THE ELASTICITY OF DEMAND
• Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.
• Price elasticity of demand is the percent change in quantity demanded given a percent change in the price.
• Demand tends to be more elastic :
– the larger the number of close substitutes. – if the good is a luxury.
Computing the Price Elasticity of Demand
• The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.
• Example:
If the price of an ice cream cone increases from $2.00 to $2.20&&+10% and the amount you buy falls from 10 to 8 cones&&&&&&&&..-20%, then your elasticity of demand would be: &&&&&&&&&&&&-2
• Elastic Demand
– Quantity demanded responds strongly to changes in price. – Price elasticity of demand is greater than one.
• Perfectly Elastic
– Quantity demanded changes infinitely with any change in price.
• Unit Elastic
– Quantity demanded changes by the same percentage as the price.
• Inelastic Demand
– Quantity demanded does not respond strongly to price changes. – Price elasticity of demand is less than one.
• Perfectly Inelastic Demand
– Quantity demanded does not respond at all to price changes. – Price elasticity of demand is zero.
Variation in Elasticity
Copyright©2003 Southwestern/Thomson Learning
Perfectly Inelastic Demand: Ed = 0
$5
4
Quantity
Demand
100
0
1. An
increase
in price . . .
2. . . . leaves the quantity demanded unchanged.
Price
Perfectly Inelastic
Inelastic Demand: Elasticity < 1
Quantity
0
$5
90
Demand
1. A 25%
increase
in price . . .
Price
2. . . . leads to an 10% decrease in quantity demanded.
4
100
Inelastic Demand
Elastic Demand: Elasticity > 1
Demand
Quantity
4
100
0
Price
$5
50
1. A 25%
increase
in price . . .
2. . . . leads to a 50% decrease in quantity demanded.
Elastic Demand
Perfectly Elastic Demand: Elasticity = Infinity
Quantity
0
Price
$4
Demand
2. At exactly $4,
consumers will
buy any quantity.
1. At any price
above $4, quantity
demanded is zero.
3. At a price below $4,
quantity demanded is infinite.
Perfectly Elastic
Copyright©2003 Southwestern/Thomson Learning
Demand
Quantity
Q
P
0
Price
P × Q = $400
(revenue)
$4
100
Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold.
Copyright©2003 Southwestern/Thomson Learning
Demand
Quantity
0
Price
Revenue = $100
Quantity
0
Price
Revenue = $240
Demand $1
100
$3
80
An Increase in price from $1 to $3 ,
, leads to an Increase in total revenue from $100 to $240
Copyright©2003 Southwestern/Thomson Learning
Demand
Quantity
0
Price
Revenue = $200 $4
50
Demand
Quantity
0
Price
Revenue = $100 $5
20
An Increase in price from $4 to $5 ,
, leads to an decrease in total revenue from $200 to $100
Elasticity Along a Linear Demand Curve
Constant slope, but elasticity declines as you go down the curve
Revenue increases as you approach the midpoint from either direction
Quantity D 11 10 9 8 7 6 5 4 3 2 1 0
V ery elastic e = 6.33
Slightly elastic Unit elastic
Slightly inelastic
Very inelastic e = .29
e = 1.0
Significance of Price Elasticity of Demand
• Firm’s try to set a price that will maximize their profit
• Elasticity plays a vital role in determining a firm’s revenue
• Since Profit = TR – TC, elasticity is important to a firm’s profit making decisions
• If Ed > 1, then demand is said to be elastic:
• An increase in price will reduce total revenue • A decrease in price will increase total revenue
• If Ed < 1, then demand is said to be inelastic:
• An increase in price will increase total revenue • A decrease in price will decrease total revenue
If Ed = 1, then demand is said to be unit elastic:Income Elasticity of Demand
Income elasticity of demand =
Percentage change
in quantity demanded
Percentage change
in income
• Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income.
• It is computed as the percentage change in the quantity demanded divided by the percentage change in income.
• Types of Goods
– Normal Goods, with income elasticities that are positive – Inferior Goods, with income elasticities that are negative
Income Elasticity Examples
• Ey = - 0.6: this good is an inferior good – a rise in income of 10% would lead to demand falling by 6%
• Ey = + 0.4: this good is a normal good – a rise in income of 10% would lead to demand rising by 4%
• Ey = + 1.6: this good is a normal good – a rise in income of 10% would lead to demand rising by 16%
Cross Elasticity of Demand
• Cross Elasticity: measures the responsiveness of demand for one good to changes in the price of a related good – either a substitute or a complement
• Goods which are complements:
– Cross Elasticity will have negative sign (inverse relationship)
• Goods which are substitutes:
– Cross Elasticity will have a positive sign (positive relationship)
Ex =
%
∆
Qd of good A
__________________
Summary
• Price elasticity of demand measures how much the quantity demanded responds to changes in the price.
• Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price.
• If a demand curve is elastic, total revenue falls when the price rises.
• If it is inelastic, total revenue rises as the price rises.
• The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income.
• The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good.
Practice
• In the table at right,
one of the price and quantity combinations is the midpoint of a demand curve facing a producer.
Which is it?
price = 7$, quantity = 100 • How do you know?
because of the three possibilities, it yields the greatest total
revenue55..700$
100 7
80 8
60 9
Practice
• If profit equals revenue, then cost must equal555...zero
• If Ey = 2, then by what % must incomes of consumers rise in order to double sales of this good?...50%
• If the price elasticity of demand for a good is unitary and price rises by 20 %, what happens to sales of the good?...sales fall by 20%
• There are 3 goods: sneakers, boots and socks. Relating two of them will always yield a positive cross elasticity of demand. Which two?...sneakers and boots
Practice
Given: Qd = 100 – 2P
•
What is the maximum price?...
50$
•
What is the maximum quantity?...
100
•
At what price and quantity is revenue maximized?
5555..
price = 25$, quantity = 50
•
What is the maximum revenue the firm can earn in this case?
5555.since TR = PQ,55 (25$)(50) =
$1,250
•
If all costs were fixed at 1000$, then what is maximum profit in this case?
Practice
Given: Ed = 0 (perfectly inelastic demand)
• Name a good whose elasticity may be similar to this. ...insulin
• If you drew this demand curve, what would it look like? ...vertical (with an infinite slope
