5 5 Demand and Elasticity A high cross elasticity of demand [between two goods indicates that they] compete in the same market. [This can prevent a supplier of one of the products] from possessing monopoly power over price. U.S. SUPREME COURT, DUPONT CELLOPHANE DECISION, 1956 Demand and Elasticity A high cross elasticity of demand [between two goods indicates that they] compete in the same market. [This can prevent a supplier of one of the products] from possessing monopoly power over price. U.S. SUPREME COURT, DUPONT CELLOPHANE DECISION, 1956

●Elasticity: The Measure of Responsiveness ●Price Elasticity of Demand: Its Effect on Total Revenue and Total Expenditure ●What Determines Demand Elasticity? ●Elasticity as a General Concept ●Changes in Demand: Movements Along the Demand Curve vs Shifts in the Demand Curve ●Elasticity: The Measure of Responsiveness ●Price Elasticity of Demand: Its Effect on Total Revenue and Total Expenditure ●What Determines Demand Elasticity? ●Elasticity as a General Concept ●Changes in Demand: Movements Along the Demand Curve vs Shifts in the Demand Curve Contents Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

●The Time Period of the Demand Curve and Economic Decision Making ●Real-World Application: Polaroid versus Kodak ●Appendix: How to Find a Legitimate Demand Curve from the Statistics ●The Time Period of the Demand Curve and Economic Decision Making ●Real-World Application: Polaroid versus Kodak ●Appendix: How to Find a Legitimate Demand Curve from the Statistics Contents (continued) Copyright© 2003 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 = %  quantity %  price Elasticity: The Measure of Responsiveness

FIGURE 5-1(a) The Hypothetical Demand Curves for Film $20 Quantity Demanded Price per Package D S D S B A Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 5-1(b) The Hypothetical Demand Curves for Film $20 Price per Package Quantity Demanded D f D f b a Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Elasticity: The Measure of Responsiveness ●Elastic demand = price elasticity of demand > 1 ●Inelastic demand = price elasticity of demand < 1 ●Elastic demand = price elasticity of demand > 1 ●Inelastic demand = price elasticity of demand < 1

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Elasticity: The Measure of Responsiveness ●Equation for Price Elasticity of Demand ♦%  Quantity  %  Price ♦[(Q 1 - Q 0 ) / (average of Q 1 and Q 0 )]  [(P 1 - P 0 ) / (average of P 1 and P 0 )] ●Equation for Price Elasticity of Demand ♦%  Quantity  %  Price ♦[(Q 1 - Q 0 ) / (average of Q 1 and Q 0 )]  [(P 1 - P 0 ) / (average of P 1 and P 0 )]

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Percentages calculated in terms of the averages of the prices and quantities ●Minus sign dropped ●Percentages calculated in terms of the averages of the prices and quantities ●Minus sign dropped Elasticity: The Measure of Responsiveness

FIGURE 5-2a 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© 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 5-2b 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 A B Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

●The Relationship between Elasticity and Slope ♦Slope depends upon specific units while elasticity does not. ♦If a demand curve has a constant slope (straight-line), the elasticity is not constant. ♦If a demand curve has a constant elasticity (unit elastic), the slope is not constant. ●The Relationship between Elasticity and Slope ♦Slope depends upon specific units while elasticity does not. ♦If a demand curve has a constant slope (straight-line), the elasticity is not constant. ♦If a demand curve has a constant elasticity (unit elastic), the slope is not constant. Price Elasticity of Demand and the Shapes of Demand Curves Copyright© 2003 Southwestern/Thomson Learning All rights reserved.

TABLE 5-1 Estimates of Price Elasticities Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 5-3 Demand Curves with Different Elasticities Price C B A C' A' B' $ Straight- line demand curve (c) Quantity Demanded 0 D D $0.75 DD “Perfectly elastic” demand curve (b) Quantity Demanded Price 0 “Perfectly inelastic” demand curve (a) Quantity Demanded Price D D 900 Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 5-3(d) Unit Elastic Demand Curve Unit- elastic demand curve U'147 D D $ Quantity Demanded Price 0 (d) S T U Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Price Elasticity of Demand ●  price   revenues if the demand curve is elastic ●  price   revenues if the demand curve is inelastic ●  price  0  revenues if the demand curve is unit elastic ●  price   revenues if the demand curve is elastic ●  price   revenues if the demand curve is inelastic ●  price  0  revenues if the demand curve is unit elastic

FIGURE 5-4 An Elastic Demand Curve 5 12 Quantity Demanded Price $ U W D D R T S V Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

What Determines Demand Elasticity? ●Nature of the good ●Availability of close substitutes ●Fraction of income absorbed ●Passage of time ●Nature of the good ●Availability of close substitutes ●Fraction of income absorbed ●Passage of time

