Chapter 4: Elasticity It measures the responsiveness of quantity demanded (or demand) with respect to changes in its own price (or income or the price of some other commodity). Elasticity of Demand:

Why is Elasticity Important? How does a firm go about determining the price at which they should sell their product in order to maximize total revenue? Total Revenue = Price  Quantity

kYou are a marketing manager for Intel kA new computer chip has been developed kDecision to Be Made ©Do you sell the new chip at a high price ($400)? ©Do you sell the new chip at a low price ($200)?

Demand and Total Revenue Quantity (millions of chips per year) Price (dollars per chip) DaDa

Demand and Total Revenue Quantity (millions of chips per year) Price (dollars per chip) DbDb

Demand and Total Revenue Quantity (millions of chips per year) Price (dollars per chip) DbDb DaDa Quantity (millions of chips per year)

Slope Depends on Units of Measurement © In these two examples, we can compare the slopes of the demand curves © We cannot do so if we are dealing with different goods and services.

Price Quantity Effect of a change of unit of measurement on Slope

Slope Depends on Units of Measurement © In these two examples, we can compare the slopes of the demand curves © We cannot do so if we are dealing with different goods and services. ©Elasticity is independent of the units of measurement.

Price elasticity of demand A measure of the responsiveness of the quantity demanded of a good to a change in its own price (ceteris paribus).

Elasticity: A Units-Free Measure Price Elasticity of Demand

Calculating Elasticity The changes in price and quantity are expressed as percentages of the average price and average quantity. This way we avoid having two values for the price elasticity of demand for the same range of the demand curve

Example: Suppose, quantity demanded changes from 150 to 100 when Price increases from 5 to 10 dollars. Find out the price elasticity of demand for this specific range of the demand curve.

Calculating the Elasticity of Demand Quantity (millions of chips per year) Price (dollars per chip) DaDa Original point

Quantity (millions of chips per year) Price (dollars per chip) DaDa Original point New point Calculating the Elasticity of Demand

Quantity (millions of chips per year) Price (dollars per chip) DaDa = -$20 = 8 Original point New point Calculating the Elasticity of Demand

Quantity (millions of chips per year) Price (dollars per chip) DaDa Original point New point P ave = $400 = -$20 = 8

Quantity (millions of chips per year) Price (dollars per chip) DaDa Original point New point P ave =$400 Q ave = 40 = -$20 = 8 Calculating the Elasticity of Demand

Calculating Elasticity = - 4

Inelastic and Elastic Demand Three demand curves that cover the entire range of possible elasticities of demand: © Perfectly inelastic © Unit elastic © Perfectly elastic

Perfectly inelastic demand © Implies that quantity demanded remains constant when price changes occur. © Price elasticity of demand = 0

6 12 Price Quantity D Elasticity = 0 Perfectly Inelastic 1 0

Unit elastic demand Implies that the percentage change in quantity demanded equals the percentage change in price. Price elasticity of demand = -1

Unit Elastic Demand 6 12 Pric e Quantity D Elasticity = -1 Unit Elasticity

Perfectly elastic demand ©Implies that if price increases by any percentage, quantity demanded will fall to 0 and if price decreases by any percentage, quantity will rise to infinity. ©Price elasticity of demand =

6 12 Price Quantity D3D3 Elasticity = Perfectly Elastic Perfectly Elastic Demand

Inelastic and Elastic Demand Inelastic demand © Implies the percentage change in quantity demanded is less than the percentage change in price. © In absolute sense, price elasticity of demand > 0 and < 1 Elastic demand © Implies the percentage change in quantity demanded is greater than the percentage change in price. © In absolute sense, price elasticity of demand > 1

Elasticity Along a Straight-Line Demand Curve Price (dollars per chip) Quantity (millions of chips per year)

Elasticity Along a Straight-Line Demand Curve Elasticity = Lowering the price from $500 to $300 results in a price elasticity of demand of -4. Elastic Price (dollars per chip) Quantity (millions of chips per year)

Elasticity Along a Straight-Line Demand Curve Elasticity = -1/ Lowering the price from $200 to $0 results in a price elasticity of demand of -1/ 4. Inelastic Price (dollars per chip) Quantity (millions of chips per year)

Elasticity Along a Straight-Line Demand Curve |Elasticity| = Price (dollars per chip) Quantity (millions of chips per year) Lowering the price from $500 to $0 results in a price elasticity of demand of -1. |Elasticity| < 1 |Elasticity| > 1

Elasticity, Total Revenue and Expenditure Elastic demand Elastic demand — a 1 percent decrease in price will result in a greater than 1 percent increase in quantity demanded. ©Total revenue will increase Unit elastic demand Unit elastic demand — a 1 percent decrease in price will result in a 1 percent increase in quantity demanded © Total revenue will not change TR = P x Q

Elasticity, Total Revenue and Expenditure Inelastic demand Inelastic demand — a 1 percent decrease in price will result in a less than 1 percent increase in quantity demanded. © Total revenue will decrease

Elasticity, Total Revenue and Expenditure Total Revenue Test © Price elasticity of demand can be estimated by observing the change in total revenue that results from a price change (ceteris paribus).

Elasticity, Total Revenue and Expenditure Total Revenue Test ©Price cut and total revenue increases Ý demand is elastic. ©Price cut and total revenue decreases Ý demand is inelastic ©Price cut and total revenue does not change Ý demand is unit elastic

Price (dollars per chip) D TR = P x Q

Price (dollars per chip) Total Revenue (billions of dollars) Quantity (millions of chips per year) D TR

Price (dollars per chip) Total Revenue (billions of dollars) Quantity (millions of chips per year) Maximum total revenue When demand is inelastic, price cut decreases total revenue When demand is elastic, price cut increases total revenue Inelastic demand Unit elastic Elastic demand

More Elasticities of Demand Cross elasticity of demand Ý Measures the responsiveness of the demand for a good to a change in the price of a substitute or complement good. Cross elasticity of demand = Percentage change Demand Percentage change in price of a substitute or complement

Cross Elasticity of Demand Price of Walkmans Quantity of Walkmans D0D0

Cross Elasticity of Demand Price of Walkmans Quantity of Walkmans D1D1 Price of a CD player, a substitute, rises. Positive cross elasticity D0D0

Cross Elasticity of Demand Price of Walkmans Quantity of Walkmans D0D0

Cross Elasticity of Demand Price of Walkmans Quantity of Walkmans Price of a tape, a complement, rises. Negative cross elasticity D0D0 D2D2

Income Elasticity of Demand Income elasticity © Measures the responsiveness of the demand to a change in income. Income elasticity of demand = Percentage change in quantity demanded Percentage change in income

Income Elasticity of Demand Income elasticity can be: 1 ) Greater than 1 (normal good, income elastic) luxury goods - ocean cruises, jewelry 2 ) Between zero and 1 (normal good, income inelastic) necessities - food, clothing 3 ) Less than zero (inferior good) potatoes, rice

Price Quantity Unit Tax and Tax Burden: S1S1 S2S2 $2

Price Quantity Unit Tax and Tax Burden: S1S1 S2S2 $2 Consumers’ part Suppliers’ part

Price Quantity Elasticity and Tax Burden: Perfectly Inelastic Demand S1S1 S2S2 $2 Consumers’ part

Price Quantity Elasticity and Tax Burden: Perfectly Elastic Demand S1S1 S2S2 $2 Producers’ part

Price Quantity Elasticity and Tax Burden: Perfectly Elastic Supply S1S1 S2S2 $2 Consumers’ part

Price Quantity Elasticity and Tax Burden: Perfectly inelastic Supply S1S1 $2 Producers’ part