1. Chapter 4 Elasticities McGraw-Hill/IrwinCopyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2. 2 Learning Objectives What is price elasticity of demand? What are categories of demand elasticity and what factors influence them? What is the relationship between demand elasticity and total revenue? What is income elasticity of demand? What is cross elasticity of demand? What is price elasticity of supply? What are categories of supply elasticity and what factors influence them? 4-2

3. 3 Price Elasticity of Demand Price elasticity of demand measures consumers’ responsiveness to price changes. How much quantity demanded will change if price changes. Ignore the negative sign since it’s always there. 4-3

4. 4 Categories of Demand Elasticity If price elasticity of demand >1: % change in quantity demanded > % change in price Elastic demand If price elasticity of demand <1: % change in quantity demanded < % change in price Inelastic demand If price elasticity of demand =1: % change in quantity demanded = % change in price Unit elastic demand 4-4

5. 5 Elastic Demand Curve A small percentage change in price: A large percentage change in quantity. The price elasticity of demand between Point A and Point B is high. Price elasticity of demand > 1. Point A Point B $8 $7 220100 Price Quantity Demand 4-5

6. 6 Inelastic Demand Curve Point A Point B Quantity100110 $10 $4 Price A large percentage change in price: A small percentage change in quantity. The price elasticity of demand between Point A and Point B is low. Price elasticity of demand < 1. 4-6

7. 7 Perfectly Inelastic Demand Curve Quantity Price Quantity demanded is constant and does not respond to price changes. Price elasticity of demand = 0. This demand curve violates the Law of Demand. Unrealistic demand curve. 4-7

8. 8 Perfectly Elastic Demand Curve Quantity Price Quantity demanded is extremely responsive to price changes. The smallest price change causes infinite change in quantity demanded. Price elasticity of demand = infinity. $4 120 4-8

9. 9 Unit Elastic Demand Curve Any percentage change in price causes the same percentage change in quantity demanded. Price elasticity of demand = 1. Elasticity is the same but not the slope along the demand curve. 4-9

10. 10 Elasticity Along a Straight Line Demand Curve At the top of demand curve: When the quantity is near zero a small absolute increase in quantity demanded means a huge percentage increase in quantity demanded. The price elasticity of demand is huge. At the bottom of demand curve: When price is near zero a small absolute increase in price means a huge. percentage increase in price. The price elasticity of demand is tiny. Elasticity =infinity Elasticity =0 Price = 0 Quantity = 0 Quantity Demand Price 4-10

11. 11 Do You Know? If a 10% price increase causes 60% fall in quantity demanded then what is the price elasticity of demand? Is it elastic, inelastic or unit elastic demand? It is elastic demand. 4-11

12. 12 Price Elasticity of Demand and Total Revenue Total revenue = Price X sales. Law of demand: As price increases, quantity demanded falls and as price decreases, quantity demanded rises. Should you increase or decrease price to increase total revenue? 4-12

13. 13 Elastic Demand and Total Revenue Elastic demand = Quantity demanded is very responsive to price change. Lower price = Gain of huge number of customers. = Increase in total revenue Price and total revenue move in the opposite direction. 8. Total revenue = ($8)(100) =$800 and is represented by this box. We are here on the demand curve. $Price Quantity 1001,000 Total revenue=($7.50)(1,000) =$7,500 and is represented by this box. 7.50 We are here on the demand curve. 4-13

14. 14 Inelastic Demand and Total Revenue Total revenue =($10)(500) = $5,000 and is represented by this box. We are here on the demand curve. Quantity500 $10 Price We are here on the demand curve. Total revenue =($2)(600) = $1,200 and is represented by this box. 600 $2 Inelastic demand = Quantity demanded is not responsive to price change Lower price = Gain of very few number of customers = Decrease in total revenue Price and total revenue move in the same direction 4-14

15. 15 Price Elasticity of Demand and Total Revenue Price Elasticity of Demand Effect of a Price Increase Effect of a Price Decrease ElasticDecrease in total revenue Increase in total revenue Unit elasticNo change in total revenue InelasticIncrease in total revenue Decrease in total revenue 4-15

16. 16 Factors That Influence Demand Elasticity Substitutes: The greater the availability of substitutes for a good, the higher the good’s price elasticity of demand. Complements: Strong complements reduce a good’s price elasticity of demand. 4-16

17. 17 Factors That Influence Demand Elasticity Product definition: The more broadly defined a product, the less elastic the product’s demand. Broadly defined products have less substitutes whereas narrowly defined products have more substitutes. 4-17

