Learning Objectives Define and measure elasticity Apply concepts of price elasticity, cross-elasticity, and income elasticity Understand determinants of elasticity Show how elasticity affects revenue

Elasticity of Demand Measures responsiveness of demand to changes in an underlying factor such as the price of the product, income, prices of related products or advertising expenditures. There is an elasticity corresponding to every factor that affects demand

Own Price Elasticity of Demand (E) Measures responsiveness or sensitivity of consumers to changes in the price of a good • P & Q are inversely related by the law of demand so E is always negative The larger the absolute value of E, the more sensitive buyers are to a change in price

Calculating Price Elasticity of Demand Price elasticity can be measured at an interval (or arc) along demand, or at a specific point on the demand curve If the price change is relatively small, a point calculation is suitable If the price change spans a sizable arc along the demand curve, the interval calculation provides a better measure

Computation of Elasticity Over an Interval arc elasticity formula E = dQ/dP * (average P / average Q)

Elasticity at a Point When calculating price elasticity at a point on demand, E = dQ/dP * (p/Q) multiply the slope of demand (Q/P), computed at the point of measure, times the ratio P/Q, using the values of P and Q at the point of measure

Qx = 408 – 2Px What is own price elasticity at Px = 154? What is the arc elasticity if Px increases from 154 to 179?

The Price Elasticity of Demand Elasticity differs along a linear demand curve.

A report reveals that sales of new houses increased by 12% after a 10% drop in the price of new houses. In a meeting, a manager says, “based on this information, we can conclude that the price elasticity for new houses is -1.2. What would you say to the manager?

Price Elasticity of Demand (E) Responsiveness E Elastic Unitary Elastic Inelastic Perfect elasticity: E = ∞ Perfect inelasticity: E = 0

Steep curve = inelastic ‘Flat’ curve = elastic Horizontal curve = infinite elasticity Vertical curve = zero elasticity

Factors Affecting Price Elasticity of Demand Availability of substitutes The better & more numerous the substitutes for a good, the more elastic is demand Percentage of consumer’s budget The greater the percentage of the consumer’s budget spent on the good, the more elastic is demand Time period of adjustment The longer the time period consumers have to adjust to price changes, the more elastic is demand

Factors Affecting Price Elasticity of Demand Definition of product (broad or narrow) Demand for cigarettes compared to demand for a particular brand. Buyer’s loyalty Sunk costs Information and education Frequency of purchases Customer storage costs

You manage your country’s agricultural exports which includes two products: Bitter Leaf and ordinary butter. Bitter Leaf has very few substitutes. The supply of your products to the world market depends on the exchange rate between your local currency and other world currencies. If your local currency appreciates and becomes more expensive, you increase the supply of your products to the world market. Suppose your local currency appreciates and becomes 10% more expensive, how would these affect the prices of your Bitter Leaf and butter on world markets?

Elasticity and incidence of tax If demand is inelastic then consumer bear more of the incidence of tax. As demand becomes more elastic, then, ceteris paribus, the incidence is shifted to the suppliers.

According to empirical study on cigarette sales, when the price of cigarettes increased by 1%, consumption of cigarettes would be lowered by 0.4% in the short run and 0.75% in the long run. What is the SR and LR own price elasticities of demand cigarettes? Explain the difference between the 2 numbers What would be the implications of imposing a tax on cigarettes based on your answers in (a) and (b) above?

Price Elasticity of Demand & TR Because a demand curve is downward sloping, a decrease in price will increase the quantity demanded If elasticity is greater than 1, the quantity effect is stronger than the price effect, and total revenue will increase

Price Elasticity & Total Revenue Quantity-effect dominates Unitary elastic No dominant effect Inelastic Price-effect dominates Price rises Price falls TR falls No change in TR TR rises TR rises No change in TR TR falls

You have 2 bottles of old wine in the cellar and decided to drink one of the two bottles with your friends. By drinking one of the two bottles, can you simultaneously enjoy the wine and increase the value of the remaining wine?

As price decreases Revenue rises when demand is elastic. Revenue falls when it is inelastic. Revenue reaches its peak when elasticity of demand equals 1.

MR, TR, & Price Elasticity Marginal revenue Total revenue Price elasticity of demand MR > 0 Elastic (E> 1) MR = 0 Unit elastic (E= 1) MR < 0 Inelastic (E< 1) TR increases as Q increases (P decreases) Elastic (E> 1) Unit elastic (E= 1) TR is maximized TR decreases as Q increases (P decreases) Inelastic (E< 1)

Marginal Revenue & Price Elasticity For all demand & marginal revenue curves, the relation between marginal revenue, price, & elasticity can be expressed as

Drugs that are not covered by patent can be freely manufactured by anyone. The advertising elasticity of the demand for all drugs is around 0.26, and 0.24 for those covered by patents. For all drugs, the own price elasticity is about -2 without advertising and about -1.6, in the long run with advertising. By how much would the demand for patented drug rise if there is a 5% increase in advertising expenditure? Suppose the drug manufacturer were to increase advertising. Explain why it should also raise the price of its drug

MORE EXAMPLES T/F and why? If the price elasticity is less than one than an increase in the price reduces revenue? A product with perfect substitutes has a price elasticity of zero A farmer is happy because a bumper crop is expected. Will the farmer increase his profits when all farmers have record crops?

