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Elasticity Powerpoint produced by Rachel Farrell (PDST) & Aoife Healion (SHS, Tullamore)

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Elasticity of demand Shows how sensitive demand is to: 1. A change in the price of the good itself Price Elasticity of Demand (PED) 2. A change in consumers’ income Income Elasticiy of Demand (YED) 3. A change in the price of another good Cross Elasticity of Demand (CED)

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Price Elasticiy of Demand Is the percentage/proportionate change in the demand (quantity) for a good caused by the percentage/proportionate change in the price of that good.

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PED is measured by using the following formula: Where: P1 = the original price of the good P2 = the new price of the good Q1 = the original quantity demanded Q2 = the new quantity demanded Delta Q = the change in quantity demanded Delta P = the change in price P1 + P2 Q1 + Q2 QPQP

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Note 1 n A negative (–) number means that the good: Obeys the law of demand (eg a normal good) When P QD or when P QD Applying this to the formula – Q + P + Q – P or Each gives a negative number

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Note 2 A positive (+) number means that the good Does not obey the law of demand (eg. a giffen good) When P QD or when P QD Applying this to the formula + Q + P – Q– P– Q– P or Each gives a positive number

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Note 3 If the numerical value (ignoring the sign) is >1 then the PED is elastic. This means that the percentage change in demand is greater than the percentage change in price. If the ans is > –1 then it is a Luxury Good (holiday) ie: even if the price changes slightly there will be a large reduction in demand.

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Elastic Demand Curve (flatter) The Price Elasticity of Demand for this product is elastic. The change in price causes a more than proportionate change in demand. Degree of slope > 45º. Luxury goods, e.g. foreign holidays. P1 Q1 Price Quantity P2 Q2 D D

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Note 4 If the result is < +1< –1 < +1 or < –1 then the PED is inelastic. This means that the percentage change in demand is less than the percentage change in price. If the ans is < –1 then it is a Necessity ie. even if the price change is large the demand will not change much as people cannot do without it.

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Inelastic Demand Curve (steeper) The price elasticity of demand for this product is inelastic. The change in price has caused a less than proportionate change in quantity demanded. Degree of slope < 45º. Necessities, e.g. Domestic use of electricity. P1 Q1 Price Quantity P2 Q2 D D

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Note 5 If the result is = +1= –1 = +1 or = –1 then the PED is equal to unity or unit elasticity. This means that the percentage change in demand is equal to the percentage change in price. If the ans is = –1 then it is a “Luxury-necessity” Eg. needs that are really wants, dvd player, I-pod…

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Equal to Unity Curve The price elasticity of demand for this product is equal to unity. The price change has caused demand to change in direct proportion to the change in price. Degree of slope = 45º. “Luxury/necessities”, e.g. a freezer. P2 Q2 Price Quantity P1 Q1 D D

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Example 1 2008 Q 1. (b) (iii) P1= €40 P2 = €50 Q1=60 units Q2=40 units 40 + 50 X –20 = -1.8 60 + 40 10 Therefore PED is elastic, obeys the law of demand, eg. luxury good…… P1 + P2 Q1 + Q2 QPQP

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Example 2 2007 SQ 3. P 1 = €1.50 P 2 = €1.00 Q 1 = 50 units Q 2 = 90 units 1.50 + 1.00 X 40 = - 1.43 50 + 90 - 0.50 Therefore PED is elastic, obeys the law of demand, eg. luxury good…… P1 + P2 Q1 + Q2 QPQP

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D Price Quantity P Exceptional PED (perfect comp) In this case any change in price will cause D to fall to zero. perfectly elastic Thus PED is perfectly elastic (or equal to infinity).

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Price Quantity D D P1 Q1 P2 Exceptional PED (vital med) In this case any change in price between P1 and P2 will have no effect on the amount demanded. perfectly inelastic Thus the PED is perfectly inelastic (or = zero).

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Factors affecting elasticity Necessity = inelastic v luxury = elastic Substitute available = elastic v no substitute available = inelastic Alternative uses = elastic Durable = elastic v non durable = inelastic

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Complementary good Eg. Set of golf clubs = dearer = elastic Golf balls = cheaper = inelastic The demand for golf balls will be influenced more by the price of clubs rather than the balls themselves.

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An increase in the price of balls is unlikely to have much effect on the demand for balls or clubs. However an increase in the price of clubs will affect both the demand for clubs and balls.

