Module 8 Price Elasticity of Demand 1

price elasticity of demand,  Define the price elasticity of demand, understand why it is useful, and how to calculate it. 2 Objectives

price elasticity of demand,  Define the price elasticity of demand, understand why it is useful, and how to calculate it.  Understand how to describe elasticities, graph demand curves to represent different elasticities, and understand what happens to elasticity along a linear downward-sloping demand curve. 3 Objectives

price elasticity of demand,  Define the price elasticity of demand, understand why it is useful, and how to calculate it.  Understand how to describe elasticities, graph demand curves to represent different elasticities, and understand what happens to elasticity along a linear downward-sloping demand curve.  Understand the relationship between the price elasticity of demand and total revenue. 4 Objectives

5 Objective 1: Define the price elasticity of demand, understand why it is useful…. price elasticity of demand  The price elasticity of demand measures the responsiveness of the quantity demanded to changes in price.

6  For example, consider the demand curve D 1. If price rises from $10 to $12, quantity demanded falls from Q a to Q 1. Objective 1: Define the price elasticity of demand, understand why it is useful…. price elasticity of demand  The price elasticity of demand measures the responsiveness of the quantity demanded to changes in price.

7  For example, consider the demand curve D 1. If price rises from $10 to $12, quantity demanded falls from Q a to Q 1.  If the demand curve is D 2, then when price rises, quantity demanded falls by a smaller amount from Q a to Q 2. Objective 1: Define the price elasticity of demand, understand why it is useful…. price elasticity of demand  The price elasticity of demand measures the responsiveness of the quantity demanded to changes in price.

8  All elasticity formulas may be stated as fractions or ratios of two percentage change values. Objective 1: ….how to calculate the price elasticity of demand

9  All elasticity formulas may be stated as fractions or ratios of two percentage change values.  The formula for the price elasticity of demand is: Objective 1: ….how to calculate the price elasticity of demand

10 Note: always uses percentage changes  The elasticity formula always uses percentage changes so that the coefficient is not biased by units. Objective 1: ….how to calculate the price elasticity of demand

11 Note: always uses percentage changes  The elasticity formula always uses percentage changes so that the coefficient is not biased by units. absolute values  Because of the law of demand the sign of the price elasticity of demand is always negative. To simplify interpretation, we will use the absolute values of the price elasticity of demand and so that the negative sign is ignored. Objective 1: ….how to calculate the price elasticity of demand

12 Objective 1: calculating the price elasticity of demand Example 1: Suppose quantity demanded increases by 12% when price rises by 6%. What is the price elasticity of demand?

13 Objective 1: calculating the price elasticity of demand Example 1: Suppose quantity demanded increases by 12% when price rises by 6%. What is the price elasticity of demand? Solving the Problem  Solving the Problem Apply the elasticity formula:

14 Objective 1: calculating the price elasticity of demand  The price elasticity of demand = 2. What does the number 2 mean?

15 Objective 1: calculating the price elasticity of demand  The price elasticity of demand = 2. What does the number 2 mean?  Let’s go back to the elasticity formula and rearrange the equation by cross multiplying. % ∆ in Quantity Demanded = |Price Elasticity of Demand| x %∆Price = 2 x %∆Price

16  For every 1 percent increase in price, quantity demanded falls by 2 percent, Objective 1: calculating the price elasticity of demand  The price elasticity of demand = 2. What does the number 2 mean?  Let’s go back to the elasticity formula and rearrange the equation by cross multiplying. % ∆ in Quantity Demanded = |Price Elasticity of Demand| x %∆Price = 2 x %∆Price

17  For every 1 percent increase in price, quantity demanded falls by 2 percent, or for every 1 percent decrease in price, quantity demanded increases by 2 percent. Objective 1: calculating the price elasticity of demand  The price elasticity of demand = 2. What does the number 2 mean?  Let’s go back to the elasticity formula and rearrange the equation by cross multiplying. % ∆ in Quantity Demanded = |Price Elasticity of Demand| x %∆Price = 2 x %∆Price

18 Example 2: Example 2: Suppose when the price of a can of protein powder is $12, quantity demanded is 17 cans. When the price falls to $8, quantity demanded increases to 23 cans. Calculate the price elasticity of demand over this range. Objective 1: calculating the price elasticity of demand

