1. © 2003 McGraw-Hill Ryerson Limited Describing Demand Elasticities Chapter 3

2. © 2003 McGraw-Hill Ryerson Limited. 6 - 2 The Concept of Elasticity u Elasticity is a measure of the responsiveness of one variable to a change in another. u The most commonly used elasticity concept is price elasticity of demand.

3. © 2003 McGraw-Hill Ryerson Limited. 6 - 3 Price Elasticity u The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

4. © 2003 McGraw-Hill Ryerson Limited. 6 - 4 Things to Note About Elasticity u Price elasticity of demand is always negative because price and quantity demanded are inversely related—when price rises, quantity demanded falls, and vice versa.

5. © 2003 McGraw-Hill Ryerson Limited. 6 - 5 Things to Note About Elasticity u Economists have developed a convention and talk about price elasticity of demand as an absolute value of the number. u Thus, price elasticity of demand is reported as if it were positive.

6. © 2003 McGraw-Hill Ryerson Limited. 6 - 6 Classifying Demand as Elastic or Inelastic u It is helpful to classify demand by relative responsiveness as elastic or inelastic.

7. © 2003 McGraw-Hill Ryerson Limited. 6 - 7 Elastic Demand u For elastic points on curves, the percentage change in quantity is greater than the percentage change in price, in absolute value.  D > 1

8. © 2003 McGraw-Hill Ryerson Limited. 6 - 8 Elastic Demand u Common sense tells us that an elastic demand means that quantity changes by a greater percentage than the percentage change in price, in absolute value.

9. © 2003 McGraw-Hill Ryerson Limited. 6 - 9 Inelastic Demand u For inelastic points on curves, the percentage change in quantity is less than the percentage change in price, in absolute value.  D < 1

10. © 2003 McGraw-Hill Ryerson Limited. 6 - 10 Inelastic Demand u Common sense tells us that an inelastic demand means that the percent change in quantity is less than the percentage change in price, in absolute value.

11. © 2003 McGraw-Hill Ryerson Limited. 6 - 11 Elasticity Is Independent of Units u Elasticity is calculated as a ratio of percentages. u Percentages allow us to have a measure of responsiveness that is independent of units.

12. © 2003 McGraw-Hill Ryerson Limited. 6 - 12 Elasticity Is Independent of Units u Having a measure of responsiveness that is independent of units makes comparisons of responsiveness of different goods easier.

13. © 2003 McGraw-Hill Ryerson Limited. 6 - 13 Calculating Elasticities u To determine elasticity, divide the percentage change in quantity by the percentage change in price.

14. © 2003 McGraw-Hill Ryerson Limited. 6 - 14 The Mid-point Formula u Using the mid-point formula, the average of the two end points are used when calculating percentage change.

15. © 2003 McGraw-Hill Ryerson Limited. 6 - 15 Graph of Price Elasticity of Demand Elasticity of demand = 1.3 Price Quantity of software (in thousands) $2 6 23 20 0 D B A 579 C (midpoint)

16. © 2003 McGraw-Hill Ryerson Limited. 6 - 16 Graph of Price Elasticity of Demand Price Quantity $10 9 8 7 6 5 4 3 2 1 C D B A  D = 0.54  D = 4 5 10 15 20 25 30 35 40 45 50 55 b) Some examples

17. © 2003 McGraw-Hill Ryerson Limited. 6 - 17 Calculating Elasticity at a Point u Let us now turn to a method of calculating the elasticity at a specific point, rather than over a range.

18. © 2003 McGraw-Hill Ryerson Limited. 6 - 18 Calculating Elasticity at a Point u To calculate elasticity at a point, determine a range around that point and calculate the elasticity using the mid- point formula.

19. © 2003 McGraw-Hill Ryerson Limited. 6 - 19 Calculating Elasticity at a Point Price Quantity $10 9 8 7 6 5 4 3 2 1 C B A 2440 2820

20. © 2003 McGraw-Hill Ryerson Limited. 6 - 20 Calculating Elasticity at a Point 612183036 4248 Price Quantity 8 7 6 5 4 3 2 1 $10 9 A 24 6054 B  D = 2.33  D = 0.11 Demand

21. © 2003 McGraw-Hill Ryerson Limited. 6 - 21 Elasticity and Demand Curves u Two important points to consider: l Elasticity is related to (but is not the same as) slope. l Elasticity changes along a straight-line demand curve.

