Elasticity and Demand Price Elasticity of Demand E

Elasticity and Demand

Price Elasticity of Demand (E) • Measures responsiveness or sensitivity of consumers to changes in the price of a good • • P & Q are inversely related by the law of demand so E is always negative – The larger the absolute value of E, the more sensitive buyers are to a change in price 2

Price Elasticity of Demand (E) Elasticity Responsiveness E Elastic Unitary Elastic Inelastic 3

Price Elasticity of Demand (E) • Percentage change in quantity demanded can be predicted for a given percentage change in price as: – % Qd = % P x E • Percentage change in price required for a given change in quantity demanded can be predicted as: – % P = % Qd ÷ E 4

Price Elasticity & Total Revenue Elastic Unitary elastic Inelastic Quantity-effect dominates No dominant effect Price-effect dominates Price rises TR falls No change in TR TR rises Price falls TR rises No change in TR TR falls 5

Factors Affecting Price Elasticity of Demand • Availability of substitutes – The better & more numerous the substitutes for a good, the more elastic is demand • Percentage of consumer’s budget – The greater the percentage of the consumer’s budget spent on the good, the more elastic is demand • Time period of adjustment – The longer the time period consumers have to adjust to price changes, the more elastic is demand 6

Calculating Price Elasticity of Demand • Price elasticity can be calculated by multiplying the slope of demand ( Q/ P) times the ratio of price to quantity (P/Q) 7

Calculating Price Elasticity of Demand • Price elasticity can be measured at an interval (or arc) along demand, or at a specific point on the demand curve – If the price change is relatively small, a point calculation is suitable – If the price change spans a sizable arc along the demand curve, the interval calculation provides a better measure 8

Computation of Elasticity Over an Interval • When calculating price elasticity of demand over an interval of demand, use the interval or arc elasticity formula 9

Computation of Elasticity at a Point • When calculating price elasticity at a point on demand, multiply the slope of demand ( Q/ P), computed at the point of measure, times the ratio P/Q, using the values of P and Q at the point of measure • Method of measuring point elasticity depends on whether demand is linear or curvilinear 10

Point Elasticity When Demand is Linear 11

Point Elasticity When Demand is Linear • Compute elasticity using either of the two formulas below which give the same value for E 12

Point Elasticity When Demand is Curvilinear • Compute elasticity using either of two equivalent formulas below 13

Elasticity (Generally) Varies Along a Demand Curve • For linear demand, price and E vary directly – The higher the price, the more elastic is demand – The lower the price, the less elastic is demand • For curvilinear demand, no general rule about the relation between price and quantity 14

Constant Elasticity of Demand (Figure 6. 3) 15

Marginal Revenue • Marginal revenue (MR) is the change in total revenue per unit change in output • Since MR measures the rate of change in total revenue as quantity changes, MR is the slope of the total revenue (TR) curve 16

Demand & Marginal Revenue TR = P Q MR = TR/ Q Unit sales (Q) Price 0 $4. 50 1 4. 00 $4. 00 2 3. 50 $7. 00 $3. 00 3 3. 10 $9. 30 $2. 30 4 2. 80 $11. 20 $1. 90 5 2. 40 $12. 00 $0. 80 6 2. 00 $12. 00 $0 7 1. 50 $10. 50 $-1. 50 $ 0 -- 17

Demand, MR, & TR Panel A Panel B 18

Demand & Marginal Revenue • When inverse demand is linear, (A > 0, B < 0) P = A + BQ – Marginal revenue is also linear, intersects the vertical (price) axis at the same point as demand, & is twice as steep as demand MR = A + 2 BQ 19

Linear Demand, MR, & Elasticity 20

MR, TR, & Price Elasticity Marginal Total revenue MR > 0 TR increases as Q increases MR = 0 MR < 0 (P decreases) Price elasticity of demand Elastic ( E > 1) Unitelastic TR is maximized ( E = 1) TR decreases as Inelastic Q increases ( E < 1) 1) ( E < (P decreases) 21

Marginal Revenue & Price Elasticity • For all demand & marginal revenue curves, the relation between marginal revenue, price, & elasticity can be expressed as 22

Income Elasticity • Income elasticity (EM) measures the responsiveness of quantity demanded to changes in income, holding the price of the good & all other demand determinants constant – Positive for a normal good – Negative for an inferior good 23

Cross-Price Elasticity • Cross-price elasticity (EXY) measures the responsiveness of quantity demanded of good X to changes in the price of related good Y, holding the price of good X & all other demand determinants for good X constant – Positive when the two goods are substitutes – Negative when the two goods are complements 24

Interval Elasticity Measures • To calculate interval measures of income & crossprice elasticities, the following formulas can be employed 25

Point Elasticity Measures 26