Demand Elasticity.

Demand Elasticity

You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per month. Your costs are rising (including the opportunity cost of your time), so you consider raising the price to $250. The law of demand says that you won’t sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase? A scenario… We will follow this scenario throughout the first section of this chapter (the section on price elasticity of demand) to illustrate and motivate several important concepts, such as the impact of price changes on sales and revenue. 2 2

Elasticity Basic idea: Elasticity measures how much one variable responds to changes in another variable. One type of elasticity measures how much demand for your websites will fall if you raise your price. Definition: Elasticity is a numerical measure of the responsiveness of Qd or Qs to one of its determinants. Here, Qd and Qs are short for quantity demanded and quantity supplied, as in the PowerPoint for Chapter 4. ELASTICITY AND ITS APPLICATION 3

Price Elasticity of Demand
Price Elasticity of Demand Price elasticity of demand = Percentage change in Qd Percentage change in P Price elasticity of demand measures how much Qd responds to a change in P. Loosely speaking, it measures the price-sensitivity of buyers’ demand. ELASTICITY AND ITS APPLICATION 4

Price Elasticity of Demand Price elasticity of demand = Percentage change in Qd Percentage change in P P Q Example: D P rises by 10% Price elasticity of demand equals P2 Q2 P1 Q1 15% 10% = 1.5 Q falls by 15% ELASTICITY AND ITS APPLICATION 5

Price Elasticity of Demand Price elasticity of demand = Percentage change in Qd Percentage change in P P Q Along a D curve, P and Q move in opposite directions, which would make price elasticity negative. We will drop the minus sign and report all price elasticities as positive numbers. D P2 Q2 P1 Q1 It might be worth explaining to your students that “P and Q move in opposite directions” means that the percentage change in Q and the percentage change in P will have opposite signs, thus implying a negative price elasticity. To be consistent with the text, the last statement in the green box says that we will report all price elasticities as positive numbers. It might be slightly more accurate to say that we will report all elasticities as non-negative numbers: we want to allow for the (admittedly rare) case of zero elasticity. ELASTICITY AND ITS APPLICATION 6

Calculating Percentage Changes
Standard method of computing the percentage (%) change: Demand for your websites end value – start value start value x 100% P Q $250 8 B D Going from A to B, the % change in P equals $200 12 A ($250–$200)/$200 = 25% ELASTICITY AND ITS APPLICATION 7

Problem: The standard method gives different answers depending on where you start. Demand for your websites P Q From A to B, P rises 25%, Q falls 33%, elasticity = 33/25 = 1.33 From B to A, P falls 20%, Q rises 50%, elasticity = 50/20 = 2.50 $250 8 B D $200 12 A ELASTICITY AND ITS APPLICATION 8

So, we instead use the midpoint method: end value – start value midpoint x 100% The midpoint is the number halfway between the start & end values, the average of those values. It doesn’t matter which value you use as the “start” and which as the “end” – you get the same answer either way! ELASTICITY AND ITS APPLICATION 9

Using the midpoint method, the % change in P equals $250 – $200 $225 x 100% = 22.2% The % change in Q equals 12 – 8 10 x 100% = 40.0% These calculations are based on the example shown a few slides back: points A and B on the website demand curve. The price elasticity of demand equals 40/22.2 = 1.8 ELASTICITY AND ITS APPLICATION 10

A C T I V E L E A R N I N G 1 Calculate an elasticity
Use the following information to calculate the price elasticity of demand for hotel rooms: if P = $70, Qd = 5000 if P = $90, Qd = 3000 11

A C T I V E L E A R N I N G 1 Answers
Use midpoint method to calculate % change in Qd (5000 – 3000)/4000 = 50% % change in P ($90 – $70)/$80 = 25% The price elasticity of demand equals 50% 25% = 2.0 12

