Download Price Elasticity of Demand

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ECON 1023
SPRING 2012
Instructor: Gibson Nene
Lecture Notes: Elasticity of Demand and Supply
Source: Microeconomics Brief Edition, First Edition by McConnell,
Brue and Flynn.
This handout has 15printed pages.
By the end of Chapter 4 you should be able to understand:
• The Price Elasticity of Demand and How It Can Be Applied
• The Usefulness of the Total Revenue Test for Price Elasticity of
Demand
• Price Elasticity of Supply and How It Can Be Applied
• Cross Elasticity of Demand and Income Elasticity of Demand
The law of demand tells us that consumers will respond to a price
decrease by buying more of a product (other things remaining constant),
but it does not tell us how much more.
• The concept of price elasticity of demand fills this gap.
What is the Price elasticity of Demand?
• A measure of the responsiveness of the ________ demanded of a
good to a change in its _____ when all other influences on buyers’
plans remain the same.
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• To determine the price elasticity of demand, we compare the
percentage change in the _________ demanded with the
percentage change in ___________.
Elastic demand
• For some products, consumers are highly responsive to price
changes.
•
Demand for such products is relatively _____or simply ______.
• In other words for these products, a small change in price leads to
a large change in the quantity of products bought by the
consumer.
Inelastic demand
• For other products, consumers’ responsiveness is only slight, or in
rare cases non-existent.
• Demand is said to be relatively ________, or simply __________.
• In other words for these products, a large change in price leads to
a small change in the quantity of products bought by the
consumer.
• It is important to note that with both elastic and inelastic demand,
consumers behave according to the law of demand; that is, they are
responsive to price changes.
• The terms elastic or inelastic describe the _________ of
responsiveness.
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Price-elasticity coefficient and formula
Ed =
Percentage Change in Quantity
Demanded of Product X
Percentage Change in Price
of Product X
• The formula on the previous slide can be restated as follows:
Ed =
Change in Quantity Demanded of X
Original Quantity Demanded of X
÷
Change in Price of X
Original Price of X
When calculating the price elasticity of demand the starting point
matters.
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Using traditional calculations (The formulas from the previous
two slides ), the measured elasticity over a given range of prices is
_________to whether one starts at the ______ price and goes
down, or the ________ price and goes up.
Example
• Suppose the price of Cheese changes from $4 to $5 per pound.
This change yields:
• ___________________________.
• Suppose the price of a pound of Cheese changes from $5 to $4.
This change yields:
• _________________________________.
• Which one of the above percentage changes in price should we use
to calculate price elasticity coefficient?
How about quantity changes?
• A quantity change from 10 to 20 yields.
• _________________________
• A quantity changes from 20 to 10 yields.
• _________________________.
• Which one of the above percentage changes in quantity should we
use to calculate price elasticity coefficient?
How do we deal with this problem?
• A way to deal with this problem is to use the average of the two
quantities and the average of the two prices.
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• Price changes
• 1st compute the _________ of the two prices
• _________________________
• Price change from $4 to $5 yields a
• ________________________
• A price change from $5 to $4 yields a
• _________________________
• Quantity changes
• 1st compute the ______________ of the two quantities
• _________________________
• Quantity change from 10 to 20 yields a
• ____________________________
• Quantity change from 20 to 10 yields
• ______________________________
Price Elasticity of Demand: The Midpoint approach
• The Midpoint formula
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• We use the average of the two quantities and the average of the
two prices as the denominators in the calculation of price elasticity.
Interpretations of Elasticity
• Because of the inverse relationship between price and quantity
demanded, the actual elasticity of demand will be a negative
number. However, we ignore the minus sign and use absolute
value of both percentage changes.
• If the coefficient of elasticity of demand is a number greater than
one, we say demand is _______________.
• If the coefficient is less than one, we say demand is ___________
• A special case is if the coefficient equals one; this is called
____________________________
Extreme cases of price elasticity of demand
• _________________ demand
• The demand curve would be vertical.
• Consumers are completely unresponsive in to change price.
• ___________________ demand
•
The demand curve would be horizontal.
•
Product demand for which quantity demanded can be any
amount at a particular price.
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• Why use percentages when calculating the price elasticity of
demand?
• __________________ measure
• Compare responsiveness ____________products
The Total Revenue Test
• Total Revenue (TR) = Price (P) x Quantity (Q)
• Total-revenue test is the easiest way to judge whether demand is
elastic or inelastic. This test can be used in place of elasticity
formula, unless there is a need to determine the elasticity
coefficient.
• Inelastic demand: Price and Total Revenue change in the ______
direction.
• Elastic demand: Price and Total Revenue change in _______
directions.
• ________elasticity: Demand has unit elasticity if Total Revenue
does not change when the price changes.
This is summarized in the table below:
If Demand is
Elastic
Unit Elastic
Inelastic
Response to an
increase in price
Response to a decrease
in price
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Inelastic Demand and Total Revenue
 Total revenue changes in the same direction as price.
