4 4 Demand and Elasticity

●Elasticity: Measure of Responsiveness ●Price Elasticity of Demand: Its Effect on Total Revenue ●What Determines Demand Elasticity? ●Elasticity as a General Concept ●Real-World Application: Polaroid versus Kodak ●Elasticity: Measure of Responsiveness ●Price Elasticity of Demand: Its Effect on Total Revenue ●What Determines Demand Elasticity? ●Elasticity as a General Concept ●Real-World Application: Polaroid versus Kodak Outline Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

●Elasticity = measure of the responsiveness of one variable to changes in another variable ●Price elasticity of demand = ●Elasticity = measure of the responsiveness of one variable to changes in another variable ●Price elasticity of demand = %  Qd %  P Elasticity: Measure of Responsiveness

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Real-World Application: Polaroid versus Kodak ●In 1989, Polaroid sued Kodak –copyright infringement of its instant-photography patents. ●Court case would determine how much Kodak should pay in compensation to Polaroid. ♦Polaroid: could have charged ↑P film without illegal competition from Kodak ♦Kodak: ↑P film → ↓Qd film ●In 1989, Polaroid sued Kodak –copyright infringement of its instant-photography patents. ●Court case would determine how much Kodak should pay in compensation to Polaroid. ♦Polaroid: could have charged ↑P film without illegal competition from Kodak ♦Kodak: ↑P film → ↓Qd film

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Real-World Application: Polaroid versus Kodak ●Relevant Question: How would ↑P film affect Polaroid’s TR? ♦Depends on how responsive Qd is to P, which depends on the shape of the D curve for film ●Court’s decision would be based on the responsiveness of Qd to P. ●Relevant Question: How would ↑P film affect Polaroid’s TR? ♦Depends on how responsive Qd is to P, which depends on the shape of the D curve for film ●Court’s decision would be based on the responsiveness of Qd to P.

FIGURE 1(a). Hypothetical Demand Curves for Film $20 Price per Package Quantity Demanded in millions D f D f b a Copyright© 2006 South-Western/Thomson Learning. All rights reserved. D is relatively responsive to P. TRa = $10 x 4 = $40 TRb = $20 x 1.5 = $30 Here P doubles and TR falls by 25%. Kodak’s claim

FIGURE 1(b). Hypothetical Demand Curves for Film $20 Quantity Demanded in millions Price per Package D S D S B Copyright© 2006 South-Western/Thomson Learning. All rights reserved. A D is relatively unresponsive to P. TRa = $10 x 4 = $40 TRb = $20 x 3 = $60 Here P doubles and TR rises by 50%. Polaroid’s claim

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Elasticity: Measure of Responsiveness ●Governments, courts, and businesses need to understand the relationship between Qd and P ●If consumers respond sharply to ∆P →D is elastic ♦E.g., graph (a) above ●If consumers are unresponsive to ∆P →D is inelastic ♦E.g., graph (b) above ●Governments, courts, and businesses need to understand the relationship between Qd and P ●If consumers respond sharply to ∆P →D is elastic ♦E.g., graph (a) above ●If consumers are unresponsive to ∆P →D is inelastic ♦E.g., graph (b) above

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Calculation of Elasticity of D ●Price Elasticity of Demand: ♦%  Qd  %  P ●Units problems: cannot judge elasticity by looking at a graph and its slope ♦∆ in units of measurement make graphs appear steeper or flatter when they convey the same info. ●Price Elasticity of Demand: ♦%  Qd  %  P ●Units problems: cannot judge elasticity by looking at a graph and its slope ♦∆ in units of measurement make graphs appear steeper or flatter when they convey the same info.

FIGURE 2(a). Sensitivity of Slope to Units of Measurement 2,0001,5001,000 D D $18 (a) Pizzas per Week Price per Pizza 3,0002, B A Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ↓P by $4 →↑Qd by 80.

