Elasticities

Chapter 3Demand Elasticities

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Why Should Managers Study Elasticity?Own-price elasticity helps managers understand the impact that price changes will have on their revenue.Income elasticity can help managers understand what income groups to target their product to.Cross-price elasticity can help managers understand who their closest competitors are.*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


Demand ElasticityDemand elasticity is the responsiveness of quantity demanded to changes in the factors that influence demand, product price, income, or prices of related products.*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


Own Price Elasticity of DemandMeasured as the percentage change in quantity demanded of a given good, relative to a percentage change in its price, all else constant.

ep = %Qx %Px*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


Own Price Elasticity and Total Revenue*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Value of price elasticity coefficientElasticity definitionRelationship among variablesImpact on revenue

|ep| > 1Elastic demand

%Qd > %PxPrice increase results in lower total revenue.Price decrease results in higher total revenue.

|ep| < 1Inelastic demand

%Qd < %PxPrice increase results in higher total revenue.Price decrease results in lower total revenue.|ep| = 1Unit or unitary elastic%Qd = %PxPrice increase or decrease has no impact on total revenue.


Graphical Representation of Relationship Between Price Elasticity and Total Revenue*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

P1P2Q1Q2ABYXIf demand is elastic,a decrease in price results in an increase in total revenue, and an increase in price results in a decrease in total revenue.P1P2Q1Q2ABYXIf demand is inelastic,a decreaseIn price results in a decrease intotal revenue, and an increasein price results in a increase intotal revenue.


Determinants of Own Price ElasticityThe number of substitute goods.The percent of a consumers income that is spent on the product.The time period under consideration.Demand is generally more inelastic:The fewer the number of substitutes or perceived substitutes available.The smaller the percent of the consumers income that is spent on the product.The shorter the time period under consideration.*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


Perfectly Elastic and Inelastic Demand*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


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Income Elasticity of DemandThe percentage change in the quantity demanded of a given good, X, relative to a percentage change in consumer income, assuming all other factors constant.

ei = %Qx %I

*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


Normal GoodGood X is a normal good if the demand for good X moves in the same direction as a change in income.Creamei = 1.72Applesei = 1.32Potatoesei = 0.15*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


Inferior GoodGood X is an inferior good if the demand for good X moves in the opposite direction of a change in income.Chickenei = -0.106*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


Cross-Price Elasticity of DemandThe percentage change in the quantity demanded of a given good, X, relative to a percentage change in the price of good Y, assuming all other factors constant.

exy = %Qx %Py

*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


SubstitutesTwo goods with a positive cross-price elasticity of demand coefficient are said to be substitute goods.Boiler chickens and beefexy = 0.20Boiler chickens and porkexy = 0.28*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


ComplementsIf two goods have a negative cross-price elasticity of demand coefficient, they are called complementary goods.Bread and eggsexy = -0.03*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


Appendix 3ADemand Elasticities


Consumer Tastes and PreferencesPreference orderings are complete.More of the goods are preferred to less of the goods.Consumers are selfish.The goods are continuously divisible so that consumers can always purchase one more or one less unit of the goods.*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


Indifference CurvesA consumers indifference curve that shows alternative combinations of the two goods that provide the same level of satisfaction or utility.*YXY1Y2X1X2U2U1Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


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Marginal Rate of SubstitutionThe ratio Y/X, which shows the rate at which the consumer is willing to trade off one good for another and still maintain a constant utility level, is called the marginal rate of substitution (MRSxy).*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


The Budget ConstraintThe consumers budget constraint shows all the combinations of two goods that can be purchased with a given income and given the prevailing prices of the two goods.*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


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Shifts in the Budget ConstraintIncrease in incomeIncrease in price of good X*Y1B1B2Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


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Consumer ChoiceThe consumer maximizes utility by choosing a combination of good X and Y, lying on the budget constraint and simultaneously lying on the indifference curve furthest from the origin.*Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


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Changes in Consumer ChoiceIncrease in incomeIncrease in price*BCopyright 2010 Pearson Education, Inc. Publishing as Prentice Hall


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Elasticities

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