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Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
1
Chapter 4
DemandElasticity
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
2
Overview
The economic concept of elasticityThe price elasticity of demandThe cross-elasticity of demandIncome elasticityOther elasticity measuresElasticity of supply
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
3
Learning objectives define and measure elasticity
apply concepts of price elasticity, cross-elasticity, and income elasticity
understand determinants of elasticity
show how elasticity affects business revenue
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
4
The economic concept of elasticity
Elasticity: the percentage change in one variable relative to a percentage change in another.
Bin changepercent
Ain changepercent Elasticity oft Coefficien
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
5
Price elasticity of demand Price elasticity of demand: the
percentage change in quantity demanded caused by a 1 percent change in price
Price %
Quantity %E
p
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Price elasticity of demand Arc elasticity: elasticity which is
measured over a discrete interval of a curve
Ep = coefficient of arc price elasticity Q1 = original quantity demanded Q2 = new quantity demanded P1 = original price P2 = new price
2/)(2/)( 21
12
21
12
PP
PP
QQEp
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Price elasticity of demand Point elasticity: elasticity measured at a
given point of a demand (or a supply) curve
1
1
εP
PdQx
dP Q=
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Price elasticity of demandThe point elasticity of a linear demand function can be expressed as:
1
1
Q
P
P
Q
p
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Price elasticity of demand
Elasticity varies along a linear demand curve
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
10
Price elasticity of demand Some demand curves have constant
elasticity
such a curve has a nonlinear equation:
Q = aP-b
where –b is the elasticity coefficient
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Price elasticity of demand Categories of elasticity
Relative elasticity of demand: Ep > 1
Relative inelasticity of demand: 0 < Ep < 1
Unitary elasticity of demand: Ep = 1
Perfect elasticity: Ep = ∞
Perfect inelasticity: Ep = 0
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Price elasticity of demand Factors affecting demand elasticity
ease of substitution proportion of total expenditures durability of product
possibility of postponing purchasepossibility of repairused product market
length of time period
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Price elasticity of demand Derived demand: the demand for
products or factors that are not directly consumed, but go into the production of a another (final) product
The demand for such a product or factor exists because there is demand for the final product
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Price elasticity of demand The derived demand curve will be more
inelastic: the more essential is the component the more inelastic is the demand curve
for the final product the smaller is the fraction of total cost
going to this component the more inelastic is the supply curve of
cooperating factors
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Price elasticity of demand A long-run demand
curve will generally be more elastic than a short-run curve
As the time period
lengthens consumers find ways to adjust to the price change, via substitution or shifting consumption
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Price elasticity of demand The relationship between price and
revenue depends on elasticity Why? By itself, a price fall will reduce
receipts … BUT because the demand curve is downward sloping, the drop in price will also increase quantity demanded
Q: which effect will be stronger?
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Price elasticity of demand As price decreases
revenue rises when demand is elastic
revenue falls when it is inelastic
revenue reaches it peak if elasticity =1
the lower chart shows the effect of elasticity on total revenue
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Price elasticity of demand Marginal revenue: the change in total
revenue resulting from changing quantity by one unit
QuantityMR
Revenue Total
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Price elasticity of demand
marginal revenue curve is twice as steep as the demand
curve
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Price elasticity of demand at the point where
marginal revenue crosses the X-axis, the demand curve is unitary elastic and total revenue reaches a maximum
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Price elasticity of demand Examples: some real world elasticities
coffee: short run -0.2, long run -0.33 kitchen and household appliances: -0.63 meals at restaurants: -2.27 airline travel in U.S.: -1.98 beer: -0.84, Wine: -0.55
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Price elasticity of demand Examples: some real world elasticities
white pan bread:-0.69 cigarettes: short run -0.4, long run -0.6 wine imports: -0.15 crude oil: -0.06 internet services: -0.6/-0.7
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Cross-elasticity of demand Cross-elasticity of demand: the
percentage change in quantity consumed of one product as a result of a 1 percent change in the price of a related product
B
Ax P
QE
%
%
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Cross-elasticity of demand Arc cross-elasticity
2/)(2/)( 21
12
21
12
BB
BB
AA
AA
PP
PP
QQEX
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
25
Cross-elasticity of demand Point cross-elasticity
B
B
A
AX P
P
Q
QE
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Cross-elasticity of demand The sign of cross-elasticity for substitutes
is positive
The sign of cross-elasticity for complements is negative
Two products are considered good substitutes or complements when the coefficient is larger than 0.5 (in ab. value)
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Income elasticity Income elasticity of demand: the
percentage change in quantity demanded caused by a 1 percent change in income
Y is shorthand for income
Y
QEY
%
%
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Income elasticity Arc income elasticity
2/)(2/)( 21
12
21
12
YY
YY
QQEY
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Income elasticity Categories of income
elasticity
superior goods: EY > 1
normal goods: 0 ≤ EY
≤ 1
inferior goods: EY < 0
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Other demand elasticities Examples: elasticity is encountered every
time a change in some variable affects demand
advertising expenditure interest rates population size
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Elasticity of supply Price elasticity of supply: the
percentage change in quantity supplied as a result of a 1 percent change in price
The coefficient of supply elasticity is a normally a positive number
Price %
SuppliedQuantity %E
S
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Elasticity of supply Arc elasticity of supply
2/)(2/)( 21
12
21
12
PP
PP
QQEs
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Elasticity of supply When the supply curve is more elastic, the
effect of a change in demand will be greater on quantity than on the price of the product
When the supply curve is less elastic, a change in demand will have a greater effect on price than on quantity
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Global application Example: price elasticities in Asia
imports almost always price inelastic if exports price inelastic, export earnings
will rise as prices rise if exports price elastic, export earnings
will rise with world incomes