22. © 2003 McGraw-Hill Ryerson Limited. 6 - 22 Elasticity Is Not the Same as Slope u The relationship between elasticity and slope means that the steeper the curve, the less elastic is demand. u There are two limiting examples of this.

23. © 2003 McGraw-Hill Ryerson Limited. 6 - 23 Elasticity Is Not the Same as Slope u When the curve is horizontal, it is perfectly elastic.  Perfectly elastic demand is a horizontal line in which quantity changes enormously in response to any change in price (  D =  ).

24. © 2003 McGraw-Hill Ryerson Limited. 6 - 24 Elasticity Is Not the Same as Slope u When the curve is vertical, we call the demand perfectly inelastic. u Perfectly inelastic demand is a vertical line in which quantity does not change at all in response to a change in price (  D = 0).

25. © 2003 McGraw-Hill Ryerson Limited. 6 - 25 Perfectly inelastic demand curve 0 Quantity Perfectly Inelastic Demand Curve Price

26. © 2003 McGraw-Hill Ryerson Limited. 6 - 26 Perfectly elastic demand curve 0 Quantity Perfectly Elastic Demand Curve Price

27. © 2003 McGraw-Hill Ryerson Limited. 6 - 27 Elasticity Changes Along Straight-Line Curves u Elasticity is not the same as slope. u Elasticity changes along the straight line supply and demand curves—slope does not.

28. © 2003 McGraw-Hill Ryerson Limited. 6 - 28 Elasticity Changes Along Straight-Line Curves  A demand curve is perfectly elastic (  D =  ) at the vertical (price) intercept.  Elasticity becomes smaller as you move down the demand curve until it becomes zero (  =  ) at the horizontal (quantity) intercept.

29. © 2003 McGraw-Hill Ryerson Limited. 6 - 29 Price Elasticity declines along demand curve as we move toward the quantity axis $10 9 8 7 6 5 4 3 2 1 012345678910  D =   D = 1  D = 0 Quantity Elasticity Along a Straight Line Demand Curve  D < 1  D > 1

30. © 2003 McGraw-Hill Ryerson Limited. 6 - 30 Interpreting elasticities u We know by the law of demand that consumers buy less as price rises u Price elasticity of demand tells us if whether consumers reduce their purchases by a lot (elastic demand) or a little (inelastic demand).

31. © 2003 McGraw-Hill Ryerson Limited. 6 - 31 Interpreting Price Elasticity of Demand  D Description of demand Interpretation D=D= Perfectly elasticQuantity responds enormously to changes in price  D >1 ElasticConsumers are responsive to price changes D=D= Unit elasticPercent change in price and quantity are equal  D <1 InelasticConsumers are unresponsive to price changes D=D= Perfectly inelasticConsumers are completely unresponsive to price change

32. © 2003 McGraw-Hill Ryerson Limited. 6 - 32 Substitution and Price Elasticity of Demand u As a general rule, the more substitutes a good has, the more elastic is its demand.

33. © 2003 McGraw-Hill Ryerson Limited. 6 - 33 Substitution and Price Elasticity of Demand u How many substitutes a good has is affected by many factors: l Time to Adjust l Luxuries versus Necessities l Narrow or Broad Definition l Budget Proportion

34. © 2003 McGraw-Hill Ryerson Limited. 6 - 34 Time to Adjust u The larger the time interval considered, or the longer the run, the more elastic is the good’s demand curve. l There are more substitutes in the long run than in the short run. l The long run provides more options for change.

35. © 2003 McGraw-Hill Ryerson Limited. 6 - 35 Luxuries versus Necessities u The less a good is a necessity, the more elastic its demand curve. u Necessities tend to have fewer substitutes than do luxuries, so their demand is less elastic.

36. © 2003 McGraw-Hill Ryerson Limited. 6 - 36 Narrow or Broad Definition u As the definition of a good becomes more specific, demand becomes more elastic. l If the good is broadly defined—for example, transportation—there are not many substitutes and demand will be inelastic.

37. © 2003 McGraw-Hill Ryerson Limited. 6 - 37 Narrow or Broad Definition u As the definition of a good becomes more specific, demand becomes more elastic. l If the definition of a good is narrowed—to travel by bus, for example—there are more substitutes.

38. © 2003 McGraw-Hill Ryerson Limited. 6 - 38 Budget Proportion u Demand for goods that represent a large proportion of one's budget are more elastic than demand for goods that represent a small proportion of one's budget.

