Elasticity

Chapter 6Elasticity

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6-2

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

6-3

Ed =

Price Elasticity of Demand Formula

• Formula for price elasticity of demand

percentage change in quantitydemanded of product X

percentage change in priceof product X

LO1

6-4

Price Elasticity of Demand Formula

• Use the midpoint formula• Ensures consistent results

Ed = ÷Change in quantity

Sum of quantities/2

Change in price

Sum of prices/2

LO1

6-5

Price Elasticity of Demand Formula

• Use percentages• Unit free measure• Compare elasticities across products

• Eliminate the minus sign• Easier to compare elasticities

LO1

6-6

Interpretation of Elasticity of Demand

• Ed > 1 demand is elastic

• Ed = 1 demand is unit elastic

• Ed < 1 demand is inelastic

• Extreme cases

• Ed = 0 demand is perfectly inelastic

• Ed = ∞ demand is perfectly elastic

LO1

6-7

Extreme Cases

D1P

Perfectly inelastic demand

Perfectly inelastic demand(Ed = 0)

0

LO1

6-8

Extreme Cases

Perfectly elastic demand

P

D2

Perfectly elasticdemand(Ed = ∞)

0

LO1

6-9

Total Revenue Test

• Total Revenue = Price X Quantity• Total Revenue Test• Inelastic demand

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

• P and TR move in opposite directions

LO2

6-10

Total Revenue Test

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

$3

2

1

0 10 20 30 40 Q

P

a

bD1

LO2

6-11

Total Revenue Test

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

$4

3

2

1

0 10 20 Q

P

c

d

D2

LO2

6-12

Total Revenue Test

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

$3

2

1

0 10 20 30 Q

P

e

f

D3

LO2

6-13

Total Revenue Test

(1)Total Quantity of

Tickets Demandedper Week, Thousands

(2)Price per Ticket

(3)Elasticity

Coefficient (Ed)

(4)Total Revenue

(1) X (2)

(5)Total-Revenue

Test

12345678

$87654321

5.002.601.571.000.640.380.20

$ 8,00014,00018,00020,00020,00018,00014,000

8,000

ElasticElasticElastic

Unit-elasticInelasticInelasticInelastic

]]]]]]]

]]]]]]]

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

LO2

6-14

Elasticity and Total Revenue

0 1 2 3 4 5 6 7 8

0 1 2 3 4 5 6 7 8

Quantity demanded

Quantity demanded

Pric

eTo

tal r

even

ue(T

hous

ands

of d

olla

rs) $20

18161412108642

$87654321

a

bc

de

fg

h

ElasticEd > 1

Unit elasticEd = 1

InelasticEd < 1

D

TR

LO2

6-15

Summary of Price Elasticity of Demand

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

6-16

Determinants of Price Elasticity of Demand

• Substitutability• More substitutes, demand is more elastic

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

more elastic

LO3

6-17

Determinants of Price Elasticity of Demand

• Luxuries versus necessities• Luxury goods, demand is more elastic

• Time • More time available, demand is more

elastic

LO3

6-18

Price Elasticity of DemandSelected Price Elasticities of Demand

Product or ServicePrice Elasticity of

Demand (Ed) Product or ServicePrice 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 2.83

6-19

Applications of Price Elasticity of Demand

• Large crop yields• Inelastic demand, lower total revenue

• Excise taxes• Inelastic demand, more total revenue

• Decriminalization of illegal drugs• Inelastic demand, more total revenue

LO3

6-20

Price Elasticity of Supply

• Measures sellers’ responsiveness to price changes

• Elastic supply, producers are responsive to price changes

• Inelastic supply, producers are not as responsive to price changes

LO4

6-21

Price Elasticity of Supply

• Formula for price elasticity of supply

LO4

percentage change in quantitysupplied of Product X

percentage change in priceof product X

Es =

6-22

Price Elasticity of Supply

• Es > 1 supply is elastic

• Es = 1 supply is unit elastic

• Es < 1 supply is inelastic

• Additionally,

• Es = 0 supply is perfectly inelastic

LO4

6-23

Price Elasticity of Supply

• Time is primary determinant of elasticity of supply

• Time periods considered• Immediate market period• Short run• Long run

LO4

6-24

Es: The Immediate Market Period

• Perfectly inelastic supply

D1

D2

Sm

Q0

Pm

P0

LO4

6-25

The Short Run

• Short run supply is more elastic than in the immediate market period

D1

D2

Ss

Q0

Ps

P0

QsLO4

6-26

The Long Run

• Long run supply is even more elastic than in the short run

LO4

D1

D2

SL

Q0

Pl

P0

Ql

6-27

Applications of Elasticity of Supply

• Antiques• Inelastic supply

• Reproductions• More elastic supply

• Volatile gold prices• Inelastic supply

LO4

6-28

Cross Elasticity of Demand

• Formula for cross elasticity of demand

Ex,y =

percentage change in quantity

demanded of product X

percentage change in priceof product Y

LO5

6-29

Cross Elasticity of Demand

• Measures responsiveness of purchases of one good to change in the price of another good

• Substitute goods if elasticity is positive• Complement goods if elasticity is negative• Independent goods if elasticity is 0

LO5

6-30

Cross Elasticity of Demand

• Applications of cross elasticity of demand• Should a company change a price?• Should the government allow a merger?

LO5

6-31

Income Elasticity of Demand

• Formula for income elasticity of demand

LO5

Ei =percentage change in quantity demanded

percentage change in income

6-32

Income Elasticity of Demand

• Measures responsiveness of buyers to changes in their income

• Normal goods if elasticity is positive• Inferior goods if elasticity is negative

LO5

6-33

Income Elasticity Insights

• High income elasticities• Most affected by a recession

• Low or negative income elasticity• Not affected that much by a recession

LO5

6-34

Cross and Income Elasticit iesCross 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

LO5

6-35

Elasticity and Pricing Power

• Charge different prices to different buyers based on price elasticities

• Business air travelers• Children discounts• College tuition