Price Elasticity of Demand

Elasticity of Demand and Supply

Calculating Percentage Change Significance of Price Elasticity of Demand (Ep) Determinants of Price Elasticity of Demand (Ep) Price Elasticity of Demand (Ep) For Next Time

Price Elasticity of Demand

A measure of the extent to which the quantity demanded of a good changes when the price of the good changes, ceteris paribus.

We know if we raise a price, the Qd will decline, but we don’t know how much.

Elasticity answers the “how much” question. In Business, we want to know the relationship between Qd

and Price Ep = % Change in Quantity Demanded

% Change in Price

Price of Latte

Suppose a retail gourmet coffee outlet is selling its premium “Latte” for $3/cup. The store generally is selling 15 cups of “Latte” per hour, and the store manager is thinking seriously of raising the price to $5/cup. He knows he will lose some sales but thinks that most of his customers are willing to pay more. Help him quantify his decision by determining how many fewer cups he can sell and still generate more revenue per hour.

Calculating Percentage Change

Percentage Change measures how much a value has changed from one time period to another

For Example, if a firm’s sales for the current month amounted to $100 million and the previous month, the same firm’s sales were $90 million. What was the percentage change?

There are two methods of calculating the percentage change

• Simple Method• Midpoint Method

Calculating Percentage Change

Simple Method

Percentage Change = Current Value-Previous Value Previous Value

or, = $100m - $90 m = $10m = 11.1%$90m $90m

Very Common Usage, especially in the business world

Calculating Percentage Change

Midpoint MethodPercentage Change = Current Value – Previous Value

(Current Value + Previous Value)/ 2

Or, = $100m -$90m = $10m = 10.5% ($100m + $90m)/2 $95m

The midpoint method is the better method because it gives similar results whether we are measuring forward or backward

Price Elasticity of Demand

From Formula Ep = % Change in Qd % Change in Price

If Price Elasticity of Demand > 1, demand is elastic If Price Elasticity of Demand = 1, demand is unit elastic If Price Elasticity of Demand < 1, demand is

inelastic

Demand Elasticity

Elastic Demand – When % Change in Quantity Demanded > % Change in Price

Unit Elastic Demand – When % Change in Quantity Demanded = % Change in Price

Inelastic Demand – When % Change in Quantity Demanded < % Change in Price

Perfectly Elastic Demand – When Quantity Demanded Changes by a very large percentage in response to an almost zero Change in Price

Perfectly Inelastic Demand – When the Quantity Demanded remains constant as Price changes

18-10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Perfectly Elastic Demand Curve

Quantity

D

14

8

6

4

2

10 15 20 25 305

12

10

The elasticity of a perfectly elastic demand curve is infinity

18-11Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Perfectly Inelastic Demand Curve

Quantity

D

30

25

20

15

10

5

5 10 15 20 25

The elasticity of a perfectly inelastic demand curve is 0

18-12Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Relativity Elasticity of Demand Curves

Quantity

D1

D2

18-14Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Elasticity of Straight Line Demand Curve

Quantity

D

11

10

9

8

7

6

5

4

3

2

1

0

Very elastice = 6.33

Slightly elastic

Unit elastic

Slightly inelastic

Veryinelastic

e = .29

e = 1.0

0 1 2 3 4 5 6 7 8 9 10 11

Significance of Price Elasticity of Demand

Profit maximization requires that business set a price that will maximize the firm’s profit

Elasticity tells the firm how much control it has over using price to raise profit

If Ep > 1, then the % Change in Qd > % Change is Price and demand is said to be elastic

• An increase in price will reduce total revenue• A decrease in price will increase total revenue

Significance of Price Elasticity of Demand

If Ep < 1, then the % change in Qd < % change in price, and demand is said to be inelastic

• An increase in price will increase total revenue• A decrease in price will decrease total revenue

If Ep = 1, then the % change in Qd = % change in Price, and demand is said to be unit elastic

• An increase in price will have no impact on total revenue• A decrease in price will have no impact on total revenue

Price Elasticity of Demand Influences

Substitute Product Availability (key determinant) -- Luxury or Necessity (Ep for luxury items is >)

-- How narrowly it is defined (coffee is inelastic but latte may have more substitutes and therefore is more elastic)

-- Time elapsed since price change (>time, >elasticity; more time to find substitutes or manage consumption)

Income Effects-- The greater the proportion of income spent

on the good, greater a price change impacts Quantity Demanded

Advertising

Purpose – Product Differentiation (Branding) To make the demand for a product greater To make the demand for a product more inelastic

D D

18-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Elasticity Thoughts

Demand Curve Slope and Elasticity (Steeper the slope, lower the elasticity)

A Units-Free Measure (% Change – Absolute Value)

Elasticity Along a Linear Demand Curve-- Slope is constant but elasticity varies

Elasticity and Total Revenue-- Price and Total Revenue change in opposite directions, demand is elastic-- Price Change leaves Total Revenue unchanged, demand is unit elastic-- Price and Total Revenue change in same direction, demand is inelastic

Price Elasticity of Supply

A measure of the extent to which the quantity supplied of a good changes when the price of the good changes, and all other influences on seller’s plans remain the same (cateris paribus)

Price Elasticity of Supply

Perfectly Elastic Supply – When the quantity supplied changes by a very large percentage in response to an almost zero increase in price

Elastic Supply – When the % change in the quantity supplied > the % change in the price

Unit Elastic Supply – When the % change in the quantity supplied = the % change in price

Inelastic Supply – When the % change in the quantity demanded is < the % change in price

Perfectly Inelastic Supply – When the quantity supplied remains the same as the price changes

Influences on Price Elasticity of Supply

Production Possibilities – page 124-- Opportunity Costs

constant or gently rising opportunity costs = elastic price elasticity

-- Fixed Production = inelastic price elasticity-- Time Elapse – longer time, > price elasticity

Influences of Price Elasticity of Supply

Storage Possibilities

The better the storability, the more elastic is the price elasticity of supply

Computing Price Elasticity of Supply

Percentage change in quantity supplied Percentage change in price

• If Price Elasticity of Supply > 1, Supply is elastic• If Price Elasticity of Supply = 1, Supply is unit

elastic• If price elasticity of supply< 1, Supply is inelastic

Cross Elasticity of Demand

A measure of the extent to which the demand for a good changes when the price of a substitute or complement changes, ceteris paribus

% Change in Quantity Demanded% Change in Price of one of itssubstitutes or complements

Income Elasticity of Demand

A measure of the extent to which the demand for a good changes when income changes, ceteris paribus

% Change in Quantity Demanded% Change in Income

Income Elasticity of Demand

If income elasticity of demand > 1 the demand for the good is income elastic

If income elasticity of demand is between 0 and 1, the demand is income inelastic

* If income elasticity of demand < 0 the demand is negative income elastic