1. Chapter 20 Elasticity: Demand and Supply

2. Price Elasticity of Demand How sensitive is the quantity demanded to changes in price? How responsive are consumers to price changes? How sensitive is the quantity demanded to changes in price? How responsive are consumers to price changes? Definitions of Price Elasticity of Demand: Definitions of Price Elasticity of Demand: the percentage change in the quantity demanded of a product divided by the percentage change in the price of the product. the percentage change in the quantity demanded of a product divided by the percentage change in the price of the product. The percentage change in the quantity demanded caused by a one percent change in the price. The percentage change in the quantity demanded caused by a one percent change in the price.

3. Price Elasticity: Mathematical Definition The price elasticity of demand, e d, is: The price elasticity of demand, e d, is: Example: if the quantity of videotapes rented falls by 3% when the price is raised by 1%, then the price elasticity of demand is 3/1 = 3. Example: if the quantity of videotapes rented falls by 3% when the price is raised by 1%, then the price elasticity of demand is 3/1 = 3.

4. Sign of Price Elasticity According to the law of demand, whenever the price rises, the quantity demanded falls. Thus the price elasticity of demand is always negative. According to the law of demand, whenever the price rises, the quantity demanded falls. Thus the price elasticity of demand is always negative. Because it is always negative, economists usually state the value without the sign. Because it is always negative, economists usually state the value without the sign.

5. Demand Curve Shapes and Elasticity Perfectly Elastic Demand Curve Perfectly Elastic Demand Curve The demand curve is horizontal. The demand curve is horizontal. Even the smallest change in price will cause consumers to change their consumption by a huge amount. Even the smallest change in price will cause consumers to change their consumption by a huge amount. Perfectly Inelastic Demand Curve Perfectly Inelastic Demand Curve The demand curve is vertical. The demand curve is vertical. The quantity demanded is totally unresponsive to the price. Changes in price have no effect on consumer demand. The quantity demanded is totally unresponsive to the price. Changes in price have no effect on consumer demand.

6. Demand Curve Shapes and Elasticity

7. Elastic and Inelastic The terms elastic and inelastic refer to a price range, not to the entire demand curve. The terms elastic and inelastic refer to a price range, not to the entire demand curve. Elastic region: where e d > 1. Elastic region: where e d > 1. Unit elastic point: where e d = 1. Unit elastic point: where e d = 1. Inelastic region: where 0 < e d < 1. Inelastic region: where 0 < e d < 1.

8. Using the Price Elasticity of Demand It tells a manager in a firm whether to raise or lower prices. It tells a manager in a firm whether to raise or lower prices. Total Revenue (TR) equals the price times the quantity sold: TR = P x Q. Total Revenue (TR) equals the price times the quantity sold: TR = P x Q. The law of demand tells us that Q falls when P rises. The law of demand tells us that Q falls when P rises. What is the optimal price to maximize total revenue? Answer: the price at the unit-elastic point. At any higher price, total revenue is decreased! What is the optimal price to maximize total revenue? Answer: the price at the unit-elastic point. At any higher price, total revenue is decreased!

9. Total Revenue and Price Elasticity PriceQuantityRevenue$1000200$200,000 $900400$360,000 $800600$480,000 $700800$560,000 $6001000$600,000 $5001200$600,000 $4001400$560,000 $3001600$480,000 $2001800$360,000 $1002000$200,000

10. Determinants of the Price Elasticity of Demand Existence of Substitutes Existence of Substitutes The more substitutes there are for a product, the greater the price elasticity of demand. The more substitutes there are for a product, the greater the price elasticity of demand. Why pay more when you can switch to the substitute? Why pay more when you can switch to the substitute? Importance of the Product in the Consumer’s Total Budget Importance of the Product in the Consumer’s Total Budget The greater the portion of the consumer’s budget a good constitutes, the more price elastic the demand for the good. The greater the portion of the consumer’s budget a good constitutes, the more price elastic the demand for the good. Too much of the consumer’s buying power is tied up in this purchase to ignore price. Too much of the consumer’s buying power is tied up in this purchase to ignore price. The Time Period under Consideration The Time Period under Consideration The longer the period under consideration, the more elastic the demand. The longer the period under consideration, the more elastic the demand.

11. Price Discrimination Price discrimination is charging different customers different prices for the same product. Price discrimination is charging different customers different prices for the same product. Why would firms want to do this? Why would firms want to do this? If different groups of customers have significantly different price elasticities of demand for the same product, total revenue can be increased by charging each of the groups a different price. If different groups of customers have significantly different price elasticities of demand for the same product, total revenue can be increased by charging each of the groups a different price. The groups must be easily identifiable, and there must be little possibility of people from different groups trading with each other. The groups must be easily identifiable, and there must be little possibility of people from different groups trading with each other.

12. Dumping Dumping: A form of price discrimination wherein an identical good is sold to foreign buyers for a lower price than to domestic buyers. Dumping: A form of price discrimination wherein an identical good is sold to foreign buyers for a lower price than to domestic buyers. Predatory Dumping: dumping intended to drive rival firms out of business. Predatory Dumping: dumping intended to drive rival firms out of business. Usually the predator raises prices after driving competitors from the marketplace. Usually the predator raises prices after driving competitors from the marketplace. Usually charges of “dumping” against foreign firms really are charges of “predatory dumping”. Usually charges of “dumping” against foreign firms really are charges of “predatory dumping”.

13. Other Demand Elasticities Demand may respond to changes in other variables. The measures of such responses are also elasticities. Demand may respond to changes in other variables. The measures of such responses are also elasticities. Cross-Price Elasticity of Demand: The percentage change in the quantity demand for one good, divided by the percentage change in price of another good. Cross-Price Elasticity of Demand: The percentage change in the quantity demand for one good, divided by the percentage change in price of another good. Measures the degree to which goods are substitutes or complements. Measures the degree to which goods are substitutes or complements. If the cross-price elasticity is positive, then the goods are substitutes. If the cross-price elasticity is positive, then the goods are substitutes. If the cross price elasticity is negative, then the goods are complements. If the cross price elasticity is negative, then the goods are complements.

14. Other Demand Elasticities, Continued Income Elasticity of Demand Income Elasticity of Demand How responsive is the demand for the product to income? How responsive is the demand for the product to income? Definition: The percentage change in the quantity demanded divided by the percentage change in income. Definition: The percentage change in the quantity demanded divided by the percentage change in income. Normal goods: goods for which the income elasticity of demand is positive. Normal goods: goods for which the income elasticity of demand is positive. That is, goods that consumers demand more of when their incomes rise. That is, goods that consumers demand more of when their incomes rise. Inferior goods: Goods for which the income elasticity of demand is negative. Inferior goods: Goods for which the income elasticity of demand is negative. Consumers will substitute away from these goods if their income permits it. Consumers will substitute away from these goods if their income permits it.

15. Necessities and Luxuries Goods with lower income elasticities are often called necessities, since the quantities demanded don’t vary much with income. (Gas, electricity, medical services, etc.) Goods with lower income elasticities are often called necessities, since the quantities demanded don’t vary much with income. (Gas, electricity, medical services, etc.) Typical income elasticities are 0.4 or 0.5. Typical income elasticities are 0.4 or 0.5. Goods with higher income elasticities are often called luxuries, since people give them up readily when their incomes fall. Goods with higher income elasticities are often called luxuries, since people give them up readily when their incomes fall. Typical elasticities are 1.5 to 2.0. Typical elasticities are 1.5 to 2.0.