Download Chapter 4 - McGraw Hill Higher Education

Chapter 4
Elasticities
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Learning Objectives
• What is price elasticity of demand?
• What are categories of demand elasticity and
what factors influence them?
• What is the relationship between demand
elasticity and total revenue?
• What is income elasticity of demand?
• What is cross elasticity of demand?
• What is price elasticity of supply?
• What are categories of supply elasticity and
what factors influence them?
2
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Price Elasticity of Demand
Price elasticity of demand
Percentage change in quantity demanded

Percentage change in price
• Price elasticity of demand measures
consumers’ responsiveness to price
changes.
• How much quantity demanded will change
if price changes.
• Ignore the negative sign since it’s always
there.
3
4-3
Categories of Demand Elasticity
•
•
If price elasticity of demand >1:
% change in quantity demanded > % change in price
Elastic demand
•
•
If price elasticity of demand <1:
% change in quantity demanded < % change in price
Inelastic demand
•
•
If price elasticity of demand =1:
% change in quantity demanded = % change in price
Unit elastic demand
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Elastic Demand Curve
• A small percentage
change in price:
• A large percentage
change in quantity.
• The price elasticity of
demand between
Point A and Point B is
high.
• Price elasticity of
demand > 1.
Price
Point A
Point B
$8
$7
Demand
100
220
Quantity
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Inelastic Demand Curve
• A large percentage
change in price:
• A small percentage
change in quantity.
• The price elasticity of
demand between
Point A and Point B is
low.
• Price elasticity of
demand < 1.
Price
Point A
$10
Point B
$4
100
110
Quantity
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Perfectly Inelastic Demand Curve
• Quantity demanded is
constant and does not
respond to price
changes.
• Price elasticity of
demand = 0.
• This demand curve
violates the Law of
Demand.
• Unrealistic demand
curve.
Price
Quantity
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Perfectly Elastic Demand Curve
• Quantity demanded is
extremely responsive
to price changes.
• The smallest price
change causes infinite
change in quantity
demanded.
• Price elasticity of
demand = infinity.
Price
$4
1
Quantity
20
8
4-8
Unit Elastic Demand Curve
• Any percentage
change in price
causes the same
percentage change in
quantity demanded.
• Price elasticity of
demand = 1.
• Elasticity is the same
but not the slope
along the demand
curve.
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Elasticity Along a Straight Line Demand Curve
At the top of demand curve:
• When the quantity is near zero a
small absolute increase in
quantity demanded means a
huge percentage increase in
quantity demanded.
• The price elasticity of demand is
huge.
At the bottom of demand curve:
• When price is near zero a small
absolute increase in price
means a huge. percentage
increase in price.
• The price elasticity of demand is
tiny.
Price
Elasticity =infinity
Demand
Quantity = 0
Elasticity =0
Price = 0
Quantity
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Do You Know?
• If a 10% price increase causes 60% fall in
quantity demanded then what is the price
elasticity of demand?
• Is it elastic, inelastic or unit elastic demand?
Price elasticity of demand
60%

10%
6
It is elastic demand.
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Price Elasticity of Demand and Total
Revenue
• Total revenue = Price X sales.
• Law of demand: As price increases,
quantity demanded falls and as price
decreases, quantity demanded rises.
• Should you increase or decrease price to
increase total revenue?
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Elastic Demand and Total Revenue
• Elastic demand
= Quantity demanded is
very responsive to price
change.
• Lower price
= Gain of huge number of
customers.
= Increase in total revenue
• Price and total revenue
move in the opposite
direction.
$Price
We are here on
the demand
curve.
We are here on
the demand
curve.
8
7.50
Total revenue
= ($8)(100)
=$800 andTotal
is revenue=($7.50)(1,000)
=$7,500
and is represented by
represented
this box.
by this.box.
100
1,000
Quantity
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Inelastic Demand and Total Revenue
• Inelastic demand
= Quantity demanded is not
responsive to price
change
• Lower price
= Gain of very few number
of customers
= Decrease in total revenue
• Price and total revenue
move in the same
direction
Price
We are here on the
demand curve.
$10
Total revenue
=($10)(500)
= $5,000 and is
represented
by this box.
$2
Total revenue =($2)(600)
= $1,200 and is represented
by this box.
500 600
We are here on
the demand
curve.
Quantity
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Price Elasticity of Demand and Total
Revenue
Price Elasticity of Effect of a
Demand
Price Increase
Effect of a
Price Decrease
Elastic
Decrease in total
revenue
Increase in total
revenue
Unit elastic
No change in total No change in total
revenue
revenue
Inelastic
Increase in total
revenue
Decrease in total
revenue
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Factors That Influence
Demand Elasticity
Substitutes:
• The greater the availability of substitutes
for a good, the higher the good’s price
elasticity of demand.
Complements:
• Strong complements reduce a good’s
price elasticity of demand.
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Factors That Influence
Demand Elasticity
Product definition:
• The more broadly defined a product, the
less elastic the product’s demand.
• Broadly defined products have less
substitutes whereas narrowly defined
products have more substitutes.
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Factors That Influence
Demand Elasticity
Necessities:
= Goods that are considered a “must have.”
• Necessities do not have good substitutes.
• Necessities have less elastic demand.
Luxuries:
• Luxury goods have more elastic demand.
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Factors That Influence
Demand Elasticity
Time:
• Consumers are more flexible in the long run
than in the short term.
• The price elasticity of demand is higher the more
time consumers have to adjust to price changes.
Share of income spent on good:
• The greater the percentage of income spent on
a good, the more price elasticity of demand for
that good.
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Factors That Influence
Demand Elasticity
Addiction:
• Fear of being addicted to a good can
result in high price elasticity of demand.
• However, for a consumer already addicted
to the good, price elasticity of demand will
be low.
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Do You Know?
• How does the price elasticity of demand vary along a
straight line demand curve?
Price elasticity decreases moving along a straight line
demand curve from the top to the bottom.
• How does a decrease in price affect total revenue when
demand is inelastic?
Total revenue will decrease.
• How do substitutes affect price elasticity of demand?
A greater availability of substitutes makes demand more
elastic.
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Income Elasticity of Demand
Income elasticity of demand measures how
quantity demanded responds to changes in
income.
Price elasticity of income
Percentage change in quantity demanded

