1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 1 1.0 Elasticity of Demand...
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- Slide 2
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 1 1.0 Elasticity of Demand and Supply SESSION 3:
CHAPTER 5 Prof. Harmon The table of contents in the left frame :
has links to each slide. The slide with the LECTURE OUTLINE lists
the main topic s. These topics begin with a whole number (e.g. 2.0
). The bottom frame : has options to print each slide and to
display closed captioning of the audio. The image of the house
appears on every slide in the upper left and operates as a hyper
link to the slide LECTURE OUTLINE Tips for Navigation in the Video
Lecture: Real World Examples SOFTWARE UPGRADES Illustrates price
elasticity of demand and its determinants CIGARETTE TAXATION
Illustrates price inelastic demand and relation to revenue Chart
Source WSJ Image Source WSJ
- Slide 3
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End Software Customers Reactions to Fees for upgrades
and maintenance Since software doesn't wear out,software companies
provide upgrades free, generating additional revenue by selling
users on new add-ons or increasing maintenance fees. These fees
have crept up to as much as 22% or even 25% of the original license
fee, from about 15% a few years ago. Some software companies now
get the majority of their profits from such recurring revenue, with
original license fees serving as an introductory loss leader. Some
customers are happy to upgrade. The recent versions of most
business applications, for example, allow better Web access to
company data than previously possible For some customers the pain
of an upgrade is outweighed by the value of the innovation. Many
companies say the a business case for the hassles of installing a
new version or adding on the latest bells and whistles.. 2 1.1
Software Upgrades Adapted from : Software Customers Force Change
WSJ 1/2/2004Software Customers Force Change Elastic Demand
Inelastic Demand
- Slide 4
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 3 1.2a One Public Policy Issue Is If cigarette
smoking continues at current rates Chart Source WSJ
- Slide 5
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 4 1.2b Cigarette Taxes Raise Revenue: Low Demand
Elasticity A price rise of 10 percent on a pack of cigarettes would
be expected to reduce demand for cigarettes in the short term: by
about 4 percent in high-income countries by about 8 percent in low-
and middle-income countries, where lower incomes tend to make
people more responsive to price changes. In both cases sales
revenue increases because the percent increase in price is larger
than the percent decline in quantity. (Remember revenue = price x
quantity.) Long-run price responsiveness is estimated to be twice
as high. Source: http://www.imf.org/external/pubs/ft/fandd/1999/
12/jha.htm Chart Source WSJ
- Slide 6
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 5 1.3 LECTURE OUTLINE 1. First SlideFirst Slide 2.0
Price Elasticity of DemandPrice Elasticity of Demand 3.0 Supply
ElasticitySupply Elasticity 4.1 Income ElasticityIncome Elasticity
5.1 Cross Price ElasticityCross Price Elasticity Substitutes,
Complements 6.0 Econ Lab EndEcon Lab End
- Slide 7
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 2.0 Price Elasticity of Demand 2.1 Price Elasticity
FormulaPrice Elasticity Formula 2.2 Numerical ExampleNumerical
Example 2.3 Three points about elasticity of demandThree points
about elasticity of demand 2.4 Categories of ElasticityCategories
of Elasticity 2.5 Demand Elasticity and Total RevenueDemand
Elasticity and Total Revenue 2.6 Constant Elasticity CasesConstant
Elasticity Cases 2.7 Determinants of ElasticityDeterminants of
Elasticity 6
- Slide 8
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 7 2.1a Price Elasticity Thus far we have talked
about the impact of changes in prices, incomes, and costs, on
demand and supply in rather general terms In fact, in the real
world of policy implementation, more precision is used The Law of
demand says that a higher price will reduce quantity demanded, BUT
BY HOW MUCH that is, will the number sold decline by only a little
or by a lot?
- Slide 9
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 8 2.1.b Formula for Price Elasticity of Demand
Price elasticity of demand measures in a standardized way how
responsive consumers are to price change elasticity is another word
for responsiveness In simplest terms, the price elasticity of
demand measures the percent change in quantity demanded divided by
the percent change in price
- Slide 10
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 9 To illustrate this process, let us write out the
algebraic formula and do an example calculation. 2.1.c Price
Elasticity of Demand Formula: In Words
- Slide 11
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 10 Generalize the price elasticity formula If the
price drops from p to p, other things constant, the quantity
demanded increases from q to q The change in price can be
represented as p and the change in quantity as q 2.1.d Price
Elasticity of Demand Formula: Algebraic Expression
- Slide 12
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 11 2.2 Demand Curve for Cigarettes For the price
elasticity to be a useful measure, we should come up with the same
result between points a and b as we get between b and a. To do this
we must take the average of the initial price and the new price and
use that as the base in computing the percent change in price. The
same process should be used for changes in quantity demanded the
average quantity demanded is 100,000 and the change in quantity
demanded is 10,000 10% change Price elasticity between point a and
b is: = 10% / - 20% = - 0.5 0.90 0 b Thousands per day D $1.10 a
95105 Price per taco in our example the base used for price is the
average of $1.10 and $0.90 = $1.00 the change in price is -$0.20
divided by $1.00 - 20%
- Slide 13
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 12 2.3.1 Three Points about Price Elasticity of
Demand: Point #1 Because the average quantity and average price are
used as a base for computing percent change, the same elasticity
results whether going from the higher price to the lower price or
the other way around
- Slide 14
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 13 2.3.2 Point #2 Elasticity expresses a
relationship between two amounts The percent change in quantity
demanded The percent change in price Because the law of demand
states that price and quantity demanded are inversely related, the
change in price and the change in quantity demanded have opposite
signs the price elasticity of demand has a negative sign
- Slide 15
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 14 2.3.3 Point #3 Since constantly referring to
elasticity as a negative number gets cumbersome, we will discuss
the price elasticity of demand as an absolute value positive number
For example, absolute value of the elasticity for cigarettes
computed earlier will be referred to as 0.5 rather than 0.5
- Slide 16
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 15 2.4.1 Three Categories of Elasticity The price
elasticity of demand can be divided into three general categories
depending on how responsive quantity demanded is to a change in
price If the percent change in quantity demanded is smaller than
the percent change in price, the resulting price elasticity has an
absolute value between 0 and 1.0 demand is inelastic quantity
demanded is relatively unresponsive to a change in price If the
percent change in quantity demanded just equals the percent change
in price a price elasticity with an absolute value of 1.0
unit-elastic demand
- Slide 17
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 16 2.4.2Numerical Ranges of the Categories If the
percent change in quantity demanded exceeds the percent change in
price, the resulting price elasticity has an absolute value
exceeding 1.0 demand is said to be elastic quantity is responsive
to changes in price Summary Elastic absolute value greater than 1.0
responsive Unit elastic absolute value equal to 1.0 Inelastic
absolute value between 0 and 1.0 unresponsive
- Slide 18
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 17 2.5.1 Elasticity and Total Revenue Knowledge of
price elasticity is especially valuable because it indicates the
effect of a price change on total revenue Total revenue (TR) is the
price (p) multiplied by the quantity demanded (q) at that price TR
= p x q What happens to total revenue when price decreases?