Copyright© 2003 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 demand = %  quantity demanded  %  income ●Price Elasticity of Supply ♦Price elasticity of supply = %  quantity of supply  %  price ●Elasticity can be used to measure the responsiveness of anything to anything else. ●Income Elasticity ♦Income elasticity of demand = %  quantity demanded  %  income ●Price Elasticity of Supply ♦Price elasticity of supply = %  quantity of supply  %  price

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Elasticity as a General Concept ●Cross Elasticity of Demand ♦Cross elasticity of demand (for product X to a change in the price of product Y) = %  quantity demanded of X  %  price of Y ♦If two goods are substitutes (complements), their cross elasticity of demand is positive (negative). ●Cross Elasticity of Demand ♦Cross elasticity of demand (for product X to a change in the price of product Y) = %  quantity demanded of X  %  price of Y ♦If two goods are substitutes (complements), their cross elasticity of demand is positive (negative).

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Changes in Demand: Movements Along vs Shifts ●  price  movement along the demand curve ●  any other factor that affects spending decisions  shift between demand curves ●  price  movement along the demand curve ●  any other factor that affects spending decisions  shift between demand curves

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Changes in Demand: Movements Along vs Shifts ●Demand Shifters ♦Consumer incomes rise ♦Tastes change in favor of the good ♦The price of substitute goods ♦The price of complementary goods ●Demand Shifters ♦Consumer incomes rise ♦Tastes change in favor of the good ♦The price of substitute goods ♦The price of complementary goods

FIGURE 5-5 Shifts in a Demand Curve D 0 D 0 (b) Quantity of Sweaters Price D 1 D 1 S D 0 D 0 (a) Quantity of Sweaters in Thousands Price $ R UT D 2 D 2 Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

The Demand Curve and Economic Decision Making ●The demand curve shows the quantity of demand buyers would hypothetically purchase at different prices during the same time period. ●It does not show the quantity actually bought at different prices at different times. ●The demand curve shows the quantity of demand buyers would hypothetically purchase at different prices during the same time period. ●It does not show the quantity actually bought at different prices at different times.

Expected Demand at Various Six-Month Prices Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Real-World Application: Polaroid versus Kodak ●In 1989, Polaroid vs Kodak—copyright infringement ●Key issue: how much profit Polaroid lost? ●Price elasticity of demand ♦growth in instant camera sales due to ■Kodak competition (lower price) OR ■Kodak’s reputation (Polaroid might have benefited from Kodak increasing potential number of customers) ●In 1989, Polaroid vs Kodak—copyright infringement ●Key issue: how much profit Polaroid lost? ●Price elasticity of demand ♦growth in instant camera sales due to ■Kodak competition (lower price) OR ■Kodak’s reputation (Polaroid might have benefited from Kodak increasing potential number of customers)

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Real-World Application: Polaroid versus Kodak ●Cross elasticity of demand ♦After 1980, decline in sales due to ■decreasing cost of 35-mm photography ●then Kodak not to blame ■Kodak’s infringement ●Kodak damages due increase ●Cross elasticity of demand ♦After 1980, decline in sales due to ■decreasing cost of 35-mm photography ●then Kodak not to blame ■Kodak’s infringement ●Kodak damages due increase

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Real-World Application: Polaroid versus Kodak ●Third issue: How much could Polaroid’s total revenue increased if Kodak not infringe? ♦Polaroid claimed lots! $9 billion or more ♦Kodak claimed neighborhood of $450 million (very close to judge’s verdict) ●Third issue: How much could Polaroid’s total revenue increased if Kodak not infringe? ♦Polaroid claimed lots! $9 billion or more ♦Kodak claimed neighborhood of $450 million (very close to judge’s verdict)

Appendix: How Can We Find a Legitimate Demand Curve from the Statistics? Appendix: How Can We Find a Legitimate Demand Curve from the Statistics?

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Finding a Legitimate Demand Curve ●In the real world we usually only observe historical price-quantity combinations, so it is often difficult to distinguish between movement along a demand curve and shifts between demand curves.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Finding a Legitimate Demand Curve ●Prices and quantities observed at different times in the real world may result from shifting demand curves and not movement along a demand curve.

TABLE 5-2 Historical Data on Price and Quantity Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Finding a Legitimate Demand Curve ●Simply connecting the points may not give a good estimate of a demand curve.

FIGURE 5-6 Plot of Historical Data on Price and Quantity Average Price Quantity Demanded in Thousands $8.20 T T S April Jan. March R May Feb. Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 5-7 Plot of Historical Data and True Demand Curves T T 98 MM F F Average Price Quantity Demanded in Thousands $8.20 J J Jan. March Feb. R W S Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

TABLE 5-3 Annual Rainfall in St. Louis, Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 5-8 Legitimate Demand Curve Est. from Statistical Data S00 S S93 S S96 S 1994 S95 S D D Price Quantity of Umbrellas Sold Copyright© 2003 South-Western/Thomson Learning. All rights reserved.