#### Transcript Elasticity

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Demand and Elasticity
Outline
● Elasticity: Measure of Responsiveness
● Price Elasticity of Demand: Its Effect on
Total Revenue
● What Determines Demand Elasticity?
● Elasticity as a General Concept
● Real-World Application: Polaroid versus
Kodak
Elasticity: Measure of
Responsiveness
● Elasticity = measure of the responsiveness
of one variable to changes in another
variable
%  Qd
● Price elasticity of demand =
%P
Real-World Application:
Polaroid versus Kodak
● In 1989, Polaroid sued Kodak –copyright
infringement of its instant-photography patents.
● Court case would determine how much Kodak
should pay in compensation to Polaroid.
♦ Polaroid: could have charged ↑P film without illegal
competition from Kodak
♦ Kodak: ↑P film → ↓Qd film
Real-World Application:
Polaroid versus Kodak
● Relevant Question: How would ↑P film affect
Polaroid’s TR?
♦ Depends on how responsive Qd is to P, which depends
on the shape of the D curve for film
● Court’s decision would be based on the
responsiveness of Qd to P.
1(a). Hypothetical
Demand Curves for Film
FIGURE
Kodak’s claim
Df
Price per Package
\$20
D is relatively
responsive to P.
b
TRa = \$10 x 4 = \$40
TRb = \$20 x 1.5 = \$30
a
10
Df
0
1.5
Here P doubles and TR
falls by 25%.
4
Quantity Demanded in millions
1(b). Hypothetical
Demand Curves for Film
FIGURE
Polaroid’s claim
DS
D is relatively
unresponsive to P.
B
Price per Package
\$20
TRa = \$10 x 4 = \$40
TRb = \$20 x 3 = \$60
A
10
Here P doubles and
TR rises by 50%.
DS
0
3
4
Quantity Demanded in millions
Elasticity: Measure of
Responsiveness
● Governments, courts, and businesses need to
understand the relationship between Qd and P
● If consumers respond sharply to ∆P →D is elastic
♦ E.g., graph (a) above
● If consumers are unresponsive to ∆P →D is
inelastic
♦ E.g., graph (b) above
Calculation of Elasticity of D
● Price Elasticity of Demand:
♦ %  Qd  %  P
● Units problems: cannot judge elasticity by
looking at a graph and its slope
♦ ∆ in units of measurement make graphs appear
steeper or flatter when they convey the same
info.
2(a). Sensitivity of Slope
to Units of Measurement
Price per Pizza
FIGURE
\$18
17
16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
0
↓P by \$4 →↑Qd by 80.
D
A
B
D
280 500
360
1,000
1,500
2,000
2,500
3,000
Pizzas per Week
(a)
2(b). Sensitivity of Slope
to Units of Measurement
Price per Pizza
FIGURE
\$18
17
16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
0
1 pizza = 8 slices
D
↓P by \$4 →↑Qd
by 640.
A
B
D
500
1,000 1,500 2,000 2,500 3,000
2,240
2,880
Slices of Pizza per Week
(b)
Calculation of Elasticity of D
● Slope of a curve changes whenever units of
measurement changes.
● ↓P by \$4 → (a) ↑Qd by 80
→ (b) ↑Qd by 640
● Same info is portrayed but slope is flatter (and looks
more elastic) when measured in slices.
● Need % ∆ not absolute ∆ (slope) to measure elasticity.
♦ E.g., if defense budget doubles, it goes up by 100% whether it
is measured in millions or billions of dollars.
Calculation of Elasticity of D
● Percentage problems:
♦ Fig. 1(b). Pa = \$10 and Qa = 4;
Pb = \$20 and Qb = 3.
∆Qd = 1, so should we take 1 as a % of 3? → 33.3%
or 1 as a % of 4? → 25.0%
● No right answer, so compromise by using the average Qs
● Average of 3 & 4 = 3.5 →%∆Qd = 1/3.5 = 28.6%
● Same is done with price: %∆P = \$10/\$15 = 66.7%
Calculation of Elasticity of D
● Drop (-) sign and use absolute values:
♦ P and Qd have a (-) relationship
ε = (∆Qd / average of 2 Q’s)  (∆P /average of 2 P’s)
● Polaroid example:
♦ Fig. 1(a): ε = (2.5/2.75)  (10/15) = 1.4
♦ Fig. 1(b): ε = (1/3.5)  (10/15) = 0.43
3(a). Perfectly Inelastic
Demand
FIGURE
Qd is 90 no matter the P.
Elasticity = 0
P
%∆Qd = 0
D
Consumer purchases do not
respond to ∆P.
E.g., goods with very low
prices that are used with
something else –salt or
shoelaces. Or an essential
medicine.
0
90
QD
3(b). Perfectly Elastic
Demand
FIGURE
P
Slight ↑P → ↓Qd to 0.
Elasticity = 
\$5
%∆Qd = infinitely large
D
Consumer are completely
responsive to ∆P.
E.g., Demand for a firm that
produces an
undifferentiated product.