What determines price elasticity?
What determines price elasticity? To learn the determinants of price elasticity, we look at a series of examples. Each compares two common goods. In each example: Suppose the prices of both goods rise by 20%. The good for which Qd falls the most (in percent) has the highest price elasticity of demand. Which good is it? Why? What lesson does the example teach us about the determinants of the price elasticity of demand? In essence, the textbook says “Here are the determinants of elasticity. The first one is availability of close substitutes. Here’s an example….” That’s great for a textbook. For teaching, I’ve found a different approach to be far more effective: having students deduce the general lessons from specific examples they can figure out using common sense. This is the approach on the next few slides. Also, see notes on the next slide for a good suggestion. ELASTICITY AND ITS APPLICATION 13

EXAMPLE 1: Breakfast cereal vs. Sunscreen
The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why? Breakfast cereal has close substitutes (e.g., pancakes, Eggo waffles, leftover pizza), so buyers can easily switch if the price rises. Sunscreen has no close substitutes, so consumers would probably not buy much less if its price rises. Lesson: Price elasticity is higher when close substitutes are available. Suggestion: For each of these examples, display the slide title (which lists the two goods) and the first two lines of text (which ask which good experiences the biggest drop in demand in response to a 20% price increase). Give your students a quiet minute to formulate their answers. Then, ask for volunteers. ELASTICITY AND ITS APPLICATION 14

EXAMPLE 2: “Blue Jeans” vs. “Clothing”
The prices of both goods rise by 20%. For which good does Qd drop the most? Why? For a narrowly defined good such as blue jeans, there are many substitutes (khakis, shorts, Speedos). There are fewer substitutes available for broadly defined goods. (There aren’t too many substitutes for clothing, other than living in a nudist colony.) Lesson: Price elasticity is higher for narrowly defined goods than broadly defined ones. You might need to clarify the nature of this thought experiment. Here, we look at two alternate scenarios. In the first, the price of blue jeans (and no other clothing) rises by 20%, and we observe the percentage decrease in quantity of blue jeans demanded. In the second scenario, the price of all clothing rises by 20%, and we observe the percentage decrease in demand for all clothing. ELASTICITY AND ITS APPLICATION 15

EXAMPLE 3: Insulin vs. Caribbean Cruises
The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why? To millions of diabetics, insulin is a necessity. A rise in its price would cause little or no decrease in demand. A cruise is a luxury. If the price rises, some people will forego it. Lesson: Price elasticity is higher for luxuries than for necessities. ELASTICITY AND ITS APPLICATION 16

EXAMPLE 4: Gasoline in the Short Run vs. Gasoline in the Long Run
The price of gasoline rises 20%. Does Qd drop more in the short run or the long run? Why? There’s not much people can do in the short run, other than ride the bus or carpool. In the long run, people can buy smaller cars or live closer to where they work. Lesson: Price elasticity is higher in the long run than the short run. ELASTICITY AND ITS APPLICATION 17

The Determinants of Price Elasticity: A Summary
The price elasticity of demand depends on: the extent to which close substitutes are available whether the good is a necessity or a luxury how broadly or narrowly the good is defined the time horizon – elasticity is higher in the long run than the short run This slide is a convenience for your students, and replicates a similar table from the text. If you’re pressed for time, it is probably safe to omit this slide from your presentation. ELASTICITY AND ITS APPLICATION 18

The Variety of Demand Curves
The Variety of Demand Curves The price elasticity of demand is closely related to the slope of the demand curve. Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity. Five different classifications of D curves.… Economists classify demand curves according to their elasticity. The next 5 slides present the five different classifications, from least to most elastic. ELASTICITY AND ITS APPLICATION 19

“Perfectly inelastic demand” (one extreme case)
Price elasticity of demand = % change in Q % change in P 0% = 0 10% D curve: P Q D vertical Q1 P1 Consumers’ price sensitivity: P2 none If Q doesn’t change, then the percentage change in Q equals zero, and thus elasticity equals zero. It is hard to think of a good for which the price elasticity of demand is literally zero. Take insulin, for example. A sufficiently large price increase would probably reduce demand for insulin a little, particularly among people with very low incomes and no health insurance. However, if elasticity is very close to zero, then the demand curve is almost vertical. In such cases, the convenience of modeling demand as perfectly inelastic probably outweighs the cost of being slightly inaccurate. P falls by 10% Elasticity: Q changes by 0% ELASTICITY AND ITS APPLICATION 20

