Econ 200 – Lecture 5
October 13, 2016
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2.
3.
4.
5.
Learning Catalytics Session
Price Elasticity of Demand
Elasticity Formula and Definitions
Determinants of Elasticity
Elasticity and Total Revenue
1
Curve Shifting and Changes in Equilibrium
S2
S1
We can often predict the
direction of an equilibrium
change, but we don’t know
the magnitude.
P2
P1
P0
Knowing the price
responsiveness of
producers and consumers
will help us answer this
question.
D1
D2
Q1 Q2
Q0
2
Curve Shifting and Changes in Equilibrium
S2
S1
Consumers with demand
D1 are more price
responsive  price goes up
less and quantity goes
down more.
P2
P1
P0
(than for consumers on D2)
D1
D2
Q1 Q2
Q0
3
What does this look like in the real world?
From September 2011 to September 2012, the price of gasoline rose
by about 7% ($3.66 per gallon to $3.91 per gallon).
Gasoline consumption fell by about 5%.
Can we quantify these changes?
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Price Elasticity of Demand
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
The price elasticity of demand is a negative number.
More negative elasticities are called “larger” or “higher” or “more
elastic” (think absolute value here).
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Price Elasticity of Demand Terminology
A “large” value for the price elasticity of demand means that quantity
demanded changes a lot in response to a price change (like D1).
A smaller value means consumers are less responsive (like D2).
-Price Elastic: If price elasticity of demand is larger (in absolute
value) than 1.
-Price Inelastic: If price elasticity of demand is smaller (in absolute
value) than 1.
6
Percentage Changes and the Midpoint Formula
Percentage changes have the unfortunate characteristic that the
percentage change from A to B is not the negative of the percentage
change from B to A.
This would mean the elasticity from A to B was different from the
elasticity from B to A, an undesirable characteristic.
7
The Midpoint Formula
The midpoint formula avoids the confusion of whether we are going
from A to B or from B to A.
Price elasticity of demand becomes:
(Q2 − Q1 ) ( P2 − P1 )
Price elasticity of demand =
÷
 Q1 + Q2   P1 + P2 

 

 2   2 
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Calculating Price Elasticity of Demand—part 1
To calculate this price
elasticity, we first need the
average quantity and price:
Average quantity =
Average price =
2,000 + 2,500
= 2,250
2
$3.50 + $3.30
= $3.40
2
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Calculating Price Elasticity of Demand—part 2
Now calculate the percentage
change in quantity and price:
Percentage change
2,500 − 2,000
=
×100
in quantity demanded
2,250
= 22.2%
Percentage change
$3.30 − $3.50
=
×100
in price
$3.40
= −5.9%
Price elasticity
22.2%
=
of demand
− 5.9%
= −3.8
 Demand in this range is price elastic.
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Calculating Price Elasticity of Demand—part 3
What if the quantity had only
increased to 2100?
Percentage change in quantity
is now:
2,100 − 2,000
×100
in quantity demanded
2,050
= 4.9%
Percentage change
=
So price elasticity of demand is now…
Price elasticity
4.9%
=
of demand
− 5.9%
= −0.8
This is smaller (in absolute value) than -1, so demand is inelastic.
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Price Elasticity of Demand Terminology
A vertical demand curve means that quantity demanded does not
change as price changes.
• So elasticity is zero.
• A vertical demand curve is perfectly inelastic
P
D
Q
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Price Elasticity of Demand Terminology
A horizontal demand curve means quantity demanded is infinitely
responsive to price changes.
• Elasticity is infinite.
• A horizontal demand curve is perfectly elastic.
P
D
Q
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How Do People Respond to Changes in the Price of Gasoline?
Gasoline demand is inelastic: the quantity demanded does not
change much as the price of gasoline changes.
It is not perfectly inelastic: it is somewhat responsive to price.
Which panel shows this?
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Which demand curve is more elastic?
a.
b.
c.
d.
D1
D2
Both curves appear to be elastic.
Neither curve appears to be elastic.
15
Which demand curve is more elastic?
a. D1
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If demand is perfectly elastic, then what is the impact of an increase in
price?
a. A decrease in quantity demanded to zero.
b. No change in quantity demanded.
c. A proportional change in quantity demanded that is
exactly equal to the proportional change in price.
d. A very small change in quantity demanded.
