Elasticity 04 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Elasticity

04

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Price Elasticity of Demand

• Measures buyers’ responsiveness to price changes

• Elastic demand

• Sensitive to price changes

• Large change in quantity

• Inelastic demand

• Insensitive to price changes

• Small change in quantity

LO1 4-2

Price Elasticity of Demand Formula

• Formula for price elasticity of demand

Ed =

LO1

Percentage Change in QuantityDemanded of Product X

Percentage Change in Priceof Product X

4-3

Price Elasticity of Demand Formula

• Use the midpoint formula

• Ensures consistent results

Change in quantity Change in price

Sum of quantities/2 Sum of prices/2

LO1

Ed = ÷

4-4

Price Elasticity of Demand Formula

• Use percentages

• Unit free measure

• Compare responsiveness across products

• Eliminate the minus sign

• Easier to compare elasticities

LO1 4-5

Interpretation of Elasticity of Demand

• Ed > 1 demand is elastic

• Ed = 1 demand is unit elastic

• Ed < 1 demand is inelastic

• Extreme cases

• Perfectly inelastic

• Perfectly elastic

LO1 4-6

Extreme Cases

LO1

D1P

Perfectly inelastic demand

Perfectly inelastic demand(Ed = 0)

0

4-7

Extreme Cases

LO1

Perfectly elastic demand

P

D2

Perfectly elasticdemand(Ed = ∞)

0

4-8

Total Revenue Test

• Total Revenue = Price X Quantity

• Inelastic demand• P and TR move in the same direction

• Elastic demand• P and TR move in opposite directions

LO2 4-9

Total Revenue Test

LO2

$3

2

1

0 10 20 30 40 Q

P

a

b

D1

• Lower price and elastic demand• Blue gain exceeds orange loss

4-10

Total Revenue Test

LO2

$4

3

2

1

0 10 20 Q

P

c

d

D2

• Lower price and inelastic demand• Orange loss exceeds blue gain

4-11

Total Revenue Test

LO2

$3

2

1

0 10 20 30 Q

P

e

f

D3

• Lower price and unit elastic demand• Blue gain equals orange loss

4-12

Total Revenue Test

LO2

Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity Coefficient and the Total-Revenue Test

(1)Total Quantity of

Tickets Demanded per Week, Thousands

(2)Price per Ticket

(3)Elasticity

Coefficient (Ed)

(4)Total

Revenue(1) X (2)

(5)Total

Revenue Test

1 $8 $8,000

2 7 5.00 14,000 Elastic

3 6 2.60 18,000 Elastic

4 5 1.57 20,000 Elastic

5 4 1.00 20,000 Unit Elastic

6 3 0.64 18,000 Inelastic

7 2 0.38 14,000 Inelastic

8 1 0.20 8,000 Inelastic

4-13

Elasticity and Total Revenue

LO2

0 1 2 3 4 5 6 7 8

0 1 2 3 4 5 6 7 8

Quantity Demanded

Quantity Demanded

Pri

ceT

ota

l Rev

enu

e(T

ho

usa

nd

s o

f D

olla

rs)

$201816141210

8642

$87654321

a

bc

de

fg

h

ElasticEd > 1

Unit ElasticEd = 1

InelasticEd < 1

D

TR

4-14

Summary of Price Elasticity of Demand

LO2

Price Elasticity of Demand: A Summary

Absolute Value of Elasticity Coefficient Demand Is: Description

Impact on Total Revenue of a:

Price Increase Price Decrease

Greater than 1(Ed > 1)

Elastic or relatively elastic

Qd changes by a larger percentage than does price

Total Revenue decreases

Total Revenue increases

Equal to 1(Ed = 1)

Unit or unitary elastic

Qd changes by the same percentage as does price

Total revenue is unchanged

Total revenue is unchanged

Less than 1(Ed < 1)

