Chapter 4

Demand Elasticity
Managerial Economics: Economic Tools for Todays Decision Makers, 5/e By Paul Keat and Philip Young

Demand Elasticity The Economic Concept of Elasticity The Price Elasticity of Demand The Cross-Elasticity of Demand Income Elasticity Other Elasticity Measures Elasticity of Supply
Managerial Economics, 5/e Keat/Young

2006 Prentice Hall Business Publishing

Learning Objectives Define and measure elasticity Apply concepts of price elasticity, crosselasticity, and income elasticity Understand determinants of elasticity Show how elasticity affects revenue

2006 Prentice Hall Business Publishing

Managerial Economics, 5/e

Keat/Young

The Economic Concept of Elasticity Elasticity: the percentage change in one variable relative to a percentage change in another.

percent change in A Coefficien t of Elasticity percent change in B

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The Price Elasticity of Demand Price elasticity of demand: The percentage change in quantity demanded caused by a 1 percent change in price.

% Quantity Ep % Price

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Managerial Economics, 5/e

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The Price Elasticity of Demand

Arc elasticity: Elasticity which is measured over a discrete interval of a demand (or a supply) curve.
Q2 Q1 P2 P 1 Ep (Q1 Q2 ) / 2 ( P 1P 2) / 2
Ep = Coefficient of arc price elasticity Q1 = Original quantity demanded Q2 = New quantity demanded P1 = Original price P2 = New price
Managerial Economics, 5/e Keat/Young

2006 Prentice Hall Business Publishing

The Price Elasticity of Demand Point elasticity: Elasticity measured at a given point of a demand (or a supply) curve.

dQ P 1 P = x dP Q1
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

The Price Elasticity of Demand The point elasticity of a linear demand function can be expressed as:

Q P1 p P Q1

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Managerial Economics, 5/e

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The Price Elasticity of Demand Some demand curves have constant elasticity over the relevant range Such a curve would look like:
Q = aP-b

where b is the elasticity coefficient This equation can be converted to linear by expressing it in logarithms:
log Q = log a b(log P)
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

The Price Elasticity of Demand

Elasticity differs along a linear demand curve.

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Managerial Economics, 5/e

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The 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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Managerial Economics, 5/e

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The Price Elasticity of Demand Factors affecting demand elasticity

Ease of substitution Proportion of total expenditures Durability of product
Possibility of postponing purchase Possibility of repair Used product market

Length of time period

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The Price Elasticity of Demand Derived demand: The demand for products or factors that are not directly consumed, but go into the production of a final product. The demand for such a product or factor exists because there is demand for the final product.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

The Price Elasticity of Demand

The derived demand curve will be more inelastic:
the more essential is the component in question. 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.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

The 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 way to adjust to the price change, via substitution or shifting consumption

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Managerial Economics, 5/e

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The Price Elasticity of Demand

There is a relationship between the price elasticity of demand and revenue received.
Because a demand curve is downward sloping, a decrease in price will increase the quantity demanded If elasticity is greater than 1, the quantity effect is stronger than the price effect, and total revenue will increase

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Managerial Economics, 5/e

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The Price Elasticity of Demand

As price decreases
Revenue rises when demand is elastic. Revenue falls when it is inelastic. Revenue reaches it peak when elasticity of demand equals 1.

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Managerial Economics, 5/e

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The Price Elasticity of Demand Marginal Revenue: The change in total revenue resulting from changing quantity by one unit.
Total Revenue MR Quantity

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Managerial Economics, 5/e

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The Price Elasticity of Demand

For a straight-line demand curve the marginal revenue curve is twice as steep as the demand.

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Managerial Economics, 5/e

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The 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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Managerial Economics, 5/e

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The Price Elasticity of Demand Some sample 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

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Managerial Economics, 5/e

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The 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.

%QA EX %PB
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The Cross-Elasticity of Demand Arc Elasticity

Q2 A Q1 A P2 B P 1B Ex (Q1 A Q2 A ) / 2 ( P 1B P 2B ) / 2

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The Cross-Elasticity of Demand Point Elasticity

QA PB EX QA PB

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The 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.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

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

%Q EY %Y
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Income Elasticity Arc Elasticity

Q2 Q1 Y2 Y1 EY (Q1 Q2 ) / 2 (Y1 Y2 ) / 2

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Managerial Economics, 5/e

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Income Elasticity
Categories of income elasticity
Superior goods: EY > 1 Normal goods: 0 >EY >1 Inferior goods demand decreases as income increases: EY < 0

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Managerial Economics, 5/e

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Other Elasticity Measures Elasticity is encountered every time a change in some variable affects quantities.
Advertising expenditure Interest rates Population size

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Managerial Economics, 5/e

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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.
% Quantity Supplied ES % Price

If the supply curve slopes upward and to the right, the coefficient of supply elasticity is a positive number.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

Elasticity of Supply Arc elasticity

Q2 Q1 P2 P 1 Es (Q1 Q2 ) / 2 ( P 1P 2) / 2

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Managerial Economics, 5/e

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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. With a supply curve of low elasticity, a change in demand will have a greater effect on price than on quantity.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young