Download 5. Income elasticity of demand

ITME no 5
Topic 3. Elasticity of demand and
supply (2)
Lecture slides available from my website:
http://www.staff.city.ac.uk/j.s.cubbin
Today’s lecture:
 Elasticity along a linear demand
curve
 The relationship between price,
demand and total revenue
 Factors that influence price
elasticity of demand
 Other demand elasticities: income,
prices of complements and
substitutes
 Price elasticity of supply.
Reading: Sloman Section 2.4.
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ITME no 5
The arithmetic versus absolute
value of elasticity
Since demand elasticity PεD is usually
negative in arithmetic terms we
sometimes refer to its absolute value,
written as | PεD|
i.e. if
PεD = - 1.5, then
|PεD|= +1.5
Suppose that, for oranges
PεD (
)= - 1.5,
While for bananas
PεD(
) = - 2.5,
We might say that demand for bananas is
more elastic for oranges – no problem.
If we are tempted to say the elasticity is
greater for bananas it is because we are
thinking in terms of |PεD| the absolute
value. But using such a phrase is
dangerous as it is potentially ambiguous.
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1. PεD along a linear demand schedule
Another reason why PεD is a better
measure of ‘responsiveness’ than the
slope of a linear demand schedule…
PεD changes along a linear demand curve
Price
|PεD|> 1
80
70
|PεD| = 1
60
50
|PεD| < 1
40
30
20
10
0
0
1000
2000
3000
4000
5000
6000
7000
8000
Quantity
Question…
As you reduce prices along a linear,
downward-sloping demand curve, what
happens to total revenue on each part of the
demand curve (elastic and inelastic)? What do
you notice about total revenue at the point
where |PεD| =1?(Hint: check extremes first)
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2. Some unusual cases where PεD is
constant along the demand schedule.
a. Perfectly elastic i.e. PεD = ∞
80
70
60
Price
50
40
30
20
10
0
1000
2000
3000
4000
5000
6000
7000
8000
Quantity
b. Perfectly inelastic i.e. PεD = 0
80
70
60
Price
50
40
30
20
10
0
0
1000
2000
3000
4000
5000
6000
7000
8000
Quantity
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c. Unitary elasticity i.e. PεD = 1
90
80
70
Price
60
50
40
30
20
10
0
0
10
20
30
40
50
60
70
80
90
Quantity (00s)
3. What factors influence PεD?
a. Closeness of substitutes
b. Proportion of income spent on the
good
d. Time elapsed since the price change
In which direction do you think these
effects work?
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4. Other demand elasticities
Cross-price elasticity of demand
=
% Δ Qdx
% Δ PY
Some key definitions:
If cross-price elasticity
is….
Then the goods are….
 positive
 substitutes
 zero
 independent
 negative
 complements
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5. Income elasticity of demand
IεD
=
% Δ Qd
% Δ income
If income elasticity
is….
Then the good is ….
 greater than one
 a luxury
 positive, but less
than one
 a necessity
 negative
 inferior
Can you provide examples of goods
and services you would hypothesise to
be luxuries? Inferior goods?
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Test your understanding…
The price of good X increases from £2 to
£2.40 and as a result the number of good Y
sold per month increases from 950 to 1050.
Using the ‘mid point’ (arc) method, the cross
price elasticity of demand is:
(a) 1.818 and goods X and Y are
complements
(b) -1.818 and goods X and Y are
substitutes
(c) –0.1818 and goods X and Y are
complements
(d) –0.55 and goods X and Y are
complements
(e) 0.55 and goods X and Y are substitutes
(For calculation, see
Cross price elasticity example.xls)
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6. Price elasticity of supply
…measures the responsiveness the
supply of a good to a change in its price.
PεS =
% Δ Qs
% Δ price
What determines PεS?



resource substitution possibilities
the rate at which costs rise as output
rises
the time elapsed since the price
change
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7. Elastic and inelastic supply
PεS = _____________
PεS = _____________
PεS = _____________
PεS = _____________
PεS = _____________
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