FIGURE 2(b). Sensitivity of Slope to Units of Measurement 2,0001,5001,000 D D $18 (b) Slices of Pizza per Week Price per Pizza 2,5003,000 2,8802,240 B Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 1 pizza = 8 slices ↓P by $4 →↑Qd by 640. A

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Calculation of Elasticity of D ●Slope of a curve changes whenever units of measurement changes. ●↓P by $4 → (a) ↑Qd by 80 → (b) ↑Qd by 640 ●Same info is portrayed but slope is flatter (and looks more elastic) when measured in slices. ●Need % ∆ not absolute ∆ (slope) to measure elasticity. ♦E.g., if defense budget doubles, it goes up by 100% whether it is measured in millions or billions of dollars. ●Slope of a curve changes whenever units of measurement changes. ●↓P by $4 → (a) ↑Qd by 80 → (b) ↑Qd by 640 ●Same info is portrayed but slope is flatter (and looks more elastic) when measured in slices. ●Need % ∆ not absolute ∆ (slope) to measure elasticity. ♦E.g., if defense budget doubles, it goes up by 100% whether it is measured in millions or billions of dollars.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Calculation of Elasticity of D ●Percentage problems: ♦Fig. 1(b). Pa = $10 and Qa = 4; Pb = $20 and Qb = 3. ∆Qd = 1, so should we take 1 as a % of 3? → 33.3% or 1 as a % of 4? → 25.0% ●No right answer, so compromise by using the average Qs ●Average of 3 & 4 = 3.5 →%∆Qd = 1/3.5 = 28.6% ●Same is done with price: %∆P = $10/$15 = 66.7% ●Percentage problems: ♦Fig. 1(b). Pa = $10 and Qa = 4; Pb = $20 and Qb = 3. ∆Qd = 1, so should we take 1 as a % of 3? → 33.3% or 1 as a % of 4? → 25.0% ●No right answer, so compromise by using the average Qs ●Average of 3 & 4 = 3.5 →%∆Qd = 1/3.5 = 28.6% ●Same is done with price: %∆P = $10/$15 = 66.7%

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Calculation of Elasticity of D ●Drop (-) sign and use absolute values: ♦P and Qd have a (-) relationship ε = (∆Qd / average of 2 Q’s)  (∆P /average of 2 P’s) ●Polaroid example: ♦Fig. 1(a): ε = (2.5/2.75)  (10/15) = 1.4 ♦Fig. 1(b): ε = (1/3.5)  (10/15) = 0.43 ●Drop (-) sign and use absolute values: ♦P and Qd have a (-) relationship ε = (∆Qd / average of 2 Q’s)  (∆P /average of 2 P’s) ●Polaroid example: ♦Fig. 1(a): ε = (2.5/2.75)  (10/15) = 1.4 ♦Fig. 1(b): ε = (1/3.5)  (10/15) = 0.43

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 3(a). Perfectly Inelastic Demand Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Qd is 90 no matter the P. %∆Qd = 0 Consumer purchases do not respond to ∆P. E.g., goods with very low prices that are used with something else –salt or shoelaces. Or an essential medicine.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 3(b). Perfectly Elastic Demand Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Slight ↑P → ↓Qd to 0. %∆Qd = infinitely large Consumer are completely responsive to ∆P. E.g., Demand for a firm that produces an undifferentiated product.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 3(c). Straight-line Demand Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Slope remains constant but ε is changing. ε (a-b) = (2/3)  (2/5) = 1.67 ε (c-d) = (2/6)  (2/2) = 0.33 Moving down the D curve ε is getting smaller because average Q is rising while average P is falling.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 3(d). Unit-elastic Demand Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Slope is changing but ε is constant and equal to 1. ε (e-f) = (7/10.5)  (10/15) = 1.0 Note: if ε = 1 → D is “unit elastic” if ε > 1 → D is “elastic” if ε < 1 → D is “inelastic”

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Elasticity of Demand and Total Revenue ●Firms want to know whether an ↑P will raise or lower their sales revenues. ♦If D is elastic: ↑P → ↓TR ♦If D is unit elastic: ↑P → TR constant ♦If D is inelastic: ↑P → ↑TR ■Recall: TR = TE = P x Qd ●Firms want to know whether an ↑P will raise or lower their sales revenues. ♦If D is elastic: ↑P → ↓TR ♦If D is unit elastic: ↑P → TR constant ♦If D is inelastic: ↑P → ↑TR ■Recall: TR = TE = P x Qd