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PED of normal goods and Total Revenue When PED > 1 You need to decrease price to increase total revenue (same direction) When PED < 1 You need to decrease increase price to increase total revenue (opp dir) When PED = 1 There is no effect on TR when P changes

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Giffen goods and change in TR For Giffen goods Price and total revenue always change in the same direction regardless of the degree of PED. The demand for Giffen goods goes up when their price is increased. As price increases more goods are sold at a higher price therefore TR must also increase. The same logic applies to a decrease in price.

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Income Elasticity of Demand (YED) Measures the relationship between a change in income and the resulting change in demand. It can be: Positive (+) = Normal Good, as Y rises D rises Negative (-) = Inferior Good & Giffen Good, as Y rises D falls

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YED can be Elastic (> I1I): Elastic (> I1I): the change in income causes a more than proportionate change in demand. (Luxury Good) Inelastic (< I1I): Inelastic (< I1I): the change in income causes a less than proportionate change in demand. (Food) Equal to unity ( = I1I): Equal to unity ( = I1I): the change in income causes a proportionate change in demand.

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Measurement of YED YED is measured by using the following formula: Where: Y1 = the original income Y2 = the new income Q1 = the original quantity demanded Q2 = the new quantity demanded Delta Q = the change in quantity demanded (sign nb) Delta Y = the change in income (sig nb) Y1 + Y2 Q1 + Q2 QYQY

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Example Income went from €200 to €250 Demand went from 5 units to 8 units 200+250 x +3 5 + 8 +50 +2.07 Normal, Luxury Good

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2002 Q 3 (a) Normal Good Y inc, QD inc (+) Eg. holiday Inferior Good Y inc, QD dec (-) Eg. potatoes

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(b) Let Y = €100 Consumer spends (40 % of €100) €40 on the good Y doubles to €200 Consumer spends (30 % of €200) €60 on the good Y Inc and QD Inc Normal Good

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(c) YED potatoes -0.1 YED designer clothes +2.5

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(d) YED = +1.8 Y D Y expected to rise by 5% Demand (Sales) will rise by 1.8 times 5% 5% X 1.8 = 9% 20,000 x 9 = 1,800 100 20,000 + 1,800 = 21,800 units

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YED = -0.5 Y D Y expected to rise by 2% Demand (Sales) will decrease by 2 times 0.5 % 0.5 % X 2 = 1% 10,0000 x 1 = 100 100 10,000 - 100 = 9,900 units

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2009 Q 1. (b) (ii) YED low price meat -0.1 YED for iphones +4.6

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2009 Q 1 (c) YED = +2.5 Y D Y decreases by 8% Sales decrease by 2.5 times 8% 8%X2.5=20% Sales falls by 20% 100,000X20 = 20,000 units 100 100,000-20,000 = 80,000 units

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Uses of YED

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Cross Elasticity of Demand (CED) Cross elasticity of demand measures the relationship between the change in price of one good (A) and the resulting change in demand for another good (B). +ive = substitute, an inc P A = an inc D B -ive = complementary, an in P A = dec in D B > 1 elastic, < 1 inelastic, = 1 unitary

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Measurement of CED CED is measured by using the following formula: The demand for product B reacts to a change in the price of product A. Where: P(A)1 = the original price of A P(A)2 = the new price of A Q(B)1 = the original quantity of B Q(B)2 = the new quantity of B Delta Q(B) = the change in quantity of B (sign nb) Delta P(A) = the change in price of A (sign nb) P(A)1 + P(A)2 Q(B)1 + Q(B)2 Q(B) P(A)

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2006 Q 1 (c) 5 + 6 X + 4 10 + 14 + 1 + 1.83 Substitute, elastic

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2003 Q 2 (b) 27 + 23 X -400 1,200 + 800 -4 + 2.5 Substitute, elastic

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1999 Q 4 (b) B = +2.5 Substitute, elastic C = -0.6 Complementary, inelastic D = + 0.3 Substitute, inelastic E = -1.4 Complementary, elastic

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Closest substitute +0.3

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Ch. 4: Elasticity. Define, calculate, and explain the factors that influence the price elasticity of demand the cross elasticity of demand the income.

Ch. 4: Elasticity. Define, calculate, and explain the factors that influence the price elasticity of demand the cross elasticity of demand the income.

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