39. © 2003 McGraw-Hill Ryerson Limited. 6 - 39 Budget Proportion u Most people shop around for the lowest price on expensive items – the demand elasticity is large for those goods. u It is not worth spending the time looking for substitutes for goods which do not take much out of one’s income.

40. © 2003 McGraw-Hill Ryerson Limited. 6 - 40 Empirical Estimates of Elasticities u The following table provides short- and long-term estimates of elasticities for a number of goods.

41. © 2003 McGraw-Hill Ryerson Limited. 6 - 41 Empirical Estimates of Elasticities

42. © 2003 McGraw-Hill Ryerson Limited. 6 - 42 Price Elasticity of Demand and Total Revenue u Total revenue is the total amount of money a firm receives from selling its product. u Revenue equals total quantity sold multiplied by the price of good. u Knowing the elasticity of demand is useful to firms because from it they can tell what happens to total revenue when they raise or lower their prices.

43. © 2003 McGraw-Hill Ryerson Limited. 6 - 43 Price Elasticity of Demand and Total Revenue u If demand is elastic (  D > 1), a rise in price lowers total revenue. u Price and total revenue move in opposite directions.

44. © 2003 McGraw-Hill Ryerson Limited. 6 - 44 Price Elasticity of Demand and Total Revenue u If demand is unit elastic (  D = 1), a rise in price leaves total revenue unchanged.

45. © 2003 McGraw-Hill Ryerson Limited. 6 - 45 Price Elasticity of Demand and Total Revenue u If demand is inelastic (  D < 1), a rise in price increases total revenue. u Price and total revenue move in the same direction.

46. © 2003 McGraw-Hill Ryerson Limited. 6 - 46 A Price Elastic Demand  D > 1 Quantity $10 8 6 4 2 0 123456789 Elasticity and Total Revenue C B F E Lost revenue Gained revenue

47. © 2003 McGraw-Hill Ryerson Limited. 6 - 47 A Price Inelastic Demand  D < 1 Quantity $10 8 6 4 2 0 123456789 Elasticity and Total Revenue C H B G Lost revenue Gained revenue

48. © 2003 McGraw-Hill Ryerson Limited. 6 - 48 A Unit Elastic Demand  D = 1 Elasticity and Total Revenue C 0 6 Price Quantity $10 8 6 4 2 12345789 J K B Lost revenue Gained revenue

49. © 2003 McGraw-Hill Ryerson Limited. 6 - 49 Total Revenue Along a Demand Curve u Demand is elastic at prices above the middle point where demand is unit elastic – a rise in price in that range lowers total revenue. u Demand is inelastic at prices below the middle point where demand is unit elastic – a rise in price in that range increases total revenue.

50. © 2003 McGraw-Hill Ryerson Limited. 6 - 50 Elastic range  D > 1  D = 1 Inelastic range  D < 1 Q0Q0 Quantity (a) 0 0 Quantity (b) How Total Revenue Changes Along a Demand Curve Q0Q0 PTR

51. © 2003 McGraw-Hill Ryerson Limited. 6 - 51 Elasticity of Individual and Market Demand u Market demand elasticity is influenced both by: l How many people reduce their quantity to zero when price increases. l How much an existing consumer marginally changes his or her quantity demanded.

52. © 2003 McGraw-Hill Ryerson Limited. 6 - 52 Elasticity of Individual and Market Demand u Price discrimination occurs when a firm separates the people with less elastic demand from those with more elastic demand.

53. © 2003 McGraw-Hill Ryerson Limited. 6 - 53 Elasticity of Individual and Market Demand u Firms that price discriminate can charge more to the individuals with inelastic demand and less to individuals with elastic demand.

54. © 2003 McGraw-Hill Ryerson Limited. 6 - 54 Elasticity of Individual and Market Demand u Examples of price discrimination include: l Airlines’ Saturday stay-over specials. l Selling new cars at a discount. l The almost-continual-sale phenomenon.

55. © 2003 McGraw-Hill Ryerson Limited. 6 - 55 Other Elasticities of Demand u Two other demand elasticities are important in describing consumer behaviour: l Income elasticity of demand. l Cross-price elasticity of demand.

56. © 2003 McGraw-Hill Ryerson Limited. 6 - 56 Income Elasticity of Demand u Income elasticity of demand is defined as the percentage change in demand divided by the percentage change in income.

