Chapter 4: Elasticity It measures the responsiveness of quantity demanded (or demand) with respect...
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Transcript of Chapter 4: Elasticity It measures the responsiveness of quantity demanded (or demand) with respect...
Chapter 4: ElasticityChapter 4: Elasticity
It measures the responsiveness It measures the responsiveness of of quantity demandedquantity demanded ( (or or demanddemand) with respect to changes ) with respect to changes in its ownin its own priceprice ( (oror income or income or the price of some other the price of some other commodity)commodity)..
Elasticity of Demand:Elasticity of Demand:
Why is Elasticity Important?Why is Elasticity Important?
How does a firm go about determining the price at which they should sell their product in order to maximize total revenue?
Total Revenue = Price Quantity
You are a marketing manager for Intel
A new computer chip has been developed
Decision to Be Made Do you sell the new chip at a high price
($400)? Do you sell the new chip at a low price
($200)?
Demand and Total RevenueDemand and Total Revenue
Quantity (millions of chips per year)
Pri
ce (
doll
ars
per
chip
)
40 80 120
100
200
300
400
Da
Demand and Total RevenueDemand and Total Revenue
Quantity (millions of chips per year)
Pri
ce (
doll
ars
per
chip
)
100
200
300
400
Db
40 60 80 120
Demand and Total RevenueDemand and Total Revenue
Quantity (millions of chips per year)
Pri
ce (
dolla
rs p
er c
hip)
Db
Pri
ce (
dolla
rs p
er c
hip)
Da
Quantity (millions of chips per year)
Slope Depends on Slope Depends on Units of MeasurementUnits of Measurement
In these two examples, we can compare the slopes of the demand curves
We cannot do so if we are dealing with different goods and services.
Pri
ce
Quantity
0 1 2 3 4 5 6 7 8
9
1
2
34
5
6
7
8
Effect of a change of unit of measurement on SlopeEffect of a change of unit of measurement on Slope
10
9 10 11
Slope Depends on Slope Depends on Units of MeasurementUnits of Measurement
In these two examples, we can compare the slopes of the demand curves
We cannot do so if we are dealing with different goods and services.
Elasticity is independent of the units of measurement.
Price elasticity of demandPrice elasticity of demand
A measure of the responsiveness of the quantity demanded of a good to a change in its own price (ceteris paribus).
Elasticity: A Units-Free Elasticity: A Units-Free MeasureMeasure
Pricein Change Percentage
DemandedQuantity in Change Percentage ε d
avg
avg
d
P P
Q
Q
Price Elasticity of
Demand
PΔ%
QΔ% d
Calculating ElasticityCalculating Elasticity
The changes in price and quantity are expressed as percentages of the average price and average quantity.
This way we avoid having two values for the price elasticity of demand for the same range of the demand curve
Example: Suppose, quantity demanded changes Example: Suppose, quantity demanded changes from 150 to 100 when Price increases from 5 to from 150 to 100 when Price increases from 5 to 10 dollars. Find out the price elasticity of demand 10 dollars. Find out the price elasticity of demand for this specific range of the demand curve.for this specific range of the demand curve.
avg
avgd
P P
Q Q
ε
6.5
3
1
5.1
5
2
5.1152
7.55
12550
Calculating the Elasticity of DemandCalculating the Elasticity of Demand
Quantity (millions of chips per year)
Pri
ce (d
olla
rs p
er c
hip)
36 44
390
410
Da
Originalpoint
Quantity (millions of chips per year)
Pri
ce (d
olla
rs p
er c
hip)
36 44
390
410
Da
Originalpoint
Newpoint
Calculating the Elasticity of DemandCalculating the Elasticity of Demand
Quantity (millions of chips per year)
Pri
ce (d
olla
rs p
er c
hip)
36 44
390
410
Da
= -$20P
= 8Q
Originalpoint
Newpoint
Calculating the Elasticity of DemandCalculating the Elasticity of Demand
Quantity (millions of chips per year)
Pri
ce (d
olla
rs p
er c
hip)
36 44
390
400
410
Da
Originalpoint
Newpoint
Pave = $400
= -$20P
= 8Q
Quantity (millions of chips per year)
Pri
ce (d
olla
rs p
er c
hip)
36 40 44
390
400
410
Da
Originalpoint
Newpoint
Pave =$400
Qave = 40
= -$20P
= 8Q
Calculating the Elasticity of DemandCalculating the Elasticity of Demand
Calculating ElasticityCalculating Elasticity
PΔ%
QΔ% d
Pricein Change Percentage
DemandedQuantity in Change Percentage ε d
avg
avg
P P
Q
Q
400/20
40/8
= - 4
Inelastic and Elastic DemandInelastic and Elastic Demand
Three demand curves that cover the entire range of possible elasticities of demand:
Perfectly inelastic Unit elastic Perfectly elastic
Perfectly inelastic demand Implies that quantity demanded remains constant when price changes occur.
