Download Price Elasticity of Demand

CHAPTER 3
ELASTICITY
(DEMAND AND SUPPLY)
Elasticity
• Elasticity is a measure of responsiveness or sensitivity
of a dependant variable to a percentage change in an
independent variable.
• Elasticity is a measure of how much buyers and sellers
respond to changes in market conditions.
The Elasticity Formula
• The change in quantity is always the dependant
variable.
• The change in market conditions is the independent
variable.
• Market conditions include price and other
determinants of demand and supply.
Elasticity of Demand
• Elasticity of demand is a measure of the responsiveness of
quantity demanded to changes in its factors.
• It measures the extent to which quantity demanded will change
following a change in its factors.
• These factors include products own price, income and price of
related goods.
Basic Types of Elasticity of Demand
1. Price elasticity of demand:
–
Responsiveness of quantity demanded to a change in a
product’s price
2. Income elasticity of demand:
–
Responsiveness of quantity demanded to a change in
income
3. Cross elasticity of demand:
–
Responsiveness of quantity demanded of one good to
changes in the price of another good.
1. Price Elasticity of Demand
• Price elasticity of demand is a measure of how
much the quantity demanded of a good responds to
a change in the price of that good.
• Price elasticity of demand is the percentage change
in quantity demanded given a one percent change
in the price.
• It is a comparison of the size of the change in
quantity demanded and the change in price that
brought it.
Price Elasticity of Demand (Cont)
• If the price of the product increases by 5% and this
result in a 10% decrease in the quantity demanded,
ceteris paribus, then;
10%
ep
5%
2
• The ratio which is 2 is the elasticity coefficient which
means that a 1% change in the price of the product will
lead to a 2% change in the quantity demanded.
Computing the Price Elasticity of Demand
Pr ice elasticity of demand ( p )
% change in quantity demanded
% change in in price
• Example: If the price of an ice cream cone increases
from R2.00 to R2.20 and the amount you buy falls
from 10 to 8 cones, then your elasticity of demand
would be calculated as:
10 8
100
10
2.00 2.20
100
2.00
20%
10%
2
Point Elasticity Formula
p
% change in quantity
% change in price
Q
Q
P
P
Q
Q
P
P
Q
P
100
100
Q
Q
P
Q
P
P
Categories of Price Elasticity of Demand
• Inelastic Demand (0 < ep<1)
• Quantity demanded does not respond strongly to
price changes.
• Price elasticity of demand is less than one.
• Elastic Demand (1 < ep< )
• Quantity demanded responds strongly to changes
in price.
• Price elasticity of demand is greater than one.
Categories of PED (Cont)
• Unit Elastic (ep =1)
• Quantity demanded changes by the same percentage as the price.
• Perfectly Inelastic (ep = 0)
• Quantity demanded does not respond to price changes.
• Perfectly Elastic (ep =
)
• Quantity demanded changes infinitely with any change in price.
(a) Perfectly Inelastic Demand: Elasticity Equals 0
Price
Demand
10%
1. . . . A 10 %
increase in price
0
100
Quantity
2. . . . leaves the quantity demanded unchanged.
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(b) Inelastic Demand: Elasticity is Less Than 1
Price
10%
1. A 10 %
increase
in price . . .
2%
Demand
0
Quantity
2. . . . leads to an 2 % decrease in quantity demanded.
(c) Unit Elastic Demand: Elasticity Equals 1
Price
10%
1. A 10 %
increase
in price . . .
Demand
10 %
0
Quantity
2. . . . leads to a 10 % decrease in quantity demanded.
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(d) Elastic Demand: Elasticity is Greater Than 1
Price
10%
1. A 10 %
increase
in price . . .
15%
Demand
0
Quantity
2. . . . leads to an 15 % decrease in quantity demanded.
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Price
1. At any price
above R4, quantity
demanded is zero.
R4
Demand
2. At exactly R4,
consumers will
buy any quantity.
0
3. At a price below R4,
quantity demanded is infinite.
Quantity
The Price Elasticity of Demand and Its Determinants
1.
Habit forming products
–
Products such as cigarettes, alcohol, drugs
2. The degree of necessity.
–
Demand for a product that are considered to be necessity
tends to be relatively inelastic whereas luxury goods
tends to be relatively elastic.
3. Availability of substitute
– The more substitutes there are for a good and the closer
they are, the more people will switch to alternatives
when the price of the good rises.
The Price Elasticity of Demand and Its Determinants (Cont)
4. The Proportion of Income spent on the product
–
The higher the proportion of our income we spent on
a good, the more elastic will be demand.
–
We spent a tiny fraction of our income on salt. Its PED is very low.
5. Advertising
–
Producers use advertising to convince consumers
that their products have no real substitutes thereby
reducing the elasticity of demand for their products.
Price Elasticity of Demand & Total Revenue
1. Inelastic Demand
–
–
–
quantity demanded changes by a percentage which
is less than the percentage change in the price.
There`s an incentive for producers to raise the price
of the product since percentage fall in quantity
demanded is smaller than the percentage increase in
the price.
However, there`s no incentive for producers to drop
the price of the product since percentage increase in
quantity will be smaller than the percentage decrease
in the price.
Price Elasticity of Demand & Total Revenue
2. Elastic Demand
–
When the percentage change in quantity demanded
is greater than the percentage change in price.
–
Producers can increase TR by lowering the price of
the product.
