Download Chapter 4

Chapter 4: Elasticity
Elasticity of Demand:
It measures the responsiveness
of quantity demanded (or
demand) with respect to changes
in its own price (or income or
the price of some other
commodity).
Why is Elasticity Important?
How does a firm go about determining
the price at which they should sell their
product in order to maximize total
revenue?
Total Revenue = Price  Quantity
You are a marketing manager for Intel
A new computer chip has been developed
Decision to Be Made
Do you sell the new chip at a high price
($400)?
Do you sell the new chip at a low price
($200)?
Price (dollars per chip)
Demand and Total Revenue
400
300
200
Da
100
40
80
120
Quantity (millions of chips per year)
Price (dollars per chip)
Demand and Total Revenue
400
300
200
100
Db
40
60 80
120
Quantity (millions of chips per year)
Price (dollars per chip)
Price (dollars per chip)
Demand and Total Revenue
Da
Db
Quantity (millions of chips per year)
Quantity (millions of chips per year)
Slope Depends on
Units of Measurement
In these two examples, we can compare
the slopes of the demand curves
We cannot do so if we are dealing with
different goods and services.
Effect of a change of unit of measurement on Slope
10
9
8
7
6
5
4
3
2
1
0
1
2
3
4
5
6
7
8
9 10 11
Quantity
Slope Depends on
Units of Measurement
In these two examples, we can compare
the slopes of the demand curves
We cannot do so if we are dealing with
different goods and services.
Elasticity is independent of the units of
measurement.
Price elasticity of demand
A measure of the responsiveness
of the quantity demanded of a
good to a change in its own
price (ceteris paribus).
Elasticity: A Units-Free
Measure
Percentage Change in Quantity Demanded
εd
Percentage Change in Price
Price
Elasticity of
Demand
Q d
%Δ Q d  Q avg

P
%Δ P
Pavg
Calculating Elasticity
The changes in price and quantity are
expressed as percentages of the average
price and average quantity.
This way we avoid having two values for the
price elasticity of demand for the same range of
the demand curve
Example: Suppose, quantity demanded changes
from 150 to 100 when Price increases from 5 to
10 dollars. Find out the price elasticity of demand
for this specific range of the demand curve.
εd
Q
 50  2
Q avg 125
2 1.5
3
5


 
   .6
P
5
1
5 1
5
Pavg
7.5 1.5
Price (dollars per chip)
Calculating the Elasticity of Demand
Original
point
410
390
Da
36
44
Quantity (millions of chips per year)
Price (dollars per chip)
Calculating the Elasticity of Demand
Original
point
410
New
point
390
Da
36
44
Quantity (millions of chips per year)
Price (dollars per chip)
Calculating the Elasticity of Demand
Original
point
410
 P = -$20
New
point
390
Da
36
Q = 8
44
Quantity (millions of chips per year)
Price (dollars per chip)
Original
point
410
P=
-$20
400
Pave = $400
New
point
390
Da
36
Q = 8
44
Quantity (millions of chips per year)
Price (dollars per chip)
Calculating the Elasticity of Demand
Original
point
410
 P=
400
-$20
Pave =$400
New
point
Qave = 40
390
Da
36
Q = 8
40
44
Quantity (millions of chips per year)
Calculating Elasticity
Percentage Change in Quantity Demanded
εd
Percentage Change in Price
Q
%Δ Q d 

%Δ P
Q avg
8 / 40
P   20 / 400 = - 4
Pavg
Inelastic and Elastic Demand
Three demand curves that cover the
entire range of possible elasticities
of demand:
Perfectly inelastic
Unit elastic
Perfectly elastic
Q d
Q avg
εd 
P
Pavg
Perfectly inelastic demand
Implies that quantity
demanded remains constant
when price changes occur.
Price elasticity of demand
=0
Price
D
Elasticity = 0
12
Perfectly Inelastic
6
0
1
Quantity
Q d
Q avg
εd 
P
Pavg
Unit elastic demand
Implies that the percentage
change in quantity demanded
equals the percentage change in
price.
Price elasticity of demand = -1
Pric
e
Unit Elastic Demand
Elasticity = -1
12
Unit Elasticity
6
D
1
2
3
Quantity
Q d
Q avg
εd 
P
Pavg
Perfectly elastic demand
Implies that if price increases by
any percentage, quantity
demanded will fall to 0 and if
price decreases by any
percentage, quantity will rise to
infinity.
Price elasticity of demand = 
Price
Perfectly Elastic Demand
Elasticity =

