Transcript Price Elasticity of Demand

Economics
Combined Version
Edwin G. Dolan
Best Value Textbooks
4th edition
Chapter
Supply, Demand,
and Elasticity
Dolan, Microeconomics 4e, Ch. 3
Elasticity
 Elasticity: A way to measure responsiveness
 How responsive is a dependant variable to a change in
the independent variable?
or
 How much “bounce” do you get in your Quantity
Demanded for a change in your price?
 Economics uses several
different types of elasticity
Price Elasticity of Demand
 Definitions of Price Elasticity of Demand:
 The percentage change in the quantity demanded of a
product divided by the percentage change in the price of
the product.
 The percentage change in the quantity demanded
caused by a one percent change in the price.
Price Elasticity of Demand - Simplified
 How sensitive is the quantity demanded
to changes in price? … How responsive are consumers
to price changes?
A producer wants to know:
 How many sales will I lose if I increase my price?
 What if I lower my price?
 What effect will that have on my revenue?
Price Elasticity:
Mathematical Definition – the easy one
 The price elasticity of demand, ed, is:
%Q
ed 
%P
D
This is the
one I
remember &
use
 Example: If the quantity of movie tickets sold falls by
3% when the price is raised by 1%, then the price
elasticity of demand is -3/1 = -3.
Calculating Percentage Change
(The simple, standard way)
P P
%P 
1
P
2
1
Q Q
%Q 
1
Q
2
1
Calculating Percentage Change
(the Midpoint Method)
 Percent Change stays
constant whether
moving up or moving
down.
Calculating %Change
(Midpoint Method)
 Price changes from $50 to $60
 What is the % Change? (rounded to a whole number)
A. 10%
B. 17%
C. 18%
D. 20%
Calculating %Change
(Midpoint Method)
 Price changes from $60 to $40
 What is the % Change? (rounded to a whole number)
A. 20%
B. 33%
C. 40%
D. 50%
Elasticity:
The all-out mathematical version
Sign of Price Elasticity
 According to the law of demand, whenever the price
rises, the quantity demanded falls.
Thus the price elasticity of demand is always
negative.
 Because it is always negative, economists usually state
the value without the sign.
Defining elasticities
 When price elasticity is between zero and -1 we say
demand is inelastic.
When demand is inelastic, revenue rises when price rises
 When price elasticity is between -1 and
- infinity, we say demand is elastic.
When demand is elastic, revenue falls when price rises
 When price elasticity is -1, we say demand is unit
elastic.
When demand is unit elastic, revenue is maximized and will
decline if price rises or falls
Demand Curve
Shapes and Elasticity
 Perfectly Elastic Demand Curve
 The demand curve is horizontal, any change in price can and
will cause consumers to change their consumption completely.
 An increase of $0.01 leads to a 100% decrease in sales
 Perfectly Inelastic Demand Curve
 The demand curve is vertical, the quantity demanded is totally
unresponsive to the price. Changes in price have no effect on
consumer demand.
 Even a large change in price will not effect the sales
 In between the two extreme shapes of demand curves are
the demand curves for most products.
Demand Curve
Shapes and Elasticity
Price Elasticity Along
a Straight Line Demand Curve
 The price elasticity of demand changes as we move
up or down a straight-line demand curve. The
price elasticity becomes more inelastic as we move
down the curve.
 If an entire demand curve (D2) is more elastic than
another (D1) it means that at every single price,
D2 is more elastic than on D1.
Elastic and Inelastic
 All downward-sloping straight-line demand curves are
divided into three parts:
 Inelastic region: where ed < 1. (bottom half of curve)
 Unit elastic point: where ed = 1. (center of curve)
 Elastic region: where ed > 1. (top half of curve)
 All elasticity measures represent the percentage of change
in the dependent variable in response to a 1% change in the
independent variable.
The Price Elasticity of Demand Along
a Straight-line Demand Curve
Determinants of the
Price Elasticity of Demand
 The degree to which the price elasticity of demand is
inelastic or elastic depends on:
 How many substitutes there are

More substitutes make for greater elasticity
 How well a substitute can replace the good or service
under consideration

Closer substitutes make for greater elasticity
 The importance of the product in the consumer’s total
budget

Larger parts of the budget create greater price elasticity
 The time period under consideration

