Elasticity of Demand How does a firm go about determining the price at which they should sell their product in order to maximize total revenue? Total Revenue.

Elasticity of Demand

• How does a firm go about determining the price at which they should sell their product in order to maximize total revenue?

• Total Revenue = Price Quantity

• You are a marketing manager for Intel

• A new computer chip has been developed

• Decision to Be Made

• Do you sell the new chip at a high price ($400)?

• Do you sell the new chip at a low price ($200)?

Demand and Total Revenue

Quantity (millions of chips per year)

Pri

ce (d

olla

rs p

er c

hip)

40 80 120

100

200

300

400

Da



Pri

ce (d

olla

rs p

er c

hip)

40 80 120

100

200

300

400

Da



Pri

ce (d

olla

rs p

er c

hip)

40 80 120

100

200

300

400

DaTotal revenuegain

Total revenueloss



Pri

ce (d

olla

rs p

er c

hip)

100

200

300

400

Db

40 60 80 120



Pri

ce (d

olla

rs p

er c

hip)

100

200

300

400

Db

40 60 80 120



Pri

ce (d

olla

rs p

er c

hip)

100

200

300

400

Db

40 60 80 120

Total revenuegain

Total revenueloss



Pric

e (d

olla

rs p

er c

hip)

Db

Pric

e (d

olla

rs p

er c

hip)

Da


Slope Depends on Units of Measurement

• In these two examples, we can compare the slopes of the demand curves

• We cannot do so if we are dealing with different goods and services.

• Elasticity is independent of the units of measurement.

• Price elasticity of demand

• A measure of the responsiveness of the quantity demanded of a good to a change in its price (ceteris paribus).

Elasticity: A Units-Free Measure

Price elasticity ofdemand =

Percentage change in quantity demanded

Percentage change in price

Calculating Elasticity

• The changes in price and quantity are expressed as percentages of the average price and average quantity.

• Avoids having two values for the price elasticity of demand

Calculating the Elasticity of Demand


Pri

ce (d

olla

rs p

er c

hip)

36 40 44

390

400

410

Da

Originalpoint


Pri

ce (d

olla

rs p

er c

hip)

36 40 44

390

400

410

Da

Originalpoint

Newpoint



Pri

ce (d

olla

rs p

er c

hip)

36 40 44

390

400

410

Da

= -$20P

= 8Q

Originalpoint

Newpoint



Pri

ce (d

olla

rs p

er c

hip)

36 40 44

390

400

410

Da

Originalpoint

Newpoint

Pave = $400

= -$20P

= 8Q


Pri

ce (d

olla

rs p

er c

hip)

36 40 44

390

400

410

Da

Originalpoint

Newpoint

Pave =$400

Qave = 40

= -$20P

= 8Q



P

Q

%

%

Price elasticity of demand =Percentage change in quantity demanded


ave

ave

PP

QQ

/

/


P

Q

%

%

Price elasticity of demand =Percentage change in quantity demanded


ave

ave

PP

QQ

/

/

400/2040/8

= - 4

Inelastic and Elastic Demand

• Three demand curves that cover the entire range of possible elasticities of demand:

• Perfectly inelastic

• Unit elastic

• Perfectly elastic


• Perfectly inelastic demand • Implies that quantity demanded remains

constant when price changes occur.

• Price elasticity of demand = 0

6

12

Pri

ce

Quantity

D1

Elasticity = 0

Perfectly Inelastic

Unit elastic demand Implies that the percentage change in quantity demanded equals the percentage change in price.

Price elasticity of demand = -1



6

12

Pri

ce

Quantity

D2

1 2 3

Elasticity = -1

Unit Elasticity


• Perfectly elastic demand

• Implies that if price increases by any percentage, quantity demanded will fall to 0 and if price decreases by any percentage, quatity will rise to infinity.

• Price elasticity of demand =


6

12

Pri

ce

Quantity

D3

Elasticity =

Perfectly Elastic

Inelastic and Elastic Demand• Inelastic demand

• Implies the percentage change in quantity demanded is less than the percentage change in price.