Price elasticity of demand = 0
avg
avg
d
d
P P
Q Q
ε
6
12
Pri
ce
Quantity
D
Elasticity = 0
Perfectly Inelastic
10
Unit elastic demandUnit elastic demand Implies that the percentage change in quantity demanded equals the percentage change in price.
Price elasticity of demand = -1
avg
avg
d
d
P P
Q Q
ε
Unit Elastic DemandUnit Elastic Demand
6
12
Pri
ce
Quantity
D
1 2 3
Elasticity = -1
Unit Elasticity
Perfectly elastic demandPerfectly elastic demand Implies that if price increases by any
percentage, quantity demanded will fall to 0 and if price decreases by any percentage, quantity will rise to infinity.
Price elasticity of demand =
avg
avg
d
d
P P
Q Q
ε
6
12
Pri
ce
Quantity
D3
Elasticity =
Perfectly Elastic
Perfectly Elastic DemandPerfectly Elastic Demand
Inelastic and Elastic DemandInelastic and Elastic Demand
Inelastic demandInelastic demand Implies the percentage change in quantity demanded
is less than the percentage change in price. In absolute sense, price elasticity of demand > 0 and
< 1
Elastic demandElastic demand Implies the percentage change in quantity demanded
is greater than the percentage change in price. In absolute sense, price elasticity of demand > 1
avg
avg
d
d
P P
Q Q
ε
Elasticity Along a Straight-Line Elasticity Along a Straight-Line Demand CurveDemand Curve
0 40 80 100 120 160 200
250
100
200
300
400
500
Pri
ce (
dolla
rs p
er c
hip)
Quantity (millions of chips per year)
Elasticity Along a Straight-Line Elasticity Along a Straight-Line Demand CurveDemand Curve
Elasticity = -4
0 40 80 100 120 160 200
250
100
200
300
400
500 Lowering the pricefrom $500 to $300results in a price elasticity of demand of -4.
Elastic
Pri
ce (
dolla
rs p
er c
hip)
Quantity (millions of chips per year)
Elasticity Along a Straight-Line Elasticity Along a Straight-Line Demand CurveDemand Curve
Elasticity = -1/4
0 40 80 100 120 160 200
250
100
200
300
400
500 Lowering the pricefrom $200 to $0results in a price elasticity of demand of -1/ 4.
Inelastic
Pri
ce (
dolla
rs p
er c
hip)
Quantity (millions of chips per year)
Elasticity Along a Straight-Line Elasticity Along a Straight-Line Demand CurveDemand Curve
|Elasticity| = 1
0 40 80 100 120 160 200
250
100
200
300
400
500
Pri
ce (
dolla
rs p
er c
hip)
Quantity (millions of chips per year)
Lowering the pricefrom $500 to $0results in a price elasticity of demand of -1.
|Elasticity| < 1
|Elasticity| > 1
Elasticity, Total RevenueElasticity, Total Revenueand Expenditureand Expenditure
Elastic demandElastic demand — a 1 percent decrease in price will result in a greater than 1 percent increase in quantity demanded. Total revenue will increase
Unit elastic demandUnit elastic demand — a 1 percent decrease in price will result in a 1 percent increase in quantity demandedTotal revenue will not change
avg
avg
d
d
P P
Q Q
ε
TR = P x Q
Elasticity, Total RevenueElasticity, Total Revenueand Expenditureand Expenditure
Inelastic demandInelastic demand — a 1 percent decrease in price will result in a less than 1 percent increase in quantity demanded. Total revenue will decrease
avg
avg
d
d
P P
Q Q
ε
Elasticity, Total RevenueElasticity, Total Revenueand Expenditureand Expenditure
Total Revenue TestTotal Revenue Test
Price elasticity of demand can be
estimated by observing the change
in total revenue that results from a
price change (ceteris paribus).
