Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 1 Chapter 4 Demand Elasticity

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 2 The economic concept of elasticity  Elasticity: the percentage change in one variable relative to a percentage change in another.

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 3 Price elasticity of demand  Price elasticity of demand: the percentage change in quantity demanded caused by a 1 percent change in price

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 4 Price elasticity of demand  Arc elasticity: elasticity which is measured over a discrete interval of a curve E p = coefficient of arc price elasticity Q 1 = original quantity demanded Q 2 = new quantity demanded P 1 = original price P 2 = new price

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 5 Price elasticity of demand  Point elasticity: elasticity measured at a given point of a demand (or a supply) curve

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 6 Price elasticity of demand The point elasticity of a linear demand function can be expressed as:

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 7 Price elasticity of demand  Elasticity varies along a linear demand curve

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 8 Price elasticity of demand  Categories of elasticity Relative elasticity of demand: E p > 1 Relative inelasticity of demand: 0 < E p < 1 Unitary elasticity of demand: E p = 1 Perfect elasticity: E p = ∞ Perfect inelasticity: E p = 0

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 9 Price elasticity of demand  Factors affecting demand elasticity ease of substitution proportion of total expenditures durability of product  possibility of postponing purchase  possibility of repair  used product market length of time period

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 10 Price elasticity of demand  A long-run demand curve will generally be more elastic than a short-run curve As the time period lengthens consumers find ways to adjust to the price change, via substitution or shifting consumption

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 11 Price elasticity of demand  The relationship between price and revenue depends on elasticity Why? By itself, a price fall will reduce receipts … BUT because the demand curve is downward sloping, the drop in price will also increase quantity demanded  Q: which effect will be stronger?

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 12 Price elasticity of demand  As price decreases revenue rises when demand is elastic revenue falls when it is inelastic revenue reaches it peak if elasticity =1  the lower chart shows the effect of elasticity on total revenue

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 13 Price elasticity of demand  Marginal revenue: the change in total revenue resulting from changing quantity by one unit

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 14 Price elasticity of demand  marginal revenue curve is twice as steep as the demand curve

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 15 Price elasticity of demand  at the point where marginal revenue crosses the X-axis, the demand curve is unitary elastic and total revenue reaches a maximum

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 16 Price elasticity of demand  Examples: some real world elasticities coffee: short run -0.2, long run kitchen and household appliances: meals at restaurants: airline travel in U.S.: beer: -0.84, Wine: white pan bread:-0.69 cigarettes: short run -0.4, long run -0.6 wine imports: crude oil: internet services: -0.6/-0.7

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 17 Cross-elasticity of demand  Cross-elasticity of demand: the percentage change in quantity consumed of one product as a result of a 1 percent change in the price of a related product

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 18 Cross-elasticity of demand  Arc cross-elasticity

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 19 Cross-elasticity of demand  Point cross-elasticity

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 20 Cross-elasticity of demand  The sign of cross-elasticity for substitutes is positive The sign of cross-elasticity for complements is negative Two products are considered good substitutes or complements when the coefficient is larger than 0.5 (in ab. value)

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 21 Income elasticity  Income elasticity of demand: the percentage change in quantity demanded caused by a 1 percent change in income Y is shorthand for income

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 22 Income elasticity  Arc income elasticity

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 23 Income elasticity  Categories of income elasticity superior goods: E Y > 1 normal goods: 0 ≤ E Y ≤ 1 inferior goods: E Y < 0

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 24 Other demand elasticities  Examples: elasticity is encountered every time a change in some variable affects demand advertising expenditure interest rates population size

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 25 Elasticity of supply  Price elasticity of supply: the percentage change in quantity supplied as a result of a 1 percent change in price The coefficient of supply elasticity is a normally a positive number

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 26 Elasticity of supply  Arc elasticity of supply

Chapter FourCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 27 Elasticity of supply  When the supply curve is more elastic, the effect of a change in demand will be greater on quantity than on the price of the product When the supply curve is less elastic, a change in demand will have a greater effect on price than on quantity