1. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 1 Chapter 4 Demand Elasticity

2. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 2 Overview The economic concept of elasticity The price elasticity of demand The cross-elasticity of demand Income elasticity Other elasticity measures Elasticity of supply

3. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 3 Learning objectives define and measure elasticity apply concepts of price elasticity, cross- elasticity, and income elasticity understand determinants of elasticity show how elasticity affects business revenue

4. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 4 The economic concept of elasticity  Elasticity: the percentage change in one variable relative to a percentage change in another.

5. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 5 Price elasticity of demand  Price elasticity of demand: the percentage change in quantity demanded caused by a 1 percent change in price

6. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 6 Price elasticity of demand  Arc elasticity: elasticity which is measured over a discrete interval of a curve E p = coefficient of arc price elasticity Q 1 = original quantity demanded Q 2 = new quantity demanded P 1 = original price P 2 = new price

7. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 7 Price elasticity of demand  Point elasticity: elasticity measured at a given point of a demand (or a supply) curve

8. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 8 Price elasticity of demand The point elasticity of a linear demand function can be expressed as:

9. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 9 Price elasticity of demand  Elasticity varies along a linear demand curve

10. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 10 Price elasticity of demand  Some demand curves have constant elasticity  such a curve has a nonlinear equation: Q = aP -b where –b is the elasticity coefficient

11. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 11 Price elasticity of demand  Categories of elasticity Relative elasticity of demand: E p > 1 Relative inelasticity of demand: 0 < E p < 1 Unitary elasticity of demand: E p = 1 Perfect elasticity: E p = ∞ Perfect inelasticity: E p = 0

12. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 12 Price elasticity of demand  Factors affecting demand elasticity ease of substitution proportion of total expenditures durability of product  possibility of postponing purchase  possibility of repair  used product market length of time period

13. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 13 Price elasticity of demand  Derived demand: the demand for products or factors that are not directly consumed, but go into the production of a another (final) product The demand for such a product or factor exists because there is demand for the final product

14. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 14 Price elasticity of demand  The derived demand curve will be more inelastic: the more essential is the component the more inelastic is the demand curve for the final product the smaller is the fraction of total cost going to this component the more inelastic is the supply curve of cooperating factors

15. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 15 Price elasticity of demand  A long-run demand curve will generally be more elastic than a short-run curve As the time period lengthens consumers find ways to adjust to the price change, via substitution or shifting consumption

16. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 16 Price elasticity of demand  The relationship between price and revenue depends on elasticity Why? By itself, a price fall will reduce receipts … BUT because the demand curve is downward sloping, the drop in price will also increase quantity demanded  Q: which effect will be stronger?

17. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 17 Price elasticity of demand  As price decreases revenue rises when demand is elastic revenue falls when it is inelastic revenue reaches it peak if elasticity =1  the lower chart shows the effect of elasticity on total revenue

18. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 18 Price elasticity of demand  Marginal revenue: the change in total revenue resulting from changing quantity by one unit

19. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 19 Price elasticity of demand  marginal revenue curve is twice as steep as the demand curve

20. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 20 Price elasticity of demand  at the point where marginal revenue crosses the X-axis, the demand curve is unitary elastic and total revenue reaches a maximum

21. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 21 Price elasticity of demand  Examples: some real world elasticities coffee: short run -0.2, long run -0.33 kitchen and household appliances: -0.63 meals at restaurants: -2.27 airline travel in U.S.: -1.98 beer: -0.84, Wine: -0.55

22. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 22 Price elasticity of demand  Examples: some real world elasticities white pan bread:-0.69 cigarettes: short run -0.4, long run -0.6 wine imports: -0.15 crude oil: -0.06 internet services: -0.6/-0.7

23. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 23 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

24. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 24 Cross-elasticity of demand  Arc cross-elasticity

25. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 25 Cross-elasticity of demand  Point cross-elasticity

26. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 26 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 (in ab. value)

27. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 27 Income elasticity  Income elasticity of demand: the percentage change in quantity demanded caused by a 1 percent change in income Y is shorthand for income

28. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 28 Income elasticity  Arc income elasticity

29. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 29 Income elasticity  Categories of income elasticity superior goods: E Y > 1 normal goods: 0 ≤ E Y ≤ 1 inferior goods: E Y < 0

30. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 30 Other demand elasticities  Examples: elasticity is encountered every time a change in some variable affects demand advertising expenditure interest rates population size

31. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 31 Elasticity of supply  Price elasticity of supply: the percentage change in quantity supplied as a result of a 1 percent change in price The coefficient of supply elasticity is a normally a positive number

32. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 32 Elasticity of supply  Arc elasticity of supply

33. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 33 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 When the supply curve is less elastic, a change in demand will have a greater effect on price than on quantity

34. Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 34 Global application  Example: price elasticities in Asia imports almost always price inelastic if exports price inelastic, export earnings will rise as prices rise if exports price elastic, export earnings will rise with world incomes