0
QD
3(c). Straight-line
Demand
FIGURE
Slope remains constant but
ε is changing.
P
ε (a-b) = (2/3)  (2/5) = 1.67
6
ε (c-d) = (2/6)  (2/2) = 0.33
a
Moving down the D curve ε
is getting smaller because
average Q is rising while
average P is falling.
b
4
3
c
d
1
2
4
5
7
D
QD
FIGURE
3(d). Unit-elastic Demand
Slope is changing but ε is constant
and equal to 1.
P
ε (e-f) = (7/10.5)  (10/15) = 1.0
Note: if ε = 1 → D is “unit elastic”
20
if ε > 1 → D is “elastic”
e
if ε < 1 → D is “inelastic”
10
f
D
7
14
QD
Elasticity of Demand and Total
Revenue
● Firms want to know whether an ↑P will raise or
lower their sales revenues.
♦ If D is elastic: ↑P → ↓TR
♦ If D is unit elastic: ↑P → TR constant
♦ If D is inelastic: ↑P → ↑TR
■Recall: TR = TE = P x Qd
Elasticity of Demand and Total
Revenue
● Further examples:
♦ If P↓ by 10% and ↑Qd by 10% → D is unit elastic and
TR are constant.
♦ If P↓ by 10% and ↑Qd by 15% → D is elastic and
↑TR.
♦ If P↓ by 10% and ↑Qd by 5% → D is inelastic and
↓TR.
FIGURE
4. An Elastic Demand
Curve
\$6
Price
5
D
R
Pt. S: TR = \$24
= area of 0RST
S
W
V
4
Pt. V: TR = \$60
D = area of 0WVU
D is elastic as
↓P → ↑TR.
3
2
1
T
0
4
U
12
Quantity Demanded
1. Estimates of Price
Elasticities
TABLE
What Determines Demand
Elasticity?
1. Nature of the good:
♦ Necessities have very inelastic demands, while
luxuries have elastic demands.
♦ E.g., ε potatoes = 0.3 and the ε restaurant meals =
1.6.
What do these numbers mean?
● 10%↑ in P of potatoes → ↓sales of potatoes by 3%.
And 10%↑ in P of restaurant meals → ↓restaurant
dining by 16%.
♦
Comes from the elasticity formula: %P * ε = %Qd
What Determines Demand
Elasticity?
2. Availability of a close substitute:
♦ If consumers can buy a good substitute for a
product whose ↑P, they will readily switch.
■ E.g., D for gas is inelastic because you can’t run
a car without it. But D for Chevron gas is elastic
because Mobile or Shell gas work just as well.
What Determines Demand
Elasticity?
3. Fraction of Income Absorbed:
♦ Very inexpensive items have an inelastic
demand. Who will use more salt if the price
falls?
♦ Very expensive items have elastic demands.
Families will buy fewer homes if housing
prices increase.
What Determines Demand
Elasticity?
4. Passage of Time:
●
D for products is more elastic in LR than SR
because consumers have more time to adjust
their purchases.
♦
E.g., suppose recent ↑P gas continues. In SR,
consumers may take fewer summer road trips to
↓Qd gas. But in LR, consumers can buy more fuel
efficient cars to further ↓Qd gas.
Elasticity as a General
Concept
● Elasticity can be used to measure the
responsiveness of anything to anything else.
● Income Elasticity:
♦ Income elasticity of D = %  Qd  % Y
● Price Elasticity of Supply:
♦ Price elasticity of S = %  Qs  %  P
Cross Elasticity of Demand
● Cross εd is used to determine whether two
goods are compliments or substitutes. It is
calculated as:
εcross = (%∆Qd good X)  (%∆P good Y)
Cross Elasticity of Demand
● Two goods are compliments if an ↑Qd for one
good → ↑Qd of the other good.
♦ E.g, ketchup and french fries or coffee and cream.
■ If ↓P of coffee → ↑purchases of coffee and cream. Cross
elasticity for compliments is (-). As ↓P of coffee falls →
↑Qd of cream.
Cross Elasticity of Demand
● Two goods are substitutes if an ↑Qd for one good
→ ↓Qd of the other good.
♦ E.g., ice cream and frozen yogurt or cans of salmon
and cans of tuna.
■ If ↑P of ice cream → ↓purchases of ice cream and
↑purchases of frozen yogurt. Cross elasticity for substitutes
is (+). As ↑P of ice cream → ↑Qd of frozen yogurt.
● Cross elasticity is often used in “anti-trust” lawsuits. If
firms face strong competition, it is difficult to overcharge
customers. A very high and (+) cross elasticity indicates
effective competition in a market.
Real-World Application:
Polaroid versus Kodak
● In 1989, Polaroid sued Kodak –copyright
infringement
● How much could Polaroid’s TR have increased if
Kodak did not infringe?
♦ Polaroid claimed lots! \$9 billion or more –because D
was inelastic
♦ Kodak claimed neighborhood of \$450 million –
because D was elastic -(very close to judge’s verdict)