Chapter 4

Demand Elasticity

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Overview
The economic concept of elasticity The price elasticity of demand The cross-elasticity of demand The income elasticity of demand Elasticity of supply
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Learning objectives
define and measure elasticity apply concepts of price elasticity, crosselasticity, and income elasticity of demand understand determinants of elasticity show how elasticity affects business revenue
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The economic concept of elasticity

Elasticity: the percentage change in one variable relative to a percentage change in another. Example, if A = f(B, other factors), then

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

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Price elasticity of demand

Price elasticity of demand: the percentage change in quantity demanded caused by a 1 percent change in price. The general formula for calculation is:

% Quantity Ep % Price
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Price elasticity of demand

Arc elasticity: elasticity which is measured over a discrete interval of a 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
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Price elasticity of demand

Point elasticity: elasticity measured at a given point of a demand (or a supply) curve. If Q = f(P), then

EX = (dQ/dP) (P1 /Q1 ) where: * dQ/dP is the derivative of Q with respect to P. * P1 and Q1 are the current values.
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Price elasticity of demand

When do we use point and arc elasticity? It depends on the available information:
If

we have the demand function, we can use the point elasticity formula. If we dont, and instead we have 2 pairs of prices and quantities, we use the arc elasticity formula.

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Price elasticity of demand

elasticity of demand at the price P=5. At this price the quantity is Q=20-25=10. Therefore EP = -2 (5/10) = -1 Now make the calculations at P=9.
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Look into your textbook p. 105, problem 2, part a. We are given the demand function, from which we get (dQ/dP) = -2, and we are asked to calculate the price

Price elasticity of demand

Look

into your textbook p. 107, problem 12, part a. Here we have 2 pairs of Q and P. We use the arc elasticity formula. EP = (60/100)/(-1/3) =-1.8

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Price elasticity of demand

Elasticity varies along a linear demand curve Although the slope is the same, elasticity varies along the D curve. Economic Reason?

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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: (let Ep represent the absolute value of price elasticity of demand ) Relatively elastic demand: Ep > 1 Relatively inelastic demand: 0 < Ep < 1 Unitary elastic demand: Ep = 1 Perfectly elastic demand: Ep = Perfectly inelastic demand: Ep = 0
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Chapter Four

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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Chapter Four

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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Chapter Four

Price elasticity of demand

A long-run demand curve will generally be more elastic than a short-run curve.

As the time period increases, 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 total revenue TR depends on elasticity. Why? By itself, a price fall will reduce TR. BUT because the demand curve is downward sloping, the drop in price will also increase quantity demanded. In order to know the final effect on TR, we need to know: 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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Chapter Four

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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Price elasticity of demand

For a linear demand curve, 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

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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 to -0.7

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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

% Q A Ex % PB
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Cross-elasticity of demand

Arc cross-elasticity

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

Exercise: Calculate the cross elasticity of demand in part b, problem 12, p. 107 of the textbook. It must be (50/65)(-1/3) = -2.3 Are these two goods substitutes or complements? How do you know?
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Chapter Four

Cross-elasticity of demand
Point cross-elasticity EX = (dQA /dPB) (PB /QA ) Exercise: In problem 10 p. 72 of the textbook,

calculate the cross elasticity of demand. Let the concerned company be A and the competitor B. Then (dQA /dPB) = 3. And the current PB = $500, and the current QA = 251400. Therefore E = 3 (500/251400) = 5.96. Are these two goods A and B substitutes or complements? How do you know?
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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 absolute 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

%Q EY %Y
Y is shorthand for income
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Income elasticity

Arc income elasticity

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

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Income elasticity

Categories of income elasticity Normal luxury (superior) goods: EY > 1

Normal necessary goods: 0 EY 1 Inferior goods: EY < 0

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Chapter Four

Other demand elasticities

Examples: elasticity is encountered every time a change in some variable affects demand

advertising expenditure interest rates population size

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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

The coefficient of supply elasticity is a normally a positive number
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Elasticity of supply

Arc elasticity of supply

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

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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 Can the concepts of demand elasticity help explain the gain from trade to Asian countries?

End of chapter 4

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