Chapter 5 Price Elasticity of Demand Lecture Slides Survey of Economics Irvin B. Tucker © 2016 south-Western, a part of Cengage Learning

What will I learn in this chapter? How to calculate price elasticity of demand and how this relates to total revenue (sales) © 2016 south-Western, a part of Cengage Learning 2

What is price elasticity of demand? The responsiveness, or sensitivity, to a change in price © 2016 south-Western, a part of Cengage Learning

What is the definition of price elasticity of demand? The ratio of the percentage change in the quantity demanded of a product to a percentage change in its price © 2016 south-Western, a part of Cengage Learning

Price Elasticity of Demand %  in Q demanded %  in price Ed = © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning Suppose a university’s enrollment drops by 20% because tuition rises by 10%, what is the price elasticity of demand? © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning -20% +10% -.20 +.10 Ed = = = 2 © 2016 south-Western, a part of Cengage Learning

Why is elasticity 2 in the previous example and not -2? Because we know from the law of demand that quantity demanded and price are inversely related © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning Problem - When we move along a demand curve between two points, we get different answers to elasticity depending on whether we are moving up or down the demand curve © 2016 south-Western, a part of Cengage Learning

How is the percent increase or decrease of two numbers calculated? Percent change is the difference between the two numbers divided by the original number © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning B D Q 3 5 11 © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning If there is a decrease in quantity demanded of 5 units at point B to 3 units at point A on a demand curve, what is the percentage decrease? (5-3)/5 = 2/5 = 40% © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning B D Q 3 5 © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning If there is an increase from a quantity demanded of 3 units at point A on a demand curve to 5 units, what is the percentage increase? (5-3)/3=2/3 = 66% © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning Economists can solve this problem of different base points by using the midpoints as the base points of changes in prices and quantity demanded © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning Price elasticity equals the  in quantity demanded sum of quantities/2 divided by  in price sum of prices/2 © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning Using the midpoints formula, how can price elasticity of demand be calculated? Q2 – Q1 Q1 + Q2 %Q %P Ed = = P2 – P1 P1 + P2 © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning What is elastic demand? A condition in which the percentage change in quantity demanded is greater than the percentage change in price © 2016 south-Western, a part of Cengage Learning

Increase in total revenue Decrease in total revenue Elastic Demand Increase in total revenue Decrease in total revenue Price decrease Price increase © 2016 south-Western, a part of Cengage Learning

Exhibit 5-1(a) Elastic Demand (Ed > 1) 40 A 30 B Price per Ticket (dollars) 20 Demand curve 10 10 20 30 40 Quantity of Tickets per Concert (thousands) 20 © 2016 south-Western, a part of Cengage Learning

Why is the demand curve in the previous slide elastic? See the price elasticity of demand calculation in the following slide: © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning 40 % change in Q = .50 = 10 50 % change in P = = .20 % change in Q % change in P .50 .20 Ed = = Ed = 2.50, which is > 1 © 2016 south-Western, a part of Cengage Learning

What is inelastic demand? The percentage change in the quantity demanded is less than the percentage change in price © 2016 south-Western, a part of Cengage Learning

Inelastic Demand Decrease in total revenue Increase in total revenue Price increase Price decrease © 2016 south-Western, a part of Cengage Learning

Exhibit 5-1(b) Inelastic Demand (Ed < 1) 40 C 30 Price per Ticket (dollars) D 20 Demand curve 10 10 20 30 40 © 2016 south-Western, a part of Cengage Learning Quantity of Tickets per Concert (thousands)

Why is the demand curve in the previous slide inelastic? See the price elasticity of demand calculation in the next slide: © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning 5 45 % change in Q = = .11 10 50 % change in P = .20 = % change in Q % change in P .11 .20 Ed = = = 0.55, which is < 1 © 2016 south-Western, a part of Cengage Learning

What is a unitary elastic demand curve? The percentage change in the quantity demanded is equal to the percentage change in price © 2016 south-Western, a part of Cengage Learning

Unitary Elastic Demand No change in total revenue Price increase Price decrease © 2016 south-Western, a part of Cengage Learning

Exhibit 5-1(c) Unitary Elastic Demand (Ed = 1) 40 E 30 Price per Ticket (dollars) F 20 Demand curve 10 10 20 30 40 © 2016 south-Western, a part of Cengage Learning Quantity of Tickets per Concert (thousands)

Why is the demand curve in the previous slide unitary elastic? See the price elasticity of demand calculation in the next slide: © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning 10 50 % change in Q = = .20 10 50 % change in P = .20 = % change in Q % change in P .20 Ed = = Ed = 1 © 2016 south-Western, a part of Cengage Learning

What is a perfectly elastic demand curve? An extreme condition in which a small percentage change in price brings about an infinite percentage change in the quantity demanded © 2016 south-Western, a part of Cengage Learning