19 Example 2: Example 2: Suppose when the price of a can of protein powder is $12, quantity demanded is 17 cans. When the price falls to $8, quantity demanded increases to 23 cans. Calculate the price elasticity of demand over this range. Objective 1: calculating the price elasticity of demand Solving the Problem  Essentially, we are given two price-quantity combinations: P a = $12; Q a = 17 and P b = $10; Q b = 8

20 Example 2: Example 2: Suppose when the price of a can of protein powder is $12, quantity demanded is 17 cans. When the price falls to $8, quantity demanded increases to 23 cans. Calculate the price elasticity of demand over this range. Objective 1: calculating the price elasticity of demand Solving the Problem  Essentially, we are given two price-quantity combinations: P a = $12; Q a = 17 and P b = $10; Q b = 8  To calculate price elasticity over a range of two prices, we need average or to apply the average or midpoint formula.

21 Objective 1:..the mid-point formula Simplify by cancelling the ½s and the 100s to give:

22 Objective 1:..the mid-point formula Simplify by cancelling the ½s and the 100s to give:

23 Now plug in the given values: Objective 1:..the mid-point formula

24 Now plug in the given values: Objective 1:..the mid-point formula The average elasticity between a and b is  0.75 

25 Objective 2 Understand how to describe elasticities,…. Understand how to describe elasticities,….

26 Objective 2 Understand how to describe elasticities,…. Understand how to describe elasticities,….

27 Objective 2 Understand how to describe elasticities,…. Understand how to describe elasticities,…. price elastic  When demand is price elastic, the change in quantity demanded is proportionally greater than the change in price.

28 Objective 2: describing elasticities,….

29 Objective 2: describing elasticities,…. price inelastic  When demand is price inelastic, the change in quantity demanded is proportionally smaller than the change in price.

30 Objective 2: describing elasticities,….

31 unit price elastic  When demand is unit price elastic, the change in quantity demanded is equal to the change in price. Objective 2: describing elasticities,….

32 The polar cases:  Perfectly inelastic demand Objective 2: describing elasticities,….

33 The polar cases:  Perfectly inelastic demand  Perfectly inelastic demand occurs when a change in price results in no change in quantity demanded. Objective 2: describing elasticities,….

34 The polar cases:  Perfectly elastic demand  Perfectly elastic demand occurs when a change in price results in an infinite change in quantity demanded. Objective 2: describing elasticities,….

35 The polar cases:  Perfectly elastic demand  Perfectly elastic demand occurs when a change in price results in an infinite change in quantity demanded. Objective 2: describing elasticities,….

36 Objective 2: graph demand curves to represent different elasticities…

37  Quantity demanded does not respond to changes in price. Examples include some types of medication such as insulin for a diabetic. Objective 2: graph demand curves to represent different elasticities…

38  Quantity demanded is extremely sensitive to changes in price to the extent that when price rises a tad, quantity demanded falls to zero. Objective 2: graph demand curves to represent different elasticities…

39  Quantity demanded is extremely sensitive to changes in price to the extent that when price rises a tad, quantity demanded falls to zero.  In theory, this is the demand curve facing a perfectly competitive firm. Objective 2: graph demand curves to represent different elasticities…

40 Objective 2: graph demand curves to represent different elasticities…

41  The demand curve is not linear. It is a rectangular hyperbola. Objective 2: graph demand curves to represent different elasticities…

42  The demand curve is not linear. It is a rectangular hyperbola.  The total revenue for each price-quantity combination remains the same. Objective 2: graph demand curves to represent different elasticities…

43  Along a linear downward-sloping demand curve, elasticity varies. Objective 2: a linear downward-sloping demand curves and elasticity

44 On the upper part of the demand curve, demand is price elastic.  Along a linear downward-sloping demand curve, elasticity varies. Objective 2: a linear downward-sloping demand curves and elasticity

45 On the upper part of the demand curve, demand is price elastic. At the midpoint of the demand curve, demand is unit elastic.  Along a linear downward-sloping demand curve, elasticity varies. Objective 2: a linear downward-sloping demand curves and elasticity

46 On the upper part of the demand curve, demand is price elastic. On the lower part of the demand curve, demand is price inelastic. At the midpoint of the demand curve, demand is unit elastic.  Along a linear downward-sloping demand curve, elasticity varies. Objective 2: a linear downward-sloping demand curves and elasticity

47 On the upper part of the demand curve, demand is price elastic. On the lower part of the demand curve, demand is price inelastic. At the midpoint of the demand curve, demand is unit elastic.  Along a linear downward-sloping demand curve, elasticity varies. The midpoint of a linear demand curve corresponds to the quantity that bisects the demand curve. Objective 2: a linear downward-sloping demand curves and elasticity

48  Changes in price and quantity demanded result in changes in the total revenue received by firms. Objective 3: …the relationship between the price elasticity of demand and total revenue.