12
D3
6
Perfectly Elastic
Quantity
Inelastic and Elastic Demand
Q d
Q avg
εd 
P
Pavg
Inelastic demand
Implies the percentage change in quantity
demanded is less than the percentage change in
price.
In absolute sense, price elasticity of demand >
0 and < 1
Elastic demand
Implies the percentage change in quantity
demanded is greater than the percentage change
in price.
In absolute sense, price elasticity of demand >
1
Price (dollars per chip)
Elasticity Along a Straight-Line
Demand Curve
500
400
300
250
200
100
0
40
80 100 120 160
200
Quantity (millions of chips per year)
Price (dollars per chip)
Elasticity Along a Straight-Line
Demand Curve
Elasticity = -4
500
Elastic
400
Lowering the price
from $500 to $300
results in a price
elasticity of demand of -4.
300
250
200
100
0
40
80 100 120 160
200
Quantity (millions of chips per year)
Price (dollars per chip)
Elasticity Along a Straight-Line
Demand Curve
500
Lowering the price
from $200 to $0
results in a price
elasticity of demand of -1/ 4.
400
Inelastic
300
250
200
Elasticity = -1/4
100
0
40
80 100 120 160
200
Quantity (millions of chips per year)
Price (dollars per chip)
Elasticity Along a Straight-Line
Demand Curve
500
|Elasticity| > 1
400
Lowering the price
from $500 to $0
results in a price
elasticity of demand of -1.
|Elasticity| = 1
300
250
200
|Elasticity| < 1
100
0
40
80 100 120 160
200
Quantity (millions of chips per year)
TR = P x Q
Elasticity, Total Revenue
and Expenditure
Q d
Q avg
εd 
P
Pavg
Elastic demand — a 1 percent decrease in
price will result in a greater than 1 percent
increase in quantity demanded.
Total revenue will increase
Unit elastic demand — a 1 percent decrease in
price will result in a 1 percent increase in
quantity demanded
Total revenue will not change
Elasticity, Total Revenue
and Expenditure
Q d
Q avg
εd 
P
Pavg
Inelastic demand — a 1 percent
decrease in price will result in a
less than 1 percent increase in
quantity demanded.
Total revenue will decrease
Elasticity, Total Revenue
and Expenditure
Total Revenue Test
Price elasticity of demand can
be estimated by observing the
change in total revenue that
results from a price change
(ceteris paribus).
Elasticity, Total Revenue
and Expenditure
Total Revenue Test
Price cut and total revenue increases
 demand is elastic.
Price cut and total revenue
decreases
 demand is inelastic
Price cut and total revenue does not
change
Price (dollars per chip)
500
400
300
250
200
100
0
D
100
TR = P x Q
200
Price (dollars per chip)
500
400
300
250
200
Total Revenue (billions of dollars)
100
0
25
D
100
200
20
15
10
TR
5
0
100
200
Quantity (millions of chips per year)
Price (dollars per chip)
500
Elastic
demand
400
Unit
elastic
300
250
200
Inelastic
demand
When demand
is elastic,
price cut
increases
total revenue
Total Revenue (billions of dollars)
100
0
25
100
200
Maximum
total revenue
20
15
When demand
is inelastic,
price cut decreases
total revenue
10
5
0
100
200
Quantity (millions of chips per year)
More Elasticities of Demand
Cross elasticity of demand
 Measures the responsiveness of the
demand for a good to a change in the
price of a substitute or complement good.
Cross elasticity
=
of demand
Percentage change Demand
Percentage change in price of
a substitute or complement
Price of Walkmans
Cross Elasticity of Demand
D0
Quantity of Walkmans
Price of Walkmans
Cross Elasticity of Demand
Price of a CD player,
a substitute, rises.
Positive cross elasticity
D0
Quantity of Walkmans
D1
Price of Walkmans
Cross Elasticity of Demand
D0
Quantity of Walkmans
Price of Walkmans
Cross Elasticity of Demand
Price of a tape,
a complement,
rises. Negative
cross elasticity
D2
D0
Quantity of Walkmans
Income Elasticity of Demand
Income elasticity
Measures the responsiveness of the demand to
a change in income.
Income elasticity
=
of demand
Percentage change
in quantity demanded
Percentage change in income
Income Elasticity of Demand
Income elasticity can be:
1 ) Greater than 1 (normal good, income elastic)
luxury goods - ocean cruises, jewelry
2 ) Between zero and 1 (normal good, income
inelastic)
necessities - food, clothing
3 ) Less than zero (inferior good)
potatoes, rice
Unit Tax and Tax Burden:
10
S2
9
8
7
6
5
$2
S1
4
3
2
1
0
1
2
3
4
5
6
7
8
9 10 11
Quantity
Unit Tax and Tax Burden:
10
$2
S2
Consumers’ part
9
8
7
6
5
S1
4
3
2
1
Suppliers’ part
0
1
2
3
4
5
6
7
8
9 10 11
Quantity
Elasticity and Tax Burden: Perfectly Inelastic Demand
10
$2
S2
Consumers’ part
9
8
7
6
5
S1
4
3
2
1
0
1
2
3
4
5
6
7
8
9 10 11
Quantity
Elasticity and Tax Burden: Perfectly Elastic Demand
10
9
8
7
6
5
$2
S2
Producers’ part
S1
4
3
2
1
0
1
2
3
4
5
6
7
8
9 10 11
Quantity
Elasticity and Tax Burden: Perfectly Elastic Supply
10
$2
Consumers’ part
9
8
7
6
5
S2
S1
4
3
2
1
0
1
2
3
4
5
6
7
8
9 10 11
Quantity
Elasticity and Tax Burden: Perfectly inelastic Supply
S1
10
9
8
7
6
5
$2
Producers’ part
4
3
2
1
0
1
2
3
4
5
6
7
8
9 10 11
Quantity