Percentage change in income
• Income elasticity is positive for normal goods.
• Income elasticity is negative for inferior
goods.
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Cross Elasticity of Demand
Cross elasticity of demand measures how the
change in price of one good impacts the
demand for another good.
Cross elasticity of demand
Percentage change in quantity demanded of good A

Percentage change in price of good B
• Cross elasticity of demand for substitutes is
positive.
• Cross elasticity of demand for complements
is negative.
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Price Elasticity of Supply
Price elasticity of supply measures
responsiveness of quantity supplied to price
changes.
Price elasticity of supply
Percentage change in quantity supplied

Percentage change in price
• Due to the Law of Supply, price elasticity of
supply is always positive.
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Categories of Supply Elasticity
•
•
•
•
Elastic supply = quantity supplied that is very
responsive to price changes.
If price elasticity of supply > 1.
% change in quantity supplied > % change in price.
•
•
Inelastic supply = quantity supplied is relatively
unresponsive to price changes.
If price elasticity of supply < 1.
% change in quantity supplied < % change in price.
•
•
•
Unit elastic supply.
If price elasticity of supply = 1.
% change in quantity supplied = % change in price.
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Behind Price Elasticity of Supply
Costs:
• Low costs result in relatively high price elasticity of
supply.
Capacity:
• Additional productive capacity makes increases price
elasticity of supply.
Specialized inputs:
• Goods that need specialized inputs for production have
lower price elasticity of supply in the short term.
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Behind Price Elasticity of Supply
Government permission:
• Need to obtain legal permission to expand
operations reduces firm’s price elasticity of
supply.
Ability to fire workers:
• Not being able to fire workers reduces firm’s
price elasticity of supply.
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Behind Price Elasticity of Supply
Time:
• Price elasticity of supply is greater in the long
run than in the short term.
• Longer time offers firms flexibility and possibility
of innovations.
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Do You Know?
• When is income elasticity of demand negative?
Income elasticity of demand is negative for inferior goods
i.e. Goods which consumers buy less with higher
income.
• What does the cross elasticity of demand measure?
Cross elasticity of demand measures how the change in
price of one good impacts the demand for another good.
• What is the sign of price elasticity of supply and why
does it have this sign?
Supply elasticity is positive since as price increases,
quantity supplied rises and as price decreases, quantity
supplied falls.
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Summary
• Price elasticity of demand measures how quantity
demanded responds to price changes.
• Elastic demand = consumers very responsive to price
changes.
• Inelastic demand = consumers not responsive to price
changes.
• Unit elastic demand = quantity demanded changes by
the same percentage as change in price.
• Factors that influence demand elasticity: availability of
substitutes, product definition, share of income spent on
the good, necessities vs. luxuries, time and strong
complements.
• Effect of change in price on total revenue depends on
the category of demand elasticity.
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Summary
• Price elasticity of income measures how quantity
demanded responds to income changes.
• Cross elasticity of demand measures how the change in
price of one good impacts the demand for another good.
• Price elasticity of supply measures responsiveness of
quantity supplied to price changes.
• Elastic supply = quantity supplied very responsive to
price changes.
• Inelastic demand = quantity supplied not responsive to
price changes.
• Unit elastic demand = quantity supplied changes by the
same percentage as change in price.
• Factors that influence supply elasticity: costs, capacity,
time, flexibility of doing business.
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Coming up
Analyzing policies with market
forces of supply and demand.
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Appendix: calculating demand elasticity
Price elasticity of demand
Percentage change in quantity demanded
=
Percentage change in price
=
(Q1  Q0 )
(Q1  Q0 ) / 2
( P1  P0 )
( P1  P0 ) / 2
Where Q1= new quantity, Q0= old quantity
P1= new price, P0= old price
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