Infinite change in quantity demanded Perfectly Elastic Demand Infinite change in quantity demanded Price change © 2016 south-Western, a part of Cengage Learning

Price per Ticket (dollars) Quantity of Tickets per Concert (thousands) Exhibit 5-2(a) Perfectly Elastic Demand (Ed=∞) 40 30 Demand Price per Ticket (dollars) 20 10 10 20 30 40 Quantity of Tickets per Concert (thousands) © 2016 south-Western, a part of Cengage Learning

Why is the demand curve in the previous slide perfectly elastic ? At a price of $20, buyers will purchase an infinite quantity. But at any other price, they will purchase zero. Therefore, the change in quantity demanded is infinite and Ed =∞. © 2016 south-Western, a part of Cengage Learning

What is a perfectly inelastic demand curve? Another extreme condition in which the quantity demanded does not change as the price changes. © 2016 south-Western, a part of Cengage Learning

Perfectly Inelastic Demand Zero change in quantity demanded Price change © 2016 south-Western, a part of Cengage Learning

Exhibit 5-2(b) Perfectly Inelastic Demand Ed = 0 40 30 Price per Ticket (dollars) 20 10 10 20 30 40 Quantity of Tickets per Concert (thousands) © 2016 south-Western, a part of Cengage Learning

Why is the demand curve in the previous slide perfectly inelastic ? Regardless of the percentage change in ticket price, buyers will purchase a quantity demanded of 20,000. Therefore, Ed =0. © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning 5.3 © 2016 south-Western, a part of Cengage Learning

If a college raises tuition, what happens to total revenue? If demand is elastic - total revenue decreases If demand is unitary elastic – total revenue is constant If demand is inelastic - total revenue increases © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning If price increases and the revenue gained is less than the revenue lost, the demand curve is price elastic > 1 © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning If total revenue does not change when price increases, the demand curve is unitary elastic =1 © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning If price increases and the revenue gained is greater than the revenue lost, the demand curve is price inelastic < 1 © 2016 south-Western, a part of Cengage Learning

Does price elasticity of demand vary along a demand curve? Yes. The price elasticity of demand coefficient of demand applies only to a specific range of prices along the demand curve. © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning

Elastic Inelastic Unitary elastic Exhibit 5-4(a) Price Elasticity of Demand Ranges 40 (Ed >1) 35 Elastic 30 25 Price per Ticket (dollars) 20 Inelastic (Ed <1) 15 Unitary elastic (Ed =1) 10 5 Demand 5 10 15 20 25 30 35 40 45 Quantity of Tickets per Concert (thousands) 48 © 2016 south-Western, a part of Cengage Learning

TR Elastic Inelastic Unitary Elastic 50 5 10 15 20 25 30 35 40 45 400 Exhibit 5-4(b) Total Revenue Curve 400 (Ed >1) 350 Elastic (Ed <1) 300 Inelastic 250 Price per Ticket (thousands of dollars) 200 Unitary Elastic (Ed =1) TR 150 100 50 5 10 15 20 25 30 35 40 45 Quantity of Tickets per Concert (thousands) 49 © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning .5 © 2016 south-Western, a part of Cengage Learning

What factors influence demand elasticity? Availability of substitutes Share of budget on the product Adjustment to a price change over time © 2016 south-Western, a part of Cengage Learning

What do substitutes have to do with a price change? The more substitutes a product has, the more sensitive consumers are to a price change, and the more elastic the demand curve © 2016 south-Western, a part of Cengage Learning

What conclusion can we make concerning substitutes? The price elasticity of demand is directly related to the availability of good substitutes for a product © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning B D D Which demand curve is for a vital medicine and which is for candy? © 2016 south-Western, a part of Cengage Learning

Why does curve A represent he demand curve for medicine? Because medicine is a necessity with few substitutes, and the price can change with little effect on the quantity demanded © 2016 south-Western, a part of Cengage Learning

Why does curve B represent the demand curve for candy? Because candy has many substitutes, a price change can bring about a big change in the quantity demanded © 2016 south-Western, a part of Cengage Learning

What does the share of one’s budget have to do with a price change? The larger the purchase is to one’s budget, the more sensitive consumers are to a price change, and the more elastic the demand curve © 2016 south-Western, a part of Cengage Learning

What does time have to do with sensitivity? The longer consumers have to adjust, the more sensitive they are to a price change, and the more elastic the demand curve © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning 5.6 © 2016 south-Western, a part of Cengage Learning

What conclusion can we make? In general, the price elasticity coefficient of demand is higher the longer a price change persists © 2016 south-Western, a part of Cengage Learning

© 2016 south-Western, a part of Cengage Learning END © 2016 south-Western, a part of Cengage Learning