The longer the time, the greater the elasticity
Using the Price Elasticity of Demand
Price Elasticity of Demand is crucially important to any
firm manager:
 It tells a manager in a firm whether to raise or lower
prices if they want to increase revenue.
 Total Revenue (TR) equals the price times the quantity
sold: TR = P x Q.
Total Revenue and
Price Elasticity of Demand
 Total Revenue (TR) equals the price (P) of a
product multiplied by the quantity sold (Q):
TR = P x Q
 Total revenue increases as price is increased if
demand is inelastic, decreases as price is increased
if demand is elastic, and does not change as price
is increased if demand is unit-elastic. (But the unitelastic range is only one specific point, so moving away from that point
will decrease revenue.)
Using the Price Elasticity of Demand
 The law of demand tells us that:
Q decreases when P rises.
What is the optimal price to maximize total revenue?
 Answer: the price at the unit-elastic point. At any
higher price – or any lower price – total revenue is
decreased!
Total Revenue and Price Elasticity
Price
Quantity
Revenue
$1000
200
$200,000
$900
400
$360,000
$800
600
$480,000
$700
800
$560,000
$600
1000
$600,000
$500
1200
$600,000
$400
1400
$560,000
$300
1600
$480,000
$200
1800
$360,000
$100
2000
$200,000
Price Discrimination
 Price discrimination is charging different
customers different prices for the same product.
 Why do firms want to do this?
 When different groups of customers have different price
elasticities of demand for the same product, total
revenue can be increased by charging each of the groups
a different price.
 The groups must be easily identifiable, and there must
be little possibility of people from different groups
trading with each other.
Dumping
 Dumping: A form of price discrimination wherein
an identical good is sold to foreign buyers for a
lower price than to domestic buyers.
 Predatory Dumping: dumping intended to drive
rival firms out of business.
 Usually charges of “dumping” against foreign firms
really are charges of “predatory dumping”.
Other Demand Elasticities
 Demand may respond to changes in other variables. The
measures of such responses are also elasticities.
j
%ΔQ
k
%ΔP
 Cross-Price Elasticity of Demand: The
percentage change in the quantity demand for one
good, divided by the percentage change in price of
another good.
 Measures the degree to which goods are substitutes or
complements.


If the cross-price elasticity is positive, then the goods are
substitutes.
If the cross price elasticity is negative, then the goods are
complements.
Other Demand Elasticities
 Income Elasticity of Demand: the percentage
change in the quantity demanded divided by the
percentage change in income.
%ΔQ
%ΔY
 Normal goods: goods for which the income elasticity of
demand is positive.
 Inferior goods: Goods for which the income elasticity
of demand is negative.
Necessities and Luxuries
 Goods with lower income elasticities are often
called necessities, since the quantities demanded
don’t vary much with income.
 Typical income elasticities are 0.4 or 0.5.
 Goods with higher income elasticities are often
called luxuries, since people give them up readily
when their incomes fall.
 Typical elasticities are 1.5 to 2.0.
The Price Elasticity of Supply
 The price elasticity of supply is the percentage change
in the quantity supplied divided by the percentage
change in price.
%Q
es 
%P
S
Price Elasticity of Supply
and Shape of Supply Curve
 The price elasticity of supply is either zero or a positive
number.
 A zero price elasticity of supply means that the
quantity supplied will not vary as the price varies.
 A positive price elasticity of supply means that as the
price of an item rises, the quantity supplied rises.
Supply Curve
Shapes and Elasticity
Supply Elasticities
in the Long and Short Runs
 The shape of the supply curve depends heavily on
the length of time being considered.
 In the short run, at least one of the resources used in
production cannot be changed.
 In the long run, the firm has long enough to change any
aspect of production, and therefore can more fully
respond.
Interaction of Price
Elasticities of Demand and Supply
 Together, both the price elasticity of demand and the price
elasticity of supply determine the full effect of a price
change.
 If the price elasticity of supply of an item is large and the
demand for it is price inelastic, then the firm can raise the
price without losing revenue.
 Conversely, if the price elasticity of supply is small and the
price elasticity of demand is large, then the firm is unable
to raise the price because the consumer will switch to
another firm or product.
Incidence and Taxes
 Incidence is the measure of who actually pays for a
cost increase or a tax.
 In general, the more elastic the demand and the
less elastic the supply the more the incidence of a
tax falls on businesses and the less it falls on
consumers.
Incidence of Tax or
cost increase:
Who Pays?
25 cent tax collected by
producer shifts supply
curve to represent cost.
Equilibrium starts at $1.
With Elastic Demand Curve the price increase to 1.20,
consumers pay 20 cents of the 25 cent tax and producers
pay 5 cents
With the Inelastic Demand Curve the price increases only
to 1.10, Consumers pay 10 cents and producers pay 15 cents
Incidence of Tax or cost increase
Tax Incidence and
Government Revenue
 A tax imposed on a good that has an inelastic demand will generate more
tax revenue than a tax on a good with elastic demand, assuming similar
supply conditions.
 The diagrams below compare the effects of a $1.00 tax on the markets for
milk (inelastic demand) and pork (elastic demand).
Dolan, Economics Combined Version 4e, Ch. 3
Effect of Prohibition on Market for Cocaine
 Suppose the demand for
cocaine is inelastic
 Sale of cocaine is prohibited,
but the prohibition is not
completely effective, shifting
the supply curve from S1 to S2
 As a result of prohibition, the
total revenue from cocaine
increases (PXQ at E2
compared with PXQ at E1)
 Some of the revenue is profit
for drug dealers, some the
extra cost of selling an illegal
good.
Supply and Demand for Cocaine
Prohibition
Legal supply
Dolan, Economics Combined Version 4e, Ch. 3