Transcript Part and/or Chapter Number and Title

Chapter 4: Elasticity of
Demand and Supply
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved
Price Elasticity of Demand
 According to the law of demand, when price
increases, quantity demanded falls. By how
much?
 To answer this question, economists use the
concept of price elasticity of demand.
Price elasticity of demand is a measure of the
responsiveness of the quantity of a product demanded
by consumers when the product price changes.
LO: 4-1
4-2
Elastic and Inelastic Demand
 For some products, consumers are highly
responsive to price changes. Demand for
such products is relatively elastic or
simply elastic.
 For other products, consumers’
responsiveness is only slight or in rare
cases non-existent. Demand is said to be
relatively inelastic, or simply inelastic.
LO: 4-1
4-3
Price Elasticity Coefficient
 The degree of price elasticity is measured
with price elasticity coefficient Ed
Ed =
Percentage Change in Quantity
Demanded of Product X
Percentage Change in Price
of Product X
LO: 4-1
4-4
Interpretations of Price
Elasticity of Demand
 Elastic Demand: price changes cause relatively large
changes in quantity demanded: Ed > 1.
 Inelastic Demand: price changes cause relatively small
changes in quantity demanded: Ed < 1.
 Unit Elasticity: price changes cause equal changes in
quantity demanded (in percentage terms): Ed = 1.
 Perfectly Elastic Demand: quantity demanded can be
any amount at a given price: Ed = ∞.
 Perfectly Inelastic Demand: quantity demanded does
not depend on price: Ed = 0.
LO: 4-1
4-5
Determinants of Price
Elasticity of Demand
 Substitutability
 the larger the number of substitute goods that are
available, the higher the elasticity
 Proportion of Income
 the higher the price of a product relative to one’s income,
the higher the elasticity
 Luxuries versus Necessities
 the more that a good is considered to be a “luxury” rather
than a “necessity,” the higher the elasticity
 Time
 the longer the time period under consideration, the higher
the elasticity
LO: 4-1
4-6
The Total Revenue Test
 Total Revenue = TR = P×Q
 Inelastic demand
 P and TR change in the same
direction
 Elastic demand
LO: 4-2
 P and TR change in opposite
directions
4-7
Inelastic Demand and TR
P
 Price falls from c to d
 Gold loss is larger
than blue gain
 TR falls when price
falls
 Therefore, demand is
inelastic (Ed < 1)
c
$4
3
2
d
1
D2
0
10
20
Q
LO: 4-2
4-8
Elastic Demand and TR
P
$3
a
2
b
1
D1
0
10
20
30
40
 Price falls from a
to b
 Gold loss is
smaller than blue
gain
 TR rises when
price falls
 Therefore,
Q
demand is elastic
(Ed > 1)
LO: 4-2
4-9
Price Elasticity of Demand:
College Tuition
 Share of education in total income is higher for lowincome families.
 Therefore, elasticity of demand for college education is
higher for low-income families.
 Colleges charge different net prices (tuition minus
financial aid) to low- and high-income families.
 Tuition increases are frequently accompanied by
increases in financial aid, so that tuition hikes are smaller
for low-income families.
 Such pricing strategy increases revenue while
maintaining income diversity of a student body.
LO: 4-4
4-10
Price Elasticity of Supply
 The concept of price elasticity can be applied to
supply: price elasticity of supply.
Es =
Percentage Change in Quantity
Supplied of Product X
Percentage Change in Price
of Product X
Price elasticity of supply is a measure of the
responsiveness of the quantity of a product supplied by
sellers when the product price changes.
LO: 4-3
4-11
Price Elasticity of Supply
and Time Periods
 Market period
 Perfectly inelastic supply
 Short run
 Fixed plant size, but can vary production
 Supply somewhat elastic
 Long run
 Adjustable plant size
 Firms can enter or exit
 Supply more elastic
LO: 4-3
4-12
Price Elasticity of Supply:
Gold Prices
 Price of gold is very volatile. Why?
 Supply of gold is very inelastic due to limited
availability and high cost of exploration, mining,
and refining.
 As a result, demand shifts reflect in large swings
in prices with little effect on quantities bought
and sold.
 Demand shifts for gold are common because it is
used as speculative financial investment, not only as
a commodity.
LO: 4-4
4-13
Income Elasticity of Demand
 The concept of elasticity can be applied to income:
income elasticity of demand.
Percentage Change in Quantity
Demanded
Ei =
Percentage Change in Income
Income elasticity of demand is a measure of the
responsiveness of the quantity of a product demanded by
consumers to changes in consumer income.
LO: 4-5
4-14
Cross Elasticity of Demand
 Cross elasticity of demand reflects relationship
between products
Exy =
Percentage Change in Quantity
Demanded of product X
Percentage Change in Price
of product Y
Cross elasticity of demand is a measure of the
responsiveness of the quantity demanded of one product to
a change in the price of another product.
LO: 4-5
4-15