1. Elasticity of Demand

2. Meaning u Suppose we want to study the effects a price change have on the demand of the goods. u It is practical to do that in terms of percentage. 1% change in price, how many % will demand change? u The study of how many % any one variable changes when another variable changes by one percent is called elasticity.

3. Types of Elasticity of Demand u Price Elasticity of Demand u Income Elasticity of Demand u Cross Elasticity of Demand

4. Price Elasticity of Demand (Ed) u Price elasticity of demand is the degree of responsiveness of quantity demanded of a good to a change in its price. u How many percent demand changes if the price change one percent. u When the percentage change in quantity is less than the percentage change in price, demand is inelastic and a fall in price lowers the total amount spent on the product. u When the percentage change in quantity is greater than the percentage change in price, demand is elastic and a fall in price raises total spending on the product.

5. Calculating

6. Interpreting an Elasticity Estimate If Ed were to = - 0.75, what does it tell us? “For every 1% change in price, Qd will change 0.75% in the opposite direction”

7. Example: P 0 = 8 P 1 = 7 Q 0 = 40 Q 1 = 48 Step 1:  Q = 48 - 40 = 8  P = 7 - 8 = -1 Step 2: Use the formula for Ed.

8. Step 3: Ed = (  Q d /  P) * P 0 / Q 0 = (8 /-1) * (8/40) = - 1.6

9. Step 4: This means that for every 1 % change in price that there is a 1.6 % change in quantity demanded in the opposite direction.

10. Since we know that an Ed = -1.6 means that a 1 % change in price results in a 1.6% change in quantity demanded in the opposite direction, What would a 20% increase in price result in?

11. Step 1: Ed = %  Q / %  P Step 2: %  Q = Ed * %  P Step 3: %  Q = - 1.6 * 20% = -32%

12. What would a 20% increase in the quantity demanded result in? Step 1: Ed = %  Q / %  P Step 2: %  P = 1 / Ed * %  Q

13. Step 3: %  P = (1 / - 1.6) * +20% = - 12.5%

14. Degrees of Price Elasticity of Demand

15. elastic demand Price Quantity D When the % change in quantity > % change in price.

16. inelastic demand Price Quantity D When the % change in quantity < % change in price.

17. perfectly elastic demand u A good with a perfectly flat demand curve has a price elasticity of demand of infinity. This would mean that a small change in price would lead to an infinitely large increase in Demand. u In perfectly competitive markets, if you can charge slightly less than your competitors, and still make a profit, you will find your customers will attempt to buy as much as you can produce.

18. perfectly inelastic demand u To have a situation where the Demand curve is a vertical line is to think of a good where a certain quantity is demanded, regardless of the price. u Heroin would be the closest ''real life'' example of such a good. Addicts will pay anything for their ''fix''.

19. unit elasticity u Unit elasticity is where the percentage change in demand exactly responds to the percentage change in price. u Unit elasticity occurs when a consumer has only a fixed sum of money to spend on a certain product. u If the price per unit of product rises he buys less of it.

20. u Example. Let us suppose that price of a good falls from 10 $ per unit to 9 $ per unit in a day. The decline in price causes the quantity of the good demanded to increase from 125 units to 150 units per day. Calculate Ed Interpret the answer Draw the curve

21. Income Elasticity of Demand (E I ) u When there is a change in the level of income of a consumer, there is a change in the quantity demanded of a good, other factors remaining the same. u The degree of change or responsiveness of quantity demanded of a good to a change in the income of a consumer is called income elasticity of demand.

22. Calculating

23. Interpreting an Elasticity Estimate If E I were to = - 0.8, what does it tell us? “For every 1% change in income, Qd will change 0.8% in the opposite direction”. We also would know that goods is inferior goods.

