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4 Elasticity McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Main Discussions • • • • • Price elasticity of demand The total revenue test Price elasticity of supply Cross elasticity of demand Income elasticity of demand 6-2 Price Elasticity of Demand • Measures buyers’ responsiveness to • • LO1 price changes Elastic demand • Sensitive to price changes • Large change in quantity Inelastic demand • Insensitive to price changes • Small change in quantity Price Elasticity of Demand Formula • Formula for price elasticity of demand Percentage Change in Quantity Demanded of Product X Ed = Percentage Change in Price of Product X LO1 Price Elasticity of Demand Formula • Use the midpoint formula • Ensures consistent results Ed = LO1 Change in quantity Change in price Sum of quantities/2 ÷ Sum of prices/2 Price Elasticity of Demand Formula • Use percentages • Unit free measure • Compare responsiveness across • LO1 products Eliminate the minus sign • Easier to compare elasticities Elasticity of Demand (1) Total Quantity of Tickets Demanded Per Week, Thousands (2) Price Per Ticket 1 $8 2 7 3 4 5 6 7 8 ] ] 6 ] 5 ] 4 ] 3 ] 2 ] 1 (3) Elasticity Coefficient (Ed) ] ] ] ] ] ] ] 6-7 Interpretation of Elasticity of Demand • Ed > 1 demand is elastic • Ed = 1 demand is unit elastic • Ed < 1 demand is inelastic • Extreme cases • Perfectly inelastic • Perfectly elastic LO1 Extreme Cases P D1 Perfectly inelastic demand (Ed = 0) 0 Perfectly inelastic demand LO1 Extreme Cases P D2 Perfectly elastic demand (Ed = ∞) 0 Perfectly elastic demand LO1 Total Revenue Test • Total Revenue = Price X Quantity • Inelastic demand • P and TR move in the same direction • Elastic demand • P and TR move in opposite directions LO2 Total Revenue Test • Lower price and elastic demand • Blue gain exceeds orange loss P $3 a 2 b 1 D1 0 LO2 10 20 30 40 Q Total Revenue Test • Lower price and inelastic demand • Orange loss exceeds blue gain P $4 c 3 2 d 1 D2 0 LO2 10 20 Q Total Revenue Test • Lower price and unit elastic demand • Blue gain equals orange loss P $3 e 2 f 1 D3 0 LO2 10 20 30 Q Total Revenue Test Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity Coefficient and the Total-Revenue Test (1) Total Quantity of Tickets Demanded per Week, Thousands (2) Price per Ticket 1 $8 2 7 5.00 14,000 Elastic 3 6 2.60 18,000 Elastic 4 5 1.57 20,000 Elastic 5 4 1.00 20,000 Unit Elastic 6 3 0.64 18,000 Inelastic 7 2 0.38 14,000 Inelastic 8 1 0.20 8,000 Inelastic LO2 (3) Elasticity Coefficient (Ed) (4) Total Revenue (1) X (2) (5) Total Revenue Test $8,000 Price Elasticity and Total Revenue $8 7 a b 6 c 5 4 d e 3 2 f g 1 Elastic Ed > 1 Unit Elastic Ed = 1 Inelastic Ed < 1 h D 0 1 2 3 4 5 6 7 8 Total Revenue (Thousands of Dollars) Quantity Demanded $20 18 16 14 12 10 8 6 4 2 TR 0 1 2 3 4 5 6 7 8 Quantity Demanded LO2 Summary of Price Elasticity of Demand Price Elasticity of Demand: A Summary Absolute Value of Elasticity Coefficient Demand Is: Impact on Total Revenue of a: Description Price Increase Price Decrease Qd changes by a larger percentage than does price Total Revenue decreases Total Revenue increases Greater than 1 (Ed > 1) Elastic or relatively elastic Equal to 1 (Ed = 1) Unit or unitary Qd changes by elastic the same percentage as does price Total revenue is unchanged Total revenue is unchanged Less than 1 (Ed < 1) Inelastic or relatively inelastic Total revenue increases Total revenue decreases LO2 Qd changes by a smaller percentage than does price Determinants of Elasticity of Demand • Substitutability • • More substitutes, demand is more elastic Proportion of Income spent • Higher proportion of income spent on the product, demand is more elastic • Luxuries vs. Necessities • • Necessity