Price elasticity of demand
“Inelastic demand” Price elasticity of demand = % change in Q % change in P < 10% < 1 10% D D curve: P Q relatively steep Q1 P1 Consumers’ price sensitivity: P2 Q2 relatively low An example: Student demand for textbooks that their professors have required for their courses. Here, it’s a little more clear that elasticity would be small, but not zero. At a high enough price, some students will not buy their books, but instead will share with a friend, or try to find them in the library, or just take copious notes in class. Another example: Gasoline in the short run. P falls by 10% Elasticity: < 1 Q rises less than 10% ELASTICITY AND ITS APPLICATION 21

“Unit elastic demand” Price elasticity of demand = % change in Q % change in P 10% = 1 10% D D curve: P Q intermediate slope Q1 P1 Consumers’ price sensitivity: P2 Q2 intermediate This is the intermediate case: the demand curve is neither relatively steep nor relatively flat. Buyers are neither relatively price-sensitive nor relatively insensitive to price. (This is also the case where price changes have no effect on revenue.) P falls by 10% Elasticity: 1 Q rises by 10% ELASTICITY AND ITS APPLICATION 22

“Elastic demand” Price elasticity of demand = % change in Q % change in P > 10% > 1 10% D D curve: P Q relatively flat Q1 P1 Consumers’ price sensitivity: P2 Q2 relatively high A good example here would be breakfast cereal, or nearly anything with readily available substitutes. An elastic demand curve is flatter than a unit elastic demand curve (which itself is flatter than an inelastic demand curve). P falls by 10% Elasticity: > 1 Q rises more than 10% ELASTICITY AND ITS APPLICATION 23

“Perfectly elastic demand” (the other extreme)
Price elasticity of demand = % change in Q % change in P any % = infinity 0% D curve: P Q horizontal P2 = P1 D Consumers’ price sensitivity: Q1 Q2 “Extreme price sensitivity” means the tiniest price increase causes demand to fall to zero. “Q changes by any %” – when the D curve is horizontal, quantity cannot be determined from price. Consumers might demand Q1 units one month, Q2 units another month, and some other quantity later. Q can change by any amount, but P always “changes by 0%” (i.e., doesn’t change). If perfectly inelastic is one extreme, this case (perfectly elastic) is the other. Here’s a good real-world example of a perfectly elastic demand curve, which foreshadows an upcoming chapter on firms in competitive markets. Suppose you run a small family farm in Iowa. Your main crop is wheat. The demand curve in this market is downward-sloping, and the market demand and supply curves determine the price of wheat. Suppose that price is $5/bushel. Now consider the demand curve facing you, the individual wheat farmer. If you charge a price of $5, you can sell as much or as little as you want. If you charge a price even just a little higher than $5, demand for YOUR wheat will fall to zero: Buyers would not be willing to pay you more than $5 when they could get the same wheat elsewhere for $5. Similarly, if you drop your price below $5, then demand for YOUR wheat will become enormous (not literally infinite, but “almost infinite”): if other wheat farmers are charging $5 and you charge less, then EVERY buyer will want to buy wheat from you. Why is the demand curve facing an individual producer perfectly elastic? Recall that elasticity is greater when lots of close substitutes are available. In this case, you are selling a product that has many perfect substitutes: the wheat sold by every other farmer is a perfect substitute for the wheat you sell. extreme P changes by 0% Elasticity: infinity Q changes by any % ELASTICITY AND ITS APPLICATION 24

