Download Elasticity

Chapter Four
Demand
What is demand?
• It is the response of customers to your
firm’s prices and all other attributes of
the good or service your firm offers.
• To “know the customer” means to
understand what influences the
customer’s demand and to what degree
changes will affect the customer’s
behavior.
Copyright © Houghton Mifflin Company.All rights reserved.
4–2
PRICE
We typically draw demand curves as
downward sloping lines -- but how steep?
What if the lower
price means this
higher quantity
demanded?
P
P2
Q
Q2
QUANTITY
Q3
PRICE
The flatter curve is MORE ELASTIC
A price change
leads to a greater
change in quantity
demanded
P
P2
Q
Q2
QUANTITY
Q3
Who Cares?
• The airline who wants to increase
passengers on a flight from Phoenix to
Los Angeles might care.
• What will a price increase do if demand
is VERY ELASTIC?
Copyright © Houghton Mifflin Company.All rights reserved.
4–5
Answer the following:
• What will a price decrease do if demand
is not elastic?
• How are the airline executives to decide
whether to raise or lower price and by
how much?
Copyright © Houghton Mifflin Company.All rights reserved.
4–6
Answer the following:
• Consider the Glaxo-Wellcome company who
produces the only known retardant of the
onset of AIDS once HIV is contracted.
• How high of a price should it set?
• What will a price decrease do?
• How is the company to decide whether to
raise or lower price and by how much?
Copyright © Houghton Mifflin Company.All rights reserved.
4–7
Definition of Price Elasticity of Demand
• Percentage change in quantity
demanded divided by percentage
change in price.
• % change in Qd/ % change in P
• (Q2-Q1)/Q1 divided by (P2-P1)/P1
• or dlogQd/dlogP
Copyright © Houghton Mifflin Company.All rights reserved.
4–8
• If price changes by 10% and quantity
demanded changes by 15%, what is the
price elasticity of demand?
• If price changes by 10% and quantity
demanded changes by 5%, what is the
price elasticity of demand?
Definition of Price Elasticity of Demand
• If price elasticity is less than 1, we say
that demand is inelastic.
• If price elasticity is greater than 1, we
say that demand is elastic.
• If price elasticity is 1, we say that
demand is unit elastic.
Copyright © Houghton Mifflin Company.All rights reserved.
4–10
Assignment:
Plot the following data
Price per Ticket
$1,000
900
800
700
600
500
400
300
200
100
Copyright © Houghton Mifflin Company.All rights reserved.
Tickets Sold per Day
200
400
600
800
1000
1200
1400
1600
1800
2000
4–11
Price
$1,000
200
800
600
PRICE
$1000
$800
$600
$400
$200
200
600 1000 1400 1800
QUANTITY
Quantity
PRICE
Price
Quantity
$1,000
200
$1000
800
600
$800
600
1000
$600
400
1400
$400
$200
200
600 1000 1400 1800
QUANTITY
PRICE
Price
Quantity
$1,000
200
$1000
800
600
$800
600
1000
$600
400
1400
200
1800
$400
$200
D
200
600 1000 1400 1800
QUANTITY
Price Elasticity Calculation
• Calculate the price elasticity of demand
between the following prices:
• from $1,000 to $600
• from $600 to $400
• from $200 to $100
Copyright © Houghton Mifflin Company.All rights reserved.
4–15
Assignment
•
•
•
•
•
from $1,000 to $600
P1 = $1,000; P2 = $600
Q1 = 200; Q2 = 1000
(Q2-Q1)/Q1 = 800/200 = 4
(P2-P1)/P1 = $600-$1000/$1,000 = $400/$1,000 = -.4
• %ChQd/%ChP = 4/-.4 = -10
Copyright © Houghton Mifflin Company.All rights reserved.
4–16
Assignment
•
•
•
•
•
•
•
from $600 to $400
P1 = $600; P2 = $400
Q1 = 1000; Q2 = 1400
(Q2-Q1)/Q1 = 400/1000 = .4
(P2-P1)/P1 = $400-$600/$600 =
-$200/$600 = -.33
%ChQd/%ChP = .4/-.33 = -1.2
Copyright © Houghton Mifflin Company.All rights reserved.
4–17
Price Elasticity
• from $200 to $100
• P1 = $200; P2 = $100
• Q1 = 1800; Q2 = 2000
• (Q2-Q1)/Q1 = 200/1800 = 1/9
• (P2-P1)/P1 = $100/$200 = -1/2
• %ChQd/%ChP = 1/9/-1/2 = -2/9
Copyright © Houghton Mifflin Company.All rights reserved.
4–18
Answers
• from $1,000 to $600 = -10
• from $600 to $400
= -1.2
• from $200 to $100
= -2/9 = -.22
Copyright © Houghton Mifflin Company.All rights reserved.
4–19
Negative Value
• What do you notice with the first three
elasticities calculated?
• from $1,000 to $600 = -10
• from $600 to $400
= -4/6= -.67
• from $200 to $100
= -2/9 = -.22
• (1) All are negative.
Copyright © Houghton Mifflin Company.All rights reserved.
4–20
Price Elasticity Is Always Negative
• We have “e” stand for price elasticity of
demand. We know that:
• (1) e is always negative --- Why?
• So we drop the negative (use the
absolute value |e|).
• (2) e declines as we move down the
demand curve.
Copyright © Houghton Mifflin Company.All rights reserved.
4–21
Price Elasticity Is Always Negative
• What do you notice regarding price
elasticity of demand from the three
calculations we’ve made?