–
However, there are no incentive to increase their
prices since, the resulting decrease in the quantity
demanded will be proportionately greater than the
increase in the price.
Price Elasticity of Demand & Total Revenue
3. Unit Elastic Demand
–
Producers cannot raise TR by decreasing or
increasing the price.
–
Because the percentage change in price will be
exactly offset by a corresponding percentage change
in the quantity demanded.
–
TR will remain unchanged.
Relationship between PED & Total Revenue
 When price is changed, the impact on a firm’s total revenue
(TR) will depend upon the price elasticity of demand
Elasticity
For a price
increase
For a price
decrease
Demand is
elastic
TR decreases TR increases
Demand is
unit elastic
TR does not
change
TR does not
change
Demand is
inelastic
TR increases
TR decreases
2. Income Elasticity of Demand
• Income elasticity of demand measures how much
the quantity demanded of a good responds to a
change in consumers’ income (Y).
• It enables us to predict how much the demand
curve will shift for a given change in income.
• It is computed as the percentage change in the
quantity demanded divided by the percentage
change in income.
Computing Income Elasticity
Percentage change
in quantity demanded
Income elasticity of demand =
Percentage change
in income
Example: A 2% rise in income causing an 8% rise in
the demand for a product.
y ED
8%
2%
4
Income Elasticity
• Types of Goods
• Normal Goods (positive income elasticity)
• Inferior Goods (negative income elasticity)
• Higher income raises the quantity demanded for
normal goods but lowers the quantity demanded
for inferior goods.
Income Elasticity
• The major determinant of income elasticity is the
degree of “necessity” of the good.
• Goods consumers regard as necessities tend to be
income inelastic
• Examples include food, fuel, clothing, utilities, and medical services.
• Goods consumers regard as luxuries tend to be income
elastic.
• Examples include sports cars, expensive clothes or foods.
Cross Price Elasticity
– It measures the responsiveness of demand for one
product to a change in the price of another (either
substitute or a complement)
– It enables us to predict how much the demand curve
for the first product will shift when the price of the
second product changes.
– Calculated as:
CED AB
%
%
Q DA
PB
Cross Price Elasticity
• If good B is a substitute for good A, A`s demand
will rise as B`s price rises. Hence CED will be
positive.
• If good B is complementary to good A, A`s
demand will fall as B`s price rises. Hence CED
will be negative.
THE ELASTICITY OF SUPPLY
• Price elasticity of supply is a measure of
how much the quantity supplied of a good
responds to a change in the price of that
good.
• Price elasticity of supply is the percentage
change in quantity supplied resulting from a
percent change in price.
The Price Elasticity of Supply
(a) Perfectly Inelastic Supply: Elasticity Equals 0
Price
Supply
R5
4
1. An
increase
in price . . .
0
100
Quantity
2. . . . leaves the quantity supplied unchanged.
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The Price Elasticity of Supply
(b) Inelastic Supply: Elasticity Is Less Than 1
Price
Supply
R5
4
1. A 25%
increase
in price . . .
0
100
110
Quantity
2. . . . leads to a 10% increase in quantity supplied.
Copyright©2003 Southwestern/Thomson Learning
(c) Unit Elastic Supply: Elasticity Equals 1
Price
Supply
R5
4
1. A 25%
increase
in price . . .
0
100 125
Quantity
2. . . . leads to a 25% increase in quantity supplied.
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(d) Elastic Supply: Elasticity Greater Than 1
(d) Elastic Supply: Elasticity Is Greater Than 1
Price
Supply
R5
4
1. A 25%
increase
in price . . .
0
100
150
Quantity
2. . . . leads to a 50 % increase in quantity supplied.
Copyright©2003 Southwestern/Thomson Learning
(e) Perfectly Elastic Supply Elasticity Equals Infinity
(e) Perfectly Elastic Supply: Elasticity Equals Infinity
Price
1. At any price
above R4, quantity
supplied is infinite.
R4
Supply
2. At exactly R4,
producers will
supply any quantity.
0
3. At a price below R4,
quantity supplied is zero.
Quantity
Copyright©2003 Southwestern/Thomson Learning
Total Revenue and Elasticity
When a price changes, the change in producers’
total revenue depends on the elasticity of demand.
Total Revenue and Elasticity
Elastic demand: a 1 percent price cut increases the quantity
sold by more than 1 percent and total revenue increases.
Unit elastic demand: a 1 percent price cut increases the
quantity sold by 1 percent and so total revenue does not
change.
Inelastic demand: a 1 percent price cut increases the
quantity sold by less than 1 percent and total revenue
decreases.
Price (dollars per pizza)
25.00
Elastic
demand
20.00
15.00
Unit
elastic
12.50
10.00
Inelastic
demand
When demand
is elastic,
price cut
increases
total revenue
Total Revenue (billions of dollars)
5.00
0
350.00
312.50
300.00
Maximum
total revenue
250.00
When demand
is inelastic,
price cut decreases
total revenue
200.00
150.00
100.00
50.00
0
25
50
Quantity (pizza per hour)
QUESTIONS
*Question 1 (Tutorial III)
a.Explain five categories of price elasticity of demand with the aid of
appropriate diagrams.
(15)
b.Discuss how the knowledge of price elasticity of demand can assist
producers to increase their total revenue.
(9)
c. Discuss the various factors that influence/determine elasticity of
demand.
(10)
*Question 2 (Tutorial III)
c. Using the elasticity concepts & diagrams, explain your answer
above.
(5)