1. Ch. 6: Price Elasticity of Demand and its Applications Econ 2420

2. 1.Price Elasticity of demand  a measure of the responsiveness of qt. demanded to a given percentage change in price. Ep. = [ % change in qt ]/ [ % change in price ]

3. 2. Examples a.As a result of a rise in the price of cigarette by 30%, sales of cigarette drops by 15%. What is the Ep. ? Ep = -.15/.30 = -.5 Ep = -.5 means that a 1% increase in price reduces sales by only 0.5%. How sensitive are cigarette sales to the price increase? Not very sensitive=> Inelastic

4. b. As a result of a 20% discount on Spring shirts, sales of Spring shirts increase by 40%. What is the Ep. ? Ep. =.4/-.2 = -2 This means that 1% decrease in price resulted in an increase in sales by 2%. How sensitive are Spring shirt sales to the price discount ? Very sensitive=> or Elastic

5. 3. Measures of Price Elasticity of Demand a. Point Price Elasticity : Ep = [% change in qt]/[% change in price] = [(change in qt/qt)]/(change in price/price) = [(change in qt /change price)] x (price/qt) Suppose the price of ice cream increases from $2.00 to $2.20 and the quantity demanded falls from 10 to 8. Find the point Ep ? Ep = [Δq/ Δ p] x [(p/q)] Ep= [-2/.2]/[2/10]= -2 = 2

6. b. Midpoint or Average price elasticity of demand : Ep = (%change in qt)/(%change in price) = ΔQ/ ΔP x (p 1 +p 2 )/ Q 1 +Q 2 ) = [2/.2] x [4.20/18]= 2.33 Note: The demand for ice cream is price elastic over this price range (same for price change) 4. Ranges of price elasticity of demand *Elastic demand Ep > 1 *Unit elastic demand Ep = 1 *Inelastic demand Ep < 1 *Perfectly elastic Ep =  *Perfectly inelastic Ep = 0

7. 5. Relationship of Total Revenue and Price Elasticity: Should you raise or lower to increase total revenue? The demand schedule for sugar

8. Generalizations Note: Price elasticity of demand is used for pricing strategy When the price elasticity of demand >1, a price increase reduces total revenue and a price decrease increases total revenue (Lower price). When the elasticity of demand with elasticity =1, a change in the price does not affect total revenue (Don’t change price). When the price elasticity of demand < 1, a price increase raises total revenue and a price decrease reduces total revenue (Raise price).

9. 6. Determinants of price Elasticity of demand.Necessities (less elastic) vs luxuries (more elastic) e.g. >demand for physician service is price inelastic >the demand for vacation travel more elastic than for business travel.Availability of close substitutes =>more substitutes=> more elastic; (butter or margarine) few substitutes=> less elastic (Gasoline).Definition of the market –narrow (ice cream) =>more elastic vs broad (food)=> less elastic).Time horizon –short-run (less elastic) vs long-run (more elastic) Example: Gasoline

10. 7a. Income Elasticity of demand - the responsiveness of qt. demanded to a given percentage change in income E I =[ (%change in qt. demanded)]/(% change in income) Examples: As result of a 5% increase in consumers’ income, car sales increase by 7.5%. What is the E I ? E I = 0.075/.05 = 1.5 This means that the demand for cars is income elastic.

11. As a result of an increase in income by 5%, the demand for food increase by 2.5%. What is the E I ? E I = 0.025/0.05 = 0.5 This means that the demand for food is income inelastic because it is less than 1.

12. Average Income Elasticity formula E I = [ΔQ/(Q 1+ Q 2 )/2]/ Δ I/(I 1 +I 2 )/2 (See handout, question # 2) Notice that E I > 0 for normal goods and E I < 0 for inferior goods.

13. b. Cross price elasticity of demand - the responsiveness of qt demanded of product X as a result of a given percentage change in the price of product Y. Exy = (%change in qt. of X)/(%change in Py) Example: As a result of an 8% increase in the price of Ford Taurus car(Y), the qt demanded(X) of Toyota Camry increases by 12%. What is the Exy for Camry? Exy = 0.12/0.08 = 1.2 This means that Ford Taurus and Toyota Camry are cross-price elastic.

14. Midpoint or Average cross price elasticity formula Exy=[(ΔQx)/(Qx 1 +Qx 2 )]/[(ΔPy)/ Py 1 +Py2] (See # 3 handout) Notice that Exy > 0 for substitute goods and Exy < 0 for complementary goods.

15. 8. Price elasticity of supply is the responsiveness of qt supplied to a given percentage change in price. Es = (%qt supplied)/(%change in price) Example : As result of an increase in the price of wheat by 20%, wheat farmers increase the qt. of wheat supplied by 30%. What is Es =.3/.2=1.5 Is supply price elastic? Yes, because Es>1.