Elasticity of Demand Chapter Mr. Henry AP Economics

Understanding Definitions: Which stretches or changes, more – something that is elastic or inelastic? Something that is elastic…

Law of Demand: other things equal, consumers will buy more of a product when its price declines and less when its price increases. But the big question is: How much more or less will they buy?

Demand Elasticity & Elastic Demand Demand Elasticity is a measure that shows how a change in quantity demanded responds to a change in price Economists say that demand is elastic when a given change in prices causes a relatively larger change in quantity demanded Elastic goods and services generally have plenty of substitutes. Can you think of examples of demand elasticity?

Inelastic Demand For some products, demand may be inelastic, which means that a given change in prices causes a relatively smaller change in the quantity demanded. Inelastic goods have fewer substitutes and price change doesn't affect quantity demanded as much. Examples of inelastic goods? Gas, electricity, water, drinks, clothing, tobacco, food, and oil

According to the Federal Highway Administration, the number of motor vehicles has been rising by an estimated 3.69 million each year since 1960 with the largest annual growth between 1998 and 1999 as well as between 2000 and Today there are over million vehicles in America.

Unit Elastic If PEoD = 1 then Demand is Unit Elastic Unit Elastic is a type of elasticity where a change in price causes a proportional change in quantity demanded It is hard to cite examples of Unit Elastic items, but the demand for movies, tires, and private education is estimated to be nearly unit-elastic

The Midpoint Method has three formulas Doing the math…Price Elasticity of Demand

Elasticity = (% change in quantity demanded / % change in price) Calculating the Percentage Change in Quantity Demanded * We always ignore the negative sign when analyzing price elasticity and present the absolute value, so PEoD is always positive / / =1 Sample Problem

Sample Problem 2 Consumers see a price change in a product from $4 to $5 and demand goes from 20 units to 10 units. Calculate & type of elasticity ÷ (20+10)/ ÷ (4+5) / 2 = 10/15 ÷ -1/4.50 = 67% ÷ 22% = 3.04 (elastic)

Question: Hollister.com wants to increase its total revenue. One strategy is to offer a 10% discount on every shirt it sells. Hollister.com knows that its customers can be divided into two distinct groups according to their likely responses to the discount. The accompanying table shows how the two groups respond to the discount. Sample Problem 3

a.Using the midpoint method, calculate the price elasticities of demand for group A and group B b.Explain how the discount will affect total revenue from each group c.Suppose Hollister.com knows which group each customer belongs to when he/she logs on and can choose whether or not to offer the 10% discount. If Hollister.com wants to increase its total revenue, should discounts be offered to group B, to neither group, or to both groups?

a.Using the midpoint method, calculate the price elasticities of demand for group A and group B b.Explain how the discount will affect total revenue from each group c.Suppose Hollister.com knows which group each customer belongs to when he/she logs on and can choose whether or not to offer the 10% discount. If Hollister.com wants to increase its total revenue, should discounts be offered to group B, to neither group, or to both groups? b. For group A, since the price elasticity of demand is.625 (6.25%) and demand is inelastic, total revenue will decrease as a result of the discount. For group B, since the price elasticity of demand is 1.25 (12.5%) and demand is elastic, total revenue will increase as a result of the discount. c. If Hollister.com wants to increase total revenue, it should definitely not offer the discount to group A and it should definitely offer the discount to group B.

– Tomorrow we will continue to look at Demand ElasticityElasticity

Summary Review from Yesterday Elastic – Increased price implies decreased total revenue. – Decreased price implies increased total revenue. – Given the law of demand, increased quantity (decreased price) implies increased total revenue. – Marginal revenue is positive. Inelastic – Increased price implies increased total revenue. – Decreased price implies decreased total revenue. – Given the law of demand, increased quantity (decreased price) implies decreased total revenue. – Marginal revenue is negative. Unit elastic is neither elastic nor inelastic so MR = 0.Elasticity

Price Elasticity of Demand %> 1 then Demand is Price Elastic (Demand is sensitive to price changes) % change in price results in a larger % change in quantity demanded E d =.04/.02 = 2 If PEoD = 1 then Demand is Unit Elastic % change in price and % change in quantity demanded are the same E d =.02/.02 = 1 If PEoD % < 1 then Demand is Price Inelastic (Demand is not sensitive to price changes) % change in price produces a smaller % change in quantity demanded E d =.01/.02 =.5 Alfred Marshall His book, Principles of Economics (1890), was the dominant economic textbook in England for many years. It brings the ideas of supply and demand, marginal utility, and costs of production into a coherent whole. He is known as one of the founders of economics and is credited with defining PED.