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If demand is perfectly elastic, then what is the impact of an increase in
price?
a. A decrease in quantity demanded to zero.
18
Refer to the figure below. Calculate the price elasticity of demand. Use the
midpoint theorem and 2 decimal places of precision.
19
Refer to the figure below. Calculate the price elasticity of demand.
Answer: -0.56
Note:
%Δ𝑄𝑄
%Δ𝑃𝑃
=
∆𝑄𝑄
𝐴𝐴𝐴𝐴𝐴𝐴 𝑄𝑄
∆𝑃𝑃
𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃
=
2
9
2
−
5
=−
5
9
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What Determines the Price Elasticity of Demand?
1. The availability of close substitutes
If a product has more substitutes available, it will have more elastic
demand.
2. The passage of time
Over time, people can adjust their buying habits more easily.
Elasticity is higher in the long run than the short run.
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More Determinants of the Price Elasticity of Demand
3. Whether the good is a luxury or a necessity
People are more flexible with luxuries than necessities, so price
elasticity of demand is higher for luxuries.
4. The definition of the market
The more narrowly defined the market, the more substitutes are
available, and hence the more elastic is demand.
5. The share of a good in a consumer’s budget
If a good is a small portion of your budget, you will likely not be very
sensitive to its price.
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Some Real-World Price Elasticities of Demand
Product
Estimated
Elasticity
Product
Estimated
Elasticity
Books (Barnes & Noble)
–4.00
Bread
–0.40
Post Raisin Bran
–2.50
Cocaine
–0.28
Automobiles
–1.95
Cigarettes
–0.25
Tide (liquid detergent)
–3.92
Beer
–0.29
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Price Elasticity of Demand for Breakfast Cereal
What is the price elasticity of demand for breakfast cereal?
The answer depends on whether you mean:
• A particular brand of a particular breakfast cereal
• A particular category of breakfast cereal
• Breakfast cereal in general
Cereal
Price elasticity
of demand
Post Raisin Bran
–2.5
All family breakfast cereals
–1.8
All types of breakfast cereal
–0.9
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Elasticity and the Pricing Decision
Why isn’t gas more expensive?
If you are a business owner, you need to decide how to price your
product.
• “How many customers will I gain if I cut my price?”
• “What will happen to my total revenue if I cut my price?”
Total revenue: The total amount of funds received by a seller of a good
or service, calculated by multiplying the price per unit by the number of
units sold.
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Effect of Cutting Price with Different Elasticities
Suppose demand for your product is relatively price inelastic.
• As you decrease the price, you gain only a few additional
customers.
• Overall, total revenue goes down.
Suppose demand for your product is relatively price elastic.
• As you decrease the price, you gain many additional
customers.
• Overall revenue goes up.
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Cutting Price When Demand Is Inelastic
Revenue before price cut (at A):
1,000 x $4.00
= $4,000
Revenue after price cut (at B):
1,050 x $3.70
= $3,885
The decrease in price does not
generate enough extra customers
(area E) to offset revenue loss (area
C).
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Cutting Price When Demand Is Elastic
Revenue before price cut (at A):
1,000 x $4.00
= $4,000
Revenue after price cut (at B):
1,200 x $3.70
= $4,440
The decrease in price generates
enough extra customers (area E) to
more than offset revenue loss (area
C).
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Total Revenue Along a Linear Demand Curve
Suppose we have a linear demand
curve.
What happens to total revenue as
price increases?
• Initially, total revenue rises,
suggesting demand is inelastic.
• But then total revenue starts to fall,
suggesting demand is elastic!
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Total Revenue Along a Linear Demand Curve—cont.
The data from the table are plotted
in the graphs.
As price decreases from $8,
revenue rises—hence demand is
elastic.
As price continues to fall, revenue
eventually flattens out—demand is
unit elastic.
Then as price falls even further,
revenue begins to fall—demand is
inelastic.
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Refer to the figure below. Calculate the change in total revenue due to the
price decrease.
31
Refer to the figure below. Calculate the change in total revenue due to the
price decrease.
Answer: -$80 (Remember from previous example: Demand was inelastic in this
portion of the curve, so firms should raise prices to increase revenue, not lower
them.)
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