Elasticity of a Linear Demand Curve
P Q $30 20 10 $0 40 60 The slope of a linear demand curve is constant, but its elasticity is not. 200% 40% = 5.0 E = 67% = 1.0 E = 40% 200% = 0.2 E = The material on this slide is not used anywhere else in the textbook. Therefore, if you are pressed for time and looking for things to cut, you might consider cutting this slide. (Note that this is my personal recommendation and is not necessarily the official position of Greg Mankiw or Cengage/South-Western.) Due to space limitations, this slide uses “E” as an abbreviation for elasticity, or more specifically, the price elasticity of demand, and the slide omits the analysis of revenue along the demand curve. Calculations of percentage changes use the midpoint method. (This is why the increase from Q=0 to Q=20 is 200% rather than infinity.) As you move down a linear demand curve, the slope (the ratio of the absolute change in P to that in Q) remains constant: From the point (0, $30) to the point (20, $20), the “rise” equals -$10, the “run” equals +20, so the slope equals -1/2 or -0.5. From the point (40, $10) to the point (60, $0), the “rise” again equals -$10, the “run” equals +20, and the slope again equals -0.5. However, the percentage changes in these variables do not remain constant, as shown by the different colored elasticity calculations that appear on the slide. The lesson here is that elasticity falls as you move downward & rightward along a linear demand curve. ELASTICITY AND ITS APPLICATION 25

Price Elasticity and Total Revenue
Continuing our scenario, if you raise your price from $200 to $250, would your revenue rise or fall? Revenue = P x Q A price increase has two effects on revenue: Higher P means more revenue on each unit you sell. But you sell fewer units (lower Q), due to Law of Demand. Which of these two effects is bigger? It depends on the price elasticity of demand. We return to our scenario. It’s not hard for students to imagine being in this position – running their own business and trying to decide whether to raise the price. To most of your students, it should be clear that making the best possible decision would require information about the likely effects of the price increase on revenue. That is why elasticity is so helpful, as we will now see…. ELASTICITY AND ITS APPLICATION 26

Price elasticity of demand = Percentage change in Q Percentage change in P Revenue = P x Q If demand is elastic, then price elast. of demand > 1 % change in Q > % change in P The fall in revenue from lower Q is greater than the increase in revenue from higher P, so revenue falls. ELASTICITY AND ITS APPLICATION 27

Elastic demand (elasticity = 1.8) increased revenue due to higher P Demand for your websites P Q lost revenue due to lower Q $200 12 If P = $200, Q = 12 and revenue = $2400. D $250 8 If P = $250, Q = 8 and revenue = $2000. In the “Normal” view (edit mode), the labels over the graph look cluttered, like they’re on top of each other. This is not a mistake – in “Slide Show” mode (presentation mode), all will be fine – try it! Point out to students that the area (outlined in blue) representing lost revenue due to lower Q is larger than the area (outlined in yellow) representing increased revenue due to higher P. Hence, the net effect is a fall in revenue. When D is elastic, a price increase causes revenue to fall. ELASTICITY AND ITS APPLICATION 28

Price elasticity of demand = Percentage change in Q Percentage change in P Revenue = P x Q If demand is inelastic, then price elast. of demand < 1 % change in Q < % change in P The fall in revenue from lower Q is smaller than the increase in revenue from higher P, so revenue rises. In our example, suppose that Q only falls to 10 (instead of 8) when you raise your price to $250. ELASTICITY AND ITS APPLICATION 29

Now, demand is inelastic: elasticity = 0.82 increased revenue due to higher P Demand for your websites P Q lost revenue due to lower Q $200 12 If P = $200, Q = 12 and revenue = $2400. D $250 10 If P = $250, Q = 10 and revenue = $2500. Again, the slide appears cluttered in “Normal” view (edit mode), but everything is fine when displayed in “Slide Show” mode (presentation mode). Point out to students that the area representing lost revenue due to lower Q is smaller than the area representing increased revenue due to higher P. Hence, the net effect is an increase in revenue. The knife-edge case, not shown here but perhaps worth mentioning in class, is unit-elastic demand. In that case, an increase in price leaves revenue unchanged: the increase in revenue from higher P exactly offsets the lost revenue due to lower Q. When D is inelastic, a price increase causes revenue to rise. ELASTICITY AND ITS APPLICATION 30

Changes in demand cause the demand curve itself to move.
The curve shifts to the right to show an increase in demand. It shifts to the left to show a decrease.

Changes in Demand Change in Quantity Demanded Change in Demand

Changes in Demand

Changes in Demand Demand is influenced by six factors:
Consumer income (ex: eating from the dollar menu vs. Texas Roadhouse) Consumer Tastes (ex: fuel efficient cars vs. bigger cars; 8 tracks vs. C.D.’s.)