The Cross-Elasticity of Demand Cross-elasticity of demand: The percentage change in quantity consumed of one product as a result of a 1 percent change in the price of a related product.

The Cross-Elasticity of Demand Arc Elasticity

The Cross-Elasticity of Demand The sign of cross-elasticity for substitutes is positive. The sign of cross-elasticity for complements is negative. Two products are considered good substitutes or complements when the coefficient is larger than 0.5.

The own price elasticity of SUVs is -2 The own price elasticity of SUVs is -2.5 while the cross elasticity of demand for SUVs with respect to gasoline prices is -0.25. Recently, the price of gasoline rose by 66% while at the same time SUV manufactures offer their customers rebates totaling $500 (1.4% of the average price of a large SUV). a. What does this imply for SUV sales. Explain fully

Income Elasticity Income Elasticity of Demand: The percentage change in quantity demanded caused by a 1 percent change in income.

Income Elasticity Categories of income elasticity Superior goods: EY > 1 Normal goods: 0 >EY >1 Inferior goods – demand decreases as income increases: EY < 0

Other Elasticity Measures Elasticity is encountered every time a change in some variable affects quantities. Advertising expenditure Interest rates Population size

T/F and why? Demand volatility will be higher, the higher the income elasticity of demand Demand facing the (more popular) “Greasy Spoon” restaurant will fall if the income elasticity for the (more upscale) “Golden Fork” is positive and income falls

Uses of Elasticities Pricing. Managing cash flows. Impact of changes in competitors’ prices. Impact of economic booms and recessions. Impact of advertising campaigns. And lots more!

Elasticity of Supply Price Elasticity of Supply: The percentage change in quantity supplied as a result of a 1 percent change in price. If the supply curve slopes upward and to the right, the coefficient of supply elasticity is a positive number.

Elasticity of Supply Arc elasticity

Elasticity of Supply When the supply curve is more elastic, the effect of a change in demand will be greater on quantity than on the price of the product. With a supply curve of low elasticity, a change in demand will have a greater effect on price than on quantity.

You are the owner of a novelty shop that sells greeting cards and flowers. You are aware that as Valentine’s Day approaches, demand for greeting cards and roses will jump up. Your knowledge of demand-supply analysis leads you to expect the prices of both products to rise. You have noticed that the price of roses, however, always increases much more sharply than the price of greeting cards. Why is that?

When does an increase in income reduce the amount spent on a product but keep the price unchanged

T/F and why? Increases and decreases in demand will lead to larger increases and decreases in price the lower the responsiveness of quantity supplied to price

Examples: Pricing and Cash Flows According to an FTC Report by Michael Ward, AT&T’s own price elasticity of demand for long distance services is -8.64. AT&T needs to boost revenues in order to meet it’s marketing goals. To accomplish this goal, should AT&T raise or lower it’s price?

Answer: Lower price! Since demand is elastic, a reduction in price will increase quantity demanded by a greater percentage than the price decline, resulting in more revenues for AT&T.

Example 2: Quantifying the Change If AT&T lowered price by 3 percent, what would happen to the volume of long distance telephone calls routed through AT&T?

Answer Calls would increase by 25.92 percent!

Example 3: Impact of a change in a competitor’s price According to an FTC Report by Michael Ward, AT&T’s cross price elasticity of demand for long distance services is 9.06. If competitors reduced their prices by 4 percent, what would happen to the demand for AT&T services?

Answer AT&T’s demand would fall by 36.24 percent!

Interpreting Demand Functions Mathematical representations of demand curves. Example: X and Y are substitutes (coefficient of PY is positive). X is an inferior good (coefficient of M is negative).

Linear Demand Functions General Linear Demand Function: Own Price Elasticity Cross Price Elasticity Income Elasticity

Example of Linear Demand Qd = 10 - 2P. Own-Price Elasticity: (-2)P/Q. If P=1, Q=8 (since 10 - 2 = 8). Own price elasticity at P=1, Q=8: (-2)(1)/8= - 0.25.

Log-Linear Demand General Log-Linear Demand Function:

Example of Log-Linear Demand ln(Qd) = 10 - 2 ln(P). Own Price Elasticity: -2.