Chapter 5 Price Elasticity of Demand Key Concepts

Chapter 5 Price Elasticity of Demand • Key Concepts • Summary • Practice Quiz © 2004 Thomson/South-Western

How is the percent increase or decrease of two numbers calculated? Percent change is the difference between the two numbers divided by the original number 2

Suppose the price of a rock concert increases by 10%, what effect will this have on sales? That all depends on the price elasticity of demand for this rock concert 3

What is elasticity? A term economists use to describe responsiveness, or sensitivity, to a change in price 4

What is price elasticity of demand? The ratio of the percentage change in the quantity demanded of a product to a percentage change in its price 5

Price Elasticity of Demand % in Q demanded Ed = % in price 6

Supposing a university’s enrollment drops by 20% because tuition rises by 10%, what is the price elasticity of demand? 7

-. 20 -20% Ed = = = +. 10 +10% 2 8

Why is elasticity 2 in the previous example and not -2? Economists drop the negative sign because we know from the law of demand that quantity demanded and price are inversely related 9

If there is an increase from 3 units to 5, what is the percentage increase? 2/3 = 66% 10

If there is a decrease from 5 units to 3, what is the percentage decrease? 2/5 = 40% 11

Problem - When we move along a demand curve between two points, we get different answers to elasticity depending on whether we are moving up or down the demand curve 12

P A 2 B 3 D Q 13

Economists can solve this problem of different base points by using the midpoints as the base points of changes in prices and quantity demanded 14

Price elasticity equals the in quantity demanded sum of quantities/2 divided by in price sum of prices/2 15

What is elastic demand? A condition in which the percentage change in quantity demanded is greater than the percentage change in price 16

P $40 $30 Elastic Demand Ed > 1 A B $20 $10 10 20 30 40 Q 17

Why is the demand curve in the previous slide elastic? The percentage change in the quantity demanded is greater than the percentage change in price 18

Elastic Demand Increase in total revenue Price decrease 19

Elastic Demand Decrease in total revenue Price increase 20

10 % change in Q = =. 66 15 10 % change in P = =. 40 25 % change in Q. 66 Ed = = % change in P. 40 Ed = 1. 65 21

$40 $30 Inelastic Demand Ed < 1 A B $20 $10 10 20 30 40 22

Why is the demand curve in the previous slide inelastic? The percentage change in the quantity demanded is less than the percentage change in price 23

Inelastic Demand Decrease in total revenue Price decrease 24

Inelastic Demand Increase in total revenue Price increase 25

5 % change in Q = =. 38 13 10 % change in P = =. 40 25 % change in Q. 38 Ed = = % change in P. 40 26

What is a unitary elastic demand curve? The percentage change in the quantity demanded is equal to the percentage change in price 27

Unitary Elastic Demand Ed = 1 $40 $30 E F $20 D $10 10 20 30 40 28

Unitary Elastic Demand No change in total revenue Price decrease 29

What is a perfectly elastic demand curve? A condition in which a small percentage change in price brings about an infinite percentage change in the quantity demanded 30

$40 $30 $10 Perfectly Elastic Demand Ed = 8 $20 10 20 30 40 31

Perfectly Elastic Demand Infinite change in quantity demanded Price change 32

What is a perfectly inelastic demand curve? A condition in which the quantity demanded does not change as the price changes 33

Perfectly Inelastic Demand Ed = 0 $40 $30 $20 $10 10 20 30 40 34

Perfectly Inelastic Demand Zero change in quantity demanded Price change 35

If a college raises tuition, what happens to revenue? If demand is elastic total revenue goes down If demand is inelastic total revenue goes up 36

If price increases and the revenue gained is greater than the revenue lost, the demand curve is price inelastic, < 1 37

If price increases and the revenue gained is less than the revenue lost, the demand curve is price elastic, > 1 38

If total revenue does not change when price increases, the demand curve is unitary elastic, value equals 1 39

Price Elasticity of Demand Ranges $40 El $35 as t ic $30 $25 In $20 el Un a $15 e it st i a l c a r $10 st y ic $5 5 10 15 20 25 30 35 40 45 40

sti c Ela las Ine Unitary Elastic $400 $350 $300 $250 $200 $150 $100 $50 Total Revenue Curve 5 10 15 20 25 30 35 40 45 41

What factors influence demand sensitivity? • Availability of substitutes • Share of budget on the product • Adjustment to a price change over time 42

What do substitutes have to do with a price change? The more substitutes a product has, the more sensitive consumers are to a price change, and the more elastic the demand curve 43

A D B D Which demand curve is for a vital medicine and which is for candy? 44

Why is A the demand curve for medicine? Because medicine is a necessity with few substitutes, and the price can change with little effect on the quantity demanded 45

Why is B the demand curve for candy? Because candy has many substitutes, a price change can bring about a big change in the quantity demanded 46

What does the share of one’s budget have to do with a price change? The larger the purchase is to one’s budget, the more sensitive consumers are to a price change, and the more elastic the demand curve 47

What does time have to do with sensitivity? The longer consumers have to adjust, the more sensitive they are to a price change, and the more elastic the demand curve 48

Key Concepts 49

Key Concepts • • What is elasticity? What is price elasticity of demand? What is elastic demand? What is a unitary elastic demand curve? What is a perfectly inelastic demand curve? What factors influence demand sensitivity? 50

Summary 51

Price elasticity of demand is a measure of the responsiveness of the quantity demanded to a change in price. Specifically, price elasticity of demand is the ratio of the percentage change in quantity demanded to the percentage change in price. 52

Price Elasticity of Demand % in Q demanded Ed = % in price 53

What is the midpoint formula for the price elasticity of demand? 54

Price elasticity equals the in quantity demanded sum of quantities/2 divided by in price sum of prices/2 55

Elastic demand is a change of more than one percent in quantity demanded in response to a one percent change in price. Demand is elastic when the elasticity coefficient is greater than one and total revenue (price time quantity) varies inversely with the direction of the price change. 56

Elastic Demand $40 $30 $20 $10 10 20 30 40 57

Inelastic demand is a change of less than one percent in quantity demanded in response to a one percent change in price. Demand is inelastic when the elasticity coefficient is less than one and total revenue varies directly with the direction of the price change. 58

Inelastic Demand $40 $30 $20 $10 10 20 30 40 59

Unitary elastic demand is a one percent change in quantity demanded in response to a one percent change in price. Demand is unitary elastic when the elasticity coefficient equals one and total revenue remains constant as the price changes. 60

Unitary elastic Demand $40 $30 $20 $10 10 20 30 40 61

Perfectly elastic demand is a decline in quantity demanded to zero for even the slightest rise or fall in price. This is an extreme case in which the demand curve is horizontal and the elasticity coefficient equals infinity. 62

$40 $30 8 $20 Perfectly Elastic Supply = $10 10 20 30 40 63

Perfectly inelastic demand is no change quantity demanded in response to price changes. This is an extreme case in which the demand curve is vertical and the elasticity coefficient equals zero. 64

$40 $30 $20 Perfectly Inelastic Supply Es = 0 $10 10 20 30 40 65

Determinants of price elasticity of demand include (a) the availability of substitutes, (b) the percentage of budget spent on the product, and (c) the length of time allowed for adjustment. Each of these factors is directly related to the elasticity coefficient. 66

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