

● Elasticity: Measure of Responsiveness

● Price Elasticity of Demand: Its Effect on Total Revenue

● What Determines Demand Elasticity?

● Elasticity as a General Concept

● Real-World Application: Polaroid versus Kodak

OutlineOutline

Copyright© 2006 South-Western/Thomson Learning. All rights reserved.


● Elasticity = measure of the responsiveness of one variable to changes in another variable

● Price elasticity of demand =

● Elasticity = measure of the responsiveness of one variable to changes in another variable

● Price elasticity of demand =% Qd

% P

Elasticity: Measure of ResponsivenessElasticity: Measure of Responsiveness


Real-World Application: Polaroid versus KodakReal-World Application: Polaroid versus Kodak

● In 1989, Polaroid sued Kodak –copyright infringement of its instant-photography patents.

● Court case would determine how much Kodak should pay in compensation to Polaroid.♦ Polaroid: could have charged ↑P film without illegal

competition from Kodak♦ Kodak: ↑P film → ↓Qd film

● In 1989, Polaroid sued Kodak –copyright infringement of its instant-photography patents.

● Court case would determine how much Kodak should pay in compensation to Polaroid.♦ Polaroid: could have charged ↑P film without illegal

competition from Kodak♦ Kodak: ↑P film → ↓Qd film



● Relevant Question: How would ↑P film affect Polaroid’s TR?♦ Depends on how responsive Qd is to P, which

depends on the shape of the D curve for film

● Court’s decision would be based on the responsiveness of Qd to P.

● Relevant Question: How would ↑P film affect Polaroid’s TR?♦ Depends on how responsive Qd is to P, which

depends on the shape of the D curve for film

● Court’s decision would be based on the responsiveness of Qd to P.

FIGURE 1(a). Hypothetical Demand Curves for Film

FIGURE 1(a). Hypothetical Demand Curves for Film

4 1.5 0

10

$20

Pri

ce p

er P

ack

age

Quantity Demanded in millions

D f

Df b

a


D is relatively responsive to P.

TRa = $10 x 4 = $40

TRb = $20 x 1.5 = $30

Here P doubles and TR falls by 25%.

Kodak’s claim

FIGURE 1(b). Hypothetical Demand Curves for Film

FIGURE 1(b). Hypothetical Demand Curves for Film

4 3 0

10

$20

Quantity Demanded in millions

Pri

ce p

er P

ack

age

DS

DS

B


A

D is relatively unresponsive to P.

TRa = $10 x 4 = $40TRb = $20 x 3 = $60

Here P doubles and TR rises by 50%.

Polaroid’s claim


Elasticity: Measure of ResponsivenessElasticity: Measure of Responsiveness

● Governments, courts, and businesses need to understand the relationship between Qd and P

● If consumers respond sharply to ∆P →D is elastic ♦ E.g., graph (a) above

● If consumers are unresponsive to ∆P →D is inelastic♦ E.g., graph (b) above

● Governments, courts, and businesses need to understand the relationship between Qd and P

● If consumers respond sharply to ∆P →D is elastic ♦ E.g., graph (a) above

● If consumers are unresponsive to ∆P →D is inelastic♦ E.g., graph (b) above


Calculation of Elasticity of DCalculation of Elasticity of D

● Price Elasticity of Demand: ♦ % Qd % P

● Units problems: cannot judge elasticity by looking at a graph and its slope♦ ∆ in units of measurement make graphs appear

steeper or flatter when they convey the same info.

● Price Elasticity of Demand: ♦ % Qd % P

● Units problems: cannot judge elasticity by looking at a graph and its slope♦ ∆ in units of measurement make graphs appear

steeper or flatter when they convey the same info.

FIGURE 2(a). Sensitivity of Slope to Units of Measurement

FIGURE 2(a). Sensitivity of Slope to Units of Measurement

2,000 1,500 1,000

D

D

500 0

10 9 8

17 16 15 14 13 12 11

7 6 5 4 3 2 1

$18

(a)

Pizzas per Week

Pri

ce

pe

r P

izza

3,000 2,500 360

280

B

A


↓P by $4 →↑Qd by 80.