Elasticity, Total RevenueElasticity, Total Revenueand Expenditureand Expenditure
Total Revenue TestTotal Revenue Test Price cut and total revenue increases
demand is elastic. Price cut and total revenue decreases
demand is inelastic Price cut and total revenue does not change
demand is unit elastic
0 100 200
250
100
200
300
400
500
Pri
ce (
doll
ars
per
chip
)
D
TR = P x Q
25
0 100 200
250
100
200
300
400
500
Pri
ce (
doll
ars
per
chip
)
0 100 200
5
10
15
20
Tot
al R
even
ue (
bill
ions
of
doll
ars)
Quantity (millions of chips per year)
D
TR
25
0 100 200
250
100
200
300
400
500
Pri
ce (
doll
ars
per
chip
)
0 100 200
5
10
15
20
Tot
al R
even
ue (
bill
ions
of
doll
ars)
Quantity (millions of chips per year)
Maximum total revenue
When demandis inelastic, price cut decreasestotal revenue
When demandis elastic, price cut increasestotal revenue
Inelastic demand
Unitelastic
Elasticdemand
More Elasticities of DemandMore Elasticities of Demand
Cross elasticity of demandCross elasticity of demand Measures the responsiveness of the
demand for a good to a change in the price of a substitute or complement good.
Cross elasticity of demand
= Percentage change Demand
Percentage change in price of a substitute or complement
Cross Elasticity of DemandCross Elasticity of DemandP
rice
of
Wal
kman
s
Quantity of Walkmans
D0
Cross Elasticity of DemandCross Elasticity of DemandP
rice
of
Wal
kman
s
Quantity of Walkmans
D1
Price of a CD player, a substitute, rises.Positive cross elasticity
D0
Cross Elasticity of DemandCross Elasticity of DemandP
rice
of
Wal
kman
s
Quantity of Walkmans
D0
Cross Elasticity of DemandCross Elasticity of DemandP
rice
of
Wal
kman
s
Quantity of Walkmans
Price of a tape, a complement, rises. Negativecross elasticity
D0D2
Income Elasticity of DemandIncome Elasticity of Demand
Income elasticity Measures the responsiveness of the demand to a
change in income.
Income elasticity of demand =
Percentage changein quantity demanded
Percentage change in income
Income Elasticity of DemandIncome Elasticity of Demand
Income elasticity can be:1 ) Greater than 1 (normal good, income elastic)
luxury goods - ocean cruises, jewelry
2 ) Between zero and 1 (normal good, income inelastic)
necessities - food, clothing
3 ) Less than zero (inferior good)potatoes, rice
Pri
ce
Quantity
0 1 2 3 4 5 6 7 8
9
1
2
34
5
6
7
8
Unit Tax and Tax Burden:Unit Tax and Tax Burden:
10
9 10 11
S1
S2
$2
Pri
ce
Quantity
0 1 2 3 4 5 6 7 8
9
1
2
34
5
6
7
8
Unit Tax and Tax Burden:Unit Tax and Tax Burden:
10
9 10 11
S1
S2
$2
Consumers’ part
Suppliers’ part
Pri
ce
Quantity
0 1 2 3 4 5 6 7 8
9
1
2
34
5
6
7
8
Elasticity and Tax Burden: Perfectly Inelastic DemandElasticity and Tax Burden: Perfectly Inelastic Demand
10
9 10 11
S1
S2
$2
Consumers’ part
Pri
ce
Quantity
0 1 2 3 4 5 6 7 8
9
1
2
34
5
6
7
8
Elasticity and Tax Burden: Perfectly Elastic DemandElasticity and Tax Burden: Perfectly Elastic Demand
10
9 10 11
S1
S2
$2
Producers’ part
Pri
ce
Quantity
0 1 2 3 4 5 6 7 8
9
1
2
34
5
6
7
8
Elasticity and Tax Burden: Perfectly Elastic SupplyElasticity and Tax Burden: Perfectly Elastic Supply
10
9 10 11
S1
S2
$2
Consumers’ part
Pri
ce
Quantity
0 1 2 3 4 5 6 7 8
9
1
2
34
5
6
7
8
Elasticity and Tax Burden: Perfectly inelastic SupplyElasticity and Tax Burden: Perfectly inelastic Supply
10
9 10 11
S1
$2
Producers’ part