Changes in Demand Substitutes (ex: butter vs. margarine)
Complements (ex: peanut butter and jelly; laptops and software)

Changes in Demand Change in Expectations (ex: PS2 vs. PS3) Number of Consumers (ex: baby boomers)

Changes in Demand The prices of the substitutes or complements influence demand of the related products.

4.3 Elasticity of Demand Read this section.

4.3 Elasticity of Demand Elasticity Total Expenditures Test
Total Revenue Test Calculating Elasticity, Mid-point method Determinants of Demand Elasticity

Elasticity Elasticity measures how sensitive consumers are to price changes. Demand is elastic when a change in price causes a LARGE change in demand.

Elasticity Demand is inelastic when a change in price causes a SMALL change in demand.

Elasticity Demand is unit elastic when a change in price causes a PROPORTIONAL change in demand.

Guided Practice What are examples of items for which an increase in price would cause you or your family to reconsider buying them?

Total Expenditures Test
Price times quantity demanded equals expenditures. Changes in expenditures depend on the elasticity of the demand curve. If the change in price and expenditures move in the opposite directions on the curve, demand is elastic. If they move in the same direction, demand is inelastic. If there is no change in expenditures, demand is unit elastic. Understanding elasticity helps producers effectively price their products.

Computing the Price Elasticity of Demand
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as:

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities
The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:

The Variety of Demand Curves
Inelastic Demand Quantity demanded does not respond strongly to price changes. Price elasticity of demand is less than one. Elastic Demand Quantity demanded responds strongly to changes in price. Price elasticity of demand is greater than one.

Computing the Price Elasticity of Demand
$5 4 Demand 50 100 Quantity Demand is price elastic

The Price Elasticity of Demand and Its Measurement
The Midpoint Formula Price elasticity of demand =

Solved Problem 6-1 Learning Objective 6.1
Calculating the Price Elasticity of Demand

The Price Elasticity of Demand and Its Measurement
Learning Objective 6.1 The Price Elasticity of Demand and Its Measurement Table 6-1 Summary of the Price Elasticities of Demand

Measures the responsiveness of demand to changes in price. It is the ratio of the percentage change in quantity demanded to the percentage change in price. Its value is always negative, but stated in absolute terms. The value of the line of the slope and the value of elasticity are not the same.

Shape of Demand According to Elasticity
Type of Demand Elastic Inelastic Inclination Relatively Flat Relatively Steep

Hypothetical Demand Elasticities for Four Products

Elasticity is a ratio of percentages, and it involves computing percentage changes. Using the values on the graph to compute elasticity, then:

Computing the Value of Elasticity
The midpoint formula to compute elasticity is:

Interpreting the Value of Elasticity
Here is how to interpret two different values of elasticity: When e = 0.2, a 10% increase in price leads to a 2% decrease in quantity demanded. When e = 2.0, a 10% increase in price leads to a 20% decrease in quantity demanded.

Elasticity Changes along a Straight-Line Demand Curve
Price elasticity of demand decreases as we move downward along a linear demand curve. Demand is elastic on the upper part of the demand curve and inelastic on the lower part.

Elasticity Changes along a Straight-Line Demand Curve
Along the elastic range, elasticity values are greater than one. - 6.4 Along the inelastic range, elasticity values are less than one. - .29

Elasticity and Total Revenue
Type of demand Value of Ed Change in quantity versus change in price Effect of an increase in price on total revenue Effect of a decrease in price on total revenue Elastic Greater than 1.0 Larger percentage change in quantity Total revenue decreases Total revenue increases Inelastic Less than 1.0 Smaller percentage change in quantity Unitary elastic Equal to 1.0 Same percentage change in quantity and price Total revenue does not change When demand is inelastic, price and total revenues are directly related. Price increases generate higher revenues. When demand is elastic, price and total revenues are indirectly related. Price increases generate lower revenues.

Total Revenue and the Price Elasticity of Demand
Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold. TR = P x Q

Elasticity and Total Revenue along a Linear Demand Curve
With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases.