FIGURE 2(b). Sensitivity of Slope to Units of Measurement

FIGURE 2(b). Sensitivity of Slope to Units of Measurement

2,000 1,500 1,000

D

D

500 0

10 9 8

17 16 15 14 13 12 11

7 6 5 4 3 2 1

$18

(b)

Slices of Pizza per Week

Pri

ce

pe

r P

izza

2,500 3,000 2,880 2,240

B


1 pizza = 8 slices

↓P by $4 →↑Qd by 640.

A



● Slope of a curve changes whenever units of measurement changes.

● ↓P by $4 → (a) ↑Qd by 80

→ (b) ↑Qd by 640● Same info is portrayed but slope is flatter (and looks

more elastic) when measured in slices. ● Need % ∆ not absolute ∆ (slope) to measure elasticity.

♦ E.g., if defense budget doubles, it goes up by 100% whether it is measured in millions or billions of dollars.

● Slope of a curve changes whenever units of measurement changes.

● ↓P by $4 → (a) ↑Qd by 80

→ (b) ↑Qd by 640● Same info is portrayed but slope is flatter (and looks

more elastic) when measured in slices. ● Need % ∆ not absolute ∆ (slope) to measure elasticity.

♦ E.g., if defense budget doubles, it goes up by 100% whether it is measured in millions or billions of dollars.



● Percentage problems:♦ Fig. 1(b). Pa = $10 and Qa = 4;

Pb = $20 and Qb = 3.

∆Qd = 1, so should we take 1 as a % of 3? → 33.3%

or 1 as a % of 4? → 25.0%● No right answer, so compromise by using the average Qs● Average of 3 & 4 = 3.5 →%∆Qd = 1/3.5 = 28.6%● Same is done with price: %∆P = $10/$15 = 66.7%

● Percentage problems:♦ Fig. 1(b). Pa = $10 and Qa = 4;

Pb = $20 and Qb = 3.

∆Qd = 1, so should we take 1 as a % of 3? → 33.3%

or 1 as a % of 4? → 25.0%● No right answer, so compromise by using the average Qs● Average of 3 & 4 = 3.5 →%∆Qd = 1/3.5 = 28.6%● Same is done with price: %∆P = $10/$15 = 66.7%



● Drop (-) sign and use absolute values:♦ P and Qd have a (-) relationship

ε = (∆Qd / average of 2 Q’s) (∆P /average of 2 P’s)

● Polaroid example:♦ Fig. 1(a): ε = (2.5/2.75) (10/15) = 1.4♦ Fig. 1(b): ε = (1/3.5) (10/15) = 0.43

● Drop (-) sign and use absolute values:♦ P and Qd have a (-) relationship

ε = (∆Qd / average of 2 Q’s) (∆P /average of 2 P’s)

● Polaroid example:♦ Fig. 1(a): ε = (2.5/2.75) (10/15) = 1.4♦ Fig. 1(b): ε = (1/3.5) (10/15) = 0.43


FIGURE 3(a). Perfectly Inelastic Demand

FIGURE 3(a). Perfectly Inelastic Demand


Qd is 90 no matter the P.

%∆Qd = 0

Consumer purchases do not respond to ∆P.

E.g., goods with very low prices that are used with something else –salt or shoelaces. Or an essential medicine.

P D

QD0

90

Elasticity = 0


FIGURE 3(b). Perfectly Elastic Demand

FIGURE 3(b). Perfectly Elastic Demand


Slight ↑P → ↓Qd to 0.

%∆Qd = infinitely large

Consumer are completely responsive to ∆P.

E.g., Demand for a firm that produces an undifferentiated product.

Elasticity =

D

QD

P

$5

0


FIGURE 3(c). Straight-line Demand

FIGURE 3(c). Straight-line Demand


Slope remains constant but ε is changing.

ε (a-b) = (2/3) (2/5) = 1.67

ε (c-d) = (2/6) (2/2) = 0.33

Moving down the D curve ε is getting smaller because average Q is rising while average P is falling.

D

P

a

b

c

d

6

4

3

1

2 4 5 7 QD


FIGURE 3(d). Unit-elastic DemandFIGURE 3(d). Unit-elastic Demand


Slope is changing but ε is constant and equal to 1.