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Elasticity of Demand and Total Revenue ●Further examples: ♦If P↓ by 10% and ↑Qd by 10% → D is unit elastic and TR are constant. ♦If P↓ by 10% and ↑Qd by 15% → D is elastic and ↑TR. ♦If P↓ by 10% and ↑Qd by 5% → D is inelastic and ↓TR. ●Further examples: ♦If P↓ by 10% and ↑Qd by 10% → D is unit elastic and TR are constant. ♦If P↓ by 10% and ↑Qd by 15% → D is elastic and ↑TR. ♦If P↓ by 10% and ↑Qd by 5% → D is inelastic and ↓TR.

FIGURE 4. An Elastic Demand Curve 5 12 Quantity Demanded Price $ U W D D R T S V Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Pt. S: TR = $24 = area of 0RST Pt. V: TR = $60 = area of 0WVU D is elastic as ↓P → ↑TR.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. TABLE 1. Estimates of Price Elasticities Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

What Determines Demand Elasticity? 1.Nature of the good: ♦Necessities have very inelastic demands, while luxuries have elastic demands. ♦E.g., ε potatoes = 0.3 and the ε restaurant meals = 1.6. What do these numbers mean? ●10%↑ in P of potatoes → ↓sales of potatoes by 3%. And 10%↑ in P of restaurant meals → ↓restaurant dining by 16%. ♦Comes from the elasticity formula: %  P * ε = %  Qd 1.Nature of the good: ♦Necessities have very inelastic demands, while luxuries have elastic demands. ♦E.g., ε potatoes = 0.3 and the ε restaurant meals = 1.6. What do these numbers mean? ●10%↑ in P of potatoes → ↓sales of potatoes by 3%. And 10%↑ in P of restaurant meals → ↓restaurant dining by 16%. ♦Comes from the elasticity formula: %  P * ε = %  Qd

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. What Determines Demand Elasticity? 2.Availability of a close substitute: ♦If consumers can buy a good substitute for a product whose ↑P, they will readily switch. ■E.g., D for gas is inelastic because you can’t run a car without it. But D for Chevron gas is elastic because Mobile or Shell gas work just as well. 2.Availability of a close substitute: ♦If consumers can buy a good substitute for a product whose ↑P, they will readily switch. ■E.g., D for gas is inelastic because you can’t run a car without it. But D for Chevron gas is elastic because Mobile or Shell gas work just as well.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. What Determines Demand Elasticity? 3.Fraction of Income Absorbed: ♦Very inexpensive items have an inelastic demand. Who will use more salt if the price falls? ♦Very expensive items have elastic demands. Families will buy fewer homes if housing prices increase. 3.Fraction of Income Absorbed: ♦Very inexpensive items have an inelastic demand. Who will use more salt if the price falls? ♦Very expensive items have elastic demands. Families will buy fewer homes if housing prices increase.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. What Determines Demand Elasticity? 4.Passage of Time: ●D for products is more elastic in LR than SR because consumers have more time to adjust their purchases. ♦E.g., suppose recent ↑P gas continues. In SR, consumers may take fewer summer road trips to ↓Qd gas. But in LR, consumers can buy more fuel efficient cars to further ↓Qd gas. 4.Passage of Time: ●D for products is more elastic in LR than SR because consumers have more time to adjust their purchases. ♦E.g., suppose recent ↑P gas continues. In SR, consumers may take fewer summer road trips to ↓Qd gas. But in LR, consumers can buy more fuel efficient cars to further ↓Qd gas.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Elasticity as a General Concept ●Elasticity can be used to measure the responsiveness of anything to anything else. ●Income Elasticity: ♦Income elasticity of D = %  Qd  %  Y ●Price Elasticity of Supply: ♦Price elasticity of S = %  Qs  %  P ●Elasticity can be used to measure the responsiveness of anything to anything else. ●Income Elasticity: ♦Income elasticity of D = %  Qd  %  Y ●Price Elasticity of Supply: ♦Price elasticity of S = %  Qs  %  P