Inelastic or relatively inelastic

Qd changes by a smaller percentage than does price

Total revenue increases

Total revenue decreases

4-15

Determinants of Elasticity of Demand

• Substitutability• More substitutes, demand is more elastic

• Proportion of Income• Higher proportion of income, demand is more

elastic

• Luxuries vs. Necessities• Luxury goods, demand is more elastic

• Time• More time available, demand is more elastic

LO1 4-16

Price Elasticity of Demand

LO1

Selected Price Elasticities of Demand

Product or ServicePrice Elasticity of Demand (Ed) Product or Service

Price Elasticity of Demand (Ed)

Newspapers .10 Milk .63

Electricity (household) .13 Household appliances .63

Bread .15 Liquor .70

MLB Tickets .23 Movies .87

Telephone Service .26 Beer .90

Cigarettes .25 Shoes .91

Sugar .30 Motor vehicles 1.14

Medical Care .31 Beef 1.27

Eggs .32 China, glassware 1.54

Legal Services .37 Residential land 1.60

Automobile repair .40 Restaurant meals 2.27

Clothing .49 Lamb and mutton 2.65

Gasoline .60 Fresh peas 2.834-17

Applications of Ed

• Large Crop Yields• Inelastic demand, lower total revenue

• Excise Taxes• Inelastic demand, more total revenue

• Decriminalization of Illegal Drugs• Inelastic demand, more total revenue

LO1 4-18

Price Elasticity of Supply

• Measures sellers’ responsiveness to price changes

• Elastic supply, producers are responsive to price changes

• Inelastic supply, producers are not responsive to price changes

LO3 4-19

Price Elasticity of Supply

• Formula to compute elasticity

• Es > 1 supply is elastic

• Es < 1 supply is inelastic

LO3

Percentage Change in QuantitySupplied of Product X

Percentage Change in Priceof Product X

Es =

4-20

Price Elasticity of Supply

• Time is primary determinant of elasticity of supply

• Time periods considered

• Market period

• Short Run

• Long Run

LO3 4-21

Elasticity of Supply: The Market Period

LO3

• Perfectly inelastic supply

D1

D2

Sm

Q0

Pm

P0

4-22

Elasticity of Supply: The Short Run

LO3

• Supply is more elastic than in market period

D1

D2

Ss

Q0

Ps

P0

Qs

4-23

Elasticity of Supply: The Long Run

LO3

• Supply is even more elastic than in the short run

D1

D2

Sl

Q0

Pl

P0

Ql

4-24

Applications of Elasticity of Supply

• Antiques

• Inelastic supply

• Reproductions

• More elastic supply

• Volatile gold prices

• Inelastic supply

LO3 4-25

Cross Elasticity of Demand

• Measures responsiveness of sales to change in the price of another good

• Substitutes – positive sign

• Complements – negative sign

• Independent goods - zero

LO4

Percentage change in quantity demanded of product X

Ex,y = Percentage change in price of product Y

4-26

Cross Elasticity of Demand

• Application

• Change the price?

• Allow a merger?

LO4 4-27

Income Elasticity of Demand

• Measures responsiveness of buyers to changes in income

• Normal goods – positive sign

• Inferior goods – negative sign

LO4

Percentage change in quantity demanded

Ei =

Percentage change in income

4-28

Income Elasticity Insights

• High income elasticities

• Most affected by a recession

• Low or negative income

• Least affected by a recession

LO4 4-29

Ex,y and Ei

LO4

Cross and Income Elasticities of Demand

Value of Coefficient Description Type of Good(s)

Cross elasticity: Positive (Ewz > 0)

Negative (Exy < 0)

Quantity demanded of W changes in same direction as change in price of Z

Quantity demanded of X changes in opposite direction from change in price of Y

Substitutes

Complements

Income elasticity: Positive (Ei >0)

Negative (Ei<0)

Quantity demanded of the product changes in same direction as change in income

Quantity demanded of the product changes in opposite direction from change in income

Normal or superior

Inferior

4-30

Elasticity and Pricing Power

• Charge different prices based on price elasticities

• Examples:

• Business air travelers

• Adult vs. child

4-31