ε (e-f) = (7/10.5) (10/15) = 1.0

Note: if ε = 1 → D is “unit elastic”

if ε > 1 → D is “elastic”

if ε < 1 → D is “inelastic”

D

P

QD

20

10

7 14

e

f


Elasticity of Demand and Total Revenue Elasticity of Demand and Total Revenue

● Firms want to know whether an ↑P will raise or lower their sales revenues.

♦ If D is elastic: ↑P → ↓TR♦ If D is unit elastic: ↑P → TR constant♦ If D is inelastic: ↑P → ↑TR

■Recall: TR = TE = P x Qd

● Firms want to know whether an ↑P will raise or lower their sales revenues.

♦ If D is elastic: ↑P → ↓TR♦ If D is unit elastic: ↑P → TR constant♦ If D is inelastic: ↑P → ↑TR

■Recall: TR = TE = P x Qd


Elasticity of Demand and Total RevenueElasticity of Demand and Total Revenue

● Further examples:♦ If P↓ by 10% and ↑Qd by 10% → D is unit elastic and

TR are constant.♦ If P↓ by 10% and ↑Qd by 15% → D is elastic and

↑TR. ♦ If P↓ by 10% and ↑Qd by 5% → D is inelastic and

↓TR.

● Further examples:♦ If P↓ by 10% and ↑Qd by 10% → D is unit elastic and

TR are constant.♦ If P↓ by 10% and ↑Qd by 15% → D is elastic and

↑TR. ♦ If P↓ by 10% and ↑Qd by 5% → D is inelastic and

↓TR.

FIGURE 4. An Elastic Demand Curve

FIGURE 4. An Elastic Demand Curve

5

12

Quantity Demanded

Pri

ce

$6

1

2

3

4

4 0

U

W

D

D

R

T

S

V


Pt. S: TR = $24 = area of 0RST

Pt. V: TR = $60 = area of 0WVU

D is elastic as ↓P → ↑TR.


TABLE 1. Estimates of Price Elasticities

TABLE 1. Estimates of Price Elasticities



What Determines Demand Elasticity?What Determines Demand Elasticity?

1. Nature of the good: ♦ Necessities have very inelastic demands, while

luxuries have elastic demands.♦ E.g., ε potatoes = 0.3 and the ε restaurant meals =

1.6. What do these numbers mean?

● 10%↑ in P of potatoes → ↓sales of potatoes by 3%. And 10%↑ in P of restaurant meals → ↓restaurant dining by 16%.

1. Comes from the elasticity formula: %P * ε = %Qd

1. Nature of the good: ♦ Necessities have very inelastic demands, while

luxuries have elastic demands.♦ E.g., ε potatoes = 0.3 and the ε restaurant meals =

1.6. What do these numbers mean?

● 10%↑ in P of potatoes → ↓sales of potatoes by 3%. And 10%↑ in P of restaurant meals → ↓restaurant dining by 16%.

1. Comes from the elasticity formula: %P * ε = %Qd



2. Availability of a close substitute:♦ If consumers can buy a good substitute for a

product whose ↑P, they will readily switch.■ E.g., D for gas is inelastic because you can’t run

a car without it. But D for Chevron gas is elastic because Mobile or Shell gas work just as well.

2. Availability of a close substitute:♦ If consumers can buy a good substitute for a

product whose ↑P, they will readily switch.■ E.g., D for gas is inelastic because you can’t run

a car without it. But D for Chevron gas is elastic because Mobile or Shell gas work just as well.



3. Fraction of Income Absorbed:♦ Very inexpensive items have an inelastic

demand. Who will use more salt if the price falls?

♦ Very expensive items have elastic demands. Families will buy fewer homes if housing prices increase.

3. Fraction of Income Absorbed:♦ Very inexpensive items have an inelastic

demand. Who will use more salt if the price falls?

♦ Very expensive items have elastic demands. Families will buy fewer homes if housing prices increase.



4. Passage of Time:● D for products is more elastic in LR than SR

because consumers have more time to adjust their purchases.

♦ E.g., suppose recent ↑P gas continues. In SR, consumers may take fewer summer road trips to ↓Qd gas. But in LR, consumers can buy more fuel efficient cars to further ↓Qd gas.

4. Passage of Time:● D for products is more elastic in LR than SR

because consumers have more time to adjust their purchases.