• First: all are negative.
• Second: e declines as we move down
the demand curve; it becomes smaller
in absolute value as price declines.
Copyright © Houghton Mifflin Company.All rights reserved.
4–22
Elastic Region e > 1
PRICE
$1000
$800
$600
Unit Elastic Point
$400
Inelastic
D Region e < 1
$200
200
600 1000 1400 1800
QUANTITY
Elasticity and Total Revenue
• Total revenue = P x Q.
• The price of the item multiplied by the
number of items sold is total revenue.
Copyright © Houghton Mifflin Company.All rights reserved.
4–24
Price per Ticket
Quantity
$1000
200
900
400
800
600
700
800
600
1000
500
1200
400
1400
300
1600
200
1800
100
2000
Total Revenue
Price per Ticket
Quantity
$1000
200
900
400
800
600
700
800
600
1000
500
1200
400
1400
300
1600
200
1800
100
2000
Total Revenue
200,000
Price per Ticket
Quantity
$1000
200
900
400
800
600
700
800
600
1000
500
1200
400
1400
300
1600
200
1800
100
2000
Total Revenue
200,000
360,000
Price per Ticket
Quantity
$1000
200
900
400
800
600
700
800
600
1000
500
1200
400
1400
300
1600
200
1800
100
2000
Total Revenue
200,000
360,000
480,000
560,000
600,000
600,000
560,000
480,000
360,000
200,000
Price per Ticket
Quantity
$1000
200
900
400
800
600
700
800
600
1000
500
1200
400
1400
300
1600
200
1800
100
2000
Total Revenue
200,000
360,000
Elastic
480,000
Region
560,000
600,000
600,000
560,000
480,000
360,000
200,000
Price per Ticket
Quantity
$1000
200
900
400
800
600
700
800
600
1000
500
1200
400
1400
300
1600
200
1800
100
2000
Total Revenue
200,000
360,000
480,000
560,000
600,000
600,000
560,000
Inelastic
480,000
360,000
Region
200,000
Price per Ticket
Quantity
$1000
200
900
400
800
600
700
800
600
1000
500
1200
400
1400
300
1600
200
1800
100
2000
Total Revenue
200,000
360,000
Elastic
480,000
Region
560,000
600,000
600,000 Unit Elastic e=1
560,000
Inelastic
480,000
360,000
Region
200,000
Total Revenue and Elasticity
• As price decreases in the elastic region,
total revenue . . .
• Increases.
• As price decreases in the inelastic
region, total revenue . . .
• Decreases.
Copyright © Houghton Mifflin Company.All rights reserved.
4–32
Determinants of Elasticity
• Number of substitutes.
• Importance of the good in a consumer’s
budget. The higher the % of the budget,
the more sensitive consumers are to a
1% price increase -- the more elastic is
the demand.
• The time period. The longer the time
period, the more elastic is the demand.
Copyright © Houghton Mifflin Company.All rights reserved.
4–33
Income and Other Elasticities
• When the price changes, we move
along the demand curve -- how much
we move is the price elasticity of
demand.
• When something other than the price
changes that affects demand, the
demand curve shifts.
Copyright © Houghton Mifflin Company.All rights reserved.
4–34
Demand would increase –
so curve would shift out.
PRICE
$1000
$800
$600
$400
$200
D1
QUANTITY
D2
How far it shifts depends on
the elasticity
PRICE
$1000
$800
$600
$400
$200
D1
QUANTITY
D2
6000
RGDP United States
5000
4000
3000
2000
1000
0
1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1989 1995
19
10
19
16
19
22
19
28
19
34
19
40
19
46
19
52
19
58
19
64
19
70
19
76
19
82
19
88
19
94
20
Changes in RGDP
-5
-10
-15
-20
United States
15
10
5
0
Income and Other Elasticities
• When something other than the price
changes that affects demand, the demand
curve shifts.
• Suppose that income changes by 10% and
sales rise by 20%. Then we say that the
income elasticity of demand is 2.
• Income elasticity is the % change in demand
divided by % change in income.
Copyright © Houghton Mifflin Company.All rights reserved.
4–39
Who Cares?
• The economy is growing --- income is
rising by 5%. What does this mean?
• You work for a construction company.
You’ve calculated that the income
elasticity of demand is 4.
• Your quantity sold will rise by 20%.
Copyright © Houghton Mifflin Company.All rights reserved.
4–40
If income elasticity is lower?
• What if income elasticity of demand is
.5?
• Then the 5% income increase would
mean a sales (quantity) increase of
• only 2.5%.
Copyright © Houghton Mifflin Company.All rights reserved.
4–41
Cross Price Elasticity
• Percentage Change of Qd
• Percentage Change of P
• This indicates relationships between
two products.
• If the price of medical services rises and
the quantity demanded of health food
rises, we say the two goods are
substitutes.
Copyright © Houghton Mifflin Company.All rights reserved.
4–42
Cross Price Elasticity
• If the price of cigarettes rises and the
quantity demanded of alcohol
decreases, we say the two goods are
complements.
• Of what use is cross price elasticity?
Copyright © Houghton Mifflin Company.All rights reserved.
4–43
OTHER ELASTICITY MEASURES
•
•
•
•
•
•
•
•
•
ADVERTISING
PROMOTION
SALES FORCE
How are these measured? What do they tell
us?
PIMS Data: 1500 business units: Average
Price elasticity = .985
Advertising = .003
Promotion = .008
Sales force = .304
Copyright © Houghton Mifflin Company.All rights reserved.
4–44