• In absolute sense, price elasticity of demand > 0 and < 1

• Elastic demand • Implies the percentage change in quantity demanded

is greater than the percentage change in price. • In absolute sense, price elasticity of demand > 1

Elasticity Along a Straight-Line Demand Curve

0 40 80 100 120 160 200

250

100

200

300

400

500

Pri

ce (

dolla

rs p

er c

hip)


Elasticity Along a Straight-Line Demand CurveElasticity = -4

0 40 80 100 120 160 200

250

100

200

300

400

500 Lowering the pricefrom $500 to $300results in a price elasticity of demand of -4.

Elastic

Pri

ce (

dolla

rs p

er c

hip)



Elasticity = -1/4

0 40 80 100 120 160 200

250

100

200

300

400

500 Lowering the pricefrom $200 to $0results in a price elasticity of demand of -1/ 4.

Inelastic

Pri

ce (

dolla

rs p

er c

hip)



|Elasticity| = 1

0 40 80 100 120 160 200

250

100

200

300

400

500

Pri

ce (

dolla

rs p

er c

hip)


Lowering the pricefrom $500 to $0results in a price elasticity of demand of -1.

|Elasticity| < 1

|Elasticity| > 1

Elasticity, Total Revenueand Expenditure

• Elastic demand — a 1 percent decrease in price will result in a greater than 1 percent increase in quantity demanded.• Total revenue will increase

• Unit elastic demand — a 1 percent decrease in price will result in a 1 percent increase in quantity demanded• Total revenue will not change


• Inelastic demand — a 1 percent decrease in price will result in a less than 1 percent increase in quantity demanded.

• Total revenue will decrease


• Total Revenue Test

• Price elasticity of demand can be estimated by

observing the change in total revenue that

results from a price change (ceteris paribus).


• Total Revenue Test

• Price cut and total revenue increases — demand is elastic.

• Price cut and total revenue decreases — demand is inelastic

• Price cut and total revenue does not change — demand is unit elastic

0 100 200

250

100

200

300

400

500

Pri

ce (

doll

ars

per

chip

)

D

25

0 100 200

250

100

200

300

400

500

Pri

ce (

doll

ars

per

chip

)

0 100 200

5

10

15

20

Tot

al R

even

ue (

bill

ions

of

doll

ars)


D

TR

25

0 100 200

250

100

200

300

400

500

Pri

ce (

doll

ars

per

chip

)

0 100 200

5

10

15

20

Tot

al R

even

ue (

bill

ions

of

doll

ars)


Maximum total revenue

When demandis inelastic, price cut decreasestotal revenue

When demandis elastic, price cut increasestotal revenue

Inelastic demand

Unitelastic

Elasticdemand

More Elasticities of Demand

• Cross elasticity of demand

• Measures the responsiveness of the demand for a good to a change in the price of a substitute or complement good.

Cross elasticity of demand =

Percentage changein quantity demanded

Percentage change in price of a substitute or complement

Cross Elasticity of DemandP

rice

of

Wal

kman

s

Quantity of Walkmans

D0


rice

of

Wal

kman

s


D1

Price of a CD player, a substitute, rises.Positive cross elasticity

D0


rice

of

Wal

kman

s


Price of a tape, a complement, rises. Negativecross elasticity

D1

Price of a CD player, a substitute, rises.Positive cross elasticity

D0D2

Income Elasticity of Demand

• Income elasticity

• Measures the responsiveness of the demand to a change in income.

Income elasticity of demand =

Percentage changein quantity demanded

Percentage change in income


• Income elasticity (in absolute sense) can be:

1 ) Greater than 1 (normal good, income elastic)• luxury goods - ocean cruises, jewelry

2 ) Between zero and 1 (normal good, income inelastic)

• necessities - food, clothing

3 ) Less than zero (inferior good)• potatoes, rice


Income elastic

Income inelastic

Income Income Income

Qua

ntit

y de

man

ded

Qua

ntit

y de

man

ded

Income elastic

Income inelastic

Income Income Income

Qua

ntit

y de

man

ded

Qua

ntit

y de

man

ded

Qua

ntit

y de

man

ded

Positiveincome elasticity

Negativeincome elasticity

m

Elasticity of Demand How does a firm go about determining the price at which they should sell their product in order to maximize total revenue? Total Revenue.

Documents

price slide

price quantity slide

year price dollars

year slide

dada slide

average price

high price

low price