24. Example: u I 0 = 4000$/month and purchases 6 kg of beef per month. I 1 = 6000$/month and purchases 8 kg of beef per month. u ΔQ = 8 - 6 = 2 ΔI = 6000 - 4000 = 2000 u Q 0 = 6 ; I 0 = 4000 u E = ΔQ / ΔI x I 0 / Q 0 = 2 / 200 x 4000 / 6 = 0.66 u The income elasticity is 0.66. It is necessities good

25. Goods are grouped depending on Income Elasticity u Normal Goods (E I >0) Luxury Goods (E I >= 1) Necessities (0 < E I < 1) u Inferior Goods (E I < 0)

26. Engel Curve: Shows the relationship between quantity demanded and disposable income given a constant price.

27. Engel Curve: Normal Good Disposable Income Qd/ut Engel Curve for a Normal Good E I > 0 Normal Good is one buy more if their income increase

28. Luxury Goods u Luxury Goods are Normal Goods but they have an E I >= 1 u Luxury Goods: If income increases, one increases consumption by more percentages than the income. u Quantity demanded is very sensitive to changes in disposable income

29. “Necessities” u “Necessities” are Normal Goods but 0 < E I < 1 u Necessities good: if income increases, one buys more of it, but not as many percentages more as the increase in income. u Quantity demand is not very sensitive to changes in disposable income

30. Engel Curve: Inferior Good Disposable Income Qd/ut Engel Curve for an Inferior Good E I < 0 Inferior good: a good one buys less if income increase.

31. u Example. Let us suppose that income of a person falls from 100 $ per unit to 90 $ per month. The decline in income causes the quantity of the good demanded to decrease from 50 units to 40 units per month. Calculate E Interpret the answer

32. Cross-Price Elasticity of Demand (E cp ) u The concept of cross elasticity of demand is used for measuring the responsiveness of quantity demanded of a good to changes in the price of related goods. u Cross elasticity of demand is defined as the percentage change in the demand of one good as a result of the percentage change in the price of another good. u The numerical value of cross elasticity depends on whether the two goods in question are substitutes, complements or unrelated.

33. Calculating u If we let E 12 = the cross price elasticity for good 1 as the price of commodity 2 changes, ∆Q 1 = the change in quantity demanded for commodity 1, and ∆P 2 = the change in price of commodity 2

34. Cross-Price Elasticity  E cp > 0  Substitute  E cp < 0  Compliment  E cp = 0  Independent

35. Example: The Cross-Price Elasticity of Beef and Pork would be calculated as: E cp, Beef, Pork = %  Q Beef / %  P Pork

36. Example The Cross-Price Elasticity of Pork and Beef would be calculated as: E cp, Pork, Beef = %  Q Pork / %  P Beef

37. Interpretation If the E cp, Pork, Beef = + 0.65 Then for every 1% increase in the price of beef, the Qd of pork would increase 0.65%. We also would know that pork and beef are substitutes

38. u Example. Price of chicken decrease from 15000 R to 11000 R per kg. The decline in price of chicken causes the quantity of fish demanded to decrease from 20 kg/m to 10 kg/m. Calculate E Interpret the answer

39. Features of price elasticity of demand FeatureElastic goodsInelastic goods PED valueGreater than 1Less than 1 A rise in price means A larger fall in demand A smaller fall in demand Slope of demand curveFlatSteep Number of substitutesManyFew Type of goodLuxuryNecessity Price of goodExpensiveCheap ExampleCarsGasoline

40. What government like to tax u Governments like to tax goods with inelastic demand curves. u Demand for petrol is inelastic: petrol has no close substitute. Motorists can reduce their usage of their car by driving fewer kilometers, but can not fill their ''tank'' with water! Motorists can convert their cars to run on liquified petroleum gas (which is considerably cheaper than petrol), but the conversion cost is high. u Other goods with high levels of taxation include alcohol and cigarettes: both very inelastic.

41. Practical Importance of Elasticity of Demand u Importance in taxation policy u Price discrimination by monopolist u Importance to businessmen u Help to trade unions u Use in international trade u Determination of rate of foreign exchange u Guideline to the producers u Use in factor pricing