Download Cross-elasticity of demand

Chapter 4 - B
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
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2
Price elasticity of demand

Elasticity varies
along a linear
demand curve
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3
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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4
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

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
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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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11
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
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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
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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
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Income elasticity

Categories of income
elasticity

superior goods:
EY > 1

normal goods: 0 ≤
EY ≤ 1

inferior goods:
EY < 0
Chapter Four
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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

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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
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Elasticity of supply

Arc elasticity of supply
Q2  Q1
P2  P1
Es 

(Q1  Q2 ) / 2 ( P1  P2 ) / 2
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22
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
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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

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CASES…………………..


1) The initial price of a cup of coffee is $1, and at that
price, 400 cups are demanded. If the price
falls to $0.90, the quantity demanded will increase to 500.




a. Calculate the (arc) price elasticity of demand for coffee.
b. Based on your answer, is the demand for coffee elastic
or inelastic?
c. Based on your answer to a., if the price of coffee is
increased by 10%, what will happen to the revenues from
coffee? Carefully explain how you know.
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CASES-2





2) The demand curve is: QD = 500 - 1/2 P.
a. Calculate the (point) price elasticity of demand
when price is $100. Is demand elastic or
inelastic?
b. Calculate the (point) price elasticity of demand
when price is $700. Is demand elastic or
inelastic?
c. Find the point at which point elasticity is equal
to -1.
Chapter Four
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26