♦ E.g., suppose recent ↑P gas continues. In SR, consumers may take fewer summer road trips to ↓Qd gas. But in LR, consumers can buy more fuel efficient cars to further ↓Qd gas.


Elasticity as a General ConceptElasticity as a General Concept

● Elasticity can be used to measure the responsiveness of anything to anything else.

● Income Elasticity:♦ Income elasticity of D = % Qd % Y

● Price Elasticity of Supply:♦ Price elasticity of S = % Qs % P

● Elasticity can be used to measure the responsiveness of anything to anything else.

● Income Elasticity:♦ Income elasticity of D = % Qd % Y

● Price Elasticity of Supply:♦ Price elasticity of S = % Qs % P


Cross Elasticity of DemandCross Elasticity of Demand

● Cross εd is used to determine whether two goods are compliments or substitutes. It is calculated as:εcross = (%∆Qd good X) (%∆P good Y)

● Cross εd is used to determine whether two goods are compliments or substitutes. It is calculated as:εcross = (%∆Qd good X) (%∆P good Y)



● Two goods are compliments if an ↑Qd for one

good → ↑Qd of the other good. ♦ E.g, ketchup and french fries or coffee and cream.

■ If ↓P of coffee → ↑purchases of coffee and cream. Cross elasticity for compliments is (-). As ↓P of coffee falls → ↑Qd of cream.

● Two goods are compliments if an ↑Qd for one

good → ↑Qd of the other good. ♦ E.g, ketchup and french fries or coffee and cream.

■ If ↓P of coffee → ↑purchases of coffee and cream. Cross elasticity for compliments is (-). As ↓P of coffee falls → ↑Qd of cream.



● Two goods are substitutes if an ↑Qd for one good → ↓Qd of the other good. ♦ E.g., ice cream and frozen yogurt or cans of salmon

and cans of tuna.■ If ↑P of ice cream → ↓purchases of ice cream and

↑purchases of frozen yogurt. Cross elasticity for substitutes is (+). As ↑P of ice cream → ↑Qd of frozen yogurt.

● Cross elasticity is often used in “anti-trust” lawsuits. If firms face strong competition, it is difficult to overcharge customers. A very high and (+) cross elasticity indicates effective competition in a market.

● Two goods are substitutes if an ↑Qd for one good → ↓Qd of the other good. ♦ E.g., ice cream and frozen yogurt or cans of salmon

and cans of tuna.■ If ↑P of ice cream → ↓purchases of ice cream and

↑purchases of frozen yogurt. Cross elasticity for substitutes is (+). As ↑P of ice cream → ↑Qd of frozen yogurt.

● Cross elasticity is often used in “anti-trust” lawsuits. If firms face strong competition, it is difficult to overcharge customers. A very high and (+) cross elasticity indicates effective competition in a market.



● In 1989, Polaroid sued Kodak –copyright infringement

● How much could Polaroid’s TR have increased if Kodak did not infringe?♦ Polaroid claimed lots! $9 billion or more –because D

was inelastic♦ Kodak claimed neighborhood of $450 million –

because D was elastic -(very close to judge’s verdict)

● In 1989, Polaroid sued Kodak –copyright infringement

● How much could Polaroid’s TR have increased if Kodak did not infringe?♦ Polaroid claimed lots! $9 billion or more –because D

was inelastic♦ Kodak claimed neighborhood of $450 million –

because D was elastic -(very close to judge’s verdict)



● Some complications involving Cross εd

♦ During 1980s, period of Kodak’s infringement, ↓P of 35-mm cameras, film, and processing→ ↑Qd 35-mm cameras, film, and processing and ↓Qd instant cameras and film (substitutes).

♦ So Kodak’s infringement need not be the only reason for reduced sales of Polaroid’s instant film.

♦ If cross εd was (+) and low → Kodak owes more

♦ If cross εd was (+) and high → Kodak owes less

● Some complications involving Cross εd

♦ During 1980s, period of Kodak’s infringement, ↓P of 35-mm cameras, film, and processing→ ↑Qd 35-mm cameras, film, and processing and ↓Qd instant cameras and film (substitutes).

♦ So Kodak’s infringement need not be the only reason for reduced sales of Polaroid’s instant film.

♦ If cross εd was (+) and low → Kodak owes more

♦ If cross εd was (+) and high → Kodak owes less

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