Elasticity of Demand

Today’s Class… Meaning of Elasticity of Demand Measurement of Elasticity of Demand Price Elasticity and Total Revenue Factors influencing price elasticity of demand Cross price elasticity of demand Income elasticity

When price of goods fall, does revenue grow?

Price Elasticity of Demand An increase in supply brings A large fall in price A small increase in the quantity demanded

Price Elasticity of Demand An increase in supply brings A small fall in price A large increase in the quantity demanded

Price Elasticity of Demand The contrast between the two outcomes in the two diagrams highlights the need to measure the responsiveness of quantity demanded to a price change. The price elasticity of demand is a measure of the responsiveness / sensitivity of the quantity demanded of a good to a change in its price.

Calculating Price Elasticity of Demand Price elasticity of demand (ED) percentage change in quantity demanded divided by percentage change in price

Price Elasticity of Demand To calculate the price elasticity of demand: We express the change in price as a percentage of the average price—the average of the initial and new price, and we express the change in the quantity demanded as a percentage of the average quantity demanded—the average of the initial and new quantity.

Price Elasticity of Demand The figure calculates the price elasticity of demand for pizza. The price initially is $20.50 and the quantity demanded is 9 pizzas an hour.

Price Elasticity of Demand The price falls to $19.50 and the quantity demanded increases to 11 pizzas an hour. The price falls by $1 and the quantity demanded increases by 2 pizzas an hour.

Price Elasticity of Demand The average price is $20 and the average quantity demanded is 10 pizzas an hour.

Price Elasticity of Demand The percentage change in quantity demanded, %DQ, is calculated as DQ/Qave, which is 2/10 = 1/5. The percentage change in price, %DP, is calculated as DP/Pave, which is $1/$20 = 1/20.

Price Elasticity of Demand The price elasticity of demand is %DQ/ %DP = (1/5)/(1/20) = 20/5 = 4.

Price Elasticity of Demand The formula yields a negative value, because of the inverse relationship between price and quantity. But it is the magnitude, or absolute value, of the measure that reveals how responsive the quantity change has been to a price change. The measure is units free because it is a ratio of two percentage changes and the percentages cancel out.

Types of Demand Curves Perfectly inelastic demand: ED=0 Inelastic demand: ED between 0 and 1 1% rise in price will cause quantity demanded to fall by less than 1% Perfectly elastic demand: ED approaching infinity Elastic demand: ED >1 a 1% rise in price will cause quantity demanded to fall by more than 1% Unit elastic demand: ED=1

Types of Demand Curves a) Perfectly Inelastic Demand b) Inelastic Demand P D P $11 $11 9 9 Price rises Price rises by 20% D 100 Q 95 105 Q Quantity doesn’t change Quantity falls by less than 20%

Types of Demand Curves Categories of Demand Curves c) Elastic Demand d) Perfectly Elastic Demand P P Consumers will buy any quantity at $9, none at a higher price $11 D 9 D $9 Price rises by 20% 85 115 Q 100 Q Quantity falls by more than 20%

Elasticity and Straight-Line Demand Curves How Elasticity Changes along a Straight-Line Demand Price A Elasticity falls as we move rightward along a straight-line demand curve $2,000 B 1,500 C 1,000 D 15,000 25,000 35,000 Quantity of Laptops

Elasticity and Straight-Line Demand Curves Demand becomes less elastic (ED gets smaller) as we move downward and rightward. Demand becomes more elastic (ED increases) as we move upward and leftward

Elasticity and Total Revenue Total Revenue TR=PxQ When the price changes, total revenue also changes. But a rise in price doesn’t always increase total revenue. Inelastic Demand (ED < 1) total revenue moves in same direction as price Elastic Demand (ED > 1) total revenue moves in opposite direction from price Unitary elastic demand total revenue remains the same as price changes

Elasticity and Total Revenue a) Inelastic Demand b) Elastic Demand P P B B $11 $11 A A 9 9 D D 95 105 Q 85 115 Q

Determinants of Price Elasticity The elasticity of demand for a good depends on: The closeness of substitutes Necessities vs Luxuries The proportion of income spent on the good The time elapsed since a price change

Closeness of substitutes The closer the substitutes for a good or service, the more elastic are the demand for it. Necessities and Luxury goods Necessities, such as food or housing, generally have inelastic demand. Luxuries, such as exotic vacations, generally have elastic demand. Proportion of income spent on the good The greater the proportion of income consumers spent on a good, the larger is its elasticity of demand. The more time consumers have to adjust to a price change, or the longer that a good can be stored without losing its value, the more elastic is the demand for that good.

Income Elasticity of Demand The income elasticity of demand measures how the quantity demanded of a good responds to a change in income, other things remaining the same Percentage change in quantity demanded divided by the percentage change in income percentage increase in quantity demanded for each 1% rise in income.

Income Elasticity of Demand Differences Price elasticity of Demand sensitivity of demand to price as we move along a demand curve virtually always negative Income elasticity of Demand relative shift in demand curve positive or negative

If the income elasticity of demand is greater than 1, demand is income elastic and the good is a normal good. If the income elasticity of demand is greater than zero but less than 1, demand is income inelastic and the good is a normal good. If the income elasticity of demand is less than zero (negative) the good is an inferior good.

Cross Elasticity of Demand The cross elasticity of demand is a measure of the responsiveness of demand for a good to a change in the price of a substitute or a complement, other things remaining the same. Percentage change in quantity demanded of one good (x) caused by a 1% change in the price of another good (y)

Substitutes: Exy >0 Complements: Exy <0 The cross elasticity of demand for a substitute is positive. Complements: Exy <0 The cross elasticity of demand for a complement is negative. Illustrate with burger and pizza : substitutes Illustrate with tooth brush and tooth paste: complements.

Next Class… Elasticity of supply Determinants of elasticity of supply Long run and short run elasticity of supply Application of the concept of elasticity.