 If price increases, revenue _________, and when price _______,
revenue falls.
• When price falls from $4 to $1
• The loss is _________ than the gain
• TR falls when price falls, i.e. TR falls from ____________.
• Therefore demand is inelastic (Ed < 1).
Elastic Demand and Total Revenue
Response of Total revenue when price changes
 Revenue changes in the opposite direction from price.
 If price increases, revenue falls, and when price falls, revenue
increases.
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• Price falls from $2 to $1
• Loss is s_________ than gain
• TR rises when price falls i.e. TR increases from ____________
• Therefore demand is elastic (Ed > 1)
Total revenue and unit elastic demand
Total revenue remains the same when price changes.
Elasticity on a Linear Demand Curve
Elasticity and the TR Curve
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• Substitutes for the product
– Generally, the more substitutes, the more elastic the
demand.
• The proportion of price relative to income
– Generally, the larger the expenditure relative to one’s budget,
the more elastic the demand, because buyers notice the
change in price more.
• Whether the product is a luxury or a necessity
– Generally, the less necessary the item, the more _______ the
demand.
Applications of Elasticity
 Governments look at elasticity of demand when levying excise
taxes. Excise taxes on products with ________ demand will raise
the most revenue and have the least impact on quantity demanded
for those products.
Cross Elasticity of Demand
• Cross Elasticity of Demand: A measure of the responsiveness of
the demand for a good to a change in the price of a substitute or
complement when other things remain the same.
• Numerically, the formula is shown for products X and Y:
Exy = (percentage change in quantity of X) / (percentage change in price
of Y)
1. If cross elasticity is ________, then X and Y are substitutes.
2. If cross elasticity is _______, then X and Y are complements.
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3. Note: if cross elasticity is zero, then X and Y are unrelated,
independent products.
Cross Elasticity of Demand: Examples
Substitutes
 Suppose that when the price of a burger falls by 10 %, the quantity
of pizza demanded decreases by 5%. The cross elasticity of
demand for pizza with respect to the price of a burger is
 The cross elasticity of demand for a substitute is positive: The
quantity demanded of a good and the price of one of its substitutes
change in the same direction.
Complements
 Suppose that when the price of soda falls by 10%, the quantity of
pizza demanded increases by 2%. The cross elasticity of demand
for pizza with respect to the price of a burger is
 The cross elasticity of demand for a complement is negative: The
quantity demanded of a good and the price of one of its
complements change in _________ directions.
Income Elasticity of Demand
• Income Elasticity of Demand: A measure of the responsiveness of
the demand for a good to a change in income when other things
remain the same.
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• It is calculated by using the following formula:
Ei = (percentage change in quantity demanded) / (percentage change in
income)
• The income elasticity of demand falls into three ranges:
 Greater than 1: ___________ good, income elastic
 Between 0 and 1: ____________ good, income inelastic
 Less than 0(negative): ______________ good
Price Elasticity of Supply
• Price elasticity of Supply: A measure of the responsiveness of the
_________ supplied of a good to a change in its _______ when all
other influences on sellers’ plans remain the same.
• To determine the price elasticity of supply, we compare the
percentage change in the quantity supplied with the percentage
change in price.
Elastic and Inelastic Supply
• Elastic supply: When the percentage change in the quantity
supplied exceeds the percentage change in price.
• Unit elastic supply: When the percentage change in the quantity
supplied equals the percentage change in price.
• Inelastic supply: When the percentage change in the quantity
supplied is less than the percentage change in price.
• Perfectly inelastic supply: When the percentage change in the
quantity supplied is zero for any percentage change in the price.
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• Perfectly elastic supply: When the quantity supplied changes by a
very large percentage in response to an almost zero percentage
change in price.
Computing the Price Elasticity of Supply
To determine whether the supply of a good is elastic, unit
elastic, or inelastic, we compute a numerical value for the
price elasticity of supply in a way similar to that used to
calculate the price elasticity of demand. We use the formula:
Es = percentage change in quantity supplied / percentage change in price
 As with price elasticity of demand, the ________________ is more
accurate.
• If the price elasticity of supply is greater than 1, supply is elastic
• If the price elasticity of supply equals 1, supply is unit elastic
• If the price elasticity of supply is less than 1, supply is inelastic
Price Elasticity of Supply and Time Periods
• The Immediate market period
– Producers are unable to adjust the quantity produced in
response to price changes.
– It is virtually impossible for producers to adjust their
resources and change the quantity supplied.
– Period is so short that elasticity of supply is __________; it
could be almost perfectly inelastic or vertical.
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• Short-run
– Pant size is fixed but production can be varied.
• Industrial producers are able to make some output
changes by having workers work overtime or by
bringing on an extra shift.
– Elasticity of supply depends on the ability of producers to
respond to price change.
Supply elasticity is more elastic in the short-run than in the market
period
• The long-run
– More adjustments such as plant size can be made over time.
– Quantity can be changed more relative to a small change in
price.
– Supply elasticity is more __________ than market period and
short run.
END