Figure 3 How Total Revenue Changes When Price Changes: Inelastic Demand
An Increase in price from $1 to $3 … … leads to an Increase in total revenue from $100 to $240 Demand Demand $3 80 Revenue = $240 $1 100 Revenue = $100 Quantity Quantity Copyright©2003 Southwestern/Thomson Learning

Elasticity and Total Revenue along a Linear Demand Curve
With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.

Figure 4 How Total Revenue Changes When Price Changes: Elastic Demand
An Increase in price from $4 to $5 … … leads to an decrease in total revenue from $200 to $100 $5 20 Demand Demand Revenue = $100 $4 50 Revenue = $200 Quantity Quantity Copyright©2003 Southwestern/Thomson Learning

Elasticity & Total Revenue Test
Elastic > 1 if P decreases => TR increases; if P increases TR decreases Unit elastic = 1 if ΔP => no ΔTR Inelastic < 1 if P decreases => TR decreases; if P increases TR increases

Figure The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service, Panel (b)

Figure The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service, Panel (c)

Relationship Between Price Elasticity of Demand and Total Revenues

The Elasticity of Demand
Computing the price elasticity of demand Percentage change in quantity demanded divided by percentage change in price Use absolute value (drop the minus sign) Midpoint method Two points: (Q1, P1) and (Q2, P2) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Elasticity of Demand
Variety of demand curves Demand is elastic Price elasticity of demand > 1 Demand is inelastic Price elasticity of demand < 1 Demand has unit elasticity Price elasticity of demand = 1 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 1 The Price Elasticity of Demand (c)
(c) Unit Elastic Demand: Elasticity Equals 1 Price Demand $5 1. A 22% increase in price… 80 4 100 2. … leads to a 22% decrease in quantity demanded Quantity The price elasticity of demand determines whether the demand curve is steep or flat. Note that all percentage changes are calculated using the midpoint method. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Price Elasticity of Demand
(d) Elastic demand: Elasticity > 1 Price A 22% increase in price… Demand $5 50 4 100 2. … leads to a 67% decrease in quantity demanded Quantity The price elasticity of demand determines whether the demand curve is steep or flat. Note that all percentage changes are calculated using the midpoint method. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Demand Elasticity and Revenue
Total revenue, TR Amount paid by buyers and received by sellers of a good Price of the good times the quantity sold (P ˣ Q) For a price increase If demand is inelastic, TR increases If demand is elastic, TR decreases © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Total Revenue Price $4 P ˣ Q=$400 (revenue) P Demand 100 Quantity Q
Q The total amount paid by buyers, and received as revenue by sellers, equals the area of the box under the demand curve, P × Q. Here, at a price of $4, the quantity demanded is 100, and total revenue is $400. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

How Total Revenue Changes When Price Changes
(a) The case of inelastic demand (b) The case of elastic demand Price Price Demand Demand $5 $5 A 90 A 70 4 4 B 100 B 100 Quantity Quantity The impact of a price change on total revenue (the product of price and quantity) depends on the elasticity of demand. In panel (a), the demand curve is inelastic. In this case, an increase in the price leads to a decrease in quantity demanded that is proportionately smaller, so total revenue increases. Here an increase in the price from $4 to $5 causes the quantity demanded to fall from 100 to 90. Total revenue rises from $400 to $450. In panel (b), the demand curve is elastic. In this case, an increase in the price leads to a decrease in quantity demanded that is proportionately larger, so total revenue decreases. Here an increase in the price from $4 to $5 causes the quantity demanded to fall from 100 to 70. Total revenue falls from $400 to $350. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Guided Practice What are examples of items for which a drop in price would NOT encourage you to buy more of an item?

Determinants of Demand Elasticity
Demand is elastic if the answer to the following questions are “yes.” Can the purchase be delayed? Some purchases cannot be delayed, regardless of price changes. (ex: medicine) Are adequate substitutions available? Price changes can cause consumers to substitute one product for a similar product. (beef vs. chicken) Does the purchase use a large portion of income? Demand elasticity can increase when a product commands a large portion of a consumer’s income. All three answers do not necessarily have to be “yes” or “no.”

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