- Slide 19
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 18 2.5.2 Elasticity and Total Revenue A lower price
means producers get less for each unit sold which tends to decrease
total revenue However, a lower price increases quantity demanded
which tends to increase total revenue Thus, the overall impact of a
lower price on total revenue depends on the net result of these
opposite effects
- Slide 20
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 19 2.5.3Elasticity and Total Revenue Specifically
When demand is elastic, the percent increase in quantity demanded
exceeds the percent decrease in price total revenue increases When
demand is unit elastic, the two are equal total revenue remains
unchanged When demand is inelastic, the percent increase in
quantity demanded is more than offset by the percent decrease in
price total revenue decreases The next slide presents these
relationships in a diagram
- Slide 21
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 20 (a) Demand and Price Elasticity 2.5.4 Diagram:
Demand, Price Elasticity and Total Revenue Panel (a) shows the
linear demand curve and panel (b) shows the total revenue generated
by each price- quantity combination along the demand curve. Since
the demand curve is linear, its slope is constant a given decrease
in price always causes the same unit increase in quantity demanded.
The price elasticity of demand is greater on the higher-price end
of the demand curve than on the lower-price end. $100 90 80 70 60
50 40 30 20 10 D 0 Quality per period 1002005008009001,000 $25,000
T o t a l r e v e n u e 0 Total revenue (b) Total Revenue TR = p x
q Price per unit Quantity per period1,000500 Inelastic E D < 1
Unit elastic E D = 1 Elastic E D > 1 (Hint: the same price
change at a high price level translates into a smaller denominator
Slope = rise/run
- Slide 22
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 21 (a) Demand and Price Elasticity $100 90 80 70 60
50 40 30 20 10 e d c b a D 0 Quality per period
1002005008009001,000 $25,000 T o t a l r e v e n u e 0 Total
revenue (b) Total Revenue TR = p x q Price per unit Quantity per
period 1,000500 Consider a movement from point a to point b on the
demand curve. Between points d and e on the lower end, the 100-unit
quantity increase is a percent change of 100/850 = 12% and the $10
price decrease is a percent decline of 10/15 = 67% a price
elasticity of 0.2 = (12%/67%) 2.5.5 Diagram: Demand, Price
Elasticity and Total Revenue The 100-unit increase in quantity
demanded is a percent change of 100/150 = 67% while the $10 drop in
price is a percent change of 10/85 = 12% the price elasticity of
demand here is 5.6 = ( 67%/12%) 67% 12% 67%
- Slide 23
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 22 (a) Demand and Price Elasticity $100 90 80 70 60
50 40 30 20 10 e d c b a D Inelastic E D < 1 Unit elastic E D =
1 Elastic E D > 1 0 Quality per period 1002005008009001,000
$25,000 T o t a l r e v e n u e 0 Total revenue (b) Total Revenue
TR = p x q Price per unit Quantity per period 1,000500 Demand
becomes less elastic as we move down the curve. Halfway down, the
elasticity equals 1.0. Since we have a linear demand curve, the
slope is constant but the elasticity varies slope is not the same
thing as elasticity. Where demand is elastic, a decrease in price
will increase total revenue because the gain in revenue from
selling more units exceeds the loss in revenue from selling at the
lower price. Where demand is inelastic, a price decrease reduces
total revenue because the gain in revenue from selling more units
is less than the loss in revenue at the lower price. 2.5.6 Summary:
Demand, Price Elasticity and Total Revenue Elastic E D >
1Inelastic E D < 1 Unit elastic E D = 1 When Elasticity is
unitary Total Revenue is at its peak
- Slide 24
- 1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3
Supply Elas.End 23 2.5.7 Example of Pricing & Inelastic Demand
When Elmo Live arrives in stores on Tuesday, it will cost $60 --
about a third more than last year's model, and above the $50 tag
that once was the high-water mark for most toys. Elmo Live hits
stores as economic uncertainty is gripping consumers and prompting
retailers such as Wal-Mart Stores Inc. and KB Toys Inc. to pitch
low-cost toys to lure customers. Source: Mattel Gambles on Pricey
Elmo for Holidays (WSK 10/9/08)Wal-Mart StoresMattel Gambles on
Pricey Elmo for Holidays (WSK 10/9/08) To be increasing prices,
sellers of Elmo must be of the view that demand is inelastic and
hence the price increases will increase revenue
- Slide 25