THE ELASTICITY OF DEMAND

Transcription

1 THE ELASTICITY OF DEMAND Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. Price elasticity of demand is the percent change in quantity demanded given a percent change in the price. Demand tends to be more elastic : the larger the number of close substitutes. if the good is a luxury. the more narrowly defined the market. the longer the time period.

2 Computing the Price Elasticity of Demand The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. Example: If the price of an ice cream cone increases from $2.00 to $ % and the amount you buy falls from 10 to 8 cones..-20%, then your elasticity of demand would be: -2 Price elasticity of demand = Percentage change in quantity demanded Percentage change in price

3 Variation in Elasticity Listed according to their constant declining absolute value along a linear demand curve Elastic Demand Quantity demanded responds strongly to changes in price. Price elasticity of demand is greater than one. Perfectly Elastic Quantity demanded changes infinitely with any change in price. Unit Elastic Quantity demanded changes by the same percentage as the price. Inelastic Demand Quantity demanded does not respond strongly to price changes. Price elasticity of demand is less than one. Perfectly Inelastic Demand Quantity demanded does not respond at all to price changes. Price elasticity of demand is zero.

4 Perfectly Inelastic Quantity demanded does not respond to price changes Perfectly Inelastic Demand: Ed = 0 Price Demand $5 1. An increase in price Quantity leaves the quantity demanded unchanged. Copyright 2003 Southwestern/Thomson Learning

5 Inelastic Demand Price Quantity demanded does not respond strongly to price changes. Inelastic Demand: Elasticity < 1 $5 1. A 25% increase in price... 4 Demand Quantity leads to an 10% decrease in quantity demanded.

6 Elastic Demand Quantity demanded responds strongly to changes in price. Elastic Demand: Elasticity > 1 Price $5 1. A 25% increase in price... 4 Demand Quantity leads to a 50% decrease in quantity demanded.

7 Perfectly Elastic Quantity demanded changes infinitely with any change in price. Price Perfectly Elastic Demand: Elasticity = Infinity 1. At any price above $4, quantity demanded is zero. $4 Demand 2. At exactly $4, consumers will buy any quantity At a price below $4, quantity demanded is infinite. Quantity

8 Total revenue is the amount paid by buyers and received by sellers of a good. Price Computed as the price of the good times the quantity sold. TR = P x Q $4 P P Q = $400 (revenue) Demand Quantity Q Copyright 2003 Southwestern/Thomson Learning

9 With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases. Price Price An Increase in price from $1 to $3 leads to an Increase in total revenue from $100 to $240 $3 Revenue = $240 $1 Revenue = $100 Demand Demand Quantity 0 80 Quantity Copyright 2003 Southwestern/Thomson Learning

10 With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases. Price Price An Increase in price from $4 to $5 leads to an decrease in total revenue from $200 to $100 $5 $4 Demand Demand Revenue = $200 Revenue = $ Quantity 0 20 Quantity Copyright 2003 Southwestern/Thomson Learning

11 Elasticity Along a Linear Demand Curve Constant slope, but elasticity declines as you go down the curve Revenue increases as you approach the midpoint from either direction Very elastic e = Slightly elastic Unit elastic e = 1.0 Slightly inelastic e =.29 Very inelastic 1 D Quantity

12 Significance of Price Elasticity of Demand Firm s try to set a price that will maximize their profit Elasticity plays a vital role in determining a firm s revenue Since Profit = TR TC, elasticity is important to a firm s profit making decisions If Ed > 1, then demand is said to be elastic: An increase in price will reduce total revenue A decrease in price will increase total revenue If Ed < 1, then demand is said to be inelastic: An increase in price will increase total revenue A decrease in price will decrease total revenue If Ed = 1, then 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

13 Income Elasticity of Demand Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income. Types of Goods Normal Goods, with income elasticities that are positive Inferior Goods, with income elasticities that are negative Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. Income elasticity of demand = Percentage change in quantity demanded Percentage change in income

14 Income Elasticity Examples Ey = - 0.6: this good is an inferior good a rise in income of 10% would lead to demand falling by 6% Ey = + 0.4: this good is a normal good a rise in income of 10% would lead to demand rising by 4% Ey = + 1.6: this good is a normal good a rise in income of 10% would lead to demand rising by 16% Ey = - 2.1: this good is an inferior good a rise in income of 10% would lead to a fall in demand of 21%

15 Cross Elasticity of Demand Cross Elasticity: measures the responsiveness of demand for one good to changes in the price of a related good either a substitute or a complement Goods which are complements: Cross Elasticity will have negative sign (inverse relationship) Goods which are substitutes: Cross Elasticity will have a positive sign (positive relationship) Ex = % Qd of good A % Price of good B

16 Summary Price elasticity of demand measures how much the quantity demanded responds to changes in the price. Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. If a demand curve is elastic, total revenue falls when the price rises. If it is inelastic, total revenue rises as the price rises. The income elasticity of demand measures how much the quantity demanded responds to changes in consumers income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good. In most markets, supply is more elastic in the long run than in the short run.

17 Practice In the table at right, one of the price and quantity combinations is the midpoint of a demand curve facing a producer. Which is it? price = 7$, quantity = 100 How do you know? because of the three possibilities, it yields the greatest total revenue..700$ Price ($) Quantity Demanded

18 Practice If profit equals revenue, then cost must equal...zero If Ey = 2, then by what % must incomes of consumers rise in order to double sales of this good?...50% If the price elasticity of demand for a good is unitary and price rises by 20 %, what happens to sales of the good?...sales fall by 20% There are 3 goods: sneakers, boots and socks. Relating two of them will always yield a positive cross elasticity of demand. Which two?...sneakers and boots Why?...because they are substitutes

19 Practice Given: Qd = 100 2P What is the maximum price?...50$ What is the maximum quantity? At what price and quantity is revenue maximized?..price = 25$, quantity = 50 What is the maximum revenue the firm can earn in this case?.since TR = PQ, (25$)(50) = $1,250 If all costs were fixed at 1000$, then what is maximum profit in this case?...since Profit = TR TC..$1,250 - $1,000 = $250

20 Practice Given: Ed = 0 (perfectly inelastic demand) Name a good whose elasticity may be similar to this....insulin If you drew this demand curve, what would it look like?...vertical (with an infinite slope) If a 100$ tax was placed on production, how much of it would truly be paid by the producer?...none at all, since the buyer has no choice, the burden is passed completely to him in the form of a higher market price