Chapter 4 DEMAND ELASTICITY

The Concept of Elasticity In general, elasticity refers to percentage relationship between two variables. Coefficient of elasticity=percentage change in A / percentage change in B Price elasticity of Demand=percentage change in Q / percentage change in P

Point elasticity=dQ/dP * P/Q Arc Elasticity = Q2 – Q1/(Q1+Q2)/2 divided by P2 – P1/(P1+P2)/2 =(Q2-Q1)/(Q1+Q2)*(P1+P2)/(P2 – P1)

Categories of Elasticity A) Elastic: Ep>1 (in absolute terms) b) Inelastic? 0<Ep<1 “ c) Unit elastic: Ep=1 D) perfectly elastic: Ep=∞ (D curve is horizontal) E) perfectly inelastic: Ep=0 (D curve is vertical)

Determinants of Elasticity Ease of substitution Proportion of total expenditure Durability of product Length of time period Global competition (in recent years, opening of borders increased demand elasticities.

Demand Elasticity and Revenue The relationship between the price elasticity of demand and revenue is: Price increaseTR↓ TR⌐ TR↑ Price decrease TR↑ TR⌐ TR↓ Draw figures here

Empirical elasticities Based on empirical research, the following results were obtained: –Coffee: -0.2 in short run; long run –Appliences: –Meals at restaurant: –Computers: –Air travel: -1.2 –First class travel:-0.4 –Potatoes: –Butter: –Peaches: –Beer: –Wine: Explain this in practical terms

Cross elasticity of demand Deals with the impact of a change in the price of related good (substitutes or complements) on the quantity demanded of a particular product. Potato chips sold by a company are complement to soft drinks sold by the same company. Ex = % change in Qa / % change in Qb –Ex > 0 substitute –Ex < 0 complement As a rule of thumb in business, two products are considered good substitutes or complements when Ex > 0.5

Income elasticity Ey shows the % change in quantity demanded resulting from a 1% change in income. Empirical studies revealed the following results: –Meals at restaurant: 1.6 –Air travel: 1.9 –Butter: 0.37 –Beer: 0.4 –Food: 0.5 –Eggs: categories: –Ey > 1 superior good –Ey > 0 and < 1 normal good –Ey < 0 inferior good (potatoes and beans) Income elasticity concept should also be taken into consideration to or new investment projects. The manager should prefer investment for superior goods in a growing economy.

Other elasticities Advertising elasticity is used by marketing consultants and managers. How an increase in advertising expenses would affect his total sales?