49  Changes in price and quantity demanded result in changes in the total revenue received by firms.  Total Revenue = Price × Quantity Sold Total Revenue = Total Expenditure Objective 3: …the relationship between the price elasticity of demand and total revenue.

50  Changes in price and quantity demanded result in changes in the total revenue received by firms.  Changes in total revenue are related to the price elasticity of demand. Total Revenue = Price × Quantity Sold Total Revenue = Total Expenditure Objective 3: …the relationship between the price elasticity of demand and total revenue.

51 elastic  If demand is price elastic, %∆quantity demanded > %∆price. Objective 3: …the relationship between the price elasticity of demand and total revenue.

52 elastic  If demand is price elastic, %∆quantity demanded > %∆price.  For example, if price rises by 10%, quantity demanded falls by more than 10%, say 12%. Objective 3: …the relationship between the price elasticity of demand and total revenue.

53 elastic  If demand is price elastic, %∆quantity demanded > %∆price.  For example, if price rises by 10%, quantity demanded falls by more than 10%, say 12%. Therefore, total revenue must fall. Price  × Quantity Sold   Total Revenue  Objective 3: …the relationship between the price elasticity of demand and total revenue.

54 elastic  If demand is price elastic, %∆quantity demanded > %∆price.  For example, if price rises by 10%, quantity demanded falls by more than 10%, say 12%. Therefore, total revenue must fall. Price  × Quantity Sold   Total Revenue  opposite  When demand is price elastic, changes in price and changes in total revenue move in opposite directions. Objective 3: …the relationship between the price elasticity of demand and total revenue.

55 inelastic,  If demand is price inelastic, %∆quantity demanded < %∆price. Objective 3: …the relationship between the price elasticity of demand and total revenue.

56 inelastic,  If demand is price inelastic, %∆quantity demanded < %∆price.  For example, if price rises by 10%, quantity demanded falls by less than 10%, say 8%. Objective 3: …the relationship between the price elasticity of demand and total revenue.

57 inelastic,  If demand is price inelastic, %∆quantity demanded < %∆price.  For example, if price rises by 10%, quantity demanded falls by less than 10%, say 8%. In this case, total revenue must rise. Price  × Quantity Sold   Total Revenue  Objective 3: …the relationship between the price elasticity of demand and total revenue.

58 inelastic,  If demand is price inelastic, %∆quantity demanded < %∆price.  For example, if price rises by 10%, quantity demanded falls by less than 10%, say 8%. In this case, total revenue must rise. Price  × Quantity Sold   Total Revenue  same  When demand is price inelastic, changes in price and changes in total revenue move in the same direction. Objective 3: …the relationship between the price elasticity of demand and total revenue.

59 unit elastic  If demand is unit elastic, %∆quantity demanded equals %∆price. Objective 3: …the relationship between the price elasticity of demand and total revenue.

60 unit elastic  If demand is unit elastic, %∆quantity demanded equals %∆price.  For example, if price rises by 10%, quantity demanded falls by exactly 10%, resulting in no change in total revenue. Objective 3: …the relationship between the price elasticity of demand and total revenue.

61 unit elastic  If demand is unit elastic, %∆quantity demanded equals %∆price.  For example, if price rises by 10%, quantity demanded falls by exactly 10%, resulting in no change in total revenue. Total revenue is maximized.  When demand is unit elastic, changes in price do not change total revenue. Total revenue is maximized. Price  × Quantity Sold   Total Revenue  Objective 3: …the relationship between the price elasticity of demand and total revenue.

62 perfectly inelastic,  If demand is perfectly inelastic, quantity demanded does not respond to changes in price but total revenue will changes when price changes. Objective 3: …the relationship between the price elasticity of demand and total revenue. Price  × Quantity Sold   Total Revenue  Price  × Quantity Sold   Total Revenue 

63 perfectly elastic,  If demand is perfectly elastic, quantity demanded is infinitely responsive to changes in price. Price  × Quantity Sold  to 0  Total Revenue  to 0 Objective 3: …the relationship between the price elasticity of demand and total revenue.