18. 18 Factors That Influence Demand Elasticity Necessities: = Goods that are considered a “must have.” Necessities do not have good substitutes. Necessities have less elastic demand. Luxuries: Luxury goods have more elastic demand. 4-18

19. 19 Factors That Influence Demand Elasticity Time: Consumers are more flexible in the long run than in the short term. The price elasticity of demand is higher the more time consumers have to adjust to price changes. Share of income spent on good: The greater the percentage of income spent on a good, the more price elasticity of demand for that good. 4-19

20. 20 Factors That Influence Demand Elasticity Addiction: Fear of being addicted to a good can result in high price elasticity of demand. However, for a consumer already addicted to the good, price elasticity of demand will be low. 4-20

21. 21 Do You Know? How does the price elasticity of demand vary along a straight line demand curve? Price elasticity decreases moving along a straight line demand curve from the top to the bottom. How does a decrease in price affect total revenue when demand is inelastic? Total revenue will decrease. How do substitutes affect price elasticity of demand? A greater availability of substitutes makes demand more elastic. 4-21

22. 22 Income Elasticity of Demand Income elasticity of demand measures how quantity demanded responds to changes in income. Income elasticity is positive for normal goods. Income elasticity is negative for inferior goods. 4-22

23. 23 Cross Elasticity of Demand Cross elasticity of demand measures how the change in price of one good impacts the demand for another good. Cross elasticity of demand for substitutes is positive. Cross elasticity of demand for complements is negative. 4-23

24. 24 Price Elasticity of Supply Price elasticity of supply measures responsiveness of quantity supplied to price changes. Due to the Law of Supply, price elasticity of supply is always positive. 4-24

25. 25 Categories of Supply Elasticity Elastic supply = quantity supplied that is very responsive to price changes. If price elasticity of supply > 1. % change in quantity supplied > % change in price. Inelastic supply = quantity supplied is relatively unresponsive to price changes. If price elasticity of supply < 1. % change in quantity supplied < % change in price. Unit elastic supply. If price elasticity of supply = 1. % change in quantity supplied = % change in price. 4-25

26. 26 Behind Price Elasticity of Supply Costs: Low costs result in relatively high price elasticity of supply. Capacity: Additional productive capacity makes increases price elasticity of supply. Specialized inputs: Goods that need specialized inputs for production have lower price elasticity of supply in the short term. 4-26

27. 27 Behind Price Elasticity of Supply Government permission: Need to obtain legal permission to expand operations reduces firm’s price elasticity of supply. Ability to fire workers: Not being able to fire workers reduces firm’s price elasticity of supply. 4-27

28. 28 Behind Price Elasticity of Supply Time: Price elasticity of supply is greater in the long run than in the short term. Longer time offers firms flexibility and possibility of innovations. 4-28

29. 29 Do You Know? When is income elasticity of demand negative? Income elasticity of demand is negative for inferior goods i.e. Goods which consumers buy less with higher income. What does the cross elasticity of demand measure? Cross elasticity of demand measures how the change in price of one good impacts the demand for another good. What is the sign of price elasticity of supply and why does it have this sign? Supply elasticity is positive since as price increases, quantity supplied rises and as price decreases, quantity supplied falls. 4-29

30. 30 Summary Price elasticity of demand measures how quantity demanded responds to price changes. Elastic demand = consumers very responsive to price changes. Inelastic demand = consumers not responsive to price changes. Unit elastic demand = quantity demanded changes by the same percentage as change in price. Factors that influence demand elasticity: availability of substitutes, product definition, share of income spent on the good, necessities vs. luxuries, time and strong complements. Effect of change in price on total revenue depends on the category of demand elasticity. 4-30

31. 31 Summary Price elasticity of income measures how quantity demanded responds to income changes. Cross elasticity of demand measures how the change in price of one good impacts the demand for another good. Price elasticity of supply measures responsiveness of quantity supplied to price changes. Elastic supply = quantity supplied very responsive to price changes. Inelastic demand = quantity supplied not responsive to price changes. Unit elastic demand = quantity supplied changes by the same percentage as change in price. Factors that influence supply elasticity: costs, capacity, time, flexibility of doing business. 4-31

32. 32 Coming up Analyzing policies with market forces of supply and demand. 4-32

33. 33 Appendix: calculating demand elasticity Price elasticity of demand = = Where Q 1 = new quantity, Q 0 = old quantity P 1 = new price, P 0 = old price 4-33