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Cross Elasticity of Demand ●Cross ε d is used to determine whether two goods are compliments or substitutes. It is calculated as: ε cross = (%∆Qd good X)  (%∆P good Y) ●Cross ε d is used to determine whether two goods are compliments or substitutes. It is calculated as: ε cross = (%∆Qd good X)  (%∆P good Y)

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Cross Elasticity of Demand ●Two goods are compliments if an ↑Qd for one good → ↑Qd of the other good. ♦E.g, ketchup and french fries or coffee and cream. ■If ↓P of coffee → ↑purchases of coffee and cream. Cross elasticity for compliments is (-). As ↓P of coffee falls → ↑Qd of cream. ●Two goods are compliments if an ↑Qd for one good → ↑Qd of the other good. ♦E.g, ketchup and french fries or coffee and cream. ■If ↓P of coffee → ↑purchases of coffee and cream. Cross elasticity for compliments is (-). As ↓P of coffee falls → ↑Qd of cream.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Cross Elasticity of Demand ●Two goods are substitutes if an ↑Qd for one good → ↓Qd of the other good. ♦E.g., ice cream and frozen yogurt or cans of salmon and cans of tuna. ■If ↑P of ice cream → ↓purchases of ice cream and ↑purchases of frozen yogurt. Cross elasticity for substitutes is (+). As ↑P of ice cream → ↑Qd of frozen yogurt. ●Cross elasticity is often used in “anti-trust” lawsuits. If firms face strong competition, it is difficult to overcharge customers. A very high and (+) cross elasticity indicates effective competition in a market. ●Two goods are substitutes if an ↑Qd for one good → ↓Qd of the other good. ♦E.g., ice cream and frozen yogurt or cans of salmon and cans of tuna. ■If ↑P of ice cream → ↓purchases of ice cream and ↑purchases of frozen yogurt. Cross elasticity for substitutes is (+). As ↑P of ice cream → ↑Qd of frozen yogurt. ●Cross elasticity is often used in “anti-trust” lawsuits. If firms face strong competition, it is difficult to overcharge customers. A very high and (+) cross elasticity indicates effective competition in a market.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Real-World Application: Polaroid versus Kodak ●In 1989, Polaroid sued Kodak –copyright infringement ●How much could Polaroid’s TR have increased if Kodak did not infringe? ♦Polaroid claimed lots! $9 billion or more –because D was inelastic ♦Kodak claimed neighborhood of $450 million – because D was elastic -(very close to judge’s verdict) ●In 1989, Polaroid sued Kodak –copyright infringement ●How much could Polaroid’s TR have increased if Kodak did not infringe? ♦Polaroid claimed lots! $9 billion or more –because D was inelastic ♦Kodak claimed neighborhood of $450 million – because D was elastic -(very close to judge’s verdict)

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Real-World Application: Polaroid versus Kodak ●Some complications involving Cross ε d ♦During 1980s, period of Kodak’s infringement, ↓P of 35-mm cameras, film, and processing→ ↑Qd 35-mm cameras, film, and processing and ↓Qd instant cameras and film (substitutes). ♦So Kodak’s infringement need not be the only reason for reduced sales of Polaroid’s instant film. ♦If cross ε d was (+) and low → Kodak owes more ♦If cross ε d was (+) and high → Kodak owes less ●Some complications involving Cross ε d ♦During 1980s, period of Kodak’s infringement, ↓P of 35-mm cameras, film, and processing→ ↑Qd 35-mm cameras, film, and processing and ↓Qd instant cameras and film (substitutes). ♦So Kodak’s infringement need not be the only reason for reduced sales of Polaroid’s instant film. ♦If cross ε d was (+) and low → Kodak owes more ♦If cross ε d was (+) and high → Kodak owes less