4. Lecture - Elasticity

8/8/2019 4. Lecture - Elasticity

1/50

Objectives

After studying this chapter, you will be able to

Define, calculate, and explain the factors that influencethe price elasticity of demand

Define, calculate, and explain the factors that influencethe cross elasticity of demand and the income elasticityof demand

Define, calculate, and explain the factors that influence

the elasticity of supply


2/50

Tough Times in the Recording Industry

More and more people are illegally downloading musicrather than paying $12 for a CD.

CD producers are loosing revenue and some of them are

trying to combat the problem by slashing the price of a CD.

Will this strategy work?

Can lower priced CDs beat illegal downloads, bringgreater revenue to the recording industry and artists, andhelp to promote the social interest?

The concept of elasticity helps to answer these questions.


3/50

Price Elasticity of Demand

In Figure 4.1a, a change in

supply brings a smallincrease in the quantitydemanded and a large fallin price.


4/50


In Figure 4.1b, a change in

supply brings a largeincrease in the quantitydemanded and a small fallin price.


5/50


The contrast between thetwo outcomes in Figure 4.1highlights the need for ameasure of theresponsiveness of the

quantity demanded to aprice change.


6/50


The price elasticity of demand is a units-free measureof the responsiveness of the quantity demanded of agood to a change in its price when all other influences

on buyers plans remain the same.Calculating Elasticity

The price elasticity of demand is calculated by using theformula:

Percentage change in quantity demandedPercentage change in price


7/50


To calculate the price elasticity of demand:

We express the change in price as a percentage of theaverage pricethe average of the initial and new price,

and we express the change in the quantity demanded as apercentage of the average quantitydemandedtheaverage of the initial and new quantity.


8/50


Figure 4.2 calculates theprice elasticity of demand

for pizza.

The price initially is$20.50 and the quantitydemanded is 9 pizzas an

hour.


9/50


The price falls to $19.50and the quantity

demanded increases to11 pizzas an hour.

The price falls by $1 andthe quantity demanded

increases by 2 pizzas anhour.


10/50


The average price is $20and the average quantitydemanded is 10 pizzas anhour.


11/50


The percentage change inquantity demanded, %(Q,

is calculated as (Q/Qave,which is 2/10 = 1/5.

The percentage change inprice, %(P, is calculated

as (P/Pave, which is$1/$20 = 1/20.


12/50


The price elasticity ofdemand is (1/5)/(1/20) =20/5 = 4.


13/50


By using the average price and average quantity, we getthe same elasticity value regardless of whether the pricerises or falls.

The ratio of two proportionate changes is the same as theratio of two percentage changes.

The measure is units free because it is a ratio of twopercentage changes and the percentages cancel out.

Changing the units of measurement of price or quantityleave the elasticity value the same.


14/50


The formula yields a negative value, because price andquantity move in opposite directions. But it is themagnitude, or absolute value, of the measure that revealshow responsive the quantity change has been to a pricechange.


15/50


Inelastic and Elastic Demand

Demand can be inelastic, unit elastic, or elastic, and canrange from zero to infinity.

If the quantity demanded doesnt change when the pricechanges, the price elasticity of demand is zero and thegood as a perfectly inelastic demand.


16/50


Figure 4.3a illustrates the

case of a good that has aperfectly inelastic demandand that has a verticaldemand curve.


17/50


If the percentage changein the quantity demandedequals the percentagechange in price, the price

elasticity of demandequals 1 and the good hasunit elastic demand.

Figure 4.3b illustrates thiscasea demand curvewith ever declining slope.(Note that the demandcurve is not linear.)


18/50


Between the two previous cases, the percentage changein the quantity demanded is smaller than the percentagechange in price so that the price elasticity of demand isless than 1 and the good has inelastic demand.

If the percentage change in the quantity demanded isinfinitely large when the price barely changes, the priceelasticity of demand is infinite and the good has perfectlyelastic demand.


19/50


Figure 4.3c illustrates thecase of perfectly elasticdemanda horizontaldemand curve.

If the percentage changein the quantity demandedis greater than thepercentage change inprice, the price elasticity ofdemand is greater than 1and the good has elasticdemand.


20/50


Elasticity Along a

Straight-Line Demand

Curve

Figure 4.4 shows howdemand becomes lesselastic as the price fallsalong a linear demand

curve.


21/50


At prices above the mid-point of the demand curve,

demand is elastic.

At prices below the mid-

point of the demand curve,demand is inelastic.


22/50


For example, if the pricefalls from $25 to $15, thequantity demandedincreases from 0 to 20pizzas an hour.

The price elasticity ofdemand is (20/10)/(10/20),which equals 4.

The average price is $20and the average quantity is

10.


23/50


If the price falls from $10to $0, the quantity

demanded increases from30 to 50 pizzas an hour.

The price elasticity ofdemand is (20/40)/(10/5),which equals 1/4.

The average price is $5and the average quantity is

40.


24/50


If the price falls from $15to $10, the quantity

demanded increases from20 to 30 pizzas an hour.

The price elasticity ofdemand is (10/25)/(5/12.5),which equals 1.

The average price is$12.50 and the average

quantity is 25.


25/50


Total Revenue and Elasticity

The total revenue from the sale of good or service equalsthe price of the good multiplied by the quantity sold.

When the price changes, total revenue also changes.

But a rise in price doesnt always increase total revenue.


26/50


The change in total revenue due to a change in pricedepends n the elasticity of demand:

If demand is elastic, a 1 percent price cut increases the

quantity sold by more than 1 percent, and total revenueincreases.

If demand is inelastic, a 1 percent price cut decreasesthe quantity sold by more than 1 percent, and total

revenues decreases.

