Download Ch04-Elasticity

Chapter 4
Demand
Elasticity
Chapter Four
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
1
Overview
The economic concept of
elasticity
The price elasticity of demand
The cross-elasticity of demand
Income elasticity
Other elasticity measures
Elasticity of supply
Chapter Four
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
2
Learning objectives
define and measure elasticity
apply concepts of price elasticity, crosselasticity, and income elasticity
understand determinants of elasticity
show how elasticity affects business
revenue
Chapter Four
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
3
The economic concept of elasticity

Elasticity: the percentage change in one
variable relative to a percentage change in
another.
percent change in A
Coefficien t of Elasticity 
percent change in B
Chapter Four
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Price elasticity of demand

Price elasticity of demand: the
percentage change in quantity demanded
caused by a 1 percent change in price
% Quantity
Ep 
% Price
Chapter Four
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Price elasticity of demand

Arc elasticity: elasticity which is
measured over a discrete interval of a
curve
Q2  Q1
P2  P1
Ep 

(Q1  Q2 ) / 2 ( P1  P2 ) / 2
Ep = coefficient of arc price elasticity
Q1 = original quantity demanded
Q2 = new quantity demanded
P1 = original price
P2 = new price
Chapter Four
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Price elasticity of demand

Point elasticity: elasticity measured at a
given point of a demand (or a supply)
curve
dQ P1
εP =
x
dP Q1
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Price elasticity of demand
The point elasticity of a linear demand
function can be expressed as:
Q P1
p 

P Q1
Chapter Four
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Price elasticity of demand

Elasticity varies
along a linear
demand curve
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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
Chapter Four
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Publishing as Prentice Hall.
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Price elasticity of demand

Categories of elasticity
Relative elasticity of demand: Ep > 1
 Relative inelasticity of demand: 0 < Ep
<1
 Unitary elasticity of demand: Ep = 1
 Perfect elasticity: Ep = ∞
 Perfect inelasticity: Ep = 0

Chapter Four
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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
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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
Chapter Four
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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
Chapter Four
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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
Chapter Four
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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?
Chapter Four
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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
Chapter Four
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Price elasticity of demand

Marginal revenue: the change in total
revenue resulting from changing quantity
by one unit
Total Revenue
MR 
Quantity
Chapter Four
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Price elasticity of demand

marginal revenue
curve is twice as
steep as the
demand
curve
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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
Chapter Four
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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

Chapter Four
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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

Chapter Four
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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
% Q A
Ex 
% PB
Chapter Four
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Cross-elasticity of demand

Arc cross-elasticity
Q2 A  Q1 A
P2 B  P1B
EX 

(Q1 A  Q2 A ) / 2 ( P1B  P2 B ) / 2
Chapter Four
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Cross-elasticity of demand

Point cross-elasticity
QA PB
EX 

QA
PB
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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)
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Income elasticity

Income elasticity of demand: the
percentage change in quantity demanded
caused by a 1 percent change in income
%Q
EY 
%Y
Y is shorthand for income
Chapter Four
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Income elasticity

Arc income elasticity
Q2  Q1
Y2  Y1
EY 

(Q1  Q2 ) / 2 (Y1  Y2 ) / 2
Chapter Four
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Income elasticity

Categories of income
elasticity

superior goods:
EY > 1

normal goods: 0 ≤
EY ≤ 1

inferior goods:
EY < 0
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Other demand elasticities

Examples: elasticity is encountered every
time a change in some variable affects
demand
advertising expenditure
 interest rates
 population size

Chapter Four
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Elasticity of supply

Price elasticity of supply: the
percentage change in quantity supplied as
a result of a 1 percent change in price
% Quantity Supplied
ES 
% Price
The coefficient of supply elasticity is a
normally a positive number
Chapter Four
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Elasticity of supply

Arc elasticity of supply
Q2  Q1
P2  P1
Es 

(Q1  Q2 ) / 2 ( P1  P2 ) / 2
Chapter Four
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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
Chapter Four
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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

Chapter Four
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
34