Chapter 4
Demand Elasticity
Chapter Four
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Overview The economic concept of elasticity The price elasticity of demand The cross-elasticity of demand Income elasticity Other elasticity measures Elasticity of supply Chapter Four
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
2
Overview The economic concept of elasticity The price elasticity of demand The cross-elasticity of demand Income elasticity Other elasticity measures Elasticity of supply Chapter Four
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
2
Learning objectives define and measure elasticity apply concepts of price elasticity, crosselasticity, and income elasticity understand determinants of elasticity show how elasticity affects business revenue Chapter Four
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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The economic concept of elasticity
Elasticity: the percentage change in one variable relative to a percentage change in another.
Coefficien t of Elasticity
Chapter Four
percent change in A percent change in B
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Price elasticity of demand
Price elasticity of demand: the percentage change in quantity demanded caused by a 1 percent change in price
E p Chapter Four
% Quantity % Price Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Price elasticity of demand
Arc elasticity: elasticity which is measured over a discrete interval of a curve E p
Q2
(Q1
Q1
P 2 P 1
Q2 ) / 2
( P 1 P 2 ) / 2
Ep = coefficient of arc price elasticity Q1 = original quantity demanded Q2 = new quantity demanded P1 = original price P2 = new price Chapter Four
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Price elasticity of demand
Point elasticity: elasticity measured at a given point of a demand (or a supply) curve
ε
P
Chapter Four
=
dQ dP
x
P 1 Q1
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Price elasticity of demand The point elasticity of a linear demand function can be expressed as:
p
Chapter Four
Q
P1
P
Q1
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Price elasticity of demand
Elasticity varies along a linear demand curve
Chapter Four
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Price elasticity of demand
Some demand curves have constant elasticity such
a curve has a nonlinear equation: Q = aP-b
where –b is the elasticity coefficient
Chapter Four
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Price elasticity of demand
Categories of elasticity Relative elasticity of demand: E p > 1 Relative inelasticity of demand: 0 < E p <1 Unitary elasticity of demand: E p = 1 Perfect elasticity: Ep = ∞ Perfect inelasticity: Ep = 0
Chapter Four
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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
Chapter Four
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Price elasticity of demand
Derived demand: the demand for products or factors that are not directly consumed, but go into the production of a another (final) product The demand for such a product or factor exists because there is demand for the final product
Chapter Four
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Price elasticity of demand
The derived demand curve will be more inelastic: the more essential is the component 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
Chapter Four
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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 ways to adjust to the price change, via substitution or shifting consumption
Chapter Four
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Price elasticity of demand
The relationship between price and revenue depends on elasticity Why? By itself, a price fall will reduce receipts … BUT because the demand curve is downward sloping, the drop in price will also increase quantity demanded Q: which effect will be stronger?
Chapter Four
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Price elasticity of demand
As price decreases revenue rises when demand is elastic revenue falls when it is inelastic revenue reaches it peak if elasticity =1 the lower chart shows the effect of elasticity on total revenue
Chapter Four
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Price elasticity of demand
Marginal revenue: the change in total revenue resulting from changing quantity by one unit
MR
Chapter Four
Total Revenue Quantity
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18
Price elasticity of demand
marginal revenue curve is twice as steep as the demand curve
Chapter Four
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19
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
Chapter Four
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Price elasticity of demand
Examples: some real world 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
Chapter Four
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Price elasticity of demand
Examples: some real world elasticities white pan bread:-0.69 cigarettes: short run -0.4, long run -0.6 wine imports: -0.15 crude oil: -0.06 internet services: -0.6/-0.7
Chapter Four
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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
E x Chapter Four
% Q A % P B
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Cross-elasticity of demand
Arc cross-elasticity
E X
Chapter Four
Q2 A
(Q1 A
Q1 A
P 2 B P 1 B
Q2 A ) / 2
( P 1 B P 2 B ) / 2
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Cross-elasticity of demand
Point cross-elasticity
E X
Chapter Four
Q A Q A
P B P B
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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 (in ab. value)
Chapter Four
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Income elasticity
Income elasticity of demand: the percentage change in quantity demanded caused by a 1 percent change in income
E Y
% Q % Y
Y is shorthand for income Chapter Four
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Income elasticity
Arc income elasticity
E Y
Chapter Four
Q2
(Q1
Q1 Q2 ) / 2
Y 2
Y 1
(Y 1 Y 2 ) / 2
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Income elasticity
Categories of income elasticity
superior goods: EY > 1
normal goods: 0 ≤ EY ≤ 1
inferior goods: EY < 0
Chapter Four
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Other demand elasticities
Examples: elasticity is encountered every time a change in some variable affects demand advertising expenditure interest rates population size
Chapter Four
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Elasticity of supply
Price elasticity of supply: the percentage change in quantity supplied as a result of a 1 percent change in price
E S
% Quantity Supplied % Price
The coefficient of supply elasticity is a normally a positive number Chapter Four
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Elasticity of supply
Arc elasticity of supply
E s
Chapter Four
Q2
(Q1
Q1
P 2 P 1
Q2 ) / 2
( P 1 P 2 ) / 2
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Elasticity of supply
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 When the supply curve is less elastic, a change in demand will have a greater effect on price than on quantity
Chapter Four
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