Determinants of Demand Elasticity Three questions can be asked about a product to give us a good idea about the product’s demand elasticity Can the purchase be delayed? Cannot postpone the purchase of a product = usually inelastic Are Adequate Substitutes Available? Can consumers switch back and forth between the product and its substitute = elastic Does the purchase use a large portion of income? If amount is large = then demand tends to be elastic If amount of income is small = demand tends to be inelastic (ie 5% increase in candy bar vs. a car)

Determinants of Demand Elasticity Can the purchase be delayed? Cannot postpone the purchase of a product = usually inelastic Are Adequate Substitutes Available? Can consumers switch back and forth between the product and its substitute = elastic Does the purchase use a large portion of income? If amount is large = then demand tends to be elastic

Total Revenue Test In economics, the Total Revenue Test is a means for determining whether demand is elastic or inelastic. If demand is elastic, a decrease in price will increase total revenue. Even though a lesser price is received per unit, enough additional units are sold to more than make up for the lower price. If demand is inelastic, a price decrease will reduce total revenue. The increase in sales will not fully offset the decline in revenue per unit, and total revenue will decline. Total Revenue is TR=P (product price) xQ (quantity sold) Are there any items that you notice / feel never go on sale??

Price $2; Quantity Demanded 10; TR=$20 Notice if price declines from $2 to $1, the qty. demanded becomes 40 and TR=$40, so TR has increased from $20 to $40 At $4 Qd was 10 units (TR 40) At $1 Qd was 20 units (TR 20) Bad day at the shop  At $3 Qd was 10 units (TR 30) At $1 Qd was 30 units (TR 30) Hope you didn’t spend much on advertising!

AP Review If a store raises its prices by 20 percent and its total revenue increases by 10 percent, the demand it faces in this price range must be A.Inelastic B.Elastic C.Unit Elastic D.Perfectly Elastic E.Perfectly Inelastic A. Inelastic

AP Review Demand is elastic if A.Consumers respond strongly to changes in the product’s price B.A large percentage change in price brings about a small percentage change in quantity demanded C.A small percentage change in price brings about a small percentage change in quantity demanded D.The quantity demanded is not responsive to price changes E.The demand curve is vertical A. Consumers respond strongly to changes in the product’s price

AP Review When a firm raises the price of its product, what happens to total revenue? A.If demand is elastic, total revenue decreases B.If demand is unit elastic, total revenue increases C.If demand is inelastic, total revenue decreases D.If demand is elastic, total revenue increases E.If demand is unit elastic, total revenue decreases A. If demand is elastic, total revenue decreases

AP Review

Suppose the price of NetFlix increased from $16.20 to $19.80 and as a result the number of NetFlix subscribers decreased from 224,000 to 176,000. Along this portion of the demand curve, price elasticity of demand is: A.0.8 B.1.2 C.1.6 D.8.0 E.9.3 B. 1.2 (Is NetFlix elastic, inelastic, or unit elasticity in this example?)

AP Review An antidrug policy which reduces the supply of bricks (ie heroin) might: A.Increase street crime because the addict’s demand for heroin is highly inelastic B.Reduce street crime because the addict’s demand for heroin is highly elastic C.Reduce street crime because the addict’s demand for heroin is highly inelastic D.Increase street crime because the addict’s demand for heroin is highly elastic E.Reduce street crime because the addict’s demand for heroin is unit elasticity B. Increase street crime because the addict’s demand for heroin is highly inelastic