Transcript The price elasticity of demand

Chapter 4
Elasticities of demand and supply
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
8th Edition, McGraw-Hill, 2005
PowerPoint presentation by Alex Tackie and Damian Ward
The price elasticity of demand
…measures the sensitivity of the quantity
demanded of a good to a change in its price
It is defined as:
% change in quantity demanded
% change in price
1
The price elasticity of demand
Example: If the price of an ice cream cone increases from $2.00 to $2.20
and the amount you buy falls from 10 to 8 cones, then your elasticity of
demand would be calculated as:
eDP = (Q2 – Q1)/Q1
(P2 – P1)/P1
(10  8)
 100
20%
10

2
(2.20  2.00)
 100 10%
2.00
2
The Midpoint Method: A Better Way to Calculate Percentage Changes
and Elasticities
The midpoint formula is preferable when calculating the price elasticity of
demand because it gives the same answer regardless of the direction of
the change.
(Q 2  Q1 ) / [(Q 2  Q1 ) / 2]
Price elasticity of demand =
(P2  P1 ) / [(P2  P1 ) / 2]
•Example: If the price of an ice cream cone increases from $2.00 to
$2.20 and the amount you buy falls from 10 to 8 cones, then your
elasticity of demand, using the midpoint formula, would be calculated
as:
(10  8)
22%
(10  8) / 2

 2.32
( 2.20  2.00)
9.5%
( 2.00  2.20) / 2
3
Elastic demand
• Demand is ELASTIC
– when the price elasticity (ignoring the negative
sign) is greater than -1
– i.e. when the % change in quantity demanded
exceeds the change in price
• e.g. if quantity demanded falls by 7% in
response to a 5% increase in price
• elasticity is -7  5 = -1.4
4
Figure 1 The Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Price
$5
4
Demand
1. A 22%
increase
in price . . .
0
50
100
Quantity
2. . . . leads to a 67% decrease in quantity demanded.
Inelastic demand
• Demand is INELASTIC
– when the price elasticity lies between -1 and 0
– i.e. when the % change in quantity demanded
is smaller than the change in price
• e.g. if quantity demanded falls by 3.5% in
response to a 5% increase in price
• elasticity is -3.5  5 = - 0.7
6
Figure 1 The Price Elasticity of Demand
(b) Inelastic Demand: Elasticity Is Less Than 1
Price
$5
4
1. A 22%
increase
in price . . .
Demand
0
90
100
Quantity
2. . . . leads to an 11% decrease in quantity demanded.
Unit elastic demand
• Demand is UNIT ELASTIC
– when the price elasticity is exactly -1
– i.e. when the % change in quantity demanded is
equal to the change in price
• e.g. if quantity demanded falls by 5% in
response to a 5% increase in price
• elasticity is -5  5 = -1
8
Figure 1 The Price Elasticity of Demand
(c) Unit Elastic Demand: Elasticity Equals 1
Price
$5
4
Demand
1. A 22%
increase
in price . . .
0
80
100
Quantity
2. . . . leads to a 22% decrease in quantity demanded.
Copyright©2003 Southwestern/Thomson Learning
Figure 1 The Price Elasticity of Demand
(a) Perfectly Inelastic Demand: Elasticity Equals 0
Price
Demand
$5
4
1. An
increase
in price . . .
0
100
Quantity
2. . . . leaves the quantity demanded unchanged.
Copyright©2003 Southwestern/Thomson Learning
Figure 1 The Price Elasticity of Demand
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Price
1. At any price
above $4, quantity
demanded is zero.
$4
Demand
2. At exactly $4,
consumers will
buy any quantity.
0
3. At a price below $4,
quantity demanded is infinite.
Quantity
Price elasticity for a linear demand curve
The price elasticity varies along the length of a
straight-line demand curve.
D
Elastic

Unit elasticity
Inelastic
D
Quantity
12
Elasticity of a Linear Demand Curve
What determines the price elasticity?
• The ease with which consumers can substitute
another good.
• EXAMPLE:
– consumers can readily substitute one brand of detergent
for another if the price rises
– so we expect demand to be elastic
– but if all detergent prices rise, the consumer cannot switch
– so we expect demand to be inelastic
14
Elasticity is higher in the
long run
• In the short run, consumers may not be able (or
ready) to adjust their pattern of expenditure.
• If price changes persist, consumers are more likely
to adjust.
• Demand thus tends to be
– more elastic in the long run
– but relatively inelastic in the short run.
15
Elasticity and revenue
When price is changed, the impact on a firm’s total revenue
(TR) will depend upon the price elasticity of demand.
Revenue of a firm = P*Q
For a price
increase
For a price
decrease
Demand is
elastic
TR
decreases
TR
increases
Demand is
unit elastic
TR does not TR does not
change
change
Demand is
inelastic
TR
increases
TR
decreases
16
Elasticity and price reductions
D
Elastic

Unit elasticity
Inelastic
D Quantity
(+)TR< (-)TR
(+)TR< (-)TR
Quantity
17
For a price fall: if
demand is elastic,
revenue from new sales
will exceed the fall in
revenue from existing
sales - total revenue will
rise;
if demand is inelastic,
revenue from new sales
will be less than the fall
in revenue from existing
sales - total revenue will
fall
Elasticity and tube fares
How should tube fares be changed to increase revenues?
• Passengers can use buses, taxis, cars etc
– so demand may be elastic (e.g. -1.4)
– and an increase in fares will reduce the number of
journeys demanded and total spending
• If passengers do not have travel options
– demand may be inelastic (e.g. -0.7)
– so raising fares will have less effect on journeys
demanded
– and revenue will improve
18
The cross price elasticity of demand
The cross price elasticity of demand for good i
with respect to the price of good j is :
% change in quantity demanded of good i
% change in the price of good j
This may be positive or negative
The cross price elasticity tends to be negative
– if two goods are substitutes: e.g. tea and coffee
The cross price elasticity tends to be positive
– if two goods are complements e.g. tea and milk.
19
Price elasticities in the UK
with respect to a 1%
price change in:
Percentage change in
the quantity demanded of
Food
Clothing
Transport
–0.4
0
0.1
Clothing and footwear
0.1
–0.5
–0.1
Travel and
communications
0.3
–0.1
–0.5
Food
20
The income elasticity of demand
The income elasticity of demand measures
the sensitivity of quantity demanded to a
change in income:
% change in quantity demanded of a good
% change in consumer income
The income elasticity may be positive or
negative.
21
Normal and inferior goods
• A NORMAL GOOD has a positive income elasticity of demand
– an increase in income leads to an increase in the quantity demanded
• e.g. dairy produce
• An INFERIOR GOOD has a negative income elasticity of demand
– an increase in income leads to a fall in quantity demanded
• e.g. coal
• A LUXURY GOOD has an income elasticity of demand greater
than 1
• e.g. wine
22
Income and the demand curve
For an increase in income:
NORMAL GOOD
D0 D1
INFERIOR GOOD
D1
D0
Quantity
Quantity
Demand curve
moves to the right
Demand curve
moves to the left
23