If demand is unitary elastic, a 1 percent price cutincreases the quantity sold by 1 percent, and totalrevenue remains unchanged.


27/50


The total revenue test is a method of estimating the priceelasticity of demand by observing the change in totalrevenue that results from a price change (when all otherinfluences on the quantity sold remain the same).

If a price cut increases total revenue, demand is elastic.

If a price cut decreases total revenue, demand isinelastic.

If a price cut leaves total revenue unchanged, demand isunit elastic.


28/50


Figure 4.5 shows therelationship between

elasticity of demand forpizzas and the totalrevenue from pizzas.

In part a (shown here),as the price falls from$25 to $12.50, demandis elastic, and totalrevenue increases.


29/50


At $12.50, demand isunit elastic and total

revenue stopsincreasing.

As the price falls from

$12.50 to zero, demandis inelastic, and totalrevenue decreases.


30/50


In part b (shown here), asthe quantity increasesfrom zero to 25, demandis elastic, and total

revenue increases.

As the quantity increasesfrom 25 to 50, demand isinelastic, and totalrevenue decreases.

At 25, demand is unitelastic, and total revenue isat its maximum.


31/50


Your Expenditure and Your Elasticity

If your demand is elastic, a 1 percent price cut increasesthe quantity you buy by more than 1 percent and your

expenditure on the item increases. If your demand is inelastic, a 1 percent price cut

increases the quantity you buy by less than 1 percentand your expenditure on the item decreases.

If your demand is unit elastic, a 1 percent price cutincreases the quantity you buy by 1 percent and yourexpenditure on the item does not change.


32/50


The Factors That Influence the Elasticity of Demand

The elasticity of demand for a good depends on:

The closeness of substitutes

The proportion of income spent on the good

The time elapsed since a price change


33/50


The closeness of substitutes

The closer the substitutes for a good or service, the moreelastic are the demand for it.

Necessities, such as food or housing, generally haveinelastic demand.

Luxuries, such as exotic vacations, generally have elasticdemand.

The proportion of income spent on the good.

The greater the proportion of income consumers spent ona good, the larger is its elasticity of demand.


34/50


The time elapsed since a price change

The more time consumers have to adjust to a pricechange, or the longer that a good can be stored without

losing its value, the more elastic is the demand for thatgood.


35/50


Table 4.1 (page 87) showsestimates of the priceelasticity of demand forvarious goods andservices.

Figure 4.6 shows how theelasticity of demand forfood varies with the

proportion of income spenton food in differentcountries.


36/50

More Elasticities of Demand

Cross Elasticity of Demand

The cross elasticity of demand is a measure of theresponsiveness of demand for a good to a change in the

price of asubstitute or a co

mpli

ment, other thingsremaining the same.

The formula for calculating the cross elasticity is:

Percentage change in quantity demanded

Percentage change in price of substitute or complement


37/50


The cross elasticity of demand for a substitute is positive.

The cross elasticity of demand for a complementisnegative.


38/50


Figure 4.7 shows theincrease in the quantity ofpizza demanded when theprice of burger (asubstitute for pizza) rises.

The figure also shows thedecrease in the quantity of

pizza demanded when theprice of a soft drink (acomplement of pizza)rises.


39/50


Income Elasticity of Demand

The income elasticity of demand measures how thequantity demanded of a good responds to a change in

income, other things equal.The formula for calculating the income elasticity ofdemand is:

Percentage change in quantity demanded

Percentage change in income


40/50


If the income elasticity of demand is greater than 1,demand is income elasticand the good is a normal good.

If the income elasticity of demand is greater than zero butless than 1, demand is income inelasticand the good is anormal good.

If the income elasticity of demand is less than zero(negative) the good is an inferior good.


41/50


Table 4.2 (page 91) showsestimates of incomeelasticity of demand for

various goods andservices.

Figure 4.8 shows estimatesof the income elasticity for

food in different countries.A higher average income isassociated with a lowerincome elasticity ofdemand for food.


42/50

Price Elasticity of Supply

In Figure 4.9a, a change indemand brings a small

increase in the quantitysupplied and a large rise inprice.


43/50


In Figure 4.9b, a change indemand brings a large

increase in the quantitysupplied and a small risein price.


44/50


The contrast between thetwo outcomes in Figure 4.9

highlights the need for ameasure of theresponsiveness of thequantity supplied to a pricechange.


45/50

Elasticity of Supply

The elasticity of supply measures the responsiveness ofthe quantity supplied to a change in the price of a goodwhen all other influences on selling plans remain thesame.

Calculating the Elasticity of Supply

The elasticity of supply is calculated by using the formula:

Percentage change in quantity supplied

Percentage change in price


46/50


Figure 4.10 on the next slide shows three cases of theelasticity of supply.

Supply isperfectly inelasticif the supply curve is vertical

and the elasticity of supply is 0.Supply is unit elasticif the supply curve is linear andpasses through the origin. (Note that slope is irrelevant.)

Supply isperfectly elasticif the supply curve is horizontal

and the elasticity of supply is infinite.


47/50



48/50


The Factors That Influence the Elasticity of Supply

The elasticity of supply depends on

Resource substitution possibilities

The easier it is to substitute among the resources used toproduce a good or service, the greater is its elasticity ofsupply.

The time frame for supply decisions

The more time that passes after a price change, thegreater is the elasticity of supply.


49/50


The time frame for supply decisions

The more time that passes after a price change, thegreater is the elasticity of supply.

Momentarysupplyis perfectly inelastic. The quantitysupplied immediately following a price change is constant.

Short-run supply is somewhat elastic.

Long-run supply is the most elastic.Table 4.3 (page 95) provides a glossary of the all elasticitymeasures.


50/50

THE END

4. Lecture - Elasticity

Documents