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Elasticity 04 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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Price Elasticity of Demand Measures buyers responsiveness to price changes Elastic demand Sensitive to price changes Large change in quantity Inelastic demand Insensitive to price changes Small change in quantity LO1 4-2

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Price Elasticity of Demand Formula Formula for price elasticity of demand E d = LO1 Percentage Change in Quantity Demanded of Product X Percentage Change in Price of Product X 4-3

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Price Elasticity of Demand Formula Use the midpoint formula Ensures consistent results Change in quantity Change in price Sum of quantities/2 Sum of prices/2 LO1 E d = ÷ 4-4

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Price Elasticity of Demand Formula Use percentages Unit free measure Compare responsiveness across products Eliminate the minus sign Easier to compare elasticities LO1 4-5

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Interpretation of Elasticity of Demand E d > 1 demand is elastic E d = 1 demand is unit elastic E d < 1 demand is inelastic Extreme cases Perfectly inelastic Perfectly elastic LO1 4-6

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Extreme Cases LO1 D1D1 P Perfectly inelastic demand (Ed = 0) 0 4-7

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Extreme Cases LO1 Perfectly elastic demand P D2D2 Perfectly elastic demand (Ed = ) 0 4-8

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Total Revenue Test Total Revenue = Price X Quantity Inelastic demand P and TR move in the same direction Elastic demand P and TR move in opposite directions LO2 4-9

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Total Revenue Test LO2 $3 2 1 0 10 20 30 40 Q P a b D1D1 Lower price and elastic demand Blue gain exceeds orange loss 4-10

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Total Revenue Test LO2 $4 3 2 1 0 10 20 Q P c d D2D2 Lower price and inelastic demand Orange loss exceeds blue gain 4-11

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Total Revenue Test LO2 $3 2 1 0 10 20 30 Q P e f D3D3 Lower price and unit elastic demand Blue gain equals orange loss 4-12

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Total Revenue Test LO2 Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity Coefficient and the Total-Revenue Test (1) Total Quantity of Tickets Demanded per Week, Thousands (2) Price per Ticket (3) Elasticity Coefficient (E d ) (4) Total Revenue (1) X (2) (5) Total Revenue Test 1$8$8,000 275.0014,000Elastic 362.6018,000Elastic 451.5720,000Elastic 541.0020,000Unit Elastic 630.6418,000Inelastic 720.3814,000Inelastic 810.20 8,000Inelastic 4-13

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Elasticity and Total Revenue LO2 012345678 012345678 Quantity Demanded Price Total Revenue (Thousands of Dollars) $20 18 16 14 12 10 8 6 4 2 $8 7 6 5 4 3 2 1 a b c d e f g h Elastic E d > 1 Unit Elastic E d = 1 Inelastic E d < 1 D TR 4-14

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Summary of Price Elasticity of Demand LO2 Price Elasticity of Demand: A Summary Absolute Value of Elasticity CoefficientDemand Is:Description Impact on Total Revenue of a: Price IncreasePrice Decrease Greater than 1 (E d > 1) Elastic or relatively elastic Q d changes by a larger percentage than does price Total Revenue decreases Total Revenue increases Equal to 1 (E d = 1) Unit or unitary elastic Q d changes by the same percentage as does price Total revenue is unchanged Total revenue is unchanged Less than 1 (E d < 1) Inelastic or relatively inelastic Q d changes by a smaller percentage than does price Total revenue increases Total revenue decreases 4-15

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Determinants of Elasticity of Demand Substitutability More substitutes, demand is more elastic Proportion of Income Higher proportion of income, demand is more elastic Luxuries vs. Necessities Luxury goods, demand is more elastic Time More time available, demand is more elastic LO1 4-16

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Price Elasticity of Demand LO1 Selected Price Elasticities of Demand Product or Service Price Elasticity of Demand (E d )Product or Service Price Elasticity of Demand (E d ) Newspapers.10Milk.63 Electricity (household).13Household appliances.63 Bread.15Liquor.70 MLB Tickets.23Movies.87 Telephone Service.26Beer.90 Cigarettes.25Shoes.91 Sugar.30Motor vehicles1.14 Medical Care.31Beef1.27 Eggs.32China, glassware1.54 Legal Services.37Residential land1.60 Automobile repair.40Restaurant meals2.27 Clothing.49Lamb and mutton2.65 Gasoline.60Fresh peas2.83 4-17

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Applications of E d Large Crop Yields Inelastic demand, lower total revenue Excise Taxes Inelastic demand, more total revenue Decriminalization of Illegal Drugs Inelastic demand, more total revenue LO1 4-18

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Price Elasticity of Supply Measures sellers responsiveness to price changes Elastic supply, producers are responsive to price changes Inelastic supply, producers are not responsive to price changes LO3 4-19

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Price Elasticity of Supply Formula to compute elasticity E s > 1 supply is elastic E s < 1 supply is inelastic LO3 Percentage Change in Quantity Supplied of Product X Percentage Change in Price of Product X E s = 4-20

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Price Elasticity of Supply Time is primary determinant of elasticity of supply Time periods considered Market period Short Run Long Run LO3 4-21

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Elasticity of Supply: The Market Period LO3 P Q Perfectly inelastic supply D1D1 D2D2 SmSm Q0Q0 PmPm P0P0 4-22

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Elasticity of Supply: The Short Run LO3 Supply is more elastic than in market period P Q D1D1 D2D2 SsSs Q0Q0 PsPs P0P0 QsQs 4-23

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Elasticity of Supply: The Long Run LO3 Supply is even more elastic than in the short run P Q D1D1 D2D2 SlSl Q0Q0 PlPl P0P0 QlQl 4-24

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Applications of Elasticity of Supply Antiques Inelastic supply Reproductions More elastic supply Volatile gold prices Inelastic supply LO3 4-25

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Cross Elasticity of Demand Measures responsiveness of sales to change in the price of another good Substitutes – positive sign Complements – negative sign Independent goods - zero LO4 Percentage change in quantity demanded of product X E x,y = Percentage change in price of product Y 4-26

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Cross Elasticity of Demand Application Change the price? Allow a merger? LO4 4-27

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Income Elasticity of Demand Measures responsiveness of buyers to changes in income Normal goods – positive sign Inferior goods – negative sign LO4 Percentage change in quantity demanded E i = Percentage change in income 4-28

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Income Elasticity Insights High income elasticities Most affected by a recession Low or negative income Least affected by a recession LO4 4-29

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E x,y and E i LO4 Cross and Income Elasticities of Demand Value of CoefficientDescriptionType of Good(s) Cross elasticity: Positive (E wz > 0) Negative (E xy < 0) Quantity demanded of W changes in same direction as change in price of Z Quantity demanded of X changes in opposite direction from change in price of Y Substitutes Complements Income elasticity: Positive (E i >0) Negative (E i <0) Quantity demanded of the product changes in same direction as change in income Quantity demanded of the product changes in opposite direction from change in income Normal or superior Inferior 4-30

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Elasticity and Pricing Power Charge different prices based on price elasticities Examples: Business air travelers Adult vs. child 4-31

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