57. © 2003 McGraw-Hill Ryerson Limited. 6 - 57 Income Elasticity of Demand u Income elasticity of demand tells us how demand responds to changes in income.

58. © 2003 McGraw-Hill Ryerson Limited. 6 - 58 Income Elasticity of Demand u An increase in income generally increases one’s consumption of almost all goods, although the increase may be greater for some goods than for others.

59. © 2003 McGraw-Hill Ryerson Limited. 6 - 59 Income Elasticity of Demand u Normal goods are those goods whose consumption increases with an increase in income. u They have income elasticities greater than zero (positive).

60. © 2003 McGraw-Hill Ryerson Limited. 6 - 60 Income Elasticity of Demand u Normal goods are usually divided into two categories: l luxuries and l necessities.

61. © 2003 McGraw-Hill Ryerson Limited. 6 - 61 Income Elasticity of Demand u Luxuries are goods that have an income elasticity greater than 1. u Their percentage increase in quantity demanded is greater than the percentage increase in income. u They are an “income elastic normal good”.

62. © 2003 McGraw-Hill Ryerson Limited. 6 - 62 Income Elasticity of Demand u Shoes are a necessity—a good that has an income elasticity less than 1, but still positive (shoes are an “income inelastic normal good”). u The consumption of a necessity rises by a smaller proportion than the rise in income.

63. © 2003 McGraw-Hill Ryerson Limited. 6 - 63 Income Elasticity of Demand u Inferior goods are those whose consumption decreases when income increases. u Inferior goods have income elasticities less than zero (negative). u Generic (store-brand) cereals are one example of inferior goods.

64. © 2003 McGraw-Hill Ryerson Limited. 6 - 64 Income Elasticities of Selected Goods

65. © 2003 McGraw-Hill Ryerson Limited. 6 - 65 Coefficient Interpretation Description Normal good  I   Qd Two cases of normal good: Income inelastic normal good (“necessity”) Income elastic normal good (“superior” good) Inferior good  I   Qd Interpreting Income Elasticity of Demand

66. © 2003 McGraw-Hill Ryerson Limited. 6 - 66 Cross-Price Elasticity of Demand u Cross-price elasticity of demand is computed by dividing the percentage change in quantity demand by the percentage change in the price of another good.

67. © 2003 McGraw-Hill Ryerson Limited. 6 - 67 Cross-Price Elasticity of Demand u Cross-price elasticity of demand tells us the responsiveness of demand to changes in prices of other goods. u Cross-price elasticity measures both how and how strongly consumers respond to changes in the price of related products.

68. © 2003 McGraw-Hill Ryerson Limited. 6 - 68 Cross-Price Elasticity of Demand u Depending on how consumers respond to changes in the price of related products, goods can be classified as l Substitutes or l Complements

69. © 2003 McGraw-Hill Ryerson Limited. 6 - 69 Complements and Substitutes u Substitutes are goods that can be used in place of one another. u When the price of a good goes up, the demand for the substitute good also goes up. u Cross-price elasticity of substitutes is positive

70. © 2003 McGraw-Hill Ryerson Limited. 6 - 70 Complements and Substitutes u Complements are goods that are used in conjunction with other goods.

71. © 2003 McGraw-Hill Ryerson Limited. 6 - 71 Complements and Substitutes u A rise in the price of a good will decrease the demand for its complement, and a fall in the price of a good will increase the demand for its complement. u The cross-price elasticity of complements is negative.

72. © 2003 McGraw-Hill Ryerson Limited. 6 - 72 Interpretation of Cross-Price Elasticity CoefficientInterpretationRatio  XY > 0 Substitute Goods  P Y  Q X  XY < 0 Complementary Goods  P Y  Q X  XY = 0 Unrelated Goods  P Y   Q X =0

73. © 2003 McGraw-Hill Ryerson Limited. 6 - 73 P0P0 D0D0 D1D1 P0P0 18 Quantity 25 Shift due to rise in income Calculating Income and Cross-Price Elasticities Price  =6.5

74. © 2003 McGraw-Hill Ryerson Limited. 6 - 74 Calculating Income and Cross-Price Elasticities P0P0 P0P0 3 Quantity of ketchup 4 Shift due to rise in price of hot dogs D1D1 D0D0 Price of ketchup  XY = -0.7

75. © 2003 McGraw-Hill Ryerson Limited Thank You