McGraw-Hill/Irwin Chapter 4: Elasticity of Demand and Supply Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

Price Elasticity of Demand  According to the law of demand, when price increases, quantity demanded falls. By how much?  To answer this question, economists use the concept of price elasticity of demand. LO: 4-1 Price elasticity of demand is a measure of the responsiveness of the quantity of a product demanded by consumers when the product price changes. 4-2

Elastic and Inelastic Demand  For some products, consumers are highly responsive to price changes. Demand for such products is relatively elastic or simply elastic.  For other products, consumers’ responsiveness is only slight or in rare cases non-existent. Demand is said to be relatively inelastic, or simply inelastic. LO:

Price Elasticity Coefficient  The degree of price elasticity is measured with price elasticity coefficient E d LO: 4-1 Percentage Change in Quantity Demanded of Product X Percentage Change in Price of Product X E d = 4-4

Interpretations of Price Elasticity of Demand  Elastic Demand: price changes cause relatively large changes in quantity demanded: E d > 1.  Inelastic Demand: price changes cause relatively small changes in quantity demanded: E d < 1.  Unit Elasticity: price changes cause equal changes in quantity demanded (in percentage terms): E d = 1.  Perfectly Elastic Demand: quantity demanded can be any amount at a given price: E d = ∞.  Perfectly Inelastic Demand: quantity demanded does not depend on price: E d = 0. LO:

Determinants of Price Elasticity of Demand  Substitutability  the larger the number of substitute goods that are available, the higher the elasticity  Proportion of Income  the higher the price of a product relative to one’s income, the higher the elasticity  Luxuries versus Necessities  the more that a good is considered to be a “luxury” rather than a “necessity,” the higher the elasticity  Time  the longer the time period under consideration, the higher the elasticity LO:

The Total Revenue Test  Total Revenue = TR = P×Q  Inelastic demand  P and TR change in the same direction  Elastic demand  P and TR change in opposite directions LO:

Inelastic Demand and TR  Price falls from c to d  Gold loss is larger than blue gain  TR falls when price falls  Therefore, demand is inelastic (E d < 1) LO: 4-2 $ Q P c d D2D2 4-8

Elastic Demand and TR  Price falls from a to b  Gold loss is smaller than blue gain  TR rises when price falls  Therefore, demand is elastic (E d > 1) LO: 4-2 $ Q P a b D1D1 4-9

Price Elasticity of Demand: College Tuition  Share of education in total income is higher for low- income families.  Therefore, elasticity of demand for college education is higher for low-income families.  Colleges charge different net prices (tuition minus financial aid) to low- and high-income families.  Tuition increases are frequently accompanied by increases in financial aid, so that tuition hikes are smaller for low-income families.  Such pricing strategy increases revenue while maintaining income diversity of a student body. LO:

Price Elasticity of Supply  The concept of price elasticity can be applied to supply: price elasticity of supply. LO: 4-3 Price elasticity of supply is a measure of the responsiveness of the quantity of a product supplied by sellers when the product price changes. Percentage Change in Quantity Supplied of Product X Percentage Change in Price of Product X E s = 4-11

Price Elasticity of Supply and Time Periods  Market period  Perfectly inelastic supply  Short run  Fixed plant size, but can vary production  Supply somewhat elastic  Long run  Adjustable plant size  Firms can enter or exit  Supply more elastic LO:

Price Elasticity of Supply: Gold Prices  Price of gold is very volatile. Why?  Supply of gold is very inelastic due to limited availability and high cost of exploration, mining, and refining.  As a result, demand shifts reflect in large swings in prices with little effect on quantities bought and sold.  Demand shifts for gold are common because it is used as speculative financial investment, not only as a commodity. LO:

Income Elasticity of Demand  The concept of elasticity can be applied to income: income elasticity of demand. LO: 4-5 Income elasticity of demand is a measure of the responsiveness of the quantity of a product demanded by consumers to changes in consumer income. Percentage Change in Quantity Demanded Percentage Change in Income E i = 4-14

Cross Elasticity of Demand  Cross elasticity of demand reflects relationship between products LO: 4-5 Cross elasticity of demand is a measure of the responsiveness of the quantity demanded of one product to a change in the price of another product. Percentage Change in Quantity Demanded of product X Percentage Change in Price of product Y E xy = 4-15