1. Lecture notes Prepared by Anton Ljutic

2. © 2004 McGraw–Hill Ryerson Limited Elasticity CHAPTER FOUR

3. © 2004 McGraw–Hill Ryerson Limited This Chapter Will Enable You to: Understand the concept of price elasticity of demand. Use a simple formula to calculate elasticity. Understand the relationship between the slope of a demand curve and elasticity. Use real world examples to demonstrate that the concept of elasticity is a powerful tool. Apply the concept of elasticity to supply, income, and to price changes of related products

4. © 2004 McGraw–Hill Ryerson Limited Price Elasticity of Demand It is the responsiveness of quantity demanded to a change in price It is calculated by: –%  in quantity demanded divided by the %  in price or (%  Qd / average Qd) x 100 (%  P / average P) x 100

5. © 2004 McGraw–Hill Ryerson Limited Interpretation of Price Elasticity of Demand Elasticity coefficient –a number that measures the responsiveness of quantity demanded to a change in price Since price and quantity always move in the opposite direction, price elasticity of demand will always be a negative number We ignore the negative sign and say that price elasticity of demand is between zero and infinity

6. © 2004 McGraw–Hill Ryerson Limited Price Elasticity of Demand and Total Revenue Total revenue (TR) –The total amount of income a firm receives from its sales –TR equals price multiplied by quantity of the product sold (TR = P x Q) Elastic demand –Quantity demanded is quite responsive to a change in price –If demand is elastic, price and total revenue move in opposite directions

7. © 2004 McGraw–Hill Ryerson Limited Price Elasticity of Demand and Total Revenue Inelastic demand –Quantity demanded is not very responsive to a change in price –If demand is inelastic, price and total revenue move in the same direction Unitary elasticity –The point where percentage change in quantity demanded is exactly equal to the percentage change in price –The elasticity coefficient is equal to one

8. © 2004 McGraw–Hill Ryerson Limited Determinants of Price Elasticity of Demand Availability of substitutes –The more substitutes there are available, the more elastic demand is The percentage of household income spent on the commodity –The larger the percentage of one’s income that is spent on a particular commodity, the more elastic is the demand for that commodity The amount of time that has elapsed since the price change –The elasticity of demand tends to be greater the longer the time period involved

9. © 2004 McGraw–Hill Ryerson Limited Elasticity Versus Slope Slope –The slope of any straight line is equal to rise over run –The slope of a straight line, downward sloping, demand curve remains the same along each point on the curve Elasticity –Elasticity does not remain constant along a straight line, downward sloping, demand curve –Elasticity can be measured for very small price and quantity changes

10. © 2004 McGraw–Hill Ryerson Limited Elasticity Along a Straight-Line Demand Curve The upper half of any straight-line demand curve is elastic, and the lower half is inelastic Elasticity and slope are different The upper half of any straight-line demand curve is elastic, and the lower half is inelastic Elasticity and slope are different P Q D Elastic Inelastic Unitary Figure 4.3

11. © 2004 McGraw–Hill Ryerson Limited Elasticity and Total Revenue P Q D Elastic Inelastic Unitary Total Revenue Maximum TR Figure 4.4

12. © 2004 McGraw–Hill Ryerson Limited Elasticity and Sales Taxes D S1S1 StSt 8 8.75 10 P Q $2 810 A sales tax of $2 results in a vertical shift of the supply curve upward by $2. The consumer pays 75 cents of the tax and the producer pays $1.25. The incidence of tax depends on elasticity A sales tax of $2 results in a vertical shift of the supply curve upward by $2. The consumer pays 75 cents of the tax and the producer pays $1.25. The incidence of tax depends on elasticity Figure 4.7

13. © 2004 McGraw–Hill Ryerson Limited Elasticity of Supply The responsiveness of quantity supplied to a change in price It will always be a positive number It is calculated using the formula: %  in quantity supplied %  in price

14. © 2004 McGraw–Hill Ryerson Limited Elasticity of Supply in Three Time Periods P Q S1S1 Market period. Perfectly inelastic supply P Q S2S2 P Q S3 Short run Inelastic supply Short run Inelastic supply Long run Elastic supply Long run Elastic supply Figure 4.13

15. © 2004 McGraw–Hill Ryerson Limited Income Elasticity (I) The responsiveness of quantity demanded to a change in income It can be positive or negative It is calculated using the formula: %  in quantity / %  in income

16. © 2004 McGraw–Hill Ryerson Limited Income Elasticity (II) Income elastic –If income elasticity is greater than one –Usually associated with luxuries Income inelastic –If income elasticity is between zero and one –Usually associated with necessities Inferior goods –Bought in lesser amount when income rises –Income elasticity will be a negative number

17. © 2004 McGraw–Hill Ryerson Limited Cross Elasticity of Demand The responsiveness of the change in the quantity demanded of a product A to a change in the price of product B It is calculated using the formula: Substitutes have a positive value for cross elasticity Complements have a negative value for cross elasticity %  in quantity demanded of product A %  in price of product B

18. © 2004 McGraw–Hill Ryerson Limited Chapter Summary: What to Study and Remember the concept of price elasticity of demand. the simple formula to calculate elasticity. the relationship between the slope of a demand curve and elasticity. real world examples that demonstrate that the concept of elasticity is a powerful tool. application of the concept of elasticity to supply, income, and to price changes of related products