Chapter 4 B Demand Elasticity Chapter Four Copyright

Overview The economic concept of elasticity The price elasticity of demand The cross-elasticity of demand Income elasticity Other elasticity measures Elasticity of supply Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 2

Price elasticity of demand p Elasticity varies along a linear demand curve Chapter Four

Price elasticity of demand p Some demand curves have constant elasticity such a curve has a nonlinear equation: Q = a. P-b where –b is the elasticity coefficient Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 4

Price elasticity of demand p Categories of elasticity Relative elasticity of demand: Ep > 1 n Relative inelasticity of demand: 0 < Ep < 1 n Unitary elasticity of demand: Ep = 1 n Perfect elasticity: Ep = ∞ n Perfect inelasticity: Ep = 0 n Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 5

Price elasticity of demand p Factors affecting demand elasticity n ease of substitution n proportion of total expenditures n durability of product p possibility of postponing purchase p possibility of repair p used product market n length of time period Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 6

Price elasticity of demand p 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 Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 7

Price elasticity of demand p 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? Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 8

Price elasticity of demand p As price decreases n revenue rises when demand is elastic n revenue falls when it is inelastic n revenue reaches it peak if elasticity =1 the lower chart shows the effect of elasticity on total revenue Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 9

Price elasticity of demand p Marginal revenue: the change in total revenue resulting from changing quantity by one unit Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 10

Price elasticity of demand p marginal revenue curve is twice as steep as the

Price elasticity of demand p at the point where marginal revenue crosses the X-axis, the demand curve is unitary elastic and total revenue reaches a maximum Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 12

Price elasticity of demand p Examples: some real world elasticities coffee: short run -0. 2, long run -0. 33 n kitchen and household appliances: -0. 63 n meals at restaurants: -2. 27 n airline travel in U. S. : -1. 98 n beer: -0. 84, Wine: -0. 55 n Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 13

Price elasticity of demand p Examples: some real world elasticities white pan bread: -0. 69 n cigarettes: short run -0. 4, long run -0. 6 n wine imports: -0. 15 n crude oil: -0. 06 n internet services: -0. 6/-0. 7 n Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 14

Cross-elasticity of demand p 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 Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 15

Cross-elasticity of demand p Point cross-elasticity Chapter Four Copyright 2009 Pearson Education, Inc. Publishing

Cross-elasticity of demand p 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) Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 17

Income elasticity p Income elasticity of demand: the percentage change in quantity demanded caused by a 1 percent change in income Y is shorthand for income Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 18

Income elasticity p Categories of income elasticity n superior goods: EY > 1 n normal goods: 0 ≤ EY ≤ 1 n inferior goods: EY < 0 Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 19

Other demand elasticities p Examples: elasticity is encountered every time a change in some variable affects demand advertising expenditure n interest rates n population size n Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 20

Elasticity of supply p 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 Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 21

Elasticity of supply p Arc elasticity of supply Chapter Four Copyright 2009 Pearson Education,

Elasticity of supply p 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 Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 23

Global application p Example: price elasticities in Asia imports almost always price inelastic n if exports price inelastic, export earnings will rise as prices rise n if exports price elastic, export earnings will rise with world incomes n Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 24

CASES…………………. . p p 1) The initial price of a cup of coffee is $1, and at that price, 400 cups are demanded. If the price falls to $0. 90, the quantity demanded will increase to 500. p p a. Calculate the (arc) price elasticity of demand for coffee. b. Based on your answer, is the demand for coffee elastic or inelastic? c. Based on your answer to a. , if the price of coffee is increased by 10%, what will happen to the revenues from coffee? Carefully explain how you know. Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 25

CASES-2 p p p 2) The demand curve is: QD = 500 - 1/2 P. a. Calculate the (point) price elasticity of demand when price is $100. Is demand elastic or inelastic? b. Calculate the (point) price elasticity of demand when price is $700. Is demand elastic or inelastic? c. Find the point at which point elasticity is equal to -1. Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 26