goods- demand is more inelastic Time • Longer time available for consumers, demand is more elastic LO1 Price Elasticity of Demand Selected Price Elasticities of Demand Product or Service Price Elasticity of Demand (Ed) Product or Service Price Elasticity of Demand (Ed) Newspapers .10 Milk .63 Electricity (household) .13 Household appliances .63 Bread .15 Liquor .70 MLB Tickets .23 Movies .87 Telephone Service .26 Beer .90 Cigarettes .25 Shoes .91 Sugar .30 Motor vehicles 1.14 Medical Care .31 Beef 1.27 Eggs .32 China, glassware 1.54 Legal Services .37 Residential land 1.60 Automobile repair .40 Restaurant meals 2.27 Clothing .49 Lamb and mutton 2.65 Gasoline .60 Fresh peas 2.83 LO1 Applications of Ed • Large Crop Yields • Inelastic demand for food items- lower total revenue for farmers • Excise Taxes • Inelastic demand- increase taxes leads to more tax revenues LO1 Price Elasticity of Supply • Measures sellers’ responsiveness to price changes • Elastic supply, producers are responsive to price changes • Inelastic supply, producers are not responsive to price changes LO3 Price Elasticity of Supply • Formula to compute elasticity • Es > 1 supply is elastic • Es < 1 supply is inelastic Es = LO3 Percentage Change in Quantity Supplied of Product X Percentage Change in Price of Product X Price Elasticity of Supply • Time is primary determinant of • LO3 elasticity of supply Time periods considered • Market period • Short Run • Long Run Elasticity of Supply: The Market Period • Perfectly inelastic supply P Sm Pm P0 D2 D1 Q0 LO3 Q Elasticity of Supply: The Short Run • Supply is more elastic than in market period P Ss Ps P0 D2 D1 Q0 Qs LO3 Q Elasticity of Supply: The Long Run • Supply is even more elastic than in the short run P Sl Pl P0 D2 D1 Q0 LO3 Ql Q Applications of Elasticity of Supply • Antiques- inelastic supply; • • LO3 sharp differences in the price depending on demand Reproductions of antiquesmore elastic supply Gold prices- volatile due to inelastic supply and fluctuating demand Cross Elasticity of Demand • Measures responsiveness of sales to • • • change in the price of another good Substitutes – positive sign Complements – negative sign Independent goods - zero Percentage change in quantity demanded of product X Ex,y = Percentage change in price of product Y LO4 Cross Elasticity of Demand • Application • Change the price of a product? Will • LO4 it have Any impact to the sales of other related products? Allow a merger? Will it reduce competition and create a monopoly? Income Elasticity of Demand • Measures responsiveness of buyers • • to changes in income Normal goods – positive sign Inferior goods – negative sign Percentage change in quantity demanded Ei = Percentage change in income LO4 Income Elasticity Insights • High income elasticities • Most affected by a recession • Low income elasticities • Least affected by a recession • Negative income elasticities • Sales increase during a recession LO4 Ex,y and Ei Cross and Income Elasticities of Demand Value of Coefficient Cross elasticity: Positive (Ewz > 0) Negative (Exy < 0) Description Quantity demanded of W changes in same direction as change in price of Z Type of Good(s) Substitutes Quantity demanded of X changes in Complements opposite direction from change in price of Y Income elasticity: Positive (Ei >0) Quantity demanded of the product changes in same direction as change in income Normal or superior Negative (Ei<0) Quantity demanded of the product changes in opposite direction from change in income Inferior LO4 Elasticity and Pricing Power • Charge different prices based on • price elasticities Examples: • Business air travelers • Adult vs. child